IDP Education's ultimate test

If you were born in Australia or another English-speaking country, you probably take your language ability for granted. You might take your education for granted too.

If you were born elsewhere though, it's a completely different story. As the prospectus for new float IDP Education states: 'English is the premier language of business and the only global language of science, research and academic publication.' If English isn't your first language, but you need to write and speak it fluently – and/or you want a high quality or prestigious education in an English-speaking country – then you'll probably need help.

IDP Education provides it in two ways. First, it co-owns and distributes IELTS, one of the major 'high-stakes' English language tests used worldwide. More than 2.5m IELTS tests are undertaken annually, of which IDP administers about one-third, at an average cost of $260 per test. English language testing generated 69% of IDP's 2015 revenue.

IELTS is no ordinary English test and it includes listening, reading, writing and speaking components. The standing of IELTS is such that, until 2011, it was the only English test accepted by the Australian government for visa purposes. It continues to be accepted by more than 9,000 organisations globally, including universities and government authorities.

IDP's secret source

IDP's second main business is student placement, which generated 26% of the company's 2015 revenue. IDP sources students from Asia and the Middle East to attend universities in Australia. For every student placed with an educational institution, IDP receives a fee averaging $2,600 from that institution.

In recent years IDP has launched a 'multi-destination strategy', however, with the company signing agreements with educational institutions in the UK, the USA, Canada and New Zealand. While 84% of its enrolments still come from Australia, revenue from these other countries is growing much faster (up 65% in 2015).

Table 1 shows IDP's revenue and profit growth over the past few years. In this review we'll focus on the 95% of revenue that come from English testing and student placement (the remaining 5% of revenue comes from operating English language schools in Cambodia, Vietnam and Thailand).

It's hard to imagine a company with more favourable tailwinds. A burgeoning middle class in Asia is demanding high quality education that their domestic markets can't provide. On the supply side, educational institutions in developed English-speaking countries usually receive higher fees from international students than they do from domestic students.

To top it off, the lower Australian dollar has made getting an education in Australia much cheaper. The proof is in the numbers, with international student enrolments rising 10% in the seven months to July 2015, on top of the 8% growth reported in calendar 2014. The Australian government is also very supportive of the industry. Providing education to international students is now Australia's fourth largest export earner.

Seek sells stake

So if IDP is such a good business, why is Seek selling its 50% stake in a public float?

Well, IDP Education does not fit Seek's 'online only' strategy. Seek bought various education businesses before deciding to keep only the online ones. After the sale of its stake in Think in 2013 and IDP Education this year, Seek's education division will consist only of online businesses.

The other 50% shareholder in IDP Education – Education Australia – will maintain its stake after the float. Education Australia is a company owned by 38 Australian universities and its shareholding is important. Not only does it lend credibility to IDP (reputation is everything in the education industry), but part-ownership also provides an incentive for these universities to continue preferring the IELTS test, as well as sourcing at least some of their international students from IDP.

Of course, Seek is also getting a decent price. At the issue price of $2.65, IDP Education had a market capitalisation of $663m. Based on 2016 forecast earnings per share of 14.2 cents, IDP's price-earnings ratio was 19 and its enterprise value/EBITDA multiple was 11.3. IDP was no bargain at the issue price although good businesses rarely are. Table 2 shows key information at the issue price.

There are many things to like about IDP, apart from the favourable tailwinds. The business requires little in the way of capital to operate; in fact, students must pay their IELTS test fee upfront. This is a strong cash flow business and it will list with net cash on the balance sheet.

There are significant barriers to entry in English language testing too. While competition has been rising – more on this shortly – convincing authorities to accept alternative tests takes time. Economies of scale exist too; IDP operates more than 400 test locations in 50 countries and size improves the utilisation of facilities and examiners.

Margin expansion

There's also the potential for margin expansion. While operating margins have been flat at around 14% for a few years now, this partly reflects the costs of implementing the multi-destination strategy in its student placement division. Costs should grow more slowly than revenue beyond 2016.

All that said, there are risks here too. IELTS has faced competition from other tests in Australia since 2011. TOEFL, its main competitor, is not only cheaper but computer-based (whereas IELTS is paper-based). IELTS has a computer-based test under development but it's probably some years away from a global launch.

Perhaps the recent appointment of a chief executive with information technology experience points the way here, but there's only so much IDP can do to expedite the process – it's only a co-owner of the test after all. Indeed, this co-ownership relationship – between IDP, the British Council and Cambridge Assessment – could eventually be problematic if the parties can't agree.

Then there are the general risks that come from a business that operates in many jurisdictions. Visa and migration regulations could change in destination countries, or there could be political or economic upsets in source (or destination) countries.

Despite that, there are few floats that have IDP Education's long-term growth potential. The demand for English tests should continue rising, with the number of IELTS tests taken having increased 17% a year since 2003.

Attractive destination

In IDP's student placement business, the multi-destination strategy is in its infancy. Even if it takes time for other countries to ramp up, though, Australia is an increasingly attractive destination for students now the currency has declined significantly.

As always, the key question is: what should you pay for this potential?

Well, a few years of revenue growth and a little margin expansion would make the forecast price-earnings ratio of 19 look much less expensive. Quality businesses like IDP usually deserve their premium prices and have, time and again, shown they can deliver superior performance.

We expected the stock to list at a premium to its $2.65 issue price and it has done so just a few minutes ago. We're willing to pay up to $3.00 a share for IDP Education, which would represent a forecast EV/EBITDA multiple of 12.8 and a free cash flow yield of 4.4%, but the current price is just a little too high. We'll start the company with a recommendation of HOLD, although we're likely to upgrade to Buy if the stock falls below $3.00 (with a maximum portfolio weighting of 5%).

Disclosure: The author owns shares in Seek.