Who's dux of the education sector?

Education, you might be surprised to learn, earns Australia more than $20bn in export revenue. That makes it Australia's third-largest export industry behind coal and iron ore. The verdict is in – international students already think Australia is the clever country.

Demand is booming, with 13% growth in the number of international students over the past year. The weakening of the dollar since 2013 means Australia is now much better value for studying, but that's not all. Our high-quality universities, laidback lifestyle and reputation for safety make for an attractive destination.

What's good for students might be ever better for investors in ASX-listed companies. So what opportunities exist in Australia's higher education sector?

For such an important sector there are fewer quality investment candidates than you might think. Indeed, there are only two higher education-focused companies in the S&P/ASX 200 index – and one of them listed last year.

The main reason is that higher education is still largely the preserve of government. Our 43 universities provide degrees, while state-based technical and further education colleges (TAFEs) provide much of Australia's vocational education and training (‘VET').

The two elephants of the education sector, Navitas and IDP Education, mainly provide services to international students before they attend university in Australia or other countries.

Successful model

Navitas partners with universities in Australia and overseas, preparing international students for their degrees. The universities obtain access to a steady flow of international students, while the students are eased into university life at their chosen destination. It's been a successful and lucrative model, with Navitas's main business – University Partnerships – growing its operating earnings (before depreciation and amortisation) from $48m to $137m over the past ten years.

Navitas's main risk is that its university partners decide to operate student preparation programs themselves. Running programs in-house means the universities retain tighter control over education standards, as well as gaining access to a lucrative fee stream. Macquarie University took its program back in-house this year and, while Navitas's diversification ensured earnings fell by only 2%, it's a risk that might surface again.

Nevertheless, Navitas is a very good business, and it's one to put on your watch list. Whilst currently not cheap enough to buy, the recommendation remains HOLD. Look out for a review of its 2016 result soon.

IDP Education has only been listed on the ASX since December 2015, but it has an excellent pedigree and impressive long-term performance. Still 50% owned by 38 Australian universities, IDP Education runs two main businesses. The first is a student placement service, which sources students from Asia and the Middle East to study at universities in Australia and other countries.

Almost 70% of revenue, however, comes from IDP Education's co-ownership and distribution of the IELTS ‘high stakes' English language test. This is no ordinary English test – it's one of only a few major tests that is globally accepted for university entry, work or immigration purposes.

Not app-y

IDP administers around one-third of the 2.5m tests undertaken annually at a cost of about $260 each. It's a diversified revenue stream although competition is rising. There's even an argument that official tests like IELTS and its main competitor, TOEFL, might eventually be displaced by apps such as Duolingo.

That's unlikely in the short to medium term but the importance of the IELTS test to IDP's earnings means the competition will need to be watched carefully. Like Navitas, IDP Education is a high-quality business but not quite cheap enough to buy. The recommendation remains HOLD.

So what of the other companies in the higher education sector? Well there's daylight between the two elephants and the rats and mice. From here on the risks rise exponentially, so be warned.

The remaining companies are mainly private providers of vocational education, a sector that is still in relative infancy. Unfortunately government de-regulation of the VET sector a few years back unleashed many opportunistic and untested education providers, who flocked to the sector to take advantage of public funding. By 2014 initial public offerings of VET businesses were flocking to the ASX.

Class of 2014

Unscrupulous student recruitment practices, aggressive business models and insufficient attention to long-term reputations was the result. Former market darlings Vocation Limited and Australian Career Network – both of which floated on the ASX during the 2014 boom – have already gone into administration. Others from the class of 2014, like Intueri Education Group, remain on life support. The government has since cracked down on the VET sector but the fallout continues.

Few private education providers have emerged unscathed – and the risks remain very high – but a couple of the smaller college operators could be interesting opportunities. Whilst very small, Academies Australasia Group runs 18 colleges in Australia and Singapore. Debt levels are too high, and the company will report a loss in 2016 due to the underperformance of a 2014 acquisition, but directors are showing confidence by buying shares on market.

Also potentially interesting is Redhill Education, which has positioned itself at the premium end of the private vocational education market. The company operates six colleges in Sydney and Melbourne and, interestingly, Academies Australasia owns a 10% stake. Redhill's earnings will fall in 2016 due to investment in new growth initiatives but the absence of debt suggests it's one of the better quality companies.

Director buying

Elsewhere in the sector, there's also been some director buying in labour hire and training group Ashley Services – another 2014 listing. But management changes and multiple profit downgrades remain cause for concern. Site Group, which provides training to clients in the energy, mining and construction sectors, is still bedding down acquisitions and its international operations add risk.

A couple of other minnows round out the sector. iCollege is apparently ‘positioned to become one of Australia's leading educators', but with continual capital raisings and a market capitalisation of just $6m, there's a long way to go. Finally, UCW aims to take advantage of the fragmented market by buying private education businesses but its acquisition-driven strategy isn't reassuring.

So what can we conclude from this roundup of the ASX-listed higher education sector?

Well, Navitas and IDP Education are the standout candidates for your watch list. Over time the listing of other education providers like Study Group – a company similar to Navitas – should deepen the sector.

But there are slim pickings from the slew of initial public offerings a few years ago. Even the two with a longer history – Academies Australasia and Redhill Education – are probably too small and risky for most investors (including us).

As is often the way, the larger companies might end up the big winners. Navitas's management hinted earlier this year that it might be interested in acquiring vocational training businesses down the track. It already owns SAE Institute, a creative media education business, and sector consolidation looks inevitable.

It's true the private education sector is small now, but it almost certainly has a big future. Keep an eye on the large companies, as well as the promising smaller players, and you could go to the top of the class.