As i noted in my first blog post, I was always curious to know how some of the high-growth market darlings goes belly up in few years time. I am more interested in business failures. I strongly believe that avoiding stupidity in investment process will yield long-term above-average results. As Charlie Munger famously quipped, “Just tell me where I’m going to die, so that I won’t go there”. Recently I was intrigued by the spectacular collapse of PE-backed fast-growing education company (lets call it as Company “T”) which operated in pre-schools and K-12 education segment. Also it was one of the rare cases which did not involve debt (as mostly would be the case for spectacular collapse). Hence i wanted to delve deeply.
Background: Company “T” started its first pre-school in 2003 and was founded by first-generation entrepreneur. In 2008, its business model caught the attention of a high-flying US-based Private equity “M” which recently started its operation in India. Over the next 4 years, it pumped 63 crores [35 crores (2008) + 15 crores (2010) + 9 crores (2011) + 4.2 crores (2012)] and the company “T” expanded furiously to 240 self-operated + 62 franchise pre-school centers and 24 K-12 schools. Company followed capex heavy self-operated model as against market leader’s franchise based model. Each pre-school center on average costs about 40 lakhs and it charged fees between 20,000 to 60,000/- per kid.
In August 2011, Company “T” came out with IPO and raised around 112 crores from the public. In FY 11, its total income was 41.15 crores and posted a net profit of 9.2 crores. As expected, Investment bankers, PE investor, and management priced the IPO issue at astronomical price (50x its diluted FY 11 earnings!!!). IPO had a poor stock market debut and ended 14% below issue price on Day 1.
Everything went fine until FY 13. Following was its financials at FY 13:
The average life span for most PE funds are around 7 years. Most of them will focus on exits starting 4th/5th year of investment. Due to this institutional imperative, I believe PE “M” shifted its focus from building the company to exiting its investment sometime towards the end of FY 13. It held around 25% of the company “T” and naturally started to worry about ways to exit. Being a 750-crore small-cap company with low liquidity in stock exchanges, selling the stake to other deep-pocketed institutions such as mutual funds, Insurance companies, other PE investors etc. was the only option left. At the same time, company “T” was still in investment mode and needed huge cash due to capex heavy self-operated model. Following is the imaginary conversation between CEO the company “T” and PE “M”:
After FY’13 annual results:
Company “T” CEO: We had good FY’13 – almost 50% growth on revenues and net profit. To maintain growth momentum, we may need more money some time next year for further expansion.
PE investor “M”: Sorry, we are already in the 5th year of our fund cycle. We can’t pump any more funds into the company. We have to start exiting our investments over the next 2 years. While we are scouting for potential investors, please execute high growth at any cost!!!
After FY’14 annual results:
Company “T” CEO: Due to poor economic conditions and high inflation, our growth moderated in FY’14. Being an consumer discretionary item, our pre-school revenues grew only 20% and due to higher expenses, our net profit was almost flat when compared to last year.
PE investor “M”: We already have hard time in finding potential suitors due to the rupee crisis. It is only since the Jan 2014, things started to look better. In addition, company need additional funds for future expansion. We can’t publish this horror results at this time. Lets “window-dress” company accounts to make it look better. Lets book additional 20 crores of revenue under ‘revenue from K-12 schools’ which are anyway going to accrue over the next 3 years. As costs are already incurred, this additional revenue will flow directly into the bottomline. Still we get cash from those schools, they will be hiding as receivables in the balance sheet. Most investors including smart money is more focussed on P&L statement, rather than on balance sheet and cash flow statement. This will be win-win for both of us: It will help company to raise additional funds and at the same time helps us to exit investment.
Company “T” CEO: Is it ethical? Will it not cause trouble?
PE investor “M”: It is well within accounting standards and besides everyone does “window-dressing” of accounts. Also before fund raising event like QIP, it is important to weave a story that the company is a big proxy for the multi-billion dollar education services sector and pull some regular PR stunts to make it a ‘hot fancied stock’ in the market. Give regular interviews with peppy numbers bandied around, also give ads to business channels (although it doesn’t make sense to advertise in business channels – it creates necessary visibility about the company among investors) etc.
Status of cash flow by FY’14: Company”T” showed 18% increase in pre-tax Cash flow from operations (CFO). Most of the times looking at standalone pre-tax CFO figures will mask underlying truth as changes in one or more heads will distort the picture. Hence i always try to look at pre-tax CFO/EBITDA which showed detoriation in FY’14 (Ideal ratio would be around 80-100%). [Note: Each year company “T” was paying variable fixed deposit amount to K-12 schools for securing exclusive rights. It masked original picture of CFO from operations. Hence i presented adjusted figures by including those fixed deposits].
On cue, the stock was pumped from 220/- to 500/- just before QIP. In Dec 2014, it fixed its QIP price at 440/- and raised around 200 crores from marque investors.
At the same time, PE “M” sold sizeable stake to a insurance company for 50 crores in Feb-March 2015 and some more in open market for another 50 crores in June 2015. It was left with 12% stake.
But the luck didn’t last long for the company. In Sept 2015, proxy advisory firm raised concerns on company’s high receivables. It opined that receipt of fees in arrears is ‘rare and an exception’ in the education business the company operates in. It also raised questions on company’s fee collection mechanism and accounting system. Although the company’s management replied to the satisfaction of the proxy advisory firm, people lost faith on the management and stock price tanked relentlessly.
During the mayhem, PE “M” also dumped its residual 12% stake in open market 2nd and 3rd week of Feb, 2016 and bailed out. However, First-gen promoter who left holding the bag was clueless and didn’t know what hit his company. Company “T” released its tepid FY’16 numbers marked by provisions and write-offs. Its net profit nose-dived to 6 crores from 60 crores in FY’15 and its debtor days climbed to 100 from 20’s in FY’13.
According to me, following are the key learnings from this episode:
- P&L statement is one of the least useful tool to analyze company’s strengths. It can be easily manipulated. Focus more on the balance sheet and cash flow statements to assess true strength of the company. Sudden raise in receivables should warrant further investigation.
- PE investors comes with institutional constraints and sometimes their short-termism nature can cause havoc in the company.
- Institutional investors often labelled as smart money is mostly ‘dumb money’. They too fall for fancied stock and behaves pretty similar to normal retail investors.
- Always be aware of any vertical movement in stock price before fund raising. More often it is management hand-in-glove with manipulators at work (If you got still doubt, would recommend reading Moneylife magazine for more case studies).
Note: This is my reading based on the sequence of events unfolded. It may or may not be true. So take it with pinch of salt!!! Looking forward to your comments and suggestions.