Citigroup is bearish on Educomp Solution and has maintained sell rating on the stock with target Rs 2380.

Citigroup research report on Educomp Solution

Target price of Rs2,380 based on 35x FY09E EPS 

We are initiating coverage on Educomp with Sell/High Risk (3H). The market is ignoring expensive valuations and high risks in Educomp’s business model and aggressive accounting policy, in our view. We see 20% downside for the stock. 

Strong top-line growth to continue in FY08E 

We forecast 102% revenue CAGR and 95% EPS CAGR over FY07-10 as Educomp penetrates beyond tier 1 & 2 cities. We see stable margins as pressure in school ventures and the ICT business is countered by leverage in Smart_Class and MathGuru. We believe there is high execution and regulatory risks in Edu-Infra and Edu-Manage. 

Adjusting for aggressive accounting policy of deep discounted ESOPs 

Deep discounted ESOPs (c.3-4% equity), convertible at Rs125, are issued to key managers. The company is using fair value of Rs834 for ESOP expensing vs. the market price of Rs2,898 when shareholders’ approval was sought. We estimate that this aggressive accounting policy could inflate EPS by Rs51 and Rs21 over the next two years. 

Points to ponder 

a) High valuations paid to acquire start-ups Edu-Infra and Edu-Manage; b) Reasons for exit taken by private equity firm just before IPO; and c) High regulatory risk in the K-12 business. 

Key risks 

a) As the company is expensing deep discounted ESOP using fair value of Rs834, reported earnings might still appear strong, keeping valuations and the stock price higher; b) concentrated shareholding; and c) high-growth phase of the company could keep valuations higher for some time.