22 September 2014 Media & Impact Investing Investing in Education What are your kids up to? Education: an underinvested space USD4.6trn is spent every year on education globally, second only to healthcare, and more than defence and R&D combined. Most of the money goes into salaries, making education an underinvested space. The global investable market cap is USD70bn, versus USD4.0trn in healthcare and USD370bn in defence. We explain why a U-turn may be near. Pressure to improve efficiency of spending In this report, we show how an unaffordable system is forcing governments to experiment with new solutions to do more with less. The US market is the world’s largest, and its educators are increasingly committed to delivering better outcomes at more reasonable prices. This is opening up new pockets of growth. Invest in solutions allowing for cost-effective education Technology is the enabler of this long-term transformation. A flurry of new services has come to the market from established companies such as Pearson (rating upgraded from Reduce to Buy), as well as newcomers. We provide investors with a roadmap to navigate their way through the changes and spot the best-positioned investments. Research team Andrea Beneventi (Media) [email protected] +33 1 7081 5752 Samuel Mary (ESG) [email protected] +44 20 7621 5190 Inigo Egusquiza (Prisa) [email protected] +34 914 36 5112 IMPORTANT. Please refer to the last page of this report for keplercheuvreux.com “Important disclosures” and analyst certification(s) Media & ESG research Contents Acknowledgments ............................................... 5 Executive summary ............................................. 6 Education market size at a glance .................. 8 1) Unaffordability: how we got there ............ 15 a) Mechanical cause of unaffordability: cost inflation 16 b) Underlying causes of unaffordability: public policies 20 US education financing and spending basics 20 How do they spend it? Mostly on salaries 22 US recession triggers boost to demand 25 Invest in companies enabling cost-effective education 27 2) Efficiency and better policies: the way out 31 Shift in public policies towards effectiveness and results 31 STEM: tilting the systems towards sciences and engineering 35 USD500m government incentive to publish open materials 36 “Gainful employment”: tightening the rules on schools 38 Qualitative variables: technology and achievement 39 3) Technology: where the future begins ....... 42 a) Innovation: the promises beyond affordability 42 The challenges for investors, in four questions 42 Why is there a need to ponder educational outcomes? 49 b) Intro to the business context: traditional print is shrinking 56 Pricing power achievable for premium services 60 Publishers collaborating on the redesign of courses 62 A closer look at EdTech: a thriving market without a leader 63 Introducing school’s spending on technology 72 c) A focus on six forces shaping the future of education 74 Open content: not yet mainstream 74 Massive Open Online Courses (MOOCs) and star-faculties 81 Open source digital learning platforms 86 Online education: heading for maturity 88 Competency-based education: a favourite among new models 92 Adaptive learning: big promises, big question mark 97 2 keplercheuvreux.com Media & ESG research Software curriculums already pervasive in K-12 104 Many opportunities on the horizon for mobile Education 106 4) Emerging markets: the second future....... 114 Emerging markets through the lens of Pearson 114 Opportunity to step up impact investments in education 118 5) The dark side of technology ......................... 125 Data privacy and security: mounting concerns over misuse 125 The backdrop: cloud-based services on the rise in schools 126 Fairness of contracting and lobbying: no major blows 133 Education and technology: jobs and inequality concerns 133 The investable space ........................................... 135 Narrow definition: educational publishing value chain 135 Broader definition: school chains and ancillary services 140 De-correlation of expectations and earnings 146 Glossary .................................................................. 151 Appendix ................................................................ 154 Pearson: Sitting in the front row – upgrade to Buy 156 Valuation premium to peers building up again 158 Why hasn’t the stock derated? 158 What will happen next? 159 Income statement forecasts and valuation 163 Best positioned in growing areas .................... 164 The educational market opportunity 164 Structural market share winner in assessment and training 169 Improving momentum in mature businesses 175 US school curriculum (K-12) market picking up in H2 176 K-12: better new adoption calendar in 2014-16 176 US college enrolment indicator slowly improving 177 US public funding for education clearly improving 179 Textbooks: transition to digital progressing well 180 Upgrade from Reduce to Buy, TP 1540p ...... 185 TP up from 950p to 1540p, average of DCF and comparables 185 Slow-burning drivers: the risk of being too early 191 3 keplercheuvreux.com Media & ESG research Appendix 1: Pearson vs. professional publishers 192 Appendix 2: Pearson’s key growth products 194 Lagardère: The French and Spanish K-12 leader 220 Prisa: A leading publisher in LatAm and Spain 222 Research ratings and important disclosures 224 Legal and disclosure information .................... 227 4 keplercheuvreux.com Media & ESG research Acknowledgments We wish to thank The Parthenon Group’s Education Practice for sharing their insights in interviews and providing feedback in the writing of the industry sections of this report, and in particular: Robert Lytle, Partner, Co-Head Education Practice Abhinav Mital, Partner Seth Reynolds, Partner Matthew Robb, Partner All opinions on companies and securities in this report reflect the view of Kepler Cheuvreux’s analysts. A glossary is provided at the end of the general section of this report. The investment universe is provided in the section “The investable space”. 5 keplercheuvreux.com Media & ESG research Executive summary In this report we go back to school to investigate the challenges educators face, and how targeted investments could help them. We find the best opportunities in solutions improving the effectiveness of education, rather than pure upselling or access, in order to tackle the high cost of schools and their poor track record in promoting excellence. A flurry of such products has come to the market from both established companies such as Pearson, and newcomers. We hope you will enjoy our guide to investing in a more knowledgeable future. Wake up! It’s time to go to school… (7:30am) The previously sleepy world of education has suddenly entered a period of transformation. For now, such change is mostly affecting the US (the focus of this report). However, developments there provide a pattern for future global dynamics. The initial part of this report analyses the tensions that have led to the change: 1) long-term unaffordability of education, driven by poor public policies, mostly focused on reducing the class sizes; 2) the ineffectiveness of those policies in promoting excellence; and 3) the regulatory and technological answers being developed. …and don’t forget your iPad! (8:00am) Secondly, we provide a critical review of the evidence that technology leads to better and more cost-effective outcomes for both schools (automated testing, competency-based education, enablers) and students (through adaptive learning, MOOCs, etc.). Public policies are the main driver of educational systems, and their focus is clearly shifting towards effectiveness and measurable outcomes (“Race to the Top”, “STEM”, Common Core”). Chart 1: Classrooms getting smaller (# students/teacher) Chart 2: Country correlation (R2) of top PISA score vs. … 35 0.50 0.45 USA UK 0.45 Germany France 30 Italy China 0.40 0.35 0.27 25 0.30 0.25 20 0.20 0.16 0.15 15 0.10 0.05 0 10 0.00 Teachers per GDP Fixed Mobile student ratio broadband broadband 5 penetration penetration 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 1970 Source: Kepler Cheuvreux Source: Kepler Cheuvreux Discuss yesterday's video session in class (8:30am) K-12 in investment In primary and secondary schools (K-12), teachers and students are showing increasing phase: hardware, awareness of and comfort with adopting mobile devices and classroom-based software software, testing and curriculum as a result of investments in digital learning hardware, software and basic content. content 6 keplercheuvreux.com Media & ESG research The book decides what I need to read (9:45am) Higher-ed: longer-term In higher-ed, subscription solutions counter the erosion from book rental and open content. opportunities in The next and most promising step is likely to be a wider adoption of adaptive learning (AL) adaptive learning technology, targeting faster, more effective learning via a better understanding of students’ existing knowledge and pace (use of student data). A growing wealth of findings suggests that AL can effectively back the value proposition of publishers’ content. When I'm a doctor, I'll be studying law (11:00am) At the post-secondary and vocational level, competency-based education (CBE) allows for Vocational: more flexible learning, and has appealing features for working professionals: no set class competency-based meeting times, personalisation, more direct connection with employers, and lower overall