30 November 2018 Hong Kong EQUITIES Hope Education (1765 HK) 1765 HK Outperform Robust organic growth with accretive M&A Price (at 14:02, 28 Nov 2018 GMT) HK$1.29 Valuation HK$ 1.57 Key points - DCF (WACC 12.0%, ERP 12.0%) Initiate with OP rating and HK$1.57 TP. 12-month target HK$ 1.57 Upside/Downside % +21.7 Robust organic growth with 14% enrolment CAGR and 5% ASP CAGR in 2018-21E with plans to add two schools in Gansu and Chongqing. 12-month TSR % +21.7 Proven history of accretive M&A shows potential for further M&A. GICS sector Consumer Services Market cap HK$m 8,600 Market cap US$m 1,098 Initiate with OP and TP at HK$1.57 Free float % 22 30-day avg turnover US$m 2.0 We initiate coverage on Hope Education with an Outperform rating. Our DCF- Number shares on issue m 6,667 based target price is HK$1.57, implying an FY19 P/E of 15x and upside of 22%. Strong capacity ramp-up and new school openings should lead to an estimated Investment fundamentals 15% CAGR in enrolment and a 5% CAGR in ASP in 2018-21E. Meanwhile, the Year end 31 Dec 2017A 2018E 2019E 2020E accretive M&A strategy has a proven track record to expand Hope Education’s Revenue m 752.4 1,026.3 1,294.0 1,558.4 EBIT m 401.2 437.6 607.6 742.6 national school network and enhance the profitability of the newly acquired EBIT growth % 68.9 9.1 38.8 22.2 schools. Reported profit m 233.1 303.9 451.5 550.6 EPS rep Rmb 0.05 0.06 0.09 0.11 Hope Education is currently the second largest Chinese Higher Education service EPS rep growth % 49.5 29.6 48.6 22.0 provider listed on the HK stock exchange with ~74k student enrolments in 2017. EPS adj Rmb 0.05 0.06 0.09 0.11 The company has a track record of M&A, having consolidated five schools before EPS adj growth % 49.5 29.6 48.6 22.0 PER rep x 24.3 18.8 12.6 10.4 its IPO on 3 August 2018 and will be included as a constituent stock in the MSCI PER adj x 24.3 18.8 12.6 10.4 China Small Cap Index on 1 Dec 2018. Total DPS Rmb 0.00 0.00 0.00 0.00 ROA % 7.9 6.5 7.4 8.2 Strong school portfolio with robust organic growth ROE % 41.9 13.7 11.2 12.2 EV/EBITDA x 7.4 6.9 5.2 4.4 Hope Education currently operates eight schools in Sichuan, Guizhou and Source: FactSet, Macquarie Research, November 2018 Shanxi. The company adopts a centralized management business model to (all figures in Rmb unless noted, TP in HKD) efficiently expand the school capacity and student enrolment. The organic capacity growth rates reached 17.9%, 12.8%, and 19.1% yoy in 2015, 2016, and 2017 respectively and the total capacity reached 95,776 under an improved utilization rate of 80.8% in 2017/2018, which reflected the improved brand Macquarie Governance and Risk Score (MGRS) On our proprietary Governance and Risk Score Hope recognition among students. The company is also trying to upgrade the education Education scores in the third quartile of our current level in the existing schools and introduce more value-added services to boost its universe coverage. ASP. Two new schools + accretive acquisitions to fuel expansion In November 2018, Hope Education announced two investments, in addition to its Guangdong new school plan, to establish new schools in Gansu and Chongqing, which will start accepting enrolments in 2H19 and 2H20, respectively. The company has acquired five schools so far and has a unique M&A strategy, in that: Analysts 1) it focuses on schools with majors that have large market demand; 2) it prefers Macquarie Capital Limited John Wang +852 3922 3578 schools with potential to ramp up capacity efficiently; 3) it prefers deals that can [email protected] be closed quickly. We observed the consistent successful progress when Hope Education took over the acquired schools and expect that the company continues Wendy Huang, CFA +852 3922 3378 [email protected] to acquire and integrate new targets in an effective manner. Frank Chen +852 3922 1433 Risks [email protected] Hope Education is ranked in the 3nd Quartile on Macquarie’s MGRS. Risks Marcus Yang +86 21 2412 9087 [email protected] include additional compliance costs from regulatory uncertainty, increased competition for M&A, and operational risks such as capacity ramp-up and student Ellie Jiang +852 3922 4110 [email protected] recruitment. Please refer to page 26 for important disclosures and analyst certification, or on our website www.macquarie.com/research/disclosures. Macquarie Research Hope Education (1765 HK) Inside Company profile Hope Education is the second largest private higher education group in China Investment Summary 3 in terms of total enrolment as of December 2017. The company provides Valuation, recommendation, risks 4 higher education services, including bachelor’s degree programme and junior college diploma programme, other educational services, self-study Strong school portfolio with robust organic examination education services, adult education, and technical education growth 8 services. Two schools + accretive acquisitions The company operates eight schools in the PRC, including three independent to fuel expansion 15 colleges: Southwest Jiaotong University Hope college, Business College of Guizhou University of Finance and Economics, and Jinci College of Shanxi Detailed Financial Data 20 Medical University; one university: Sichuan Tianyi College; four junior colleges: Appendices 23 Sichuan Hope Automotive Vocational College, Sichuan Vocational College of Culture & Communication, Guizhou Vocational Institute of Technology, Sichuan TOP IT Vocational Institute; and one technician college: Sichuan Revenue, Net Profit, and OPM Forecast Hope Automotive Technician College with total enrolment of 86,561 students as of 1H18. It owns a sophisticated centralized management model, with 2000 60% headquarters managing logistics, supply and service procurement and 1500 infrastructure construction at each school. 40% 1000 Hope Education went public on 3 Aug 2018, and raised about HK$3.1bn in net 20% proceeds. The company plans to deploy 40% for future school and land 500 acquisitions, 30% for capex on new buildings, 20% to repay debts, and 10% 0 0% for working capital and general corporate purposes. Hope Education will be 2016 2017 2018E 2019E 2020E 2021E included as a constituent stock in MSCI China Small Cap Index on 1 Dec Revenue (Rmb mn) Net Profit (Rmb mn) 2018. OPM (%) Source: Company data, Macquarie Research, Nov. 2018 Fig 1 Enrolment and ASP estimates for Hope Education 160000 14500 140000 14000 120000 13500 100000 13000 80000 12500 60000 12000 40000 11500 20000 11000 0 10500 2016 2017 2018E 2019E 2020E 2021E Enrolment ASP(Rmb) Source: Company data, Macquarie Research, November 2018 Fig 2 1765 HK rel HSI performance, & rec history Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, November 2018 (all figures in Rmb unless noted, TP in HKD) 30 November 2018 2 Macquarie Research Hope Education (1765 HK) Investment Summary DCF valuation suggests an equity value of HK$7.8bn Our DCF analysis derives an equity fair value of HK$7.8bn for Hope Education, based on 1.0x beta, WACC of 12.0%, and terminal growth rate of 3%. Hope Education is adopting efficient strategies for both robust organic growth and accretive M&A for long term growth. The company has a track record of successful M&A deals dating back to 2011. It has also achieved sustainable robust organic growth in capacity as well as enrolments. Our DCF-based fair value of HK$1.57 implies a 15x P/E and represents 22% upside to the current share price. Second largest private higher education provider with robust capex capability and accretive expansion strategies Hope Education exhibits strong managerial capabilities to achieve robust capacity expansion. The organic capacity growth rate reached 17.9%, 12.8%, 19.1% yoy in 2015, 2016, 2017 respectively excluding the impact from M&A and the total dormitory housing capacity reached 95,776 in 2017/2018, while the utilization rate increased from 75.2% in 2014/2015 to 80.8% in 2017/2018. The company also signed two more new schools in Gansu and Chongqing in Nov. 2018 in addition to its Guangdong school to strength the geographic presence. Meanwhile, on the M&A side, since 2011, Hope Education has made five acquisitions and successfully ramped up the capacity and enrolment for the existing schools and the acquired schools. We estimate the M&A momentum will continue with additional 1-2 deals per year, which will provide a 10-20% incremental revenue and enrolment. Scenario analysis suggests a 12-month fair value of HK$0.97-1.95 Due to the uncertainty of the future M&A and the impact from regulation, we performed a scenario analysis on Hope Education. We assumed a bull case and a bear case to deduce the DCF-based valuation of the company. In the bull case, we assumed a 5% higher enrolment and a 3% higher mixed ASP from the base case, whereas in the bear case, we assumed a 5% lower enrolment and a 3% lower mixed ASP from the base case. The DCF model suggested a HK$1.95 share price for the bull case and a HK$0.97 share price for the bear case.