Wall Street sees a bright side in ‘healthy’ tech selloff By Reuters


© Reuters. FILE PHOTO: A street sign is seen in front of the New York Stock Exchange on Wall Street in New York

By Lewis Krauskopf

NEW YORK (Reuters) – Some of Wall Street’s biggest players are viewing the stock market’s recent tech-led selloff as a bout of turbulence rather than the start of a longer slide — and they don’t see it as a reason to run for the door.

Invesco this week called the Nasdaq’s sharp decline a “healthy period of consolidation” while fund manager Lord Abbett said U.S. stock valuations are likely merited, based on an analysis of companies’ earnings.

On Sept. 4, Goldman Sachs (NYSE:) reiterated its year-end price target of 3,600 on the S&P 500, roughly 6% above the index’s close on Wednesday, while UBS Global Wealth Management recommended clients “ease into the markets” rather than stay on the sidelines.

Their optimism highlights how the Federal Reserve’s pledge to keep interest rates at record lows and hopes of a breakthrough in a vaccine for COVID-19 have underpinned market gains this year, though many remain wary that the U.S. presidential election and massive options bets on tech-related stocks could exacerbate market swings in the remaining months of 2020.

“What we think we are going through is a healthy correction, removing the froth,” said Troy Gayeski, co-chief investment officer of SkyBridge, an alternative investments firm. “We certainly could fall more. But if you’re a tech investor you had to understand that the valuations were very high.”

The Nasdaq posted its best day since April on Wednesday, a day after falling into correction territory, commonly defined as a fall of 10% or more from a recent peak. The other major indexes also rebounded on Wednesday after steep declines.

“I think of this rout not so much as a correction, but as a digestion,” Kristina Hooper, Invesco’s chief global market strategist, said in a recent note.

Second-quarter reported earnings on the S&P 500 were 23.1% above expectations, far above the trailing five-year average of 4.7%, analysts at Lord Abbett said in a recent note.

“Earnings momentum, and the magnitude of analyst earnings revisions, is outpacing that in other markets, suggesting that higher valuations on U.S. equities are merited,” the report said.

Still, some believe more volatility is in store. A recent poll of investors from UBS Global Wealth Management showed 65% viewed politics as their top concern, with the Nov. 3 U.S. presidential election just weeks away.

Prominent investor Stanley Druckenmiller – a skeptic of this year’s rally – again sounded a bearish note on Wednesday, warning on CNBC https://www.cnbc.com/2020/09/09/stanley-druckenmiller-says-were-in-a-raging-mania-and-the-next-3-to-5-years-will-be-challenging.html that the stock market is in a mania fueled by the Federal Reserve.

Uncertainty over huge options purchases by SoftBank Group Corp (T:) also hung over markets, creating another risk.

Gayeski, of Skybridge, said he could see an opportunity to increase equity risk if there was a sharper drop, such as the Nasdaq falling 20% or the S&P 500 declining 15% from their respective highs and there were other supportive signs for the market such as the Fed’s expanding its balance sheet further.

Any selling that spreads beyond the big tech-related stocks that have led markets higher could be an indication that the pullback may be extending further, said Willie Delwiche, an investment strategist at Baird.

In the coming days, Delwiche is looking for signs of increasing investor caution — such as buying of put options, outflows from equity funds and diminishing bullish views in surveys — that indicate any over-exuberance has waned.

Another indicator is how investors respond to key technical support levels, said Keith Lerner, chief market strategist for Truist/SunTrust Advisory. The Nasdaq, for example, on Tuesday closed below its 50-day moving average for the first time since April, but was back above it on Wednesday.

“If you see these markets just slice through support levels, that’s a sign that the sellers have the upper hand,” Lerner said.





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Smith Micro: The Future Is Bright (NASDAQ:SMSI)


“Smith Micro (SMSI) is the gift that keeps on giving,” I told several of my colleagues the day after the company’s most recent Q2 2020 conference call. That might seem like a strange thing to say when my number one holding dropped 10% after what most investors evidently interpreted as a disappointing Q2 conference call. But for me, SMSI dropping 10% was yet another gift, another opportunity to continue accumulating shares in a company whose enormous potential I believe most market participants do not yet understand.

In this post-COVID-19 environment, many retail investors have become accustomed to quick, short-term gains in popular retail trading names. As a result, they seem to be showing little interest in or patience for companies that guide their shareholders—as SMSI did on their Q2 call–to wait until 2021 to reap the rewards of the hard work in process. In its August 2020 announcements, SMSI disclosed substantial progress toward winning new customers that will rapidly grow their revenue, EPS, and cash flow.

As the broader market has turned away from SMSI following their August 2020 update, many in my network—people who have exhaustively researched both the company and the industry landscape in which it operates—happily acquired shares of SMSI, excited by the news that the company continues to progress with its products and its relationships with mobile carriers. My interpretation of their Q2 conference call was that the company was more bullish—and more transparent—than ever. Subsequent research and interviews have only bolstered that opinion. In this article, I will explain why I believe SMSI is now by far the best risk vs. reward scenario I am following. While risks clearly exist for SMSI, shares could realistically quintuple or more over the next 1-2 years.

SafePath: Expect New Customer Wins

On February 3, 2020, I published an article on Seeking Alpha, in which I indicated SMSI was on the verge of a deal with Canadian carrier Telus (TU). I came to this conclusion based on research conducted by me and several colleagues. I highlight this because we became aware of this deal long before anyone in the market was aware, and published these findings on Seeking Alpha almost six months before SMSI announced the deal and TU rolled out the Telus Tracker+.

Today, I am sharing similar research findings and going on record that I believe SMSI will officially sign at least one major carrier to its SafePath platform within the next six to 12 months. Honestly, I am quite confident this will happen within the next six months, but due to the continued uncertainty of the COVID-19 pandemic, investors should be prepared for possible delays to product launches by the carriers. Below, I will highlight what I have learned through my own research and note how those findings seem to correspond to public statements made by SMSI management on their most recent conference call.

Anyone familiar with SMSI realizes the company is definitely working hard to win the New T-Mobile (TMUS) business for its SafePath platform. Details on that, as well as SafePath’s integration with Circle, will be included in a separate section below. In this section, I want to remove TMUS from the picture to focus on other recent developments with SMSI and its SafePath platform.

My research indicates that SMSI is very close to signing a deal for its SafePath platform with a United States Tier 1 carrier. The company seemed to corroborate this on the most recent call, noting an “accelerating roadmap to meet clearly-stated prospect maps.” CEO Bill Smith noted, with more clarity than ever, that “all” of these customer prospects “are in the late sales stage,” which he then defined as being “currently in contract negotiations.”

What many investors likely do not realize is that “contract negotiations” with SMSI do not begin until a company and SMSI have mutually invested significant time and resources into their relationship, developing and testing products. In other words, a company does not negotiate a contract with SMSI and then hope that SMSI can deliver. Rather, a company vets SMSI, working with them to develop a product exactly as the customer wants, ensuring that SMSI can pivot and make changes as requested. Only after these steps does a carrier become comfortable enough with SMSI to begin negotiations to finalize the terms of a contract and to develop a product rollout roadmap.

To be clear, then, by the time a carrier reaches the contract negotiation stage with SMSI, they cannot easily walk away from the deal and duplicate the product in-house or with an SMSI competitor—nor would they want to. By the time SMSI reaches contract negotiations, they have proven their value to the carrier, built a strong relationship, and are beginning to make initial plans for product(s) rollout.

Clearly, not only is the company talking about signing carriers to deals with SafePath, but they are actively investing in human resources to meet the stated needs of these prospective customers. This investment is apparent in both SMSI’s nearly doubling its R&D expenses year-over-year and its continued hiring that I’ve noted in previous articles. Their commitment to invest in themselves is also apparent from following their LinkedIn page.

Although I am currently unable to determine with sufficient precision to go on record with which US Tier 1 carrier SMSI is on the verge of landing, I am nonetheless confident they will have major news on this front within the next year. Furthermore, I am confident that deal—as significant as it would be by itself—will not be the only deal SMSI is able to seal. In addition to a US Tier 1 carrier, SMSI is clearly in deep discussions and contract negotiations with multiple carriers of all sizes around the world. The impact of these prospective customers on SMSI’s valuation will be discussed in the “Valuation” section below.

SafePath & T-Mobile

Investors have clearly grown impatient with SMSI and TMUS. For those unfamiliar with that story, for at least the past 18 months, SMSI followers expected them to land a deal with TMUS for their SafePath platform. While unconfirmed, the timeline outlined by CEO Bill Smith for landing a possible deal with TMUS seems to have followed—and been delayed by—the merger announcement, the subsequent lawsuits, and now the actual integration of TMUS and Sprint. SafePath’s current revenues and margins primarily derive from legacy Sprint customers. With the merger of TMUS and Sprint, and with no deal between SMSI and TMUS, investors understandably worry that SMSI would lose out on a deal with TMUS, leading to a near-complete loss of its largest revenue generator.

Certainly, SMSI helped bolster their position within TMUS with their recent acquisition of the Circle operator business. This placed SMSI on both sides of the family safety offerings in the Sprint-TMUS merger. While SMSI served Sprint, Circle operated TMUS’s FamilyMode. By purchasing Circle’s operator business, SMSI now controls both the Sprint and TMUS family safety products. Of note, SMSI indicated that TMUS was aware this deal was happening and, at least informally, gave their seal of approval.

SMSI has been clear that their purchase of Circle was not a desperate lunge to win TMUS business, but rather an effort to blend their SafePath product with Circle’s parental control features to create a “best-in-breed” unified product offering. This integration, which will become SafePath 7.0, is expected to be complete no later than the end of September 2020 .

While SMSI has made clear and quick progress on this front, a new deal with TMUS has yet to be finalized (they are currently offering Safe & Found to legacy Sprint customers under the former Sprint deal terms, and FamilyMode to legacy TMUS subscribers under the former Circle deal terms). In discussions with SMSI management about their relationship with the new TMUS, they have indicated it’s “as strong as it could be” and that they have “an open dialogue” with their colleagues at TMUS.

Based on my research, the delay in a new, unified deal with TMUS has nothing to do with SMSI. Instead, the delay results from the fact that TMUS was handicapped in its planned integration with Sprint due to the multiple lawsuits and other legal hurdles needed to officially clear the merger. Add to that a global pandemic and you have perfectly understandable reasons for TMUS to be slightly behind on their merger integration plans. In any case, SMSI certainly has not been sidelined by TMUS. But until TMUS is able to actually integrate the old Sprint network with its own, offering a unified family safety product would be pointless. With that in mind, I agree with SMSI that they are unlikely to finalize a new contract with TMUS until 2021.

In addition to SMSI being the incumbent now on both sides of the Sprint – TMUS merger, SMSI has something else going for them. Specifically, SMSI and TMUS’s priorities and goals align, making them very likely natural and successful partners moving forward. TMUS (and other mobile operators) has a long-term goal—one that will be bolstered by widespread availability of 5G—of getting into the family home, of competing not just with other mobile carriers, but cable and internet providers in the home. SMSI would make a competent and natural ally with TMUS (and other mobile operators) in their ability to control IoT devices from one location: namely, from one app in a person’s mobile phone.

ViewSpot Success

In addition to the parabolic rise and future possibilities of SafePath, SMSI’s newest offering, ViewSpot, has started to gain traction. In January of this year, SMSI announced a contract win with AT&T Mexico, bringing ViewSpot into 1,500 of its retail stores. On the Q2 conference call management noted yet another win, this time with a “pre-paid carrier.” Many times, SMSI is not allowed by its customers to name them, and this has apparently been the case with Cricket Wireless and ViewSpot.

Very clearly, Cricket Wireless is the new ViewSpot customer. The “Cricket Explore” app is now available in the Google Play Store. Several of my research colleagues and I have visited Cricket stores throughout the country, and in every single store we visited Cricket Explore was being used. This means that SMSI’s ViewSpot is now likely in well over 4,000 Cricket stores nationwide.

Cricket ExploreRecent research also indicates that ViewSpot may be making its way into Verizon (VZ) stores, but I need further evidence to state this authoritatively. Any readers who are able to provide insight or help in verifying this are welcome to provide comments in the “Comments” section below.

One final note on ViewSpot: industry veterans have told me that ViewSpot has opened the door with at least one carrier who is now interested in SafePath. Although ViewSpot appears to be turning into a successful acquisition in its own right, if it leads to one SafePath deal with a carrier, it will more than pay for itself on that alone.

CommSuite: Far From Finished

Not long ago, CommSuite was SMSI’s “bread and butter” that kept the lights on as they integrated their SafePath product. Recently, however, CommSuite has started a slow, but steady glide down in terms of revenue. On the Q2 call management noted that approximately 75% of the Q2 CommSuite revenue came from the legacy Sprint business, and 25% from the legacy Boost business.

Moving forward, it remains uncertain what TMUS will do to transition or harvest the legacy Sprint business. Likewise, it’s unclear how DISH Network (DISH) will handle the legacy Boost business. It is possible that TMUS will sunset CommSuite or even let it slowly continue to glide down. At this point, it’s simply too early to determine how CommSuite will fare at the new TMUS.

Where I see the most opportunity for CommSuite is with DISH.

Dish WirelessSince DISH is essentially starting a mobile network from scratch—or at least from what was left of Boost—SMSI should have an advantage as the incumbent with its CommSuite service at Boost. SMSI and Boost have long enjoyed a positive working relationship, and I believe CommSuite and SafePath both will be favored by DISH as they begin to launch their post-paid service.

Valuation

At this time, given all of the variables mentioned in my article, I find it difficult to give as precise a perspective on valuation as I have in past articles. Undoubtedly, due to two factors, SMSI 2020 EPS will be lower than I expected and communicated in previous articles. The two reasons are:

(1) COVID-19 disruptions: mobile carriers across the US closed for several weeks/months during 2020. Even after re-opening, foot traffic in these stores is significantly lower than prior to the pandemic. One of the primary ways Sprint gained Safe & Found subscribers was through in-store promotions and sales associate bonuses for selling customers the product. Less traffic clearly means fewer sales. Furthermore, with children and parents home together more, and with many people facing the consequences of unemployment and cutting back expenses, Safe & Found churn has been higher than pre-pandemic. These COVID-related issues have resulted in lower than expected revenues for SafePath so far in 2020.

(2) Increased OpEx: due to increasing interest from multiple carriers, SMSI made a strategic decision to invest in human resources related to R&D in order to win new business. While it is highly unlikely SMSI officially wins and announces those wins in 2020—and even if they do—the revenue generation associated with those wins will not start contributing until 2021. Ultimately, while these current expenses deflate 2020 EPS, they are long-term extremely bullish for SMSI and its value.

BullishAgain, because of these two factors mentioned above and the multiple variables associated with new carrier wins, the extent of SMSI involvement with the carriers’ ecosystem, and the terms of those contracts, I cannot provide a precise valuation of SMSI besides giving my opinion that “SMSI is WAY undervalued” if they: (NYSE:A) sign a contract with new TMUS for SafePath 7.0; and/or (NYSE:B) sign a contract with a new Tier 1 carrier for SafePath; and/or (NYSE:C) sign a contract with DISH for SafePath; and/or (NYSE:D) sign a contract with TMUS or DISH for CommSuite; and/or (NYSE:E) continue to win new ViewSpot customers.

It seems highly likely that at least some of the positive scenarios I outlined in items A-E above happen. In actuality, it is quite possible that all five will happen. But the valuation of SMSI will vary greatly based on how many of those possibilities come to pass, and based on how large the customers are who sign these deals and the exact terms of the agreement. In the meantime, I find it quite likely, based on the details I outlined in this article, that SMSI earns at least $0.50/share next year, while still aggressively growing the topline with 90% gross margins and significant operating leverage with OpEx leveling out.

With all of this in mind, absent a fundamental change to SMSI’s business, I will not consider selling any significant number of shares until SMSI reaches $10/share.

Risks

Investors should consider several risks with SMSI, including:

(1) COVID-19. The dynamics related to the pandemic that I highlighted in the “Valuation” section above could continue to weigh on SMSI’s business. Furthermore, the longer the pandemic continues, the more likely other carriers delay the rollout of their products and features related to a contact with SMSI. This would obviously delay the revenue generation for SMSI associated with those contracts.

(2) Customer concentration. SMSI’s business is still overly reliant on their legacy Sprint business, both with SafePath and CommSuite. Clearly, as I showed in this article, SMSI is trying to broaden its base; but until they do, the issue of customer concentration risk remains.

(3) Competition. Although SMSI bought some of their main competition in the above-mentioned Circle acquisition, SMSI still faces competition. I believe SMSI has an advantage based on their relationship with mobile carriers and their ability to connect to their broader ecosystem. The increased SMSI OpEx in late 2019 and so far in 2020 gives us an indication of both the time and expense a competitor would need to unseat SMSI once SMSI becomes the incumbent with a carrier for SafePath. So although competition certainly exists, we should understand that SMSI cannot be unseated overnight.

Conclusion

SMSI progress has been delayed by a complex and lengthy merger between Sprint and TMUS, as well as by the global COVID-19 pandemic. During this time, however, SMSI has invested in its business and products to give themselves an even brighter future. I am convinced by management’s increasingly bullish tone and transparency, as well as through my discussions with people familiar with the industry, that SMSI is on the cusp of landing multiple new SafePath customers, one of whom will be a US Tier 1 carrier. SMSI will also be the incumbent with SafePath and CommSuite as DISH gets its new network off the ground, and continues to notch ViewSpot wins. The fact that shares have been widely available in the $3.50-4.50 range presents investors with a gift, an opportunity to continue acquiring shares on the cheap before SMSI growth in revenue, earnings, and cash flow explodes in 2021 and beyond.

Disclosure: I am/we are long SMSI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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Bright Scholar Education Holdings Ltd-ADR (BEDU) Management on Q3 2020 Results – Earnings Call Transcript


Bright Scholar Education Holdings Ltd-ADR (NYSE:BEDU) Q3 2020 Results Conference Call July 23, 2020 8:00 AM ET

Company Participants

Ruby Yim – Investor Relations

Junli He – Executive Vice Chairman

Wanmei Li – Co-Chief Executive Officer

Zi Chen – Co-Chief Executive Officer

Dora Li – Chief Financial Officer

Conference Call Participants

Sheng Zhong – Morgan Stanley

Christine Cho – Goldman Sachs

Operator

Good morning, and thank you for standing by for Bright Scholar’s 2020 Third Fiscal Quarter Earnings Conference Call. At this time, all participants are in listen-only mode. After management’s prepared remarks there will be a question-and-answer session. Today’s conference is being recorded.

I would now like to turn the meeting over to your host for today’s conference, Ms. Ruby Yim, Investor Relations Counsel.

Ruby Yim

Thank you, operator. Good morning, and good evening. Welcome to Bright Scholar’s Third Fiscal Quarter ended May 31, 2020 Earnings Call.

Joining me today are Mr. Junli He, our Executive Vice Chairman; and Ms. Wanmei Li, our Co-CEO; Mr. Zi Chen, our Co-CEO and Ms. Dora Li, our Chief Financial Officer.

As a reminder, today’s conference call is being broadcast live via a webcast. In addition, a replay will be available on our website following the call. By now, you should have received a copy of our press release that was distributed on July 22, 2020 after market closed Eastern time. If you have not, it is available on the IR section of our website.

Before we get started, let me remind you that today’s call may contain Forward-Looking Statements within the meaning of Section 21E of the Securities Exchange Act of 1934. As amended and as defined in the U.S. Private Securities Litigation Reform Act of 1995.

These forward-looking statements include, without limitation, the Company’s business plans and development which can be identified by terminology such as may, will, expect, anticipate, aim, estimate, intend, plan, believe, potential, continue, is, shall, unlikely to, or other similar expressions.

Such statements are based upon management’s current expectations and current market and operating conditions and relate to events that involve known or unknown risks, uncertainties and other factors, all of which are difficult to predict and many of which are beyond the Company’s control, which may cause the Company’s actual results, performance or achievements to differ materially from those in the forward-looking statements.

Further information regarding this and other risks, uncertainties or factors is included in the Company’s filings with the U.S. Securities and Exchange Commission. The Company does not undertake any obligation to update any forward-looking statement as a result of new information, future events or otherwise, except as required under law.

During this call, we will be referring to GAAP and non-GAAP financial measures. We use certain non-GAAP measures as supplemental measures to review and assess our operating performance. These non-GAAP financial measures have limitations as analytical tools and investors should not consider them in isolation or as a substitute for net income attributable to a Company or other consolidated statement or comprehensive income data prepared in accordance with the U.S. GAAP.

Please note, all numbers are in RMB and all comparisons refer to year-over-year comparisons, unless otherwise stated. With that, I would turn the call over to our Executive Vice Chairman. Junli He. Junli.

Junli He

Thanks, Ruby. Good morning and good evening. Welcome to Bright Scholar’s third quarter fiscal 2020 earnings call. During this difficult time with the continuation and the resurgence of COVID-19 around the world ourselves and our visitors affected by this unprecedented crisis. We extend our sympathies to those who are suffering personally from the impact of the pandemic and our business gratitude does help fighting the pandemic on the front line.

In the instance of so many challenges, I’m incredibly proud of our teams around the globe showing exemplary dedication in ensuring our students education journey to the list of disruptive.

Let’s begin our earnings report, for those who are new to our company, we have, included in our earnings presentation, a brief corporate introduction for Side 5 to 13, which you can download it for our IR website. Again, all numbers are in RMB and all comparisons referred to year-over-year and as otherwise stated.

I will go through the prepared remarks on behalf of the senior management team. Then I will turn the call over to Dora to provide a more details to our financials before we take your questions.

Please turn to the Slide 15 for the highlights of our third fiscal quarter and the nine-months performance with detailed breakdown by the second business inside of 16 and the 17. Despite the disruptions and the short-term impact from the COVID-19 pandemic Bright Scholar’s performance during the third fiscal quarter has demonstrated our continued progress in executing our growth strategy and the heighted a resilience of our underlying business. The revenue of the quarter was RMB739.4 million, representing a year-over-year increase of 6.7%.

Our net income was RMB68 million, which was negatively impacted by the mandatory closure of our schools, kindergartens and the learning centers. For the nine-month period, the revenue was RMB2.714 billion representing a year-over-year increase of 46.6%. The adjusted gross profits, adjusted operating income, adjusted EBITDA increased by 41.9%, 23.9% and the 37.3% year-over-year, respectively.

We are confident in the strength that our well positioned growth platforms, namely domestic K-12 schools, overseas schools, complimentary educational services, and education technology. We are building good momentum as we accelerate the execution of our more mature growth strategy, a brief updates as follows.

First, our domestic K-12 business, the demand of our K-12 education has continuously been strong in-spite of the pandemic, as shown in slide 18, in comparison to the nine-months of last fiscal year, the average student enrollment increased by 10.6% year-over-year.

Underpinning the strong demand for our K-12. education services are consistent industry leading and timely performance as you may refer to in slide 19.As of May 22, 2020, 93.6% of students in the 2020 graduating class of our international schools in China have received the offers from the top 50 institutions, including three from Oxford, three from Cambridge, four from the University of Chicago and 12 from University of California Berkeley.

One of our key growth strategy is to expand our nationwide network with asset led models through our strategic partnerships and deep collaboration with kindergarten. As of the release date ,we have entered agreements with kindergarten and other partners to add 61 kindergartens in eight schools to our school network. As a total capacity of approximately 35,500 students in China.

Second, our school business. As with our educational service providers. The business in the third quarter was impacted by COVID-19 related school clothing, mandated by government mainly with a result of boarding in the middle seat.

While full impact of this global pandemic remains uncertain for our overseas schools, we have taken measures to minimize disruptions and also putting an initiative in place to reduce costs to improve the efficiency of the business during this challenging time in anticipation of any potential resurgence for extended periods.

Our global network schools of our student options to complete their study at different locations in the coming school year, along with our virtual global schools.

Third, our complimentary education services has adapted a business strategy and taking actions to help mitigate any adverse impact on business and operation during the COVID-19 pandemic. We are pleased to report that class reduced it to a close to 80% for some of the business units. In addition we have realized and exact resources to – market of which pandemic has been content to expand our business. Really believe in times to capitalize on post pandemic market opportunities with new products and services for the summer.

Fourth, education technology. Our new business segment has shown in Slide 13, the adoption of the emerging technology has a profound impact on education industry. And for students enter the company Bright Scholar has continuously been evolving to mitigate changing needs of our students. As well navigate unprecedented situation COVID-19. Where this changes presented challenges in the short term, we are focus on this opportunities presented to us by new technology and then learning behaviors.

In the quarter, we added back two strategic initiatives to capitalize on those opportunities. Early in May, we announced the acquisition of 61% of the equity interest in main institute. Main institute to provide high quality and outcome focused online service including academic Olympia, the comprehensive selection of academic courses as well other work recognized international courses. In June we announced the launch of our virtual future global school with online, offline OMR model, which will be operation from the beginning of a fiscal 21.

The virtual school will deliver high quality international curriculum, interactive and then intelligent learning management system. It creates a new blended learning experience combining the best of a classroom and online education that offers human connection between teachers and the students around the world.

They especially our service offerings, utilizing technology to enhance access the high quality education where further strength our market leadership is the face of pandemic. As we offer a new age of learning.

While the pandemic is causing uncertainty and the near term impact our revenue and profit continuous growth in their first three quarters and long-term goals and the strategy remain unchanged. We expect most of our business will bounce back stronger post COVID-19. Secular trends driving our business remain intact and we may committed to balancing operations discipline with continued to invest in the key strategic areas to drive long-term growth.

I’m prudent the financial management enabled us to have financial flexibility to continue to invest in our business and the return value for our shareholders. The Board of Directors have approved – declared the cash dividend of $0.12 per ADS, a 20% increase from the last fiscal year.

With that note I would turn the call over to Dora.

Dora Li

Thank you, Derek. Let’s turn back to our financials. Please be reminded that all numbers are in RMB and all comparisons refer to year-over-year comparisons, unless otherwise stated. Please also refer to our earnings press release for detailed information of our comprehensive – comparative financial performance on year-over-year basis.

Please turn to Slide 21. Although heavily impacted by COVID-19, we still delivered solid results with top-line up 6.7% to 739.4 million for the quarter and up 46.6% to 2714.4 million for the nine-months of fiscal 2020.

The change in revenue is primarily contributed by an increase in overseas schools revenue, which was acquired in July of 2019, partially offset by the decreased revenue in kindergarten due to the temporary mandatory closure of schools.

Domestic K-12 schools include international schools, bilingual schools and kindergartens was down 24.8% for the quarter and up 3.7% on a nine-month basis, as mentioned primarily due to decrease in boarding and annual fees revenue for K-1 to K-12. And the tuition revenue decreased for kindergarten as a result of mandatory school closure impacted by COVID-19.

For our international schools, revenue for the quarter was up 7.6%, primarily due to 12.9% increase of students enrollment. On a nine-month basis, revenue was up 17.7% due to 13.9% increase in student enrollment.

Our bilingual schools revenue for the quarter down 4.9% due to a decrease in annual and boarding fees. On the nine-month basis revenue up to 10.3%, mainly attributed to 11.8% increase in student enrollment.

Kindergarten, revenue for the quarter and the nine-month basis was down 96% and 26.7%. Primarily due to decreased intuition fees news as a result of mandatory closure. Overseas schools, overseas schools is important part of global strategy, the revenue was 210.4 million for the quarter accounted for 28.5% of total revenue. On a nine-month basis, revenue was 766.8 million accounted for 28.2% of total revenue.

Overseas schools grow 2,204% in revenue, and 2,467% in gross profit in the nine-month basis for fiscal 2020. Average number of students was 3219 from quarter, and 3246 for the nine-months basis. The year-over-year growth in revenue and gross profit was primarily due to the inclusion of the acquired overseas schools during the comparable period.

Revenue from complementary education was down 3.2% for the quarter due to COVID-19 impact on training business, including [indiscernible] impressions as well as study for and account’s business. On a nine-month basis revenue was up 23.1%.

On Slide 22, cost of revenue for the quarter was 60.5% of total revenues compared to 54.1% in the same quarter of last fiscal year. On a nine-month basis cost of revenue was 60.5% of total revenue compared to 58.7% in the same period last fiscal year. The increase in cost of goods sold for the quarter and the nine-months was primarily due to the inclusion of acquire overseas business on a comparable basis.

Teaching staff cost, the primary cost contributor accounted for 34.2% of total revenue down from 35.3% for the quarter. On a nine-month basis teaching staff cost was 32.8% down from 38.4%. Our domestic K-12 average student teacher ratio for the nine-months of fiscal 2020 was 9.0 compared to 8.9 in the same period of last fiscal year.

On Slide 23, our gross profit and the margin. Gross profits were down 8.2% for the quarter and up 40.2% on the nine-month basis and gross margin were down 6.4 percentage points to 39.5% for the quarter. And on the nine-month basis, gross margin was down 1.8 percentage points to 39.5%.

Continuing on Slide 24. For the third fiscal quarter adjusted SG&A as a percentage of total revenue was up to 26.9% from 19.5% in the same quarter last fiscal year. On the nine-month basis adjusted SG&A as a percentage of total revenue was 22.8% compared to 20.9% in the same period of last fiscal year. The increase in SG&A expenses for the quarter on nine-months was primarily due to the inclusion of acquired overseas business on a comparable basis.

Adjusted SG&A as percentage of revenue for domestic K-12 schools for the quarter was up 9.4% up from 8.4% in the same quarter last year, primarily due to the pre opening expenses for the new international school plan to open in the coming years. On the nine-month basis adjusted SG&A as a percentage of revenue for domestic K-12 schools was 7.7% down from 10.9% in the same period of last fiscal year.

As percentage of revenue adjusted and allocated corporate expenses, mainly headquarter expenses for the quarter was 5.5% up from 3.7%. On nine-months basis it was 3.6% down from 5.1%. Adjusted and allocated corporate expenses for the quarter was 40.4 million compared to 24.9 million last year due to a one time option expensive adjustment. On a nine-month basis, it was 99 million compared to 94.8 million in the same period last fiscal year.

To elaborate more on the adjusted SG&A expenses, please refer to Slide 25. Continue to Slide 26, adjusted EBITDA for the quarter was down 25.5% to 164.5 million, adjusted EBITDA margin was 22.2% compared to 31.9%. On a nine-month basis, adjusted EBITDA up 37.3% to 665.4 million adjusted EBITDA margin was 24.7% compared to 26.3%.

Adjusted net income for the quarter, down 70.9% to 46.6 million. Adjusted net margin was 6.3% compared to 23.1%. On the nine-month basis, adjusted net income down 7.3% to 333.6 million. Adjusted net margin was 12.3% compared to 19.4%.

On Slide 27, our cash and bank balance. As of May 31, 2020,our cash and cash equivalent and restricted cash totaled RMB2092 million as compared to RMB2433 million in February 29, 2020. We also have a short-term investment of RMB1966 million as of May 31, 2020.

Moving on to Slide 29, underscoring the strong confidence in the company’s future prospects. The company continues to execute its second share repurchase program. And the recent insider purchase has been made from the open market by our chairlady, Executive Vice Chairman and Independent Director. Following the cash dividends of $0.10 per ADS in September 2019, the Board of Director has declared. The second cash dividend for $0.12 per ADS.

Continuing to Slide 30. We are reaffirming our revised guidance for fiscal year 2020. For the fiscal year ending August 31, 2020, we expect our total revenue in the range of 3.37 billion and the 3.47 billion representing a growth of 31% to 35% based on existing business and without potential acquisition.

We also accept average student enrollment to be between approximately 61,800 and 62,800 representing an increase of 11% to 13%. We are also in preparation to open 17 kindergartens and one International School for fiscal 2021. Beyond fiscal 2021, we have seven schools and 44 kindergarten contracted for operations. Please refer to table in Slides 32 and 33 for the combined income statement.

Slide 34 shows the reconciliations for SG&A EBITDA and an income on a GAAP to non-GAAP results. Slide 35 shows our balance sheet and cash flow statements and cash flow statements. For the nine-months ended May 31, 2020, the company’s capital expenditure was approximately RMB 107.3 million up 2.1% compared to the same period of last fiscal year. And Slide 36 shows our average students enrollment and average tuition fee across our network.

This concludes my financial update. Now I would turn to Junli He for his closing remarks, Junli.

Junli He

Thank you, Dora. Our transformative business model, moderated growth strategy, global school network, diversified portfolio, technology enabled OMO offerings and most importantly our exceptional group of employees will enable us to fulfill our mission with distinction and position into the future. We look forward to keep you updated of our continued progress that we executed on our growth strategy to enhance value for both students and stakeholders.

This concludes our prepared remarks and we would like to open the call for questions. Operator.

Question-and-Answer Session

Operator

[Operator Instructions] The first question comes from the line of Sheng Zhong with Morgan Stanley. Please go ahead.

Sheng Zhong

Thank you for taking my question. I have two questions. First one, can you give us more color about your OMO strategies. What the OMO will be title on the floor or on the supplementary services. And the second question is, because of the pandemic a lot of institutions actually is in very difficult situation, do you see more M&A opportunity in this current state. Thank you.

Junli He

Hi, Zhong, thank you for asking the questions. I would touch on both of them, this is Junli. For the OMO what we are doing right now, we are actually developing a platform that were opened for business for the first quarter of fiscal 2021. So that program were combine our experience for offline schools and also offer a mix of curriculum online for students around the globe.

For example, we are going to offer eight hour classes, so student anywhere, if they are in China or UK or another parts of the world can take class online. Of course for those who are in China they also have the advantage to take down the class offline in our physical schools.

For students who are attending to our UK school, for example because of the pandemic they cannot go back to the UK. They have the option to take some classes, online, with their teachers in UK, but also they can go sports and other things offline in our physical schools. So start with a level and English tutoring as well, but we intend to have a more broad selection down the road including a [indiscernible] as well.

But you also asked about the complimentary education, because of the pandemic we already moved some of those online already. For example, even as children we already moved online – most of the students are taking class online during the closure of the learning centers.

But the platform will recognize developing a more sophisticated than the tutors center would require, because learning management is interactive. So they actually can keep track of a students’ learning records across the entire school year or over the number of school years. That is for the OMO.

And also, you are absolutely right, this pandemic approved a lot of opportunities for position because many of the other businesses are suffering. Many of them actually end up brink of closing down there. We have been contacted by a number of organizations that are experiencing financial difficulties.

Without help, they are probably going to go through some kind of closure or bankruptcy process. We are actively looking into some of those opportunities, that we believe the best opportunity to take action, would be the next six or year not right now. And the validation would come – that force.

Sheng Zhong

Understand. Thank you very much. So just a follow-up about the M&A opportunity, do you see more opportunity in the supplementary service side or you mean the school.

Junli He

Actually both, to give you maybe some color, we try to work for hours of business in the UK in the U.S. for example, many of the private schools because they don’t have a strong balance sheet as we do, so I mentioned that we says cash and cash equivalents – net cash is a short-term investment. We have almost RMB4 billion which is somewhere about US$570 million or US$580 million. So we are going to be fine for to go through this pandemic and we don’t have any problem, but many of them don’t have expenses like that.

Literally without income, they are going to go down. So they are asking for help, those schools K-12 schools can be bought at I would say compared to last year, maybe half of the price in some cases or even less. So what we are on this fair footing, because our overseas business also impacted, we are taking opportunities to make it more efficient and a screen our business but once we go through these, because we are really in pandemic right now, but if once we go through this, we are on very strong footing. I think that’s a good time to take off to some opportunities overseas.

In China, particularly for K-12 schools there are also some opportunities, the evaluation as I mentioned kindergarten significantly compared to let’s say the same time last year. But China has reasonably controlled the pandemic. So I think most likely there maybe some particular areas, or cities, most of the country is going back to normal for this coming school year.

So there would be some opportunities, but the schools are doing fine as you know, even though students may not go back to school for boarding the meals, but it is continuing to enroll either online or offline for the school. So the school business is doing fine. So there are some opportunities to K-12 schools there as well.

But there are huge opportunities for complimentary part of it, because many of – I have to ask them we don’t have this – we have seen a lot of them potentially, I would say maybe I have them really experience province and we of course have seen some opportunities came to us at very attractive valuation in normal situation without pandemic.

Sheng Zhong

Thank you very much. That is very helpful.

Junli He

Thank you.

Operator

The next question is with Christine Cho with Goldman Sachs. Please go ahead.

Christine Cho

Sure, thank you Junli and Dora. I have two quick questions. One is I know that that situation remains quite fluid with right plan, do you have a sense of kind of what you are expecting for the overseas schools in the next few quarters. And secondly, I know you are preparing for the opening of Fettes College in Guangzhou and I was wondering how the preparations are going for the opening in September, Thank you.

Junli He

Sure. Again this is Junli, for overseas schools, we have seven schools in the UK and one school in the U.S., the seven schools in UK there are two buckets, three of them are independent schools. Most of our students are local student, and local means students are [indiscernible] UK. So they are a less impact, just like any local schools in most they may be stay at home, but still taking classes out in school, of course, just like in the school we have in China, you would not be able to charge them on boarding in the meals, but tuition is there.

And I think relative to the U.S. UK has done a better job in terms of controlling the pandemic, we are looking at – I just got update last week [indiscernible] has maybe 300 to 400 new cases a day and also by clusters. So of course, I don’t know that for sure, but most likely the schools are going to back to be opened in fall for the school.

So the independent schools, again, schools taken most students from UK, I think there are going to be fine. There are four schools that have take a mode of student as to the international students depends on where the students are. It is a hard to say they are going to come back.

I think if there are percentage of those students would not go back to the UK for school, but for those schools we have somewhere between 20% to 40% of students come here from China, if not going back to the UK, they can remain register and continue study in one of our campus in China.

So we would not lose those students, but somebody coming from, let’s say, Brazil or Russia, or we don’t have exact information on whether or not they would have come back or not. Of course we have some – already but given the situation in UK is fair and clear, we don’t know for sure yet, but we would expect there would be some losses of students for the coming quarter.

But relative other – to our competitors, many of them actually are shutting down. We are much better position because one we have our China campus to support our students from China then two, we have virtual schools to support students. And we also have other programs for the students as well.

The schools in the U.S. is a little bit troubling, actually in Massachusetts, but [indiscernible] also doing a better job than other states in the U.S. But it really depends on what are the actions that – taking from the U.S. government or local government or whether or not that school is going to open on not, or these students from other countries were back to the U.S. and remain again uncertain at this point of time.

We do expect out students would have come back given where they are. For example maybe in Brazil is actually the situation even worse than what it is in Massachusetts. Maybe they would come back. But most of the Chinese students may decide to go to school to our China campus or do that online.

But regardless, I would think that most of students will continue to study, maybe more than half at least a half of them were doing it online. But some of the students maybe lost, but I would think as the situation have become more clear we would have a better idea of where we are going.

But either way, we are prepared for a resurgence of the COVID-19 and prepared to take care of our students when they come to our campus. We have kept our parents posted as how we take actions to protect our student. We send out more than 50 pages of kind of procedure outline everything for [indiscernible], and students what happens if – what time we have to going to make sure that we take care obviously. We have launched a campaign called a WeCare. That is specifically for that.

For Fettes College Guangzhou, we just like to open that in September for sure. We are in the final inning of recruiting the students and then of course it pushes for the opening that is a definitive opening in September.

Christine Cho

Okay. Thank you. That is clear.

Operator

[Operator Instructions] This concludes our question-and-answer session. I would like to turn the congress back over to Junli He for any closing remarks. Thank you.

Junli He

Thank you. Thank you very much for joining the conference call. Please feel free to contact us if you have any further questions. We wish everybody a good day and stay healthy.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.





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Bright Horizons Family Solutions: Pre- And Post-COVID, Major Trouble Ahead (NYSE:BFAM)


Trading at 21x LTM (pre-COVID) EV/EBITDA and 33x FCF, the market views Bright Horizons Family Solutions (NYSE:BFAM), the child-care center operator, as a secular growth story largely untouched by the current maelstrom. Prima facie, this seems justified, as the business has put up high-single-digit revenue/low-double-digit EBIT growth CAGRs over the last decade; sports impressive returns on invested capital; and didn’t miss a beat during the financial crisis (EBITDA flattened out but never fell). But in my view the market has it all wrong. The reality is that BFAM’s margins haven’t grown in five years – despite continuing to raise tuition fees, improving utilization each year, and above-trend growth in higher-margin segments like back-up care. On closer inspection, BFAM has actually been a serial closer, not opener, of new centers – speaking to a much less attractive blue-sky runway than is currently perceived. Today, with enrollment at all-time highs heading into a recession (or depression), and with the balance sheet levered (2.5x funded/3.5x included rents), at the very least the “acquire, restructure and improve” growth story is over. In the worst case, the company could need to be recapitalized (since it is burning $50-$100mm/month in the current status quo, is already too levered, and faces huge operational deleverage in a worse economic environment). When the dust settles, I think 2021 EPS could be ~$1.75/share, or 60% below current consensus, and assuming just modest multiple compression, the stock could fall 65% even if the more draconian balance sheet restructuring scenario does not come to pass.

After a business summary/quick history, the investment thesis goes something like this:

  • Even pre-COVID, the growth story was running out of puff and misunderstood by the market;
  • COVID itself creates meaningful risks for the balance sheet;
  • potential for large earnings deleverage in a normalized post-COVID environment; and
  • perspectives on valuation post this crisis and key risks.

Business summary

BFAM is a child-care center operator, maintaining 1,084 centers across North America and Europe. Back in 2011, the company operated 760 centers; since then, growth has been mostly driven by rolling-up other providers. Child-care centers are generally good businesses, driven by long-term structural drivers (more urban density; more women/dual-parents in the workforce; more employer recognition of the benefits of company-sponsored child-care) as well as attractive underlying economics at scale (low initial and maintenance capital requirements, and high incremental margins). Partially offsetting these attractions, the market remains extremely fragmented, with the top 10 providers constituting <10% of the center-based market, and ~90% of the market operated by groups with <10 total centers.

The company has three segments: full-service, back-up, and educational. Full-service – 82% of LTM revenues/62% of LTM EBIT – encompasses, as you might expect, full-service child-care centers, offering care Monday-Friday, 7am-6pm, that vary widely in size and scope, but average around 126 children (at capacity) in the US and 82 children in Europe. About 30% of the centers in this segment are operated on a “cost-plus” model, where a corporation pays for the build out and maintenance of a center (on behalf of its employees), and BFAM earns a management fee that supplements the fees it charges that company’s employees (which are subsidized by the employer). The other 70% of the centers are operated under a “profit and loss” model, where BFAM undertakes all the costs of the operation, and earns all the rewards associated therein. The majority of P&L centers still have a corporate sponsor(s) associated with it, but these centers also serve third-party, unaffiliated families (often from locations at group office parks, etc). Personnel costs constitute the majority of operating costs in both models – around 70% in total blended, with a higher proportion for the cost-plus model and a lower proportion for the P&L model (where BFAM incurs a wide variety of other costs). Rent is generally the next highest discrete cost (at ~8-10% of COGS); with the other cost items (20-25% of COGS) comprising cleaning, maintenance, electricity, other overhead, etc.

BFAM guides that gross margins in the segment range from 20% to 25%, with the higher number coming from P&L centers, and the lower end from cost-plus centers. As you can imagine, most all the cost line-items are fixed and so incremental returns on higher child enrollment are high. Returns on invested capital in both models are also attractive: clearly BFAM is not committing much capital in the cost-plus centers; and even for the P&L centers, fit-out costs (for fixtures, etc) are very low relative to operating costs (basically all personnel, rent, and facilities maintenance). Low/mid-20s gross margins translate into ~10% EBIT margins on a segment basis, with a large portion of company SG&A (~11% of company-wide revs) – and basically all of amortization – allocated to this segment.

Back-up care – 14% of LTM revenues, but 30% of LTM EBIT – constitutes the provision of “last-minute” outsourced care and support for children (and the elderly). The reason margins are so much higher in this segment (mid-20s EBIT margin vs 10% for full-service) is that BFAM is essentially a platform provider of third-party care providers (through its call center and online service), taking a fee both from employers to organize and maintain the service and also from parents on a per-use basis. In my view, back-up care is the real “jewel” of the business – it is just much smaller in absolute earnings power than the full-service segment.

There is no denying that BFAM has executed impressively over the last 10+ years. In 2009, BFAM was doing 21% gross/8% EBIT margins on an $850mm revenue base; in 2019, BFAM printed 25.4% gross/13% EBIT margins on $2.06bn of total revenue. This represents a revenue/gross profit/EBIT CAGR of 8.4%/10.2%/13.6%, respectively. The growth algorithm has been quite simple:

  • Raise fees: Average tuition was $1435/month in 2012 (the earliest disclosure I could find); today it is $1825/month, representing a 3.5% CAGR in this time period. The company guides to ongoing tuition hikes of 3-4% annually.
  • Increase enrollment: There is no doubt that enrollment/utilization was sub-scale a decade ago. Whilst disclosures are spotty, BFAM has hiked enrollment by 7%, 12%, 5%, and 4%, respectively, over the last four years, collectively amounting to 31% growth in enrollment over this period. The last time a negative enrollment period was disclosed was 2010 (-6.4%).
  • Acquire, improve, and close: Acquisitions form the core of the BFAM model. BFAM operates 1,084 centers today, having grown from 760 at end-2011 – but in that time it has acquired a total of 510 centers. In other words, whilst total center growth has compounded at 4% in this period, net center growth has been negative 1%, as the company systematically acquires, improves, and subsequently closes underperforming centers. Whilst this juices enrollment growth (consolidating children into fewer, better-performing centers), it also creates challenges going forward, as we shall discuss, given the company has enjoyed many years of optimization of its center base at this point.
  • Growth in adjacent businesses: The education/advisory business has been a strong secular grower, from a non-existent base (revenue/EBIT went from $8mm/$0mm in 2009 to $82mm/$21mm in 2019). This has helped flip the broader entity as other segments have stagnated in earnings power, but for the purposes of this thesis still remain too small to move the needle (<8% of group EBIT today).

Running out of steam before COVID?

Despite the historical success of these various drivers, what’s most interesting is how the core segments (full-service and back-up) have stalled out – in earnings power terms, not revenue terms – in the last few years. That is, between 2009 and 2015, Full-Service EBIT margins expanded from 6.6% to 9.8%, as the top-line compounded at 7.3%. Similarly, back-up EBIT margins grew in tandem, from 19% to 31.3%, alongside a revenue CAGR of 10.2%. But from 2015 to 2019, margin growth has stuttered: Full-service margins in 2019 were 9.9% (despite ongoing revenue expansion of 6.4%); back-up margins have gone into reverse, falling 4+ pts to 27% – despite further top-line growth CAGR of 10.2%. Why, then, did margin expansion stop despite ongoing revenue growth?

Firstly, Bain acquired the business at the margin low-point in 2009 (coming out of the GFC), and no doubt extracted significant operational and cost synergies during its ownership (the business was relisted in 2013 and Bain fully exited in 2016). Many of the most attractive and synergistic acquisition targets also appear to have been monetized during this period (underperforming chains in London and Holland, for example). The retrospective, cynical view on private-equity ownership suggests this pattern – where margins expand during the PE hold period and then a fall-off thereafter – is not uncommon. But there are other reasons as well: coming out of the recession labor was far more available and at lower rates; this made it easier to hire (and keep) personnel, juicing margins in both full-service and back-up. In recent years, however, a tight employment market has made controlling personnel costs much tougher.

It is also likely that BFAM spent the initial period coming out of the GFC back-filling the most attractive areas and locations – dense urban areas in prosperous areas of the richest cities in the US and Europe – that by 2016 or so were largely penetrated. Thus, growth in more recent years appears to have been in less dense, and perhaps less wealthy, locales. In addition, as previously mentioned, the child-care market is highly fragmented, and capital requirements for single locations are not high. It seems likely competition for labor (and desirable rent locations) has contributed to the margin stagnation: since 2015, COGS have outgrown full-service segment revenues (7% CAGR vs 6.3% CAGR) and other expenses (SG&A) have grown even faster still (8.3% CAGR).

Near-term COVID impact is about the balance sheet…

COVID changes the equation for BFAM in many ways, both near- and medium-term. The company has said little about the impact thus far, other than closing half its centers worldwide, pulling 2020 guidance, and announcing cost-cutting measures. I expect at a minimum, the balance sheet to come under severe strain over the next few months.

With half the centers closed and most of the world on lockdown, I think it’s fair to assume enrollment even at those centers that remain open will be extremely low for the extent of the initial wave. Within the full-service segment, I assume half of the centers generate zero revenue (since they are closed); and half see attendance -75%; back-up care revenues I have estimated fall 50% (since most everyone is working from home, last-minute child care needs must necessarily come down); meanwhile I assume the Education segment revenue cadence is unchanged (generous). Even so I get revenues on a monthly basis of ~$38mm (vs 2019 LTM run rate of $173mm company-wide), I make no adjustment for the likelihood that many of BFAM’s most profitable centers – those in the NYC surroundings, for example – are quite likely to be the most affected, and thus most damaging to BFAM’s PnL, given the particular spread of the virus.

On the cost side, if BFAM can furlough 50% of its staff – i.e., all those who work at the closed centers – at no cost, and if personnel runs to 65% of COGS in aggregate, then monthly labor cost falls to $42mm. I assume rent still gets paid; this is ~$13mm a month. Then for all other COGS I assume a blanket cut of 25%. This suggests total monthly COGS of $79mm or -$40mm of gross profit per month. SG&A ex amortization likely comes down – I budget -25%, but even so the monthly operational burn is ~$55mm. Interest expense adds another ~$4-5mm per month.

Thus, I think it’s reasonable to conclude BFAM is currently burning $60mm cash per month in the current status quo. Note that I believe this is very much a minimum burn rate, because in practice it may be quite difficult to furlough/lay off staff in a frictionless manner for this kind of business. Hiring for childcare is not like hiring for McDonald’s (NYSE:MCD): rich families paying ~$1.5-2k per month to have their children taken care of often develop a personal relationship with their carers and expect a certain level of continuity, familiarity, and trust from their child-care provider. Even pre-COVID, safety and training regimens for new hires in child-care are rigorous and costly; it may not be simple, nor desirable, for BFAM to simply wield the axe now in the hope that business doesn’t suffer later. Similarly, I make no adjustment for the likelihood that many of BFAM’s most profitable centers – those in the NYC surroundings and in London, for example – are quite likely to be the most affected, and thus most damaging to BFAM’s PnL, given the particular shape of how the virus has spread thus far.

Beyond operational burn, working capital is a major problem. Parents normally pay for care monthly in advance, and at year end, BFAM had $191mm of deferred revenue (basically one month’s revenue in the Full-Service segment) and also ran negative working capital outside of deferred revenue due to favorable trading terms elsewhere in the business. Even if we assume suppliers exercise forbearance, the simple draining of deferred revenue from the balance sheet – which will be accomplished with most all the centers in lockdown for a couple of months – necessitates another $100-200mm of funding to be found, on top of the ongoing burn rate.

At this point it’s worth mentioning that BFAM is quite levered: it carried $1bn of funded net debt at year end (about 2.5x LTM EBITDA of $395mm); on a rent-adjusted basis this leverage is a bit more threatening at 3.5x. If we assume, then, the lockdown costs the business $120mm cash in operational burn (so two lost months at minimum burn rates) and another $130mm of lost deferred revenue, pro-forma leverage – against pre-COVID earnings levels – rises to 3.2x/4.1x (funded/including rents).

Clearly this isn’t levered to the gills, but it is enough to constrain future acquisitions for quite a while, at the very least. And, since the company only carries $27mm cash (and has $225mm only of revolver capacity available), this may prompt liquidity question marks (or worse) in a more bearish scenario.

Post-COVID earnings power looks structurally lower

But the main reason I like this short is NOT the near-term balance sheet impact of the temporary lockdown; it’s because I think the mid-/longer-term earnings power of the business will be significantly impaired from current levels, even if the longer-term reaction to COVID from a behavioral perspective is fairly muted. That is to say, even if we all go back to work in 12 months, and even if we can all agree that child-care is a necessary and valuable service, I can’t see how pre-COVID enrollment/utilization levels (let alone fees) are maintained through a recession (or, heaven forbid, a depression). And the PnL looks supremely vulnerable to even small changes in both of these items. (Note: this of course pre-supposes social distancing is done and dusted and normal child-care centers can be used similarly to before the crisis – perhaps a generous assumption).

The fact that this recession is different, as regards to its impact on BFAM, is something the market appears to be missing, precisely because last recession the business seemed so bulletproof. In 2008-2010, revenues kept growing (albeit at a lower rate), and EBITDA didn’t decline – not bad at all for the GFC! No doubt the market is today sanguine about the rebound potential here because the business was so resilient back then. But the market is missing that the starting point for the earnings power of the business today – mid-teens EBIT margins, 19% EBITDA margins – is a full 5+pts higher now than back then, and that this higher baseline level of earnings speaks to much higher – and thus more vulnerable – operating leverage in the model (that is, 10-15pts higher enrollment, and 35%+ higher fees in nominal terms). Furthermore, it ignores the very specific, COVID-related residual risks that are likely to crimp earnings potential even in a fully-normalized, post-COVID world.

Consider the unit economics today. Based on 10-K disclosures, the average Full-Service center does $1.65mm of annual revenue (blending US and Europe), and generates an average 23.5% gross margin (using blended averages for P&L/cost-plus models). This equates to ~$388k in gross profit per center – or, at company-wide segment EBIT margins (10% in 2019), around $39k in EBIT per average center. Since the average center – again, blending US and Europe – can hold 111 children at capacity, and since a simple average of fees on a monthly basis is $1,825/month/child, at those average revenue levels the implied utilization rate is around 70%. Actually, we know utilization is higher than this since younger children who garner fatter fees – infants and toddlers – should be a smaller component of total enrollment. Adjusting this assumed utilization rate slightly higher to account for this, to 75% (probably still too low based upon external research) suggests that gross profit per child per month is around $390. Keep in mind that average fees in 2012 were $1,435 per child per month; they are now $1,825 per child per month. That is to say – the entirety of the Full-Service center gross profit being earned today is simply the sum of fee increases pushed through during the last seven years.

That aside, what could a post-COVID environment look like? Well, I think it’s reasonable to assume at least some parents will be permanently scarred by COVID such that they fear for their children’s health in a child-care center. There will also be at least some structural trend towards work from home – likely alleviating some of the demand for out-of-home child-care at the margin. Of course, it also seems pretty clear we will go through either a recession or depression – none of which is good for household incomes and expensive line-items like $2k/month child-care. Finally, BFAM is over-indexed to large urban agglomerations where the virus has been particularly virulent – NYC area, SF, and London – and where the majority of its highest-performing centers are located (judging by average fees and density) – again, likely a significant negative during the new normal to come. Add it all up and I think a 10% decline in enrollment, along with some fee compression, is more than generous for a normalized base case, say from 2021.

Assuming a 10pt decline in utilization to 65%, then, and say a 5% decline in average fees, and I think average unit revenue falls to ~$1.5mm (vs $1.65mm today). On the cost side, personnel costs are probably largely fixed in numeric terms (you can’t necessarily fire 10% of your employees if you have 10% less kids), but maybe you can cut salaries in line with lower fees, so let’s lower the personnel cost by 5%; meanwhile other COGS – rent, facilities – are basically fixed if not higher (since we will definitely see stricter maintenance and cleaning requirements for all public spaces post-COVID). In total, I have gross profits per unit dropping to $291k, and gross margins fall to 19.3% – or around 420bps below where they are today. And in reality I think enrollment and fees could well fall further than this…

Whilst no doubt SG&A costs can be cut somewhat in this kind of reversal, the very fact that historically gross margin improvement was mostly responsible for EBIT margin improvement suggests in reverse the same should be true (looking at the group PnL, gross margins went from 21% in 2009 to 25.4% last year as EBIT margins went from 8% to 13%). Thus, a 400bps+ contraction in gross margins – based off just a 10pt enrollment drop and giving back not even one year’s worth of price hikes (since average tuition falls just to $1,733/month vs $1,715/month in 2018) suggests to me that Full-Service segment EBIT margins could realistically fall from current levels near 10% back near levels seen in 2010-11, or 6-7%.

But what about the Back-up segment? Whilst clearly harder to forecast as all the drivers are not readily observable, it further stands to reason that in a much weaker employment/recessionary environment, and one in which some portion of the workforce is out of work and/or working from home, there would be less demand for high-priced, last-minute child-care services. Still, it is hard to handicap how much lower demand translates into lower revenue, so I am simply assuming a minimal 10% decline here in nominal revenues, along with slightly higher decremental margins, for my 2021 estimates. I am not touching the Education segment.

What’s BFAM worth in the new normal?

Putting it all together, in even this somewhat mild downside scenario, I think group EBIT could fall to ~$180mm (vs $268mm in FY19) and EBITDA is closer to $300mm (vs $395mm in FY19); keeping tax and interest expense relatively constant implies FY21E EPS of $1.75/share – 60% below the current consensus of ~$4.25 (which is basically flat vs realized FY19 and may be stale at this point). At the same time, pro-forma leverage jumps to 3.8x funded/4.7x including rents (assuming deferred revenue normalizes back in the company’s favor and just the $120mm of cash burnt during two months of lockdown). Remember again this assumes no further burn/deterioration in the cap structure over the rest of 2020, and (I believe) a mild recessionary downside scenario in 2021…so I think reality could certainly look worse than this.

It is tough to estimate what the market may capitalize this kind of lower earnings profile at going forward. No doubt there will be some residual support for the name, as well as assumed bounce-back potential if/when the economy returns to growth (perhaps late 2021 or early 2022). Still, I find it hard to believe the name would not at least partially re-rate, especially as in this scenario the company would be breaking the historical pattern (namely, seeing strongly negative comps in this crisis versus the last), would probably trip covenants, and may at least have questions posed about its leverage burden. Thus, even a high residual multiple of say 20x EV/EBIT would imply a much lower stock price around $42, or 65% downside. Alternately, even at 20x EV/EBITDA – basically the current multiple, and where Bain paid to take out BFAM back in 2009 – the stock would be worth only $80 in this scenario, still good for substantial downside before considering derating potential. And to be clear I fully expect the balance sheet to be in much worse shape by the time we get to 2021, adding further pressure to residual equity value.

Upside case, other risks

Nothing in life or investing is without risk, and of course that applies here too. There is a chance BFAM could sail through this recession – perhaps the economy bounces back rapidly, and completely; perhaps BFAM is able to offset lower enrollments and/or lower fees with aggressive cost cuts and other efficiencies. More likely though is perhaps a higher multiple applied to lower or similar FY19 earnings (thanks, Jerome Powell!) and – in a fast recovery scenario – an unchanged perception of the business as a strong secular growth story. In that scenario I could see the stock push back up to recent valuation highs around 28x EV/EBITDA and 45x FCF – which, even with the added cash burn through COVID, would imply a stock north of $160 and up near the recent highs, so ~33% downside from here.

The other major risk is another PE-led takeout (given the history here). However, I am less concerned about this risk since Bain paid “only” 20x EV/EBITDA based on a much less profitable and less-scaled business – i.e., around the current pre-COVID multiple – and the absolute ticket size on a takeout is much larger now than then. Also, the business is now levered significantly (again a legacy of the original buyout) so PE can’t rerun the same levered playbook here even if the equity component derates significantly. Mostly, though, COVID, social distancing, and work from home have the potential to fundamentally change the calculus for a business like this over the long-term, such that a buyout near-term – before the dust settles and we can at least glimpse what the new normal looks like – seems remote.

Disclosure: Short BFAM

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.





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Paratek Pharmaceuticals: A Bright 2020 Ahead – Paratek Pharmaceuticals, Inc. (NASDAQ:PRTK)


[Man] progresses in all things by resolutely making a fool of himself.”― George Bernard Shaw, Advice to a Young Critic

Paratek Pharmaceuticals (PRTK) reported solid Q4 results after the bell Tuesday. This ‘best of breed‘ antibiotic concern is seeing some enthusiasm in the market in the early going today as investors applaud the company’s progress and anticipate huge revenue growth in FY2020. The earnings report and management guidance triggered a 20% surge in the shares on Wednesday. We revisit this ‘Tier 3‘ biopharma concern and provide key highlights from the fourth quarter and what might lie ahead for the company in 2020.

Company Overview:

Paratek Pharmaceuticals is a Boston-based biopharma concern focused on the development of antibiotics. Its main asset is NUZYRA (omadacycline), which was just launched one year ago. NUZYRA is a once-daily IV and oral modernized tetracycline that has demonstrated activity against a wide spectrum of bacteria, including Gram-positive, Gram-negative, and drug-resistant strains. It has been approved for the treatment of adults with community-acquired bacterial pneumonia (CABP) and acute skin and skin structure infections (ABSSSI).

Paratek also receives mid-single-digit to low double-digit royalties from Almirall for the licensing of Seysara (sarecycline), an antibiotic approved for the treatment of acne vulgaris in October 2018. The stock trades at approximately $4.25 a share and has an approximate market cap of $140 million.

Fourth-Quarter Highlights:

The company posted a GAAP loss of 81 cents a share, 16 cents a share above expectations.

Revenues came in at just under $9 million, down some 47% from the third quarter and some $6 million below the consensus. However, this is due to the unevenness of various milestone and developmental payouts as well as procurement agreements. In December, the company entered into a game-changing 5-year contract valued up to $285 million with the Biomedical Advanced Research and Development Authority, or BARDA, to support the development of NUZYRA for the treatment of pulmonary anthrax.

More importantly, NUZYRA sales came in at $5.4 million for the fourth quarter, this is 74% sequential growth from the third-quarter levels. The increase was from daily demand, not the BARDA contract which will kick in this year (see below). For the eleven months, NUZYRA was on the market in 2019 it rang up $11.5 million in revenues.

The company also guided that it sees NUZYRA producing $66 million in sales in FY2020, an almost six-fold jump from 2019 levels. Approximately $38 million of these sales will come from the initial BARDA procurement of 2,500 anthrax treatment courses. Total revenues for FY2020 including milestone and other payouts should be in the range of $75 million to $80 million. This guidance is the main reason for the approximate 10% jump in the shares in trading today.

Analyst Commentary & Balance Sheet:

H.C. Wainwright reiterated its Buy rating and $18 price target this morning. This was the first analyst activity on PRTK so far in 2020. I would expect other positive analyst commentary on Paratek over the next week given guidance provided with the fourth-quarter results.

As of year-end 2019, Paratek had $215.4 million in cash, cash equivalents and marketable securities. Management stated on its press release that it ‘anticipates its cash runway will extend through the end of 2023 with a pathway to cash flow break-even.’

Verdict:

The picture around Paratek seems to have gotten quite a bit more optimistic on the back of solid NUZYRA sales in the fourth quarter and in my opinion, encouraging guidance for FY2020. While the overall antibiotic space continues to see substantial economic challenges, Paratek is my top and only pick in this sub-sector of the market here in 2020.

Democracy is reproached with saying that the majority is always right. But progress says that the minority is always right.”― G.K. Chesterton, What I Saw in America

Bret Jensen is the Founder of and authors articles for the Biotech Forum, Busted IPO Forum, and Insiders Forum.

Live Chat on The Biotech Forum has been dominated by discussion of these types of buy-write opportunities over the past several trading sessions. To see what I and the other seasoned biotech investors are targeting as trading ideas real-time, just initiate your two-week no obligation free trial into The Biotech Forum by clicking HERE.

Disclosure: I am/we are long PRTK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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