Tree House Education and Accessories: Withering away - Sell

Pre-school and K-12 service provider Tree House Education and Accessories’ (Tree House) stock has been withering. Its share price has fallen by about 80 per cent — from the February 2015 high of about Rs.500 to around Rs.107 currently — erasing all the gains made since its IPO in 2011.

The company announced a merger with its competitor, Zee Learn, on terms that are not favourable to Tree House investors. The question for investors is whether the depressed price offers a bargain hunting opportunity.

Accounting concerns

Concerns that cropped up in the past six months seem to indicate otherwise. Existing Tree House investors can cut their losses and exit as the share price may not recover in a hurry due to a few factors. One, the stock’s precipitous fall raises red flags. The stock has been under pressure because of issues raised about the company’s high receivables. Tree House had about Rs.63 crore receivables as of September 2015, against its quarterly revenue of Rs.57 crore.

The management clarified that receivables reduced to Rs.43 crore as of November 2015 and of this, Rs.17.5 crore was revenue to be received over three years. This, however, raises concern about revenue recognition practices.

Another reason for the stock price fall was the concern over pledged shares. The promoters had pledged their entire holdings in December 2014.

This was brought down to 29 per cent in March 2015 but steadily increased to 43 per cent as of September 2015. When the stock price fell, possibly on receivables concerns, there were fears on margin calls. Adding to this, promoters pared their stake from 30 per cent to 20.5 per cent in early December through a block sale. This depressed the stock price leading up to the merger, possibly hurting the swap ratio. The swap ratio — 53 shares of Zee Learn with a face value of Rs.1, for every 10 shares of Tree House with a face value of Rs.10 — is unfavourable to Tree House investors.

Using Zee Learn’s closing price of about Rs.41 (on the day before the merger was announced), the implied valuation of Tree House was Rs.217 per share. This was less than half the December 2014 Qualified Investor Placement valuation of Rs.440 per share. The swap price discounts Tree House’s trailing 12-month earnings about 14 times — much lower than the company’s three-year average price to earnings multiple of about 30 times. The low valuation is worrisome as Tree House has stronger operating metrics than Zee Learn. For one, over 80 per cent of Tree House’s pre-schools are self-operated, compared to the franchise model of Zee Learn.

As a result, Tree House commands high operating and net profit margins of over 50 per cent and 20 per cent respectively.

In contrast, Zee Learn’s operating and net margins in 2014-15 — its best ever — were about 23 per cent and 8 per cent respectively. Tree House’s profit was Rs.61 crore, compared with Rs.10 crore of Zee Learn in 2014-15. The terms of the fire-sale raise concerns about why the investors were short-changed.

Worries ahead

Zee Learn’s stock price is richly valued. The current price of Rs.33 discounts its trailing 12-month earnings by about 115 times. The share may face price pressure.

Given the unfavourable terms, the merger may also face delays in getting shareholder approvals. This may prolong the uncertainty and stock price volatility.

There may also be worries about the path forward for the combined entity, which will have about 2,000 pre schools and over 100 primary schools.

The Tree House management indicated that it would leverage the value of each brand and build an asset-light company. While this could turn out positive in the long term, there may be short-term pains in the merger that may impact returns.