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Morningstar | Navitas' FVE Lowered to AUD 5.10 Following Rejection of BGH Offer

We have reduced our fair value estimate for Navitas by 7% to AUD 5.10 per share following the board of directors' decision to deny due diligence access to the BGH consortium. We previously expected the AUD 5.50 per share BGH offer to easily proceed to acquisition considering the premium to the prevailing share price and the involvement of founder and recent CEO Rod Jones. However, the current state of disagreement between BGH and the board and the increase in management’s earnings guidance suggests the offer price will need to increase for it to proceed. We’ve therefore moved our fair value estimate from the offer price back to its standalone value, which we’ve increased to reflect the detail management provided on the stronger than expected longer-term contract outlook. However, at the current share price of AUD 5.10, we consider Navitas shares to be slightly undervalued. Management’s effective guidance upgrade partly explains why the Navitas share price hasn’t fallen following the rejection of the BGH offer.

Navitas’ higher earnings guidance mainly reflects a stronger than expected outlook for new contracts within its University Partnerships, or UP, division, which comprises around three fourths of group EBITDA. We were surprised by Navitas’ decision to deny due diligence access to the BGH consortium but even more surprised by the detailed earnings guidance provided for four of the next five years to help justify remaining independent. The outlook for new UP contracts is unusually strong with management now expecting eight new contracts to be signed in fiscal 2019 and a further 10 contracts "in the pipeline." This compares with five new contracts signed over the past three years, a book of 38 agreements in total, and is the main reason for the increase in our stand-alone fair value. In addition, the company has improved earnings disclosure which implies stringer than expected underlying margins for the SAE division.

Shareholders are clearly unhappy at the board’s decision to reject the BGH offer, as demonstrated by the 49% shareholder vote against chairman Tracey Horton being re-elected at the annual general meeting last week. Considering around 50% of shareholders reportedly want due diligence to proceed, around 90% of the shares are held by just 20 entities, and that the share price has rarely reached AUD 5.50 in recent years, it’s possible that BGH will revise its offer and either continue to push for due diligence access or launch a hostile takeover offer without. The process leaves Rod Jones in an interesting situation considering his disagreement with the company, his son’s senior executive role, and his desire to return to the board if the offer does not proceed. Mr Jones also reportedly claimed at the AGM that management guidance is not backed up by solid data and is very dangerous, although his involvement with the offer arguably means his opinions may not be entirely objective.

We continue to believe Navitas’ lack of an economic moat is its Achilles heel. Although contractual agreements protect the company from competition in the short to medium term, contract renewals expose it to the competitive pressures of a reasonably commoditised industry. Over the past five years, group EBIT has fallen at a CAGR of 1% due to UP and AMEP contract losses and the closure of the U.S. SAE colleges. The EBIT margin has also fallen from 17% in fiscal 2011 to 12% in fiscal 2018, although this likely reflects diseconomies of scale from contract losses to some degree. Management prefers to highlight the 100% contract renewal rate within the UP division since the loss of the Macquarie contract in fiscal 2014 which indicates that Macquarie was a blip. Navitas also now offers joint venture arrangements with universities which effectually creates a perpetual contract and removes contract renewal risk if the joint venture performs well, although JVs only comprise four of the 38 UP agreements currently.

For over a year, management has guided to a group revenue CAGR of 3% between fiscal 2017 and 2020, including the impact from the lost AMEP contracts. However, we estimate the new guidance implies a 10% CAGR between fiscal 2018 and 2023, including the impacts of both the lost AMEP contracts and the closure of the SAE colleges in the United States. In fiscal 2023 for example, guidance appears to imply revenue of around AUD 1.5 billion which is 37% above our prior forecast. The bulk of the difference appears to be due to management’s assumptions about the contribution from new UP contracts, sales initiatives, and efficiencies within the UP division.

At the time of the investor day in September 2018, the company highlighted eight "…leads that could become partnerships within the next 18-36 months…" which we interpreted as reasonably low probability leads. However, the company now claims eight contracts are either signed or highly likely to be signed in fiscal 2019 alone. We have added revenue associated with the new contracts to our model, which comprise 16% of UP divisional EBITDA by fiscal 2023 and we’ve also increased our long-term group EBITDA margin from to 18% from 17%. This is higher than the 17% guidance provided at the investor day but more in line with the latest guidance and implied underlying margins. However, we’ve also removed the AUD 30 million sale proceeds for the SAE U.S. colleges as it is looking more like they will be closed rather than sold.

The changes to our forecasts drive a 15% increase in our fiscal 2023 revenue forecast to AUD 1.3 billion, although this is still 13% below guidance which we think looks optimistic relative to historical growth rates, and we cannot see any significant changes to underlying industry trends which would justify a higher growth rate. Our fiscal 2023 EBITDA forecast has increased by 22%, with higher margins driven by operating leverage adding to the revenue boost. However, our forecast remains 8% below the AUD 250 million guidance. We previously, and continue to assume, that Navitas retains all its existing contracts. Although the improved contract outlook is encouraging, we see no reason to assume that the company has recently gained a competitive advantage that will enable an ongoing step change in contract wins. In the longer term, it’s also possible that information technology will impact the business models of both universities and Navitas in this information-based sector.