Back to school - A 50-year-old business on PE 7x

Over the past few years we have made an intentional shift slightly up the market cap spectrum towards larger small caps and small/mids, away from nano and microcaps. We’ve done this for several reasons, notably the very attractive opportunity set in this part of the market (particularly in tech) and the structural challenges of listed nano and microcaps.

But we recently made an exception to the rule with the purchase of a line of shares in Kip McGrath, a global franchise tutoring business that next year will celebrate its 50^th birthday.

Trading on an estimated 3x EV/Cash EBIT at our purchase price, with a decades long track record of growth and an experienced capital allocator now chairing the board, we couldn’t say no.

The Kip McGrath Model

Kip McGrath (ASX:KME) operates 406 franchise tutoring centres and 37 corporate, primarily in the UK and Australia.

Despite the franchise segment being the life blood of the business, the Company only recently decided to refocus back on it, after years where corporate store growth had been the priority.

It was this strategy shift, along with a change in board composition, that put KME back on our primary watchlist.

We like franchise businesses and own 3 in the Inception Fund today. The key to a successful franchise operation is to recognise you have two customers: the end client (in this case the student/parent/grandparent) and the franchisee. KME’s renewed acknowledgement of this was encouraging.

KME charge ~$60/lesson with multiple students in the group, centres host an average of 70-80 lessons/week and KME’s franchise fee averages c.18%. Roughly $115m of network revenues is generated across the global footprint.

Market Tailwinds

KME is operating in a growing market with education as a share of GDP rising over the long term, and in some segments the cost of education well outpacing wage growth. Lessons are almost entirely funded privately by parents and grandparents.

The broader private tutoring market remains largely unregulated making it difficult to estimate market size and growth rates accurately, although some estimates have the Australian market alone now worth >$1b and growing 8-9% pa over the next decade. 

The significance and importance of education for primary and high school kids is universally accepted while rising property prices (largely owned by baby boomers), the bank of Grandma & Grandpa, downsizing of properties and lower birth rates (more $ per grandkid) all support the funding of said education well into the future.

This is particularly important for KME as it focuses on helping kids in mostly working class suburbs that have fallen 1-2 years behind their peer group. COVID also increased attention on the risk of kids falling behind their cohort due to school closures and interrupted learning and is an issue many parents are still battling with today.

It is worth noting that there is a recent increased push for enhanced regulation of tutoring particularly around topics such as mandatory safety checks, approved accreditations and a national audit.

Tighter regulations and stricter controls would no doubt be a benefit to a corporatized tutoring business with a 50 year operational history like KME.

AI presents unknown risks to the tutoring business, but also opportunities to provide enhanced tools for learning. For the kids that KME focus on helping, it is often the iPad or computer that is responsible for them falling behind, so assuming online AI tools will be what remediates their learning is probably overly simplistic.

AI does pose a risk, but we think the new board and management are aware of it and factoring it into their decision making. Like many businesses, the AI risk (and opportunity) remains a watch and wait.

Has the business been growing?

Due to various strategy changes, entry/exits into new territories, acquisitions (since divested) and subsequent changes in how they report, it is difficult to get a clear read of underlying growth of the business over the many years it has been listed, but there are a few metrics we can use to assess it.

The first is total revenue, which has grown at a CAGR of 7-8% pa over the last decade (a crude metric given the various changes mentioned above but hints at a growing core business nonetheless) while EBITDA is up roughly 4x to hit $8.5m in FY25.

The next is network revenue, which is the total amount of revenue generated by all KME stores (franchise and corporate).

Since 2020, Global Network Revenue has increased from $83.9m to now annualising at $115m, for a CAGR of 6.5%. This is despite total centres declining from ~520 to ~430 over that time period.

And what about the crown jewel?

When we focus in on the franchise business, which is the part of the business we are most attracted to, we see that franchise fees (i.e. royalties only, excluding new franchise sales) have increased from $2.6m to $18.4m over the last 20 years, for a CAGR of 10.3%.

It should be noted that the primary driver of franchise fee revenue over that period was the increased adoption of the full-service franchise offering (“Gold Level”) which charges a higher fee in return for expanded services.

It is the resumption of growth in new franchise sales that would likely be the most material catalyst for a re-rate from the 7x cash PE KME trades on today.

Also worth noting is that weekly revenue per centre has grown strongly over the last 3 years, indicating a healthier base of franchisees:

It may not be a hyper growth business, but for the core revenue stream we focus on to have grown 10% pa over the very long term? We view that as attractive.

It must be said that the above growth has been achieved with a strategy and corporate focus that we have broadly disagreed with for many years, which is key to our thesis of “why now?”

KME is a business we have followed for over a decade and despite it trading cheaply at times, we did not purchase stock.

It was when the board was renewed and the company flagged a change in strategy that we took a closer look.

New Board, New CEO and Refocus on Franchise

Damian Banks joined the KME board in April 2024 and became Chairman soon after.

We first met Damian when he was running Konekt, at the time one of the largest workplace health and injury management businesses in Australia, where he joined as Chairman in 2011, CEO in 2012 and had installed his management team by 2013.

At that point the stock was 2.7c/share. Six years later Konekt was acquired by APM for 70c/share (65c + 5c dividend) and anyone that backed Damian was well rewarded (we’ll take a 2,593% increase in our share price this time too, thanks Damian).

Damian has invested approximately $700,000 of his own money into KME since joining the board, paying prices roughly around current levels.

Earlier this year it was announced that the long-time CEO would be leaving, which suggested a broad strategy change was underway.

During COVID, KME bought a US business called Tutorfly, diversifying away from the core business. Unfortunately, this did not work, with the business underperforming and losing serious money.

In May this year it was announced that the US business would be shut down, and a trading update showed that the core business continued to perform reasonably well.

The Company also began to give clearer guidance on CAPEX and leases, allowing shareholders like us that focus on free cash flow to more easily evaluate the business.

Then in June, Melinda Smith (previous COO of Goodstart Early Learning, Australia’s largest childcare group) was announced as the new CEO, and commenced in November.

While assessing any key management personnel takes time and assessment of long-term performance, our discussions with previous employers indicated Melinda is highly regarded. After meeting her, she did indeed appear to be the perfect candidate to lead KME in its next phase.

What is it worth today?

The closure of the US business and the refocus on franchise creates a cleaner, more profitable business that is far easier to value.

Here’s an overview of underlying cash performance (ex-CEO transition costs and onerous leases) in FY25 and estimates based on FY26 and FY27:

We value businesses based on sustainable free cash flow. That means, for example, that we use the annual CAPEX and lease costs moving forward rather than the accounting inputs from D&A, which can be murky due to one-offs in the past.

For KME, amortisation of product and development costs is running significantly higher than the ongoing CAPEX required to maintain it.

CAPEX is expected to be $1.7m, of which approx. $1m is related to ongoing IT maintenance spend and $0.2-0.4m is acquisition of centres and therefore growth CAPEX, but we’ll assume for simplicity it is all maintenance CAPEX. Leases are c.$1.3m pa.

Guidance is for revenue to increase more than costs, implying modest EBITDA growth, and underlying reported NPAT growth in the early double digits for FY26.

Important to note is that Cash NPAT will be significantly higher than Reported NPAT due to D&A exceeding CAPEX and leases in FY26 by > $1m. These will converge over time, but in the meantime, we use Cash NPAT for valuations.

Capital Allocation – Key To Shareholder Returns From Here

We are largely invested in KME because we are backing Damian and Melinda to allocate capital efficiently. Pleasingly, the company has substantial free cashflows, a strong balance sheet (~$6m net cash today) and various options to place capital accretively.

One option is the ~400 franchise stores, each of which are in theory potential M&A opportunities.

We noted our preference for the franchise business model, but healthy franchise networks do operate corporate stores as a testing bed for new products and services, and as liquidity for selling or retiring franchisees.

Another option, and our preference given where the stock is trading, is to aggressively buyback stock at current levels. The buyback is ongoing, which we support.

While KME is highly cash generative, dividends are less interesting to Australian based investors like us. Due to KME’s portion of earnings derived from the UK, the Company’s capacity to pay fully franked dividends is reduced, so expect a lower payout ratio than what you might initially assume based on its cash generation.

Damian’s exit from Konekt was via a trade sale, which was rewarding for any shareholder that participated. We think that after a few years of refocusing and optimising the business, a trade sale is a likely exit here, and we trust the board and new CEO to maximise the opportunities ahead of them in the meantime.

It is only a modest position size in our Fund, due simply to the small size of the Company, but we feel comfortable we have acquired a business run by smart operators, with a long-term track record for growth and market tailwinds all at a very low multiple of free cash flow.

More often than not, that tends to lead to good outcomes.