Pandemic school closures and travel restrictions affected K-12 schools across Europe, the Middle East, and Africa in 2020-2021. S&P Global Ratings downgraded Lernen Bondco PLC (Cognita), Bach Finance Ltd. (Nord Anglia), and GEMS MENASA (GEMS), each by one notch, in 2020. Those rating actions captured sector-wide decreases in revenue and profits from before the onset of the pandemic. Inspired Education Holdings Ltd. (Inspired) faced the same COVID-19-related headwinds, but its lower-than-peers' leverage and higher exposure to local students provided more leeway to absorb the fallout. Our view of its credit quality therefore remained unchanged during this period.

These schools have since restored earnings to pre-pandemic levels, even though differences in exposure to expatriate students, the ability to move to online teaching, and flexibility to discount fees created variations in their recovery paths over the past three years. However, the investments needed to continue to expand their footprint will likely curb deleveraging from still-elevated debt levels, thereby reducing further ratings upside potential.

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Industry Outlook

K-12 private education benefits from stickiness and predictability of revenue

Parents generally consider private education, especially the K-12 segment, to be a non-discretionary expense, potentially making it one of the last household spending items to face pressure in a tough macroenvironment. This makes the education sector resilient and cushions K-12 operators in a downturn. In addition, students tend to remain in the same school for a few years, and schools closely monitor churn rates. This translates to stable and fairly predictable revenue, supported by tuition fee increases and new school openings, and keeps margins stable.

Regulation continues to be a key risk for growth

Compulsory education is highly exposed to regulatory changes in the different geographies of operations. For example, in 2021 Chinese regulators banned direct foreign ownership of private schools that impart mandatory education for Chinese nationals (versus international schools in China that educate non-Chinese nationals). This forced Nord Anglia to cease to control and deconsolidate its China Bilingual schools, which accounted for 5% of the group's total capacity that same year. In Dubai, the Knowledge and Human Development Authority (KHDA) prohibited fee hikes for schools for four years in a row, and the inability to pass through cost inflation placed pressure on school operators' margins. GEMS responded by focusing on cost efficiencies and delaying investments. Positively for GEMS, KHDA's March 2023 approval of a 3% fee increase for the 2023-2024 school year should alleviate some of the pressure. Also, we understand that potential changes into the value-added tax regiment for U.K. private school could impact revenue generation, particularly those with higher dependency on U.K. domestic demand. However, the impact on such a tax remains uncertain for now as there is no concrete announcement, most likely to be made after the next general elections, which are expected to occur later in 2024 (at the latest by January 2025).

We currently do not factor into our assumptions for the rated schools any pronounced changes in their respective regulatory environments. However, we do not rule out that regulatory changes could affect the sector's performance in the medium term.

Increasing geographic diversification partially mitigates regulatory risk

The education sector is characterized by high fragmentation with a large proportion of players with one or small number of schools in the portfolio and, in some cases, still owned by the founders. Our rated universe represents the largest players in the sector, and we view continuous consolidation on the market, with mergers and acquisitions (M&A) underpinning the growth strategy of most large players. This has allowed rated companies to expand their school portfolio into new geographies--a trend we think will continue--thereby creating diversification that reduces risks related to market concentration and regulations.

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Peer Analysis

All rated peers have recovered their pre-pandemic rating levels

The pandemic-related revenue pressure varied from entity to entity.   Cognita was more exposed to lower demand from expatriate students, especially from Singapore, because of the travel restrictions. Exposure to expatriates represented more than 60% of its EBITDA in 2019. Also, Cognita offered significant discounts in certain jurisdictions. Nord Anglia rapidly moved to online teaching education from February 2020 limiting the pressure without a notable effect on earnings, followed by Cognita and others shortly after. GEMS' earnings dropped mainly due to less revenue contribution from ancillary school bus services as schools moved online. Revenue from its schools, however, only took a mild hit since its enrollments contracted a mere 2.5% in fiscal 2021. Inspired's revenue were the least affected among its rated peers', largely because Inspired has relatively sizable exposure to local students and geographies less affected by COVID-19 restrictions, such as Latin America and Africa.

Same business risk profiles but different dynamics

Increasing size and geographic diversification carries some execution risk.  GEMS has the largest student base, with 138,000 students and a total capacity of 154,000 seats at end-November 2023. Although it is still highly concentrated geographically, with 44 of its 60 schools and over 90% of its students located in the United Arab Emirates, mainly Dubai, and Qatar. Strong demand lifted GEMS' revenue by over 10% in fiscal 2023 relative to fiscal 2022. However, the other three peers have continued its geographic expansion through M&A and further investments. For example, in October 2023, Nord Anglia acquired two Venues schools in New York and Brazil, and Cognita closed, among others, the acquisition of Repton in Dubai in 2023. Inspired recently completed the acquisition of Alpha Group in the U.K. Nord Anglia's revenue grew by about 25% in 2023, and both Cognita and Inspired experienced a nearly 50% increase, spurred by acquisitions in new markets, boosting their geographic diversification.

However, we note that recent acquisitions have been completed at higher valuation multiples, close to mid-teens, than historical cases of high single digit. Although we acknowledge the possibility of significant synergies, this aggressive M&A strategy also bears some execution risks that we factor into our analysis.

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Utilization has returned to pre-pandemic levels, while capacity and fee increases have contributed to revenue growth

All four peers felt utilization pressure during the pandemic, affecting those with a larger proportion of expatriate students the most. Since then, although utilization rates differ, they have all recovered strongly.

Nord Anglia has historically demonstrated the lowest utilization rates, below 80%. However, there are large differences from region to region. The low utilization rates in China continue to drag on the overall utilization following the regulatory changes in 2021, and the levels are still below historical levels in Europe. Cognita has rapidly recovered the 80% mark that it had in 2019 and Inspired increased its utilization to 85% in 2023 from nearly 75% in 2019.

In contrast to many other regions, the growth story in Dubai remained quite smooth. GDP growth was above 3% in 2023, backed by solid activity across the main economic sectors, which led to a rise in the population of about 3%, capturing an increasing expat population. As a result of increased demand and despite higher capacity, the utilization rates for GEMS hit a high 89.8% at end-November 2023, up from 83% trough in 2020. Most of GEMS' schools are present in premium and mid-market+ segments and operate at full capacity, with the historic oversupply in the premium segment in Dubai no longer weighing on the performance. We expect favorable demographic dynamics, as well as continuous focus from the management on improved utilization to lead to increased enrollments for all four rated peers.

The inflationary dynamics over the past 12-18 months have pushed rated companies to increase fees across all geographies, subject to some regulatory constraints, such as in the UAE. Although inflationary pressures have also affected the cost base of the group, especially teachers' wages, schools have managed to maintain, if not raise, the differential between fee increases and salary increases. This has allowed the companies to absorb other inflationary pressures such as energy costs and maintain stable margins.

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Cognita's EBITDA margins are still behind those of its peers.   Although Cognita's EBITDA margins rose to S&P Global Ratings-adjusted 23.0% in 2023 from adjusted 21.5% in 2019, it still remains largely below its peers with adjusted EBITDA of above 30% as of August 2023. Cognita has historically had a portfolio of lower-margin-generating schools. However, we note that recent acquisitions such as Repton in Dubai indicate a modest change in strategy to more margin-accretive schools. That said, we do not expect Cognita to reach EBITDA margins above 30% over the next three years, due to past greenfield projects and despite the evolving nature of the school portfolio. We expect that GEMS' EBITDA margin to expand closer to that of Nord Anglia, toward 32%-33%, reflecting mainly improved capacity utilization.

The highly acquisitive nature of the industry results in high restructuring expenses that might constrain profitability margins. We observed this when Inspired's EBITDA margins fell 350 bps to 30.4% in 2023. We expect Inspired's margins to recover toward 32% in 2024 based on acquisitions and synergies.

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We consider reputation, brand equity, pricing point, and market position as the key profit drivers.  School reputation is a top driver in consistent revenue generation and cash flow. When choosing a school for their children, parents tend to focus on the school ranking, grade performance, and access to better-known universities. All four companies actively expanded their portfolio to enhance their market position and three of them have recently acquired schools with distinct history, scale, and appeal to local markets. This allowed them to operate under distinct brand lines and offer different curricula or, even, language focus, which we believe gives them a competitive advantage versus smaller and less diversified players. Strong market position in any given market allows to further consolidate the brand equity and capitalize on the name, particularly in countries where public schools are scarce, and the sector is dominated by private operators.

Highly leveraged financial risk profiles with sustained pressure on cash flow

Due to high asset intensity of school operations, all for school operators carry significant debt burden including sizable lease liabilities and exhibit highly leveraged capital structures.  All the entities covered in this report have a highly leveraged financial risk profile, though there are visible differences on their leverage profiles. In the past, all entities have recurred to debt, in some cases accompanied of equity support, to fund expansion plans. This has included large M&A transactions and capital investment for greenfield and brownfield projects.

Cognita has historically been the company with the highest S&P Global Ratings-adjusted debt to EBITDA, which we now expect to drop to 8.0x by 2024 from 10.0x in 2023. Nord Anglia's leverage is affected by the presence of preference shares on its capital structure, which we consider as debt, given the fact that they are redeemable under certain circumstances such as IPO, default of debt or change of control events. However, we do not expect the company to redeem these in the short term. Excluding these instruments, we expect leverage to fall toward 7.2x in 2024 from 7.5x in 2023. Inspired Education and GEMS have historically reported the lowest leverage of the four rated peers, with adjusted debt to EBITDA of 5.0x-6.0x in 2023. However, we expect Inspired's leverage ratio to near 6.3x in 2024 following the recent additional debt raised through the add-on to the term Loan B as part of their M&A strategy. In contrast, we expect GEMS' leverage to continue to decline, towards 5.0x-5.2x in 2024. We expect all four entities to continue to reduce their leverage towards 2025 supported by the integration of the new acquisitions and increasing cash balances in the case of GEMS.

Nord Anglia is the only entity of those mentioned in this report that we considered to be owned by a financial sponsor. Therefore, as per our "Corporate Methodology: Ratios and Adjustments" (published April 1, 2019, on RatingsDirect), we do not net any cash balances from gross leverage to arrive to S&P Global Ratings-adjusted debt.

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Resumed capital expenditure (capex) amid higher interest rates will limit free operating cash flow (FOCF) despite our expectation of increasing profits.  After COVID-19-related disruptions caused some capex delays, industry players have been returning to, or surpassing, historical levels of capital investment and expansion as they accelerate growth strategy. Improved demand and rapidly increasing utilization rates of some existing assets are driving investment decisions. Still, school operators are facing oversupply in most of their markets, as evidenced by an average utilization rate of about 80%. As such, we expect the groups will focus their investments on the most profitable school models and key geographies, as well as steadily adding capacity in already well-established assets, which tend to be less risky investments.

Inspired has a significant pipeline of greenfield and brownfield projects that could require capital expenditure of up to 20% of revenue in 2024 (after similar amounts in 2023). This is higher than other rated companies. We expect GEMS to invest 10%-12% of its revenue in capex in 2024-2025, up from 8% in 2023, and that Cognita will invest 10% in 2024 (in line with 2023) as it pursues increasing capacity in key geographies such as the Middle East, before spending normalizes at 7%-8% in 2025. Nord Anglia's investment remains at 6%-7% of revenue as the group continues to build capacity in targeted areas to enhance its offering.

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The aggregate interest expenses rose about 45% in 2023, due to higher interest base rates and new debt to fund acquisitions. This is despite the interest rate hedges both Inspired and Cognita had in place. We expect interest rates to remain high in 2024 and forecast the cumulative interest expense to rise 10%-15%, dampening potential FOCF gains for all the four entities.

FOCF after leases continues to be a key area of focus given the large lease portfolio usually found in this industry. Factoring in higher interest expenses and higher capex for all four companies, we expect that higher EBITDA will not translate into higher FOCF after leases for 2024). We anticipate only a small recovery in 2025, when we expect the combined capex for the peer group to decline 15%-20%. There will, however, be pronounced differences across this peer group, with Inspired and Cognita slowing down their growth capital investment. FOCF will remain weak for both players. We assume Cognita will see only marginally positive FOCF in 2024, while Inspired will continue to see negative FOCF after leases in 2024, as it did in 2023, because of their high discretionary capex. Despite higher capex, we expect that GEMS will generate annual FOCF of $50 million-$90 million in 2024-2025.

Privately Owned Means High Tolerance For Leverage

All four companies are privately owned, explaining the relatively higher leverage tolerance as they expand in the fragmented market.

Family shareholders hold majorities at Cognita and GEMS, with Jacob Holding owning 60% in the former and the Varkey family owning 60% in the latter. We view these shareholders as strategic owners given the long-term horizon of the investment. Inspired was founded and is de facto controlled by Mr. Nadim Nsouli; we therefore do not view the company as financial sponsor-owned despite the presence of some minority shareholders that we typically view as financial sponsors. This is similar to our view on the 35.5% minority stake held by private equity fund CVC Capital Partners in GEMS. Meanwhile, Nord Anglia was acquired in September 2017 by CPP Investments and funds advised by Hong Kong-based private equity firm Baring Private Equity Asia Ltd. (BPEA, now part of EQT).

We deem all four ownership structures as moderately negative under our recently revised criteria, "Management And Governance Credit Factors For Corporate Entities" (published Jan. 7, 2024), given the high tolerance for leverage. For Inspired, Cognita and GEMS, we also note the overlap between the shareholders, the founders' and their relatives' executive functions in their respective companies, as well as the oversight function via board seats of some family members.

Revenue Growth And Stable EBITDA Margins Ahead

We expect Nord Anglia, GEMS, Cognita, and Inspired to continue to benefit from revenue growth and stable EBITDA margins over the next two years, on the expectation of further consolidation in the market, fee increases and improved utilization. However, exposure to different economic outlooks across the various geographies, as well as a varying degree of competitive pressure from supply and demand dynamics, suggests the school operators' growth prospects will also differ. We expect that significant investments into new and existing assets, continued M&A, and higher interest expenses could cramp the companies' deleveraging efforts over the next 12 months and hinder their ability to convert strengthening EBITDA into higher FOCF after leases.

The stable outlooks on the long-term ratings on these school operators indicate that each company is well positioned within the thresholds for the respective ratings. Still, on one hand, increasing leverage or persistent negative FOCF could hurt their credit quality. On the other hand, solid and sustained FOCF after leases and a clear deleveraging path, including a supportive financial policy, would be credit positive. We see geopolitical tensions as a major tail risk, particularly in the Middle East, if the situation were to escalate. This, however, is not our current base case.

Related Research

• Full Analysis: GEMS Menasa, March 21, 2024
• Tear Sheet: Nord Anglia Education (Bach Finance Ltd.), Feb. 21, 2024
• Inspired Education Affirmed At 'B' On Proposed Add-On For Acquisitions And Good Underlying Performance; Outlook Stable, Feb. 9, 2024
• Lernen Bondco (Cognita) Affirmed At 'B-' On Additional Liquidity And Good Operating Performance; Outlook Stable, Feb. 6, 2024
• Nord Anglia (Bach Finance Ltd.) Proposed $600 Million Term Loan Add-On Assigned 'B' Issue Rating And '3' Recovery Rating, Feb. 6, 2024
• Tear Sheet: GEMS MENASA (Cayman) Ltd., Nov. 23, 2023
• UAE Schools Operator GEMS MENASA Upgraded To 'B' On Positive Enrollments Traction And Reducing Leverage; Outlook Stable, Feb. 17, 2023
• Dubai's Debt Reduction Strengthens Government Balance Sheet, May 22, 2023