Hedge Fund Quiz: Economies of Scale

Economies of scale.

If costs per unit decline as volume increases, because fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent firm operating at large scale will enjoy lower costs than its competitors.

Edison Schools IPO’d at $18 per share and now it trades near $14.   Your boss runs in and throws the Edison School’s 2001 annual report on your desk and a top-rated analyst’s report on Edison.   “Get back to me in thirty minutes on what should we do: Buy a boat-load of stock, buy some, buy a little, short or stand aside?”  Your Boss says that management owns a lot of stock along with “smart” money.

You glance at the analyst report:

Greg Capelli, MBA, at Credit Suisse First Boston issued a $30 dollar price target in his fifty-page report.   Capelli says that Edison Schools is extremely undervalued because of “first-mover advantage” and “INCREASING OPERATING LEVERAGE THROUGH ECONOMIES OF SCALE.”

As a refresher you whip out Greenwald’s Competition Demystified:

LOCAL CHAMPIONS

In an increasingly global environment, with lower trade barriers, cheaper transportation, faster flow of information, and relentless competition from both established rivals and newly liberalized economies, it might appear that competitive advantages and barriers to entry will diminish. The fate of once powerful American firms in industries like machine tools (Cincinnati), textiles (Burlington Industries, J. P. Stevens), and even automobiles (Chrysler, GM, and Ford) seems to support this position. Either profits have shrunk or companies have disappeared entirely under the onslaught of imports. But this macro view misses  one essential feature of competitive advantages—that competitive advantages are almost always grounded in what are essentially “local” circumstances.

Consider the history of Wal-Mart, one of the greatest economic success stories of the late twentieth century. The retail business, especially discount retailing, is not an industry with many trade secrets or rare skills. The practices for which Wal-Mart is known, like “everyday low prices” and efficient distribution, are hardly proprietary technologies, impossible for other firms to duplicate. Yet Wal-Mart has successfully dominated many, although not all, of the markets in which it competes. The way in which it achieved this position is instructive.

Wal-Mart began as a small and regionally focused discounter in a part of the country where it had little competition. It expanded incrementally outward from this geographic base, adding new stores and distribution centers at the periphery of its existing territory. The market that it dominated and in which it first enjoyed competitive advantages was not discount retailing in the United States, but discount retailing within a clearly circumscribed region. As it pushed the boundaries of this region outward, it consolidated its position in the newly entered territory before continuing its expansion. As we shall see, when it moved too far beyond its base, its results deteriorated.

An Analyst ALWAYS ASKS:

OK, now you dig in quickly to the Edison Schools AR_2001

What do you say to your boss?  Your comments should be no more than a sentence or two of explanation backed up by a few simple calculations.   Besides the financials, what do you point out in the annual report?   Take no more than twenty minutes.   You go immediately to the important data and disregard the rest.

Address Capelli’s “First Mover Advantage” comment.

Next week, I will post analysis.

AFTER you have answered, you can see the future for investors in Edison:  https://youtu.be/QUYKSWQmkrg

UPDATE 4/17/2017

ETF Insanity is destroying price discovery–opportunity will return.

https://vimeo.com/209940152/f2154e4d3d

15 responses to “Hedge Fund Quiz: Economies of Scale

  1. Hey John,

    Long time reader and forum contributor, non-professional personal investor. I time-capped myself at 20 min, and here’s what I came up with, would love to hear any tips or ideas:

    My one sentence report to my boss:

    “We should buy a little stock because while the revenues are increasing and they’re headed towards a first up year with real earnings, the economies of scale are not there in the actual report.”

    Here’s my reasoning behind this assessment:

    Reading a 10k efficiently means reading the overview from management, and then checking the balance sheets to see if their story is corroborated with the real numbers. The big thing they marked was a massive increase in revenue, due to large part a massive increase in the number of schools they operated on, but here’s the problem: their “economies of scale” don’t seem to exist, not nearly as large as the analyst is making it out to be. I wouldn’t be surprised if that analyst is already in a large position and is forcing a strong buy to pad his own returns.

    For example, revenue increased 60%, but the liabilities grew quite a bit as well. And they even explain this too: their biggest expenses are overhead (salaries, supplies) and building leases. They claim their economy of scale is in clustering schools, so they could share resources, but the numbers don’t tell that story: each school needs a requisite number of teachers and administrators, and the school buildings need to be leased. Those numbers seem to grow roughly at the same rate as their revenue does, but not quite. Their net losses are decreasing, and they should be profitable in 2-3 years (roughly 2003-2004), which is promising if we value the company based on earnings potential alone. But then we look at free cash flows, and that is remaining negative, in spite of growing their cash reserves by double. How can they have so much extra cash and yet not create a considerable difference in cash flow?

    Therefore, it seems to me like the path to success could be realized in a few years, which is the perfect landscape for a value investor, so there does seem to be a case for a modest return here, but the lack of FCF and disappointing numbers relating to economies of scale don’t provide the catalyst to really go all in, and I think we’d have a better use of capital in other investments. My personal believe in realizing true value here would come from repurposing two of their biggest expenses into assets:

    1. Pay their people less (we know that won’t end well)
    2. Stop leasing the schools and start buying the buildings/landing – use the McDonalds and Equinox model. They go from being just a school company to a real estate company, where the liabilities in leases turn into assets in appreciating equity, but of course that requires a higher up-front cost. But with so much extra cash at their disposal and their focus on wanting to be an R&D company, I can’t imagine that would be such a stretch of an ask for them to invest a bit more money into reversing one of their biggest issues.

    • OK Adam, you put a lot of thought and hard work into this. C+. Don’t fret, as a beginner, I would have told my boss, I only buy what Jim Cramer touts on CNBC.

      Seriously, without signs of improving margins on sales growth or a look at their regional density of schools/facilities, then you are guessing at future economies of scale.

      A Pass.
      See my next post discussing this example. Also, the other comments on this case are excellent. Read those carefully.

      Keep at it!

  2. Pass on Edison Schools. This is not a business that can produce sustainable competitive advantages from economies of scale. Running schools is a local business with primarily variable costs — 76% of Edison’s costs are “direct site expenses” associated with individual schools, whereas “fixed” administration, curriculum and development expenses are only 14% of costs.

    On a school level, Edison is profitable and has generated a consistent 14-17% site-level margin over the last 5 years even though student enrollment has grown from 7K to 57K, which is reflective of limited economies of scale at the local level. Despite being able to leverage corporate overhead through its growth phase (corp expenses as % of revenue have declined from 33% to 15% over L5Y), Edison is still unprofitable at a corporate level, and had EBITDA of negative $83K per student in the most recent year. They haven’t turned a profit since they’ve been in business, which obviously results in a dismal return on investor capital. Using conservative assumptions (5% growth in revenue per student, 17% site margin, only 5% growth in fixed corporate costs – despite 46% CAGR over L5Y… , and D&A / pre-opening expenses growing in-line with student growth), my rough math suggests that Edison will need to nearly triple its student base and have corporate costs decline to 5% of revenue, to show a positive pre-tax net income.

    Where Capelli’s analysis and management’s sales pitch are flawed is in their belief that significant economies of scale will materialize. Schools are a local business, and so the costs of opening new schools, running them and growing volume are variable based on the number of schools you operate. You can’t leverage fixed costs by growing the number of schools, which has been the source of their explosive growth. In 5 years, they grew from 4 schools to 113 but school-level margins were flat. Fixed costs are a small portion of the business, so they won’t move the needle on opex as enrollment grows. Fixed cost leverage will be a small driver of returns– economies of scale can’t be the main thesis. Per the company’s pitch, perhaps national scale and centralized R&D and support systems help Edison outcompete local school districts and provide better service, but it’s ultimately highly unlikely to generate a cost advantage.

    Also, I’d question Capelli’s presumption that first mover advantage will create long term value. First mover advantage isn’t a competitive advantage in an industry without real barriers to entry, and economies of scale clearly isn’t one of those here. (I believe) anyone can become a new private school operator, and they would compete away any excess returns that the first mover enjoys.

    Ultimately Edison operates in a local business and its fat corporate overhead will not realistically create a profitable enterprise regardless of how many new schools they open in the next few years. Instead of having 14 operational vice presidents and operating in 21 states and DC, perhaps they should follow Walmart’s model of creating local monopolies. A more targeted clustering strategy could potentially create the scale economies they’re seeking.

  3. Economies of scale are limited by student to teacher ratios, students to school ratios. Highly regulated environment. Unionized workforce. Account receivable growth is off the charts. Cash conversion cycle terrible. They have tapped the capital markets nearly every year for the past 3 years. Negative CFO. Check out the common size income statement on page 31 (page 36 of the pdf). Direct site expenses how failed to show meaningful improvement despite the significant growth in students. It has remained steady at 84%-86%. If economies of scale existed this expense should be showing large decreases, but it’s limited due to the ratio of students to teachers and students to school. The only evidence of economies of scale is in the improvement of administration, curriculum and development expenses and it seems that any further improvement in that area is highly unlikely. Being able to use the same curriculum for every school/student is where the economy of scale exists. The excess cash is from continued dilution of existing shareholders. Operations are burning cash and net working capital is increasing at a rapid rate. This is a great short candidate.

  4. Hi,
    I also did not see any proof about any economy of scale.
    As for the first mover advantage.. I guess they could have an advantage if their business model proves/proved successful. But the profitability and the economy of scale is not there yet and that may be the reason that the stock traded at $14 and not $30.
    I don’t think it makes sense that a business like that would have a great economy scale. To expand you need more properties and more employees. Running schools is not so flexible I’d imagine.
    I’d wait to see how things develop.

  5. One of my favourite blogs John. Please keep it up.
    I’m a learning (not professional) investor – any feedback is welcome.

    First mover but they acknowledge growing competition, which will increase downward pressure on already nonexistent profit margins.

    Expenses growing at larger percentage than enrolment so highly questionable economies of scale.

    Expanding into other states with different law. Same approach may not work in states like NY.
    Existing legal proceedings
    Partly self insured
    Similarly with expansion into high schools

    Not profitable
    Don’t count depreciation and amortisation in their key metrics – eg gross contribution
    Don’t count training etc as costs
    Considerable stock based compensation diluting equity
    Extended term of stock options – as above and shows misaligned interests
    Not counting stock compensation when calculating % operating costs to total revenue

    Two tables show different operating losses? – one consistent losses p27 and the 2nd shrinking p31

    Agreements can be terminated by customers.
    Real estate investment is potentially not their speciality.

    Notes receivable growing rapidly?

  6. Had a very quick glance here are my thoughts:
    1. The company is in losses but the losses are declining. Why?
    2. They are gaining scale (revenue grew 10 x in 5 years, multi-fold increase in students) AND overall costs as %age of sales are declining – esp Admin/curriculum costs have gone down from ~35% to ~15% in 5 years. Of course, it makes sense that curiculum development is a fixed cost whether you have 5K students or 50K.
    3. A challenger would need such huge scale to get profitable, hence Edison may have first mover advantage.

    Points to look for more details:
    Given you need huge scale to be profitable, Is the market big enough to support more players?

    • Great unit based analysis. I would have focused on the density of their schools in particular regions, but you got there another way.

      Shorting: This rallied up to $20, before sinking to a premium take-out price of $1.76 per share. You were right.

  7. This is a pass, based on some simplistic analysis. The two key variables for me are revenue/student and net loss per student, the difference between the 2 being the total cost per student.
    In 1996:
    Revenue/student: 5,393
    Net Loss/student: (1,597)
    Total Cost/student: 6,990

    In 2001
    Revenue/student: 6,593
    Net Profit/student: (668)
    Total Cost/student: 7,261

    In 5 years, their total cost/student has actually increased 5%, despite a 697% increase in enrollment – this looks like economies of scale are non-existant.

    Further, if their business model is based on generating an ever increasing amount of $/student in revenue, they will hit a wall – there is only so much money they can extract from local governments for providing these services before they become uncompetitive with the existing model. They could try cutting costs, but given that their largest costs are teachers and building leases, this is probably not likely.

    One thing I considered is that they could increase profit through driving utilization – given that their cost structure is largely fixed, perhaps they could increase the number of students per building – most of this incremental revenue would flow directly to the bottom line. PROBLEM: there are waiting lists at a substantial portion of their schools – they are already running at capacity, so this won’t fix their problems.

    If I had more mettle, I would probably recommend a short. However, given that this was 2001, and stocks had just enjoyed an unprecedented (and irrational) run up in value, I would recommend a simple pass.

  8. First mover advantage can be valuable when returns are above cost of capital, however competition will gradually reduce the returns over time, generally to the cost of capital. The key is to first mover advantage is the high ROIC, returns above cost of capital.

  9. Pass. The company is losing money with no evidence of economies of scale in the numbers. Realizing such economies seems improbable given their business model and the heterogeneous nature of public schools in the USA, to say nothing of the politics, unions, etc.

    At first glance, you’d think the business would look better financially because they’re not constructing schools, just managing/”improving” existing ones. But consider this from the report:

    “Our management agreements typically provide for the district or charter board to maintain ultimate oversight and supervision over the school. In addition to regular reporting requirements and the ability to terminate the management agreement on performance grounds, such oversight may take several forms, including the right to reject Edison’s candidate for school principal and the right to make adjustments to the curriculum.”

    The company has a lack of control, plus there’s “friction” and considerable variance from district to district due to the localized nature of public schooling.

    Returning to Greenwald, I don’t see how they can consolidate their position, realize efficiencies, and “conquer” new territories (a la Walmart) given that local control of schooling is *designed* to resist consolidation, even if the Federal Government sometimes tries.

  10. John,
    When I had a longer look at notes receivable the company provides financing to schools and acts as guarantor. And the interest rates the company provide to schools looks lower than those they’re receiving from the likes of their suppliers like IBM. Seems like the equivalent of channel stuffing.
    On page 62.
    $28 in 2000 to $61 in 2001
    In order for the loans to be repaid, the Company generally assists charter school boards in obtaining thirdparty lender Ñnancing. Often third party Ñnancing requires the company to guarantee loans

  11. Dear James:
    I will comment in a day or so. The big question is whether this company has economies of scale because growth financed by debt without competitive advantage can turn into disaster if the firm can’t earn its cost of capital.

    You may be right, but let’s focus on competitive advantages–but thanks for your insight.

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