Thinking Points

  • Recently IPO’d Surala Net (TSE: 3998) caters to underperforming students which have historically been ignored by private education companies.
  • The company’s franchising, B2B2C business has allowed it to quickly gain traction as an E-learning platform for cram schools in Japan.
  • Surala is already profitable with a long runway for growth both in Japan and internationally.

Note: I decided to write about Surala Net because our fellow Kenkyo Premium member, Paul, asked whether I had heard of the company recently. After a few minutes of reading, I took a liking, and continued reading for another couple of hours. Paul shared a Nikkei Asian Review article that gives a good introductory picture of the company. I would recommend reading that before continuing with this article. There will be some overlapping information here, but I think you’ll find this article useful overall.

Overview

Surala Net (TSE: 3998) offers e-learning solutions, primarily to schools and cram schools. These e-learning tools come with a couple key functionalities like animated instructions to keep students engaged, and algorithms to identify weaknesses and tailor curriculum to individual needs. While simple, Surala’s offering addresses a market which was historically neglected by cram schools: The underperforming student.

Education in Japan

Most people who completed formal education would probably agree that progress in a classroom setting generally moves at the pace of the slowest student. The stands true in Japan. Now, the typical outside-of-school educational offering in Japan primarily comes in three forms:

  1. Cram school (supplemental, after-school classes offered by private organizations, usually to prepare students for high school and college entrance exams)
  2. Private tutor
  3. Correspondence Program (Additional instructional material, usually either through mail or online)

To give you an idea, here is broadly how education works in Japan. High schools and colleges both have entrance exams. In order to get into good schools, students need to score well on standardized tests/entrance exams. In order to score well, parents pay for educational programs outlined in the bullets above.

These programs are often expensive.

Although a little dated, a 2008 Japan Ministry of Education, Culture, Sports, Science, and Technology (MECSST) study showed that over 70% of middle school students were enrolled in an education program outside of school. Cram schools, which are the most common form of outside-of-school education programs in Japan, costed 26,000 yen (or $240 USD) per month on average.

Imagine being a parent to an underperforming child while holding a job that puts you in the poverty-level income bracket. Pretty tough.

Surala is trying to cut into this group of underperforming children.

Wait, but why?

While Surala itself caught my interest, I also found Sulara’s founder-CEO Takahiko Yunokawa’s background very interesting.

Before Surala, Takahiko worked for Venture Link (Now C&I Holdings), a company which made its name by building small businesses into franchises. A few notable franchises include: Tully’s Coffee (Coffee shops), Curves (Fitness), and Gulliver (Used car sales). The company’s reputation is bittersweet, with a series of franchisee lawsuits followed by a bankruptcy in 2012.

Nevertheless, Takahiko spent time building out franchises, which he talks about in a 2013 interview with Amateras (Japanese). He mostly worked on food service franchising operations until 2004, when Venture Link started supporting a cram school franchisor.

After analyzing the cram school industry, Venture Link (along with Takahiko) decided to open one cram school franchise location to get hands-on experience. Within a year and a half, the cram school had one of the largest student base in the country. It was a major business success, except for one big problem: student grades weren’t improving.

Venture Link discovered a key structural problem while operating its cram school. The teachers were mostly college students and the quality of education delivered was all over the board. In 2005, with hopes to solve this problem, the company decided to try its hands at e-learning. In 2007, part of its e-learning system was ready for deployment and the company set up its first e-learning only cram school in Tokyo. This is the birth of Surala.

With no reputation in the industry, the new cram school ended up collecting a group of underperforming students. The big names in the industry had already taken all the high performing students whose parents had deep pockets.

One day, a student with failing grades commented:

“This is the first time I’ve ever enjoyed English class”

That’s when Takahiko started seeing the value of Surala in society.

Surala’s independence and franchise structure

The year 2008 would still be considered the early days in Educational Technology. Venture Link had built the Surala platform, but the large overhead combined with a limited scale made it difficult for Surala to turn a profit. In fact, the company was losing 7 billion yen ($650,000 USD) per year. Meanwhile, Venture Link’s main franchise support business was under distress. At a time when Surala needed increased funding for development, Venture Link was unable to deliver. In 2009, Takahiko started thinking about separating Surala from Venture Link as a standalone business. A year later in 2010, he organized a Management Buy Out (MBO) with Globis Capital Partners.

The company marked its first profitable year in 2013.

Surala has been working on a franchise system of its own. Unlike most franchisors, which require all franchisees to put up money in order to set up shop, Surala waives this requirement for independent business operators. The reason for this comes directly from Takahiko’s experience with Venture Link. Regardless of industry, the biggest complaint from new franchisees was that the franchisor’s story changed once the franchise contract was signed. Though most established business operators can handle the front-heavy time and capital investment to get the franchise location up and running, this is often a major source of stress for independent business operators.

Takahiko found a structural problem. For the franchisor, the upfront payment from franchisees is a big source of revenue. In many cases, franchisors setup a sales team specifically for bringing new franchisees in. Of course, these sales teams have a revenue target to meet – an incentive to highlight the bright side of owning a franchise and no real reason to talk about the down side. Hence, there is a misalignment of incentives wherein the franchisee often feels like they got the short end of the deal.

In Surala’s case, the employees recruiting new franchisees also support the franchisee once contracts are signed. The deals are structured so that the franchisor either makes no money or very little money until the franchisee is profitable. With this structure, Surala HQ has more incentive to support franchisees. This also means that an increase in franchise locations doesn’t immediately convert to more profit – something for investors to keep in mind.

Current operations

As of the end of 2017, Surala is used in 561 cram schools (12,696 IDs), 132 schools (18,912 IDs), and 594 individual IDs. Here is a quick summary view from the most recent filing:

 

 

The total figures don’t quite add up. This is because Surala has international operations – 23 schools combining for 1,810 IDs (vs. 998 last year), mostly in Sri Lanka and Indonesia. The company also reported 691 IDs as “Other”. I’m not quite sure what this is.

Here is a chart showing the number of schools and IDs over the past 8 years up to September 2017:

Notice that there are two types of billing for schools: per ID and per campus. This is pretty straightforward. The per ID schools bill according to the number of students enrolled. An increase in IDs for schools with per campus billing does not generate any additional revenues.

Also notice that the ID count for per ID billing schools has increased consistently over the last 8 years. In the footnotes of both Surala’s December 2017 publication and FY 2017 filing, the company notes that new school franchises are all billed per ID. The per campus billing schools all carried over from when Surala was a part of Venture Link/C & I Holdings. In other words, don’t mind any fluctuation in ID count for per campus billing schools, but pay close attention to ID count for everything else.

The company has not yet reported any sort of KPI on third party content, but it outlines a service flow chart which shows that it at least plans on offering third party content down the line:

Source: Surala IR

Interestingly, one of the largest correspondence education companies in Japan, Benesse Holdings (TSE: 9783) owns 6.59% of Surala.

Japan’s Ministry of Economy, Trade, and Industry (METI) provides interesting data on cram schools:

As for schools, MESST provided useful data:

Unsurprisingly, Japan’s student base is shrinking. That said, Surala has only been installed in 1.2% of cram schools and 0.04% of schools. There is still plenty of room for expansion within Japan. CEO Takahiko had previously commented that the per student margin is much higher in Japan compared to SE Asian countries like Indonesia or Sri Lanka, but the SE Asian countries have considerable growth opportunities, especially since cram schools are still a new concept.

IPO and current metrics

Here is the outline of initial listing from the Japan Exchange Group. As of December 18, 2017, the company was listed on the Mothers (Market of the high-growth and emerging stocks) section of the Tokyo Stock Exchange. Offering price per share was 2,040 yen (2,454 M yen, $23 M USD market cap). First quote came in at 4,345 yen (5,227 M yen, $49 M USD market cap). At February 23, 2018 closing, the stock traded at 4,915 yen per share, or 6,122 M yen ($57 M USD) in market cap.

Source: Tokyo IPO & Nikkei

Normally, I would look at the elevated valuation multiples and discard the company as an actionable investment quickly. Though the 69 PE multiple still is intimidating, Surala has already surpassed its breakeven point with its 1.2% cram school and 0.04% school share in Japan. Additionally, the company already started laying the groundwork for a competition-less SE Asian market. I don’t think the high multiple is particularly crazy given Surala’s track record as a real business generating real income and projecting real growth.


Kenkyo Investing
Kenkyo Investing

Kenkyo Investing applies a value investing approach to Japanese equities, providing insights that are often unavailable to non-Japanese speakers.