A mountain to climb ■ A bad outcome and further questions but a viable business: A hit to management credibility is one of the potential side-effects facing VET in the aftermath of a negative DEECD review outcome. We previously felt a key risk was that the review could reveal wider-ranging compliance issues, but believed this was unlikely; clearly, we were wrong. While we don't think state governments are necessarily influenced by RTOs in other states, we recognise potential 'contagion' risk for the brand, mitigated by the elimination of third-party training and assessment and the new Quality Advisory Committee. Attempting to look through the fallout, three questions are important: 1) do industry trends remain supportive, 2) does VET has a viable business and 3) if so, if there is value at the current stock price? We believe the answer is yes to all three, but concede VET has a mountain to climb in order to prove this and that the length of time required is far from clear. ■ Conclusion of DEECD review: In a much worse outcome than previously expected, VET reached a settlement with the Victorian DEECD on the review of two RTOs. As a result, VET will forfeit $19.6mn of funds ($5mn EBITDA impact) with further impact from lower than expected Victorian enrolments during this period and restructuring of the outsourcing (Solutions) business. Positively, VET was awarded a new DEECD contract (we believe this is meaningful) and confirmed it has equivalent scope in the RTOs that weren’t reviewed. VET guided to FY15 reported EBITDA of $53- 57mn (from consensus of ~$63-64mn). ■ Earnings and valuation: Negative EPS revisions of ~17-18% across the forecast period and changes to our valuation to take into account residual uncertainties results in our target price moving from $3.30 to $1.55.
DEECD review
■ As discussed in previous research notes, VET had over the course of the last two months indicated that it expected an immaterial outcome from the Victorian Department of Education and Early Childhood Development (DEECD) review of three qualifications for which VET received funding.
■ During the course of the review (and consistent with typical industry practice), funding to the two (of four in total) Victorian Registered Training Organisations (RTOs) that delivered the qualifications (Cert III in Warehousing Operations, Cert III in Competitive Systems & Practices, Cert II in General Education for Adults), namely BAWM and Aspin, was put on hold.
■ The review related to VET's Solutions business (involving outsourced third-party training providers) as opposed to the Direct or Enterprise businesses.
■ During the course of the review the Board was consistently advised that the issues raised by the DEECD were able to be resolved without a material impact on VET. We understand that management placed some reliance on both senior management in the Victorian business and the view of independent industry consultants in forming this view.
■ This was consistent with feedback we received from experienced industry observers.
■ However, the DEECD ultimately concluded that over-reliance on third parties to identify and refer students resulted in some students being enrolled in courses inappropriate for their needs, and that there were inadequate controls in place to manage third parties delivering training and assessment, resulting in lower quality training than intended for students' job-seeking needs.
■ The DEECD required a larger payment from Vocation than expected to settle its concerns, with VET choosing to forfeit $19.6m in funds rather than extend the review for a further period.
■ VET will receive $9mn in previously withheld funding and the EBITDA impact of the forfeited $19.6mn is expected to be ~$5mn.
■ While BAWM and Aspin will continue to train currently enrolled students (under normal funding arrangements), as part of the review finding both will relinquish their funding contracts at the end of training of current students (expected early 2015).
■ All new enrolments in Victoria are being consolidated under Vocation's two other RTOs, which have equivalent scope (i.e. the necessary accreditation) for the Victorian operations.
Business and financial impact and risks
■ VET has decided to restructure its business model in Victoria to eliminate third-party training and assessment providers (this model was never applied in other states). While this remains common industry practice (and fulfils a necessary role in some aspects in our view), our read is that VET has concluded that the risks associated with outsourcing/partnership model are unacceptably high.
■ A transitioning process had already been in place to an extent from FY15, but VET has effectively accelerated the restructure. We expect that VET will seek to use some of the providers more as a student acquisition channel with VET having control of the crucial functions of systems and processes around assessment, training and outcomes
The overall financial impact stemming from the review outcome and related business decisions led to VET providing guidance for FY15 EBITDA of $53-57mn, which represents a ~$6-11mn downgrade relative to consensus expectations at the time of ~$63-64mn.
■ The negative parts of the outcome include the $5mn impact from the funds forfeited as well as the effect of lower than expected Victorian enrolments during the period of the review and the impact of restructuring the Solutions business.
■ Offsetting the expected negative impacts to an extent are the other two RTOs (with equivalent scope—i.e., these can offer the same qualifications, but directly through Vocation) as well as the award of a new DEECD contract (under the Building Brighter Futures program), which we believe could be meaningful in size.
■ We take some comfort from the fact that the DEECD awarded Vocation with a new (out of cycle) contract and read this as a statement of support for Vocations direct training business.
■ One of the inherent potential risks to the outlook is the extent to which VET is successful in restructuring the Solutions business. We believe that outsourcing (also commonly known as auspicing) is unlikely to be banned but that standards are being tightened and that a paucity of alternatives may prompt the previous third-party providers to embrace the new model.
■ While there are many moving parts to the expected impact, we estimate VET could be allowing for a ~$6-7mn hit on the Solutions business – i.e. for this amount to not be successfully captured into the in-house business.
■ We understand VET is not contractually obliged to pay third-party providers for the costs (training etc.) associated with the funding withheld as part of the settlement, but this could be a residual risk.
■ Another potential risk is potential contagion, or reputational damage, to the brand and/or other parts of the business. Clearly this cannot be dismissed, but as far as Victoria is concerned we believe the new contract as mentioned above is at least some sign that the DEECD is happy with the ex-Solutions business.
■ We are not convinced that other state governments will necessarily pay a lot of attention to what happens to unrelated RTOs in other states in making their own funding and contract award decisions, but again concede this has to be seen as an inherent risk.
■ As part of the restructure of the Victorian business, VET has implemented an overhaul of the senior management team in Victoria, including the appointment of Ross Robinson (ex-Real) taking over as CEO of Vocational Education and Training and overseeing the restructure.
■ The recently established Quality Advisory Committee (chaired by Claire Field and reporting to the Vocation board) should help mitigate the risk of contagion in our view.
Earnings revisions and valuation
■ Our revised FY15 estimates sit in the mid-point of the EBITDA guidance range.
■ While some of the items are non-recurring in nature (the impact of the funds forfeiture and the costs of restructure), we have not at this stage adjusted for these items. Were we to do so, we believe 'normalised' FY15 EPS would be closer to 17.4cps compared to our current 15.3cps estimate.
We believe the higher education business (at least $24-25mn EBITDA in FY15) is growing very strongly, underpinned by VET-FEE-HELP, and that Queensland is also performing well under the new entitlement funding system.
■ Press reports have started to comment on the outcome of the NSW funding contracts. We do not know how Vocation will fare in this regard, but suspect that it may be limited by confidentiality arrangements in terms of disclosure. We believe VET's guidance factors in very little upside from NSW in 2H15.
■ We have taken a view that VET can grow earnings in FY16, underpinned by the same industry trends we have previously discussed. The risks to this outlook include those discussed above as well as inherent regulatory risk.
VET Price at posting:
96.0¢ Sentiment: Buy Disclosure: Held
