This IPO Flunks The Close Scrutiny Test

Whatever its ultimate merits, the federal No Child Left Behind Act education reform has already achieved what I had imagined to be impossible: It has expanded the universe of anxieties plaguing parents. The NCLB promotes "high-stakes" tests -- the sort that if kids fail, they may get to spend a second year in third grade or to exit high school without a diploma.

To give their kids a boost, more parents are paying for tutors. That's a reason such test prep outfits as Princeton Review (REVO) saw sales in its elementary- and secondary-school segment soar by 72%.

Now here comes Educate, the Baltimore parent of the nation's leading tutoring chain, Sylvan Learning Centers, with 1,039 outposts in North America. Led by Goldman Sachs (GS), Educate aims soon to sell stock in an initial public offering estimated at $225 million. Given Sylvan's good reputation and the fast growth in supplemental educational services -- more of them now sold to public schools and funded by the feds -- you might be tempted to ask your broker for shares. My advice: Don't. I say that not because Educate isn't growing. First-half revenue rose 33%, to $169 million. But when you think about Educate, don't forget your ABCs.

A as in Audit Committee. In many IPOs, selling stockholders don't give up control. They aren't in this case, either, as Educate's chief owner, private equity firm Apollo Advisors, plans to keep 53%. An example of this control is Educate's decision to wait up to a year to comply with a rule that only independent directors serve on the board's audit committee. Instead the panel will be headed temporarily by an Apollo principal until the board finds the right outsider. Kevin Shaffer, Educate's chief financial officer, said this is a "critical position," so the board is conducting a thorough search. He hopes it will be done within six months.

B as in Balance Sheet. Of the 15 million shares set to go in the IPO at an estimated $15 each, 10 million are being dumped by current owners, principally Apollo. None of the proceeds will go to Educate, which figures to net just $67.5 million. All of that is going to repay some of the debt the company took on when Apollo acquired it. Educate owes this money to a syndicate of lenders, including three of the IPO's top underwriters, J.P. Morgan Chase (JPM), Merrill Lynch (MER), and Bank of America (BAC). Assuming all goes as planned, Educate still will owe long-term debt of $106 million -- all of it at variable interest rates. Some of that risk is hedged via interest-rate swaps. But as its registration statement notes, if rates go up, "our interest expense would increase, our ability to borrow additional funds may be reduced, and the risks related to our substantial indebtedness would intensify."

C as in Cost. The IPO is set to value Educate at some $790 million. That is, $639 million in equity value, plus the $152 million in net debt now on its books. Is that reasonable? We have a couple of points of comparison. The first is Princeton Review, which has no net debt. The market values its equity near $195 million, or 1.7 times revenue over the past four quarters. Educate is set to sell its stock at 2.8 times trailing revenue. Next we can look at what Apollo paid for Sylvan's operations, which form the bulk of what is now Educate. Apollo's purchase closed in June, 2003, at a price of $283 million. That was 1.3 times the prior year's revenues. Shaffer notes that Sylvan is now refocused on better opportunities, such as NCLB.

Put it together, and what all this spells to me is a test of how to make money on Wall Street. But only the sellers will pass.

By Robert Barker

American Apparel's Future

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