Rating Action Overview

• GEMS MENASA (GEMS) is the largest K-12 schools operator in the United Arab Emirates (UAE), with EBITDA margins of about 30%-35% and good cash flow visibility.
• The company proposes to fully refinance its capital structure through the issuance of $1,650 million term loan B and senior secured notes, leading to an opening leverage of adjusted debt to EBITDA of about 7.5x in fiscal 2019.
• We are assigning our preliminary 'B' ratings to GEMS and to the company's secured first-lien loan and bond.
• The stable outlook reflects our view of broadly stable EBITDA margins and positive free operating cash flow (FOCF) generation, with expected S&P Global Ratings-adjusted debt to EBITDA of 6.5x-7.0x in 2020.

Rating Action Rationale

Our preliminary 'B' rating on GEMS reflects our view of its large scale, with more than 120,000 students, its position as the largest K-12 (kindergarten through grade 12) operator in Dubai, and its above-peer profitability, with adjusted EBITDA margins of close to 35%. It also takes into account the company's highly leveraged financial risk profile, with S&P Global Ratings-adjusted debt to EBITDA of about 7.5x in fiscal 2019 (ending Aug. 31, 2019) following the proposed refinancing. In addition, the preliminary rating is supported by our expectation of continued strong operating performance and positive FOCF generation from fiscal 2019, following a sharp reduction in capital expenditure (capex) compared with previous years. We also assume the company will not embark on aggressive debt-funded acquisitions. This should support deleveraging to below 7x in the coming years.

GEMS opened its first school in Dubai in 1968, and has since expanded to a 48-school network, present in all the main cities of the UAE, including Dubai, Abu Dhabi, and Sharjah, as well as in Qatar, catering mainly to expatriate families. We view its diversification across curricula (British, American, Indian, and International Baccalaureate) and price-points as a strength, the latter in particular differentiating it from some of its peers that only cater for the premium or super-premium private school clientele. GEMS's strategy is focused on providing good quality, affordable education, with the "mid-market" price segment (annual fees of $2,000-$5,000, as per company definition) accounting for 59% of enrolments, followed by the "mid-market plus" ($5,000-$15,000) for 19%, and "premium" ($15,000-$30,000) for 22% of enrolments as of February 2019. We believe this offering supports revenue stability, since competition in the UAE-schools landscape is fiercer in the premium segment, especially with the recent arrival of new entrants.

GEMS operates in a fragmented and maturing market, and it intends to focus on defending its market share (28% in Dubai, which accounts for 90% of UAE private schools market) rather than increasing it. In the education sector, competition could intensify if new local education providers with access to capital enter the market, attracted by high margins, good earnings visibility, and strong industry growth. We understand that GEMS will concentrate on filling the schools built in the past few years. Capacity utilization is quite high on average, at about 82% as of fiscal 2018, yet in maturing centers (15 schools opened after September 2014, as per company definition) and new schools (three openings since 2017), capacity utilization is still ramping up from about 60% and 25%, respectively. We believe the company will successfully fill existing capacity, supporting EBITDA margins.

Although the company is adding 14 schools in the U.K. and one in Switzerland to its portfolio in fiscal 2020 through the acquisition of Bellevue Education, the bulk of its schools will still be located in the UAE. Organic growth will therefore depend on local market dynamics, macroeconomic conditions in the UAE, and any changes in fee regulation. Prior to fiscal 2019, annual fee increases of 1x-2x to an inflation-linked index of about 2%-3% were applicable to all schools and a function of each school's Dubai Schools Inspection Bureau rating, leading to price increases well over the consumer price index (CPI) for GEMS. Still, we anticipate that Dubai's decision to freeze school fee increases for the 2018-2019 school year will cut into fiscal 2019 EBITDA and margins. Hence, we expect EBITDA will remain flat compared with fiscal 2018, at about $340 million (33% margin), also due to some cost increases, but despite enrolment growth. Fee increases will be reinstated from 2020, however, at less favorable conditions. We expect revenue growth will decline to mid-single digits from double-digits, while EBITDA margins will remain broadly stable at 30%-35%.

We view GEMS' business model as comparable with that of other rated K-12 operators, such as Bach Finance Ltd. (trading as Nord Anglia), Lernen Bondco Ltd. (trading as Cognita), and Inspired Education Holdings Ltd. Although GEMS benefits from a larger scale in terms of enrolment numbers and higher EBITDA margins than peers, its concentration in one country and high exposure to the expatriate population partly mitigates these strengths, in our view. We believe that the company's high margins are linked to the specific nature of operating in a market such as the UAE, where there is historically high growth and a large relatively non-price sensitive expatriate population that can only access private education services (public schools only cater for Emiratis). However, we do not rule out potential margin volatility as the market matures and competition increases. Furthermore, any economic shocks could lead to a decline in the expatriate community's size in the country.

As part of GEMS' proposed refinancing, the new capital structure will comprise a $1,650 million term loan B and senior secured notes, both maturing in 2027, and an undrawn $200 million six-year revolving credit facility (RCF). We understand the proceeds from the new debt will be used to repay the existing $1,250 million of financial debt, fund the Bellevue acquisition in the U.K. for about $85 million, repurchase sale and leaseback assets in Qatar for $82 million, pay dividends of $115 million, and for transaction fees. Furthermore, financial debt post-transaction will include $33 million of vehicle loans and $32 million of existing debt at Bellevue schools, expected to be repaid in the near future. In our adjusted debt calculation of $2.7 billion, we include $1.0 billion of operating lease obligations related to school premises (EBITDA adjustment of about $95 million), and pension obligations of about $75 million. Finally, we net cash on balance sheet of about $150 million in fiscal 2019 (the company has minimal trapped cash).

Following the debt issuances, we expect S&P Global Ratings-adjusted debt to EBITDA of about 7.5x in fiscal 2019. We expect the ratio will be below 7x in 2020, supported by positive FOCF generation.

FOCF has been historically negative ($150 million-$200 million), because the company has been investing in improving existing schools and opening new schools, with $1 billion invested since 2014. This strategy stemmed from strong growth in the Dubai market and favorable fee regulation, whereby a higher school rating based on quality of performance (on a six-category scale from "very weak" to "outstanding") leads to higher fee increases, thereby incentivizing greater spending on schools. The company has now decided to significantly cut spending since it has built sufficient capacity for the next four to five years, in a market that is slowly reaching maturity and on the back of a less capex-incentivizing fee framework from 2020. Assuming capex of $80 million-$120 million (half of which is maintenance), generally favorable working capital dynamics (upfront fee collection), minimal dividends, and no debt-funded mergers and acquisitions, the company should post FOCF of $50 million-$100 million in the next two years.

GEMS is 100% owned by the holding company GEMS Menasa Holdings Ltd. (Cayman Islands). The refinancing will be accompanied by the buy-out of a 21% minority shareholder's stake by a long-term strategic private equity investor, CVC, who will get a 30.5% share of GEMS Menasa Holdings' capital. The Varkey family, which founded the company, will remain a majority shareholder. We expect GEMS Menasa Holdings' credit quality will mirror that of GEMS because, post the introduction of the new minority shareholder, GEMS Menasa Holdings will have no significant assets and liabilities other than GEMS.

Our ratings are preliminary and will be converted to final upon receiving the final documentation of the instruments rated, provided all terms and conditions, including the overall amount of term loan B and bond of $1,650 million, are aligned with our initial assumptions, including the existence of minimal liabilities at holding company level (GEMS Menasa Holdings). If this is not the case, we reserve the right to withdraw or revise the ratings.

Outlook

The stable outlook reflects our view that GEMS will maintain its strong market position in the UAE educational space, with adjusted EBITDA margins remaining at or about 30%-35%, supported by the increasing capacity utilization in the maturing schools and growth in support services.

We see the company's focus on the affordable pricing segment and scale in Dubai's K-12 market as likely to support stable earnings and cash flow generation in the future.

We also expect the company will deleverage to below 7x of adjusted debt to EBITDA (post-refinancing opening leverage of about 7.5x), approaching about 6.5x-7.0x in the next two years as FOCF turns meaningfully positive, thanks to low capex (5%-10% of revenues), limited dividends (maximum of $50 million annually), and no major acquisitions.

Downside scenario

We could lower the rating if the company adopts a more aggressive financial policy, leading to leverage exceeding 7.5x of adjusted debt to EBITDA and FOCF generation remaining negative over a prolonged period. This could occur as a result of debt-financed acquisitions, higher-than-expected dividends, or increased capex. While not expected, leveraging of the company's parent GEMS Menasa Holdings may also constrain the rating.

Upside scenario

We believe there is limited likelihood of an upgrade over the next 12 months. We could raise the rating if we believe the company was able to maintain an adjusted debt to EBITDA of less than 5.0x together with meaningful positive FOCF generation on a sustainable basis. Such a scenario would likely result from continued strong margin performance and a track record of prudent financial policy.

Company Description

GEMS is a leading operator of K-12 schools principally in the UAE, with a small presence in Qatar, catering to the expatriate population. The company posted revenues of $1,023 million and EBITDA of $243 million in fiscal 2018.

As of Feb. 28, 2019, it had enrolled 123,486 students and had capacity for 150,249 seats, representing a utilization rate of 82%. GEMS provides education services from kindergarten through to the end of secondary school in its 48 schools, covering all major curricula (British, American, Indian, International Baccalaureate). The company was founded in 1959 and is headquartered in Dubai.

GEMS remains under the control of the founding family, the Varkey family (owns 66.5% via two separate minority family vehicles). They are in the process of replacing existing minority shareholders with a new long-term private equity investor, CVC, who will have a 30.5% share of the equity.

In conjunction with the refinancing, GEMS is in the process of acquiring Bellevue schools in the U.K. (bought from existing shareholders). The transaction will add 14 schools in the U.K. and one school in Switzerland, about $50 million of revenue from 2020.

Our Base-Case Scenario

In our base case for 2019 and 2020, we assume:

• Demand for GEMS' services is dependent on the presence of a sizable expatriate population in the UAE. This is therefore correlated with the UAE's GDP growth, but has historically surpassed GDP rates.
• GDP growth for the UAE of 1.9% in 2019 and 2.6% in 2020.
• From fiscal 2020, GEMS can achieve a standard approximate 2% school fee increase, with schools achieving a higher rating than in the previous year, benefitting from a multiplier of 1.5x-2.0x, solely in the year the rating has improved.
• CPI growth of 2.1% in 2019 and 2.3% in 2020 for the UAE
• The UAE dirham is pegged to the U.S. dollar, hence no risks related to translation differences.
• Revenue growth of about 3.0%-3.5% in 2019 and 5.0%-7.0% in 2020, driven by increasing enrolments principally at the maturing schools and selective fee increases. Bellevue schools will bring about $50 million of additional revenues, however they have lower EBITDA margins than the UAE schools, 15% versus 30%-35%.
• Adjusted EBITDA margins fluctuate between 30% and 35%, due to higher capacity utilization at maturing schools and school portfolio optimization. However this is lower than the historical average of 35%-36% due to salary cost increases, ramp-up costs and the current cap on fees.
• No acquisitions other than that of the Bellevue schools for $85 million and the $82 million repurchase of a sale-leaseback asset in Qatar. Both transaction will be done in conjunction with the refinancing.
• Capex of $80 million in 2019, increasing to $125 million in 2020, as per management guidance, including about $50 million-$60 million of maintenance capex. This compares with 2018 capex of $340 million.
• About $50 million cash outflow from working capital in 2019, neutral thereafter.
• Exceptional dividend of $115 million in 2019 as part of the transaction. Going forward, we factor in $50 million of dividend payments per year, although discretionary.

Based on these assumptions, we arrive at the following credit measures:

• S&P Global Ratings-adjusted debt to EBITDA of about 7.5x in fiscal 2019 and about 6.5x-7.0x in fiscal 2020.
• Positive FOCF of about $50 million-$80 million in fiscal 2019 and $70 million-$100 million in fiscal 2020.
• EBITDA interest coverage of about 2.0x-2.5x for the next two years.

Liquidity

We assess GEMS' post-refinancing liquidity as adequate, based on our estimate that its liquidity sources will cover its uses by more the 1.2x over the next 12 months. Liquidity is supported by the new $200 million RCF maturing in 2025 and the absence of any debt maturities until 2026, following the full refinancing of its capital structure.

We also believe that the group has sound relationships with banks, based on its history of relying on bilateral and syndicated loans for its financing.

At the same time, with none of its securities traded on any stock exchange, GEMS doesn't currently have a track record in capital markets.

Principal liquidity sources following the refinancing:

• Cash on the balance sheet of $28 million as of Feb. 28 2019.
• New RCF of $200 million put in place in conjunction with the refinancing, maturing in 2025, fully available at transaction close.
• Funds from operations of about $150 million.

Principal liquidity uses over the same period:

• No major debt maturities until 2026 when the term loan B and bond are maturing, although the term loan amortizes by 1% annually.
• Capex of about $102 million.
• Working capital outflow, including seasonal swings of about $75 million, related to the timing of school fee payments.

Covenants

GEMS has no maintenance covenants in its new loan and notes, while the RCF will have a springing covenant defined as net senior secured leverage of maximum 8.5x, tested quarterly only when the RCF is drawn more than 40% in cash.

Issue Ratings - Recovery Analysis

Key analytical factors

• We rate the $1,650 million of term loan B and senior secured notes preliminary 'B', with a preliminary recovery rating of '3', indicating our expectations for meaningful recovery prospects (50%-70%; rounded estimate: 65%).
• The term loan B and the senior secured notes rank pari passu and their recovery prospects are supported by the relatively small amount of priority claims. Also, the undrawn $200 million RCF ranks pari passu with the term loan B and bond.
• Our hypothetical default scenario assumes lower student enrolments due to increased competition, reputational damage, or changes in the local economic or political climate, leading to a decline in the number of expatriates.
• We value GEMS as a going concern, given its strong brand position and high student enrolment in the education sector in Dubai and the wider UAE.

Simulated default assumptions

• Year of default: 2022
• Jurisdiction: Dubai

Simplified waterfall

• EBITDA at emergence: $208 million (capex represents 6% of three-year average sales, and the cyclicality adjustment is 5% in line with this specific industry sub-segment. We did not make any further operational adjustments.)
• Multiple: 6.5x (this is higher than the anchor industry multiple of 5.5x. The higher multiple is supported by the better revenue visibility and FOCF generation ability for K-12 operators compared with other business models within business services sector.)
• Gross recovery value: $1.4 billion
• Net recovery value for waterfall after administration expenses (5%): $1.3 billion
• Priority claims*: $33 million
• Estimated first-lien debt claims*: $1.9 billion
• Recovery expectation: 50%-70% (rounded estimate: 65%)

*All debt amounts include six months of prepetition interest.

Ratings Score Snapshot

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• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
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• Criteria | Corporates | Recovery: Methodology: Jurisdiction Ranking Assessments, Jan. 20, 2016
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014
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