Shares of IDP Education (ASX: IEL) fell over 7.52% on Thursday after a disappointing trading update but remain undervalued.

Tighter immigration and visa settings are likely to negatively affect IDP Education’s near-term student placement and testing volumes more than we previously anticipated.

Given current headwinds, we significantly cut our near-term earnings before interest and taxes (“EBIT”) forecasts by 20% on average over the next three years and decreased our fair value estimate for narrow-moat IDP Education by 8% to $22.50. However, our long-term estimates, including our midcycle 26% EBIT margin forecast, are relatively unchanged.

While governments in IDP’s three key destination markets are currently reducing migration levels, annual net migration will still likely rebase above prepandemic levels. For example, Australia’s net migration for fiscal 2023 ballooned to 518,090 due to a spike in demand for education services as borders reopened. The Australian government aims to roughly halve net migration to 260,000 by fiscal 2025, which is still 8% higher than the 241,340 net migrants in fiscal 2019. The international education industry, and immigration more broadly, remain important economic growth drivers, and shares in IDP remain undervalued as we expect the firm to benefit in the longer term.

Acknowledging changing industry conditions, the firm guided to fiscal 2024 adjusted EBIT to be broadly in line with fiscal 2023 adjusted EBIT of $228 million. This is mainly due to an expected material slowdown in volumes, with management guiding to a 15%-20% decline in English testing volumes and a 15%-20% increase in student placement volumes in fiscal 2024. This compares with first-half fiscal 2024 English testing volumes declining 12% and student placement volumes increasing 33%. The expected full-year student placement performance implies significant outperformance relative to industry volumes that are likely to decline and is impressive, considering IDP’s volumes increased by 53% in fiscal 2023.

Business strategy and outlook

IDP Education is a global leader in education services, providing English language testing and teaching, student placement services, digital marketing, and education events.

The English language testing business is IDP’s largest business segment, comprising 64% of fiscal 2022 revenue. As part-owner of International English Language Testing System, or IELTS, IDP operates one of the world’s most widely accepted English language tests for access to education institutions, professional bodies, and visas.

Over the past decade, IELTS has lost English proficiency certification exclusivity for most of the institutions where IELTS is accepted, leading to increased competition for test takers. With the acquisition of the British Council’s Indian operations, another part-owner of IELTS, IDP has set the stage for reduced competitive pressures in India, the world’s largest English language testing market.

Student placement services is IDP’s second-largest business segment, comprising 27% of fiscal 2022 revenue. Over the decade prior to the covid-19 pandemic, IDP’s student placement services business has also been IDP’s main engine for growth, with growth primarily coming from India as a fast-growing source country and the United Kingdom and Canada as fast-growing destination countries.

Since the covid-19 pandemic and the ensuing temporary closure of Australia’s borders to foreign students, IDP’s Australian student placement business had shrunk by more than half. Although some of this volume has been picked up by other destination countries, IDP’s overall student placement business only recovered to pre-pandemic levels in fiscal 2022. Given that half of IDP’s prospective students find IDP through word-of-mouth, we believe IDP’s key near-term challenge will be to reignite demand for its student placement services.

Economic moat

Learn how to identify companies with a sustainable competitive advantage.

We award IDP a narrow moat rating, primarily derived from network effects in its English language testing business. We think these network effects provide IDP with a competitive advantage which is durable for at least the next decade.

IDP, together with the British Council, or BC, and Cambridge Assessment, or CA, is a part-owner of the International English Language Testing System, or IELTS, including its test materials and brand. IDP and BC function as the exclusive distributors and administrators of the test and CA is responsible for developing the test materials. As part-owner of IELTS, IDP effectively operates as a gatekeeper between prospective students, employees and migrants who need to pay IDP for access to opportunities to study, work, and migrate.

The IELTS brand is one of the world’s most recognized and trusted certifiers of English proficiency and is used by over 11,000 education institutions, employers, and migration authorities globally. As IDP is granted more licensing rights as an English proficiency certifier, the IELTS certification itself becomes more valuable for its wider acceptance and thereby attracts additional prospective students, employees, and migrants. This in turn incentivizes additional education institutions, employers, and migration authorities to accept the IELTS certification to tap into large pools of prospective students, employees and migrants, thereby creating a network effect.

We believe that this market dynamic has created a self-reinforcing mechanism whereby a small number of first- and fast-movers have reached widespread acceptance of their respective certification schemes and have establish an oligopolistic market structure with barriers to entry.

IDP’s student placement services business acts as a broker between students and education institutions by advising prospective students on study options and assisting with applications to education institutions and migration authorities. IDP has student recruitment services agreements with hundreds of education institutions across Australia, the UK, Canada, the US, New Zealand, and Ireland.

IDP’s student placement services business benefits from a virtuous cycle and shows traces of a network effect. As IDP increases the quantity and quality of its available study options, the value of IDP’s student placement services increase for prospective students. Similarly, as IDP grows the number of prospective students using its services, IDP can offer prospective education institutions access to a larger pool of prospective students, which can increase the quantity and quality of customers of their education services.

However, even though IDP operates one of the largest student placement services businesses in the world, this part of the business does not enjoy a sufficiently strong competitive advantage to warrant an economic moat.

The education market is characterized by information asymmetry where uninformed buyers, or students, need to navigate options whose value and accessibility cannot easily be determined by them. Similarly, from the perspective of education institutions, it is difficult to assess the likelihood of success for prospective students. Companies like IDP help alleviate some of these challenges by advising students on appropriate study options commensurate with their preferences and abilities and by providing a measure of certainty to students that their applications to education institutions and migration authorities will be accepted. IDP competes in this market with other placement services, most of whom focus on a particular source or destination country, as well as with education institutions’ own direct marketing channels.

Although IDP displays traces of a network effect due to its large pool of students and its broad offering of destinations, its competitors’ pools of students and institutions also have critical mass to effectively compete with IDP. We do not consider brand or reputation to provide a meaningful moat due to the difficulties inherent in assessing prospective students. We also believe that from the perspective of the education institution, student brokers are undifferentiated producers of volume, thereby limited pricing power. Throughout the network, the marginal value of additional students and additional education institutions is limited.

IDP’s English language schools and education events are largely commoditized services, and its consultancy services are currently nascent and do not display competitive advantages yet.