New Oriental Education: A long term potential

Business Model of EDU – how does it generate revenue?

Let’s have a closer look at the business model of New Oriental Education, i.e. what are its primary sources of revenue? The largest portion of revenue is derived from its physical (private) school enrollments. The largest growing segments include K-12 after-school and U-Can (middle & high school) offerings. It’s international programs (exam preparations and consulting) were becoming an important segment, until the pandemic put the programs to a sudden halt. Naturally, the company’s online segments saw an increase in student enrollments at the beginning of the year.

Offline-Merges-online (OMO) programs. The OMO offering is an important part of EDU’s business. It offers a dual approach: a standardized classroom teaching system in addition to launching innovative & interactive online courseware, creating a more interactive and high-quality learning experience for the students. It’s a relatively new way of teaching, but EDU’s management truly believes in its potential, stating it raises the standard for the whole industry. The company is also able to realize higher margins through OMO systems versus traditional course offerings. 

Koolearn. It’s online-only platform, Koolearn, accounts for around 5% of total revenue. It is listed on the Hong Kong Stock Exchange, with a market cap of 26,54 bln HK$ (3.42 bln USD). Since 2018, New Oriental Education owns 53,19 % of Koolearn, this currently values its participation at 1,75 bln USD. Besides the 53% stake of EDU, a substantial part of Koolearn is owned by Tencent (19,24% stake). During fiscal year 2020, Koolearn suffered substantial losses of over 70% of its revenue for the year as they devoted significant resources to enhance the quality of their courses and services. Whether or not Koolearn is successful in attracting students can be an important driver – and risk – for the company going forward.

Offline offerings. As mentioned previously, the offline segment remains the building block on which all the other initiatives are made possible. The company is pursuing an aggressive acquisition strategy in the offline segment, driving revenue higher by acquiring existing schools. In its FY2020 earnings call, it disclosed to add around 20 to 25% capacity in FY2021. As a result of the COVID-19 pandemic, management believes it will prepare them to further take market share from other players, as they believe smaller players may not be able to sustain their business during this crisis.

Stock Performance

EDU has made quite a good run during the past year as a result of its aggressive expansion strategy, stable results and increasing enrollment numbers. Chinese stocks listed on NYSE have generally done quite well as a whole. EDU was up 40% in 2020 while its main competitor, TAL Education Group was up 36%. With the Shanghai Stock Exchange up 17%  in 2020, both stocks have outperformed the Shanghai Stock exchange by a substantial amount.

The recent “dip” for New Oriental Education likely came as a result of its financial reporting on October 13^th. EDU’s first quarter results for FY2021, which ended on August 31^st, 2020, reflected lower results compared to Q1 FY2020 following the continued challenges in facing the COVID-19 pandemic. Revenues fell 8% while operating income fell 38.9 % on a quarter-to-quarter basis. However, EDU’s management remained positive on the companies’ position going forward:

“Looking ahead, we believe that our financial performance will bottom out starting from the second fiscal quarter. As one of the market leaders in China, we are confident that our continued improved services and, best-in-class learning experience would enable us to capture more market share and deliver long-term value for our shareholders.” (Q1 2021 Earnings Release)

Let us further compare the position of EDU amongst its competitors.

Competitors in the Chinese private education market

Looking at the competitors in the Chinese private education market, we notice that TAL Education group is currently the largest in terms of market capitalization and revenue, while New Oriental Education reports higher student enrollment figures.

Because of their high growth rates, these companies are trading at high valuation multiples. The difference in terms of market cap of TAL Education Group VS New Oriental Education can likely be assigned to TAL increasing its revenue at a faster pace than EDU.

GSX Techedu, another competitor in the private education space, has reported staggering growth numbers since its IPO in June, 2019.  This lead some fund managers to believe these numbers are overstated and in fact, fraudulent[2]. As a result of different accusations, the Securities and Exchange Commission opened an investigation on the 2^nd of September. GSX Techedu reported financial results on the 20^th November 2020, stating that they remain cooperative with the SEC and do not expect any material impact on its results because of these investigations.

Key Performance Indicators (KPI’s) of EDU

Let’s take a closer look at some important KPI’s for private education companies in rapid expansion: revenue growth, new student enrollments and free cashflow.

Revenue

EDU’s consolidated revenue increased 15.6% YoY to 3.2 bln USD. This increase was mainly due to the growth in revenues from K-12 AST, test preparations and other courses. Student enrollment increased from 8.4 million in FY2019 to 10.6 million in FY2020, representing a yearly growth of 26%. This offsets the decrease in revenues from overseas test preparation courses due to the COVID-19 pandemic. Revenue from books increased 11.9% to 348M USD. The revenue growth also came with an increase in operating cost, which was up 13.8% from last year. Marketing costs increased by 15.9% which displays the companies attempt to attract more students for private education. EDU does not disclose revenue or net income figures per subsidiary.

Revenue vs Free cashflow

Let’s review how the company did when comparing revenue to free cash flow.

It’s usually not a good sign that cash flow is growing slower than revenue. This can be a warning that a company doesn’t have (enough) leverage and is spending far too much to chase after growth. However, in the context of New Oriental Education, it makes sense, as the company is massively expanding. So investors should not be too worried if this trend continues, as long as new schools and learning centres are being opened/acquired across the country.

Valuation Metrics

As mentioned before, EDU is currently being valued at high valuation multiples. This means the market has already priced in some future growth, resulting in high P/E values and other metrics. The below valuations were calculated at market close on Monday, January 18th.

Although EDU’s valuation multiples (P/E, Price/Sales) indicates high expectations, when we compare EDU’s valuation to its competitor, TAL Education Group, the stock does not indicate extreme overvaluation (on a relative basis). Analysts will pay close attention to what extent EDU is able to keep on growing its revenue and evaluate whether the stock is over or undervalued. We saw this when EDU’s share price took a hit following the recent Q1 results.

Looking at the balance sheet, we can conclude that EDU has a strong financial position. While reporting solid growth figures, it does not do so by taking on lots of debts. Its debt ratio is 57%, while the current assets are mostly cash or short-term investments in commercial products (from Chinese banks). The company holds over 65% of its assets in cash.

The high cash position might indicate the company is finding it increasingly difficult to acquire or set up new learning centres. It can also indicate the company is looking for a takeover target in the education (tech) sector. The company recently attracted another 1.5 bn USD from capital markets from a combined offering in both Hong Kong and NYSE on the HK exchange.

Peter Lynch’s 6 categories of stocks: EDU, a Fast Grower

According to Peter Lynch, one of the world’s greatest fund managers, stocks can be categorized into 6 groups[3].

EDU can clearly be classified as a fast grower, with a revenue growth YoY of 15.57%. One advantage of investing in a stock like EDU is that you can hold it for as long as it can keep the growth rates up. However, growth should not come from unusual income like sales of assets irrelevant to the core business.

Discounted Cashflow (DCF) Method

Let’s look at another method of determining whether EDU is correctly priced. The Discounted Cashflow analysis aggregates the future (free) cashflows, which can be calculated given certain growth estimates. Note that cash flows that are obtained in the future must be discounted to their present value.  DCF methods often use the WACC (Weighted Average Cost of Capital) as the discount factor, as this is the rate at which the company finances its long-term needs. As EDU is a holding company containing multiple fast-growing subsidiaries, the company WACC might be difficult to obtain from its balance sheet. We instead opt for an industry WACC, obtain from Stern University (Stern NYU, 2020).[4] The analysis can be found below.

202012-EDU-DCF-analysis-Tijs-Maes

Immediately, it becomes clear that assumptions regarding growth estimates are crucial to this exercise. This is also one of the reasons that research analysts pay such close attention to revenue growth. This makes a lot of sense, as a company that is able to grow its revenue (and associated free cashflow) faster than its funding costs,  should be worth more than its book value[5].

We believe a stable growth of free cash flow under the medium analysis is achievable, but the company might also be able to surprise investors with high growth numbers in the next couple of years. According to the above analysis, we think the current market cap of 29 billion slightly underestimates EDU’s ability in generating future growth. A range from 30 to 35 billion USD is more likely to reflect EDU’s long-term potential.

Opinion of other investors/analysts

Analysts covering the stock recently increased the price target for the company. They were increasingly positive on the stock following the FY2021 Q1 results. Analysts raised their rating to “Buy” as they concluded the impact of COVID-19 was less bad than expected.

Although considered favourable amongst some investors, New Oriental Education has seen peaks in short interest of more than 20% over the last months.

EDU’s risk 1: Restrictions to international travel

The disruption from the COVID-19 pandemic still presents EDU with a number of challenges, which makes the short-term outlook somewhat uncertain.

As mentioned previously, it’s international segments were becoming an important high-margin division. EDU offers exchange programs, consulting services and overseas test preparation centers. Because of the pandemic, revenues for the overseas test preparation business fell by 50% in FY2020.

Secondly, the pandemic also caused a decrease in its VIP personalized classes segment (36% decline in dollar terms). If the virus would continue its spread in Asia, these high-end segments could continue to be impacted. We think that this is less likely to occur as China has been very successful in tackling the virus through effective governmental action (monitoring, track & tracing, travel restrictions etc.).

EDU’s risk 2: Koolearn

In recent earning calls, management remained somewhat conservative on EDU’s ability to generate revenue from its fully online offerings through Koolearn. We would have expected the online-only segment to have been very successful during the pandemic, but this wasn’t reflected in Koolearns financial results (ending May 2020). Revenue “only” grew 17.6 % year-on-year. From our point of view, it’s one of the largest risks for EDU as Koolearn is accumulating a lot of losses. In FY2020, net loss of Koolearn was over 75% of its revenue (up to 750 million RMB), mainly caused through increased operating and SG&A expenses.

It’s worth mentioning that any factors that would mitigate this risk, such as improved bottom-line results of Koolearn, could also become an important catalyst for EDU’s share price going forward.

EDU’s risk 3: Fraudulent reporting of its competitor

Another factor that makes us cautious about the short-term is the SEC investigation on SGX Techedu, one of EDU’s competitors in the online education space. We expect SGX to discuss these matters when reporting its audited full-year financial results in February 2021. If revenues would indeed be fraudulent, this will affect the private education sector as a whole – although we do not see any indications of EDU inflating revenues the way SGX could be doing. If EDU’s share price would drop significantly as a result of the investigation, it might also be an opportunity for investors to take a position in the stock.

In this final section, we’ll discuss our recommendation with regards to the current share price of EDU and explain the potential catalysts & risks worth noting for investors.

Conclusion

Despite EDU’s strong performance over the past years, we believe that EDU’s financials are not fully reflecting where the company is heading in the coming years. As schools and learning centers are physical assets, the company needs to attract and train its teachers, further develop its offering to market needs and increase its network to attract new students. This process takes time. We expect short-term results to reflect a transition phase from the downward pressures of COVID-19 and its capital-intensive acquisition plan of increasing the number of schools and learning centers. We believe this will continue to affect EDU’s share price on the short-term.

Despite these short-term clouds, our outlook for the medium to long term is positive. If EDU succeeds in rapidly increasing the number of student enrollments, the company is set for a strong performance with minimal downside for investors. The Chinese private education market is expected to grow at a faster rate than China’s GDP, giving worldwide investors an attractive opportunity to increase their exposure to China through New Oriental Education.

Entry point & price target

In their latest earnings call, management indicated that “the recovery will happen step by step and more back loaded, in Q3 and Q4.” We expect further downward pressure on the stock in the short-term as revenues will remain affected by the international travel restrictions, which hurts its overseas business. These risks will be largely reflected in the Q2 financial reporting, set to release in February 2021. At that point, we would consider taking on a first (buy) position in the stock around the 145-150 USD region (NYSE:EDU). If growth outlooks remain positive, we believe the stock is able to rally close to the 200 USD region.

How to take on a position in EDU

Investors who believe the stock can rally through the short-term uncertainties can buy New Oriental’s shares on the American NYSE, the ticker being EDU. At the time of writing, the stock is trading at 172,81 USD per common share. New Oriental Education is also trading on the Hong Kong Stock Exchange (HKEX), ticker: 9901 at a price of 1.365,00 HK$. Alternatives for buying the share include setting up a position in the options market. Our preferred strategy would be to take on a small to medium position first, and increase the position gradually if the trend remains positive.

Deloitte. (2017, 10). Trends in the Chinese Education Industry. Retrieved from Deloitte.com: https://www2.deloitte.com/cn/en/pages/international-business-support/articles/trends-in-the-chinese-education-industry.html

EDU. (2020). Q1 2021 Earnings Release. Beijing. Retrieved from https://investor.neworiental.org/static-files/86d25853-aac1-4fa0-88e9-bf6bbd9db047

Fintel.io. (2020, 11). Short Interest EDU. Retrieved from https://fintel.io/ss/us/edu

Koncept Analytics. (2019, 11). China Education Market (K-12, After-School Tutoring & Higher Education) Report: Insights, Trends and Forecast (2019-2023). Retrieved from Research and Markets: https://www.researchandmarkets.com/reports/4858618/china-education-market-k-12-after-school?utm_source=dynamic&utm_medium=GNOM&utm_code=23zbgn&utm_campaign=1330929+-+Outlook+on+China%27s+%24572Bn+Education+Market%2c+2019-2023%3a+K-12%2c+After-School+Tutor

Koolearn. (2020). Annual Report FY2020.

Stern NYU. (2020, 12). Cost of Capital by Sector (US). Retrieved from http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/wacc.htm

Yahoo Finance. (2020, 11 13). Quote EDU / Quote TAL. Retrieved from https://finance.yahoo.com/quote/EDU/key-statistics?p=EDU

[0] Compounded Annual Growth Rate (CAGR)

[1] The Variable Interest Entities (VIE’s) are the local entities operating in China, in this case the different branches and physical schools. They are indirectly controlled (trough legal contracts and clauses) by parent companies in another country, mainly for tax optimization purposes.

[2] Fund Managers who stated a potential fraud at GSX Techedu include famous short-seller Andrew Left (Citron Research) and Carson Block (Muddy Waters Research).

[3] Source: https://library.jitta.com/en/blogs/peter-lynch-6-types-of-stock

[4] Note that the industry WACC is based on US firms data. These numbers can be used for our analysis as EDU finances itself mostly with equity obtain from US equity listings. 

[5] A company’s book value equals its total assets minus its total liabilities