Description

Basic Investment Thesis:  Distance learning in China should be a growth market for the foreseeable future.  The government has been testing distance learning for ten years with good success.  Enrollment and tuition gains tend to make the market a 10% grower, but that could accelerate if the Ministry of Education (MOE) expands the number of schools participating beyond 67.  There is also significant demand for study material and tutoring in China.  While that market is highly fragmented, ChinaEdu seems to have a strong strategy to pursue profitable growth in this market with 101online.  Finally, ChinaEdu has substantial "hidden assets" that should provide downside protection.  They own their office inside the second ring road in Beijing and their "non-core" private schools also have substantial land holdings.  When the land values are combined with the substantial cash position on the balance sheet ($54 million), it almost equals the entire market capitalization of the company.

Core Business (80% of revenues, 88% of gross profits):  ChinaEdu's core business is distance learning over the Internet.  Essentially, the company provides the backend and technical know-how to teach a particular University's curriculum over in the Internet.  Students must register and take exams at a distance learning center, which recruits the students, does administration, and collects the students' tuition.  The tuition split goes 20% to ChinaEdu for providing the distance learning infrastructure, 50% to the distance learning center, and the University get's a 30% cut for the use of its "brand" and curriculum.  ChinaEdu provides the back-end solution to 27 of the 67 Universities which have permission from the Ministry of Education to offer distance degrees.  It should be noted that student base usually consists of working adults who never earned a bachelor's degree or who only have an associate's degree and need a bachelor's to advance their careers.  The company had 157,000 students enrolled during the spring semester of 2010.  Most of the learning centers (~410) are independent from ChinaEdu.  However, ChinaEdu also owns some distance learning centers (27 as of last quarter) while they receive a commission from 30 other independent learning center operators for helping them get the necessary approvals from the MOE to operate.  ChinaEdu plans to drive additional growth by opening more learning centers over time.  In terms of competition, Open Online and China Cyber Learning are the key competitors for the learning centers business.  For the distance learning business, ChinaCast (they have relationships with 15 of the 67 approved distance learning universities) and the universities themselves represent the key competitors.

101 Online (5% of revenues, 6% of gross profits):  ChinaEdu also offers study materials at 101online (chinaedu.com).  They offer interactive tutoring at prcedu.com.  The business model works in two ways.  Students can apply for an all-you-can eat annual subscription (3,000 RMB) or can pay on a per study material or per question basis with pre-paid cards purchased from distributors.  While the barriers to entry are low in this kind of business, one only needs to look at some public peers to see that there appears to be substantial demand for both study materials and tutoring services in the PRC (See the financials from CEU or the recent IPOs DL, AMBO, and XRS).  It remains to be seen how much scale ChinaEdu will get in this business and how defensible the business will be, but their offering appears compelling to the casual browser (I would encourage you to visit the site).

Non-Core Assets (15% of revenues, 6% of gross profits): ChinaEdu also owns several private primary and secondary schools.  These are profitable businesses and the company "owns" substantial campuses with each of these. (Owned is in quotes, because ownership in the PRC is really a very long term lease)  They are:

• Anqing Foreign Language School (Grades 1-12) - Campus is owned with 159k sq. meters.
• Pingdingshan Bilingual School (Grades 1-9) - School is owned. 7800 sq. meters.
• Jingzhou School (Southern Campus) (Grades 1-9) - ChinaEdu has a 54% ownership stake. Jingzhou High School and another partner own the rest. Campus is owned with 190k sq. meters.

The company also owns a foreign language/international curriculum school (no property with this one) which partners with BCIT to provide English language classes.  This venture has not worked out as hoped.

Other Owned Land:  The company also "owns" its headquarters office which is a 3,458 sq. meter floor in an office building on the 2^nd ring road in Beijing.  I am no China land expert, but DTZ says Beijing office property prices are about $5,000 USD per sq. meter (http://www.dtz.com/Global/Research/Property+Times+Beijing+Q3+2010).  This suggests their headquarters office alone could be worth $17 million, though I would welcome feedback from someone who knows Beijing property valuations better than I do.

Valuation: 

There are 17.4 mil diluted ADS equivalents outstanding.  At $7.00 per share this implies a market. cap of $121.8 mil.  The company has $53.9 mil in cash and ST investments and no debt.  This implies an EV of $68 million.  The company did EBITDA of of $15million in 2009 (including stock based comp) and will likely do ~$19 million this year.  Free cash flow should be well north of $10 million.  Peers generally trade at much higher multiples (though admittedly some are growing faster).  Here is a small sampling:

Ticker:                   EV/Forward EBITDA:

EDU                       23.2x

DL                         16.6x

AMBO                    15.4x

CAST                      5.2x

CEU                        3.4x

CEDU                     3.6x

CEDU screens very expensive on a P/E due to the high net cash balance which is why I have focused on EV/EBITDA.  I believe this is one reason the stock is overlooked (in addition to being an underfollowed, U.S.-listed Chinese microcap).

For an additional margin of safety, the properties (which were acquired several years ago) are carried on the books for $32 million.  They are probably worth at least $45 million if they were liquidated today.  Basically, I think if you liquidated this company tomorrow, you would get most of your money back even if the business doesn't earn another dime.

Ownership:

Trent Stedman and affiliates own 1.2 mil ADS or 6.8%.  As far as I can tell he is a private investor who occasionally goes activist (see Bitstream).  If anyone knows Mr. Stedman and can put me in touch let me know.

McGraw-Hill was a seed investor and has a seat on the board.  They own 1.1 mil ADS-equivalent.

Renmin University is ChinaEdu's largest university partner, has a seat on the board, and the endowment owns  0.5 mil ADS equivalent.

Columbia Pacific Advisors appears to be the family office of Daniel Ray Baty founder and chairman of Emeritus corp (ESC), a senior-living operator and owns 0.5 million ADS equivalents.  I'm not really sure what the Asian connection is.  I read that he started a chain of hospitals in Malaysia: http://seattletimes.nwsource.com/html/businesstechnology/2008140676_columbiaasia270.html. Columbia Pacific also made a bid for a Seattle Hotel the Red Lion.

China Rock is a hedge fund focused on Chinese companies lead by Chun Ding who worked at and then was staked by Farrallon. http://money.cnn.com/2008/09/17/news/newsmakers/lashinsky_steyer.fortune/index3.htm  They owned 0.2 mil ADS equivalent as of last 13-F season.

Bottom-line, it looks like there are some people in the mix that could make things happen.

Risks:

• There is regulatory risk here. If the MOE decides they don't like distance learning that would be a problem for ChinaEdu's business. Futhermore, if the MOE stops CEDU from expanding their learning centers that could hurt the growth story.
• There is also acquisition risk here. ChinaEdu has a substantial pile of cash. So far management has been disciplined about acquisitions (after learning from some initial pre-IPO missteps that they can be difficult), but there is a risk that the company will spend its pile of cash on a bad acquisition. The most recent use of cash has been for share repurchase so I am hopeful that management proves to be good at capital allocation.
• Property risk. Some of our margin of safety is derived from Chinese property values. Should they decline substantially, so will our margin of safety.
• Fraud risk. This seems to be top of mind for investors in Chinese U.S.-listed Chinese stocks. I think CEDU is legit for a number of reasons. First, the company has used Deloitte Touche Tohmatsu as its auditor since it's been public. While that is no guarantee the financials are good, it is a significant step in the right direction vis a vis the no-name auditors many Chinese firms use. Second, ChinaEdu underwent a standard IPO as opposed to listing via RTO. Third, this management team has something to lose. The CEO has an MBA from Columbia. The CFO has her MBA from MIT and undergrad from Dartmouth. The COO has a Masters in EE from Rutgers. While degrees from fancy schools don't mean you are not a crook, if there were a random sample of Chinese company managements I would bet the ones that dumped hundreds of thousands into their education are probably a little less likely to commit fraud than the guys that came out of nowhere. Fourth, the company has been repurchasing shares ($11 million worth in 2009). I don't know of any Chinese frauds that actually bought back shares. Fifth, the board appears to be legit as opposed to made up of management cronies.
• DSOs appear high due to one university partner that seems to take a long time paying its bill. I believe this to be Renmin university which owns the stock and has a seat on the board. Ultimately, I believe they continue to pay on time, but it is worth watching.
• There have been a bunch of recent IPOs in the Chinese education space. An IPO cluster like that is usually a precursor to some substantial multiple compression for the industry (think Chinese solar companies a few years ago, hedge fund IPOs, etc. etc.). Obviously, it is hard for me to imagine the CEDU multiple compressing much. I also think these recent IPOs with high valuations have a currency to bid for a company like CEDU so it may not be a completely bad thing, but I thought it was worth noting at least that there is an ample supply of U.S.-listed Chinese education companies.
• Liquidity. There is none. Don't say I didn't warn you.

Catalyst

• Company buys back more stock.
• Private buyer or strategic makes a bid for the company.
• Earnings/cashflow continue to grow.