NEW ORIENTAL ED & TECH -ADR EDU S
September 29, 2010 - 2:08pm EST by
straw1023
2010 2011
Price: 98.00 EPS $2.01 $2.15
Shares Out. (in M): 39 P/E 48.8x 45.6x
Market Cap (in $M): 3,802 P/FCF 48.8x 45.6x
Net Debt (in $M): -423 EBIT 77 83
TEV ($): 3,379 TEV/EBIT 43.9x 40.7x
Borrow Cost: NA

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Description

Note: price now 96.50. please adjust multiples accordingly.
New Oriental Education and Technology Group (EDU) is a Chinese company that offers foreign language (mainly English) and test preparation education services throughout China. As of 5/31/2010, EDU had 367 schools and learning centers in over 40 cities throughout China. Although they have a very small online business, the vast majority of the instruction is in brick-and-mortar classrooms. As well, the business is extremely seasonal as the bulk of their revenue and almost all of their earnings come during the summer and winter breaks (FY Q1 and Q3, respectively).
The stock is tremendously over-valued on a fundamental basis even if we accept management's analysis of the latest quarter at face value. As well, the latest numbers draw into question the integrity of the financials as there is a tremendous unexplained gap between enrollment growth (and operating income) and revenue growth. The gap suggests that management is padding revenue numbers by including discounting in both the top line and expenses.
As many value investors have discovered recently (e.g., CRM, OPEN, GMCR, etc.), the timing of short trades against growth/momentum stocks is all important. As such, this write-up will discuss not only valuation, but also critical timing/catalyst issues. It should be noted that I am writing up EDU as a short after the stock has fallen about 20% over the past week. I believe that based on the information that was reported, we finally have a catalyst to crater this stock to its true value. Note that even with the Q1 news, the stock is still flat since it reported its Q4 numbers (in mid July). I think now is the ideal time for a short position as we should all happily forgoe top-ticking the short in exchange for a catalyst.
I believe the news released today will shatter the growth/momentum story beyond repair and a critical mass of long investors are going to dump the stock over the coming days. The numbers reveal three undeniable things: (1) enrollment growth is slowing dramatically, (2) there is no operating leverage in the model, and (3) most importantly, there is tremendous margin pressure from the "thousands" of competitors. And today's selloff will also take away the price momentum factor. Wall Street has been bullish on this stock (and several analysts rushed in today to defend the stock), but a second look at Q1 results may cause some "buys" to turn into "holds."
Valuation [when i started writeup, price was 98. now 96.5] 
shares: 38.8mm * $98 = $3,802mm
cash: $423mm (no debt)
TEV = $3,379mm
Let's start by using the numbers produced for FY 2010 (ended May 31, 2010) because managment now claims that FY2011 numbers will include unfair expense numbers:
Enrollment in language and test prep: 1,807,700
Total number of schools and learning centers: 367 (as of May 31, 2010)
Net Revenue: $386.3mm
COR: 147.3mm (38.1%)
S&M: 58.4 (13.8%)
G&A: 103.3 (26.7%)
OpInc: 77.3 (20.0%)
NOPAT: $65.7mm (51.4x)
Note: The medium-term tax rate will be between 15% (the Hi-Tech tax rate, which EDU partially qualifies for) and 25% (statutory rate). I imagine the long-term tax rate will move towards a standard 25%, but I will leave this analysis to you. I will use a 15% tax rate throughout this analysis.
Until today's Q1 release, management had stated the following multi-year projections:
Revenue Growth: +30%
Op Income Growth: +25%
For FY 2011, management stated that it would achieve 30%-ish revenue growth via: (1) +15% enrollment growth, (2) +7% raw price increases and (3) +7% mix change as students moved to smaller, more expensive classes.
Focusing on margin, we know several things: (1) The basic business model offers no operating leverage. It is an extremely linear model. More students require more classrooms and more teachers. There are very few overhead costs. This is clearly very different from online education programs in the U.S.; (2) The mix change to smaller classes increases the revenue, but it does not increase the operating margin (as a % of revenue); this makes sense as larger classes have a higher revenue for a given amount of teacher time (cannot charge 20x more for 1:1 tutoting than for 20 student group class).
One other thing to note is that the raw price increases and mix improvement could not continue forever. Eventually, an equilibrium mix would be achieved and prices could not keep rising significantly faster than inflation (and the competitive environment challenges whether prices can rise at all). At the end of the day, long-term growth must come from enrollment. Thus, putting an enormous multiple on mix growth is an error.
Thus, even if we believe managment's enrollment projections, we are paying over 50x for a company without any operating leverage that is growing unit sales at +15% (with a one-time hiccup of only 8%). And further, this company operates in an extremely competitive environment. It has limited scale advantages although it does have a brand name due to its size. I would argue that the brand for teaching vocational language skills is not terribly valuable, but this is judgment.
-
Today, the company reported Q1 numbers. And remember that Q1 is by far the most important quarter because it includes the summer break, when students take EDU classes. Enrollment was up a disastrous +8%. Management offers several excuses for the low growth, but even the excuses they offer do not explain the entire shortfall from their predicted +15% number (and based on Wall Street revenue predictions, the whisper enrollment growth was closer to +17%). The anemic enrollment growth suggests that demand and competition will continue to hamper growth. This will knock the growth story from the stock and cause a snowball of selling from growth/momentum players.
The long position has been offered some hope in the revenue number. Although it fell slightly short of the whisper number, the revenue was up 29%, right where management had promised. How can EDU miss its enrollment number by 7% but hits its revenue number?
Here are the facts:
- Enrollment up +8%
- Op Income up +8%
- Revenue +29%
How can these three items be reconciled? Management does not offer a complete answer to this obvious question in the press release.
First, the innocent answer:
The innocent answer is that management was able to raise revenue per enrollment by +20% via raw price increase and getting students to attend smaller, more expensive classes. And op income only increased 8% due to high expenses preparing for future growth. In particular, EDU over-hired teachers and other staff. If true, then we still have a company that only grew enrollment by 8%. We cannot put a super-high multiple on the mix expansion because this must come to an equilibrium. And can they really keep increasing apples-to-apples prices by significantly more than inflation? So, it seems that the portion of revenue growth that is sustainable is much closer to 10%. A 50x multiple is much too high for this.
Now, all the difficult questions:
How did mgmt get it so wrong on call?
Before this quarter, revenue per enrollment growth had been in the 10% range and management had usually assigned the increase to mix upsell (small classes). In the Q4 conference call, management suggested it would rise to +15% (half from mix and half from apples-to-apples price increases) in FY 2011. This statement was made in mid-July, with Q1 more than half complete. How was management able to dramatically exceed revenue per enrollment and why was this not alluded to on the call? Further, management stated that op income would increase 25% on that call. The reason op income was so low (staff overhiring) would have been known then. 
Why no margin improvement from raw price increases?
If we saw only mix improvement, it is possible we would not see any op margin improvement, but if we also see raw price increases far exceeding inflation, we would expect to see significant op margin expansion. And even before this quarter, we have seen no margin expansion. And in a highly competitive environment, we would expect to see pricing pressure.
How does mix keep improving?
As well, how can repeatedly see mix improvement due to smaller classrooms. Shouldn't we expect and equilibrium to be reached fairly quickly? How can they keep getting students to take smaller and smaller classes at an increasing rate? It is possible, but it seems unlikely.
In short, I cannot arrive at an innocent explanation for these questions. I keep coming back to: management padded its revenue numbers by selling classes at large markups (but offering discounts to students) and then passing the discounts through the expense line. I very well could be wrong, but I can come up with no other way to explain the facts as presented by management. Is it possible that even though numerical demand was up only 8%, they were able to upsell (smaller class size) at a higher rate than past quarters and charge more for the same experience? Management dramatically overestimated enrollment while underestimating upsell and price increases. Seems highly unlikely.
Risk
The major risk here is that EDU executes its "one stop shop" strategy while improving its brand. At some point, their scale and brand would produce a competitive moat and the growth runway would be there to justify the multiple.
 

Catalyst

The near term catalyst is the reaction to today's numbers as well as the next two quarters. Several key elements of growth/momentum are no longer present: (1) Slowing revenue growth, (2) Dramatically slowing unit sales, (3) Price momentum gone, and (4) Operating margin shrinking. I also expect some Wall Street analysts to review their decision once the Q1 conference call is made in October.
The more speculative catalyst (which I am sure will be asked about on the call) is whether management can explain these seemingly incongruent facts regarding revenue, enrollment, and rapid expansion of spending leading to low margins.
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    Description

    Note: price now 96.50. please adjust multiples accordingly.
    New Oriental Education and Technology Group (EDU) is a Chinese company that offers foreign language (mainly English) and test preparation education services throughout China. As of 5/31/2010, EDU had 367 schools and learning centers in over 40 cities throughout China. Although they have a very small online business, the vast majority of the instruction is in brick-and-mortar classrooms. As well, the business is extremely seasonal as the bulk of their revenue and almost all of their earnings come during the summer and winter breaks (FY Q1 and Q3, respectively).
    The stock is tremendously over-valued on a fundamental basis even if we accept management's analysis of the latest quarter at face value. As well, the latest numbers draw into question the integrity of the financials as there is a tremendous unexplained gap between enrollment growth (and operating income) and revenue growth. The gap suggests that management is padding revenue numbers by including discounting in both the top line and expenses.
    As many value investors have discovered recently (e.g., CRM, OPEN, GMCR, etc.), the timing of short trades against growth/momentum stocks is all important. As such, this write-up will discuss not only valuation, but also critical timing/catalyst issues. It should be noted that I am writing up EDU as a short after the stock has fallen about 20% over the past week. I believe that based on the information that was reported, we finally have a catalyst to crater this stock to its true value. Note that even with the Q1 news, the stock is still flat since it reported its Q4 numbers (in mid July). I think now is the ideal time for a short position as we should all happily forgoe top-ticking the short in exchange for a catalyst.
    I believe the news released today will shatter the growth/momentum story beyond repair and a critical mass of long investors are going to dump the stock over the coming days. The numbers reveal three undeniable things: (1) enrollment growth is slowing dramatically, (2) there is no operating leverage in the model, and (3) most importantly, there is tremendous margin pressure from the "thousands" of competitors. And today's selloff will also take away the price momentum factor. Wall Street has been bullish on this stock (and several analysts rushed in today to defend the stock), but a second look at Q1 results may cause some "buys" to turn into "holds."
    Valuation [when i started writeup, price was 98. now 96.5] 
    shares: 38.8mm * $98 = $3,802mm
    cash: $423mm (no debt)
    TEV = $3,379mm
    Let's start by using the numbers produced for FY 2010 (ended May 31, 2010) because managment now claims that FY2011 numbers will include unfair expense numbers:
    Enrollment in language and test prep: 1,807,700
    Total number of schools and learning centers: 367 (as of May 31, 2010)
    Net Revenue: $386.3mm
    COR: 147.3mm (38.1%)
    S&M: 58.4 (13.8%)
    G&A: 103.3 (26.7%)
    OpInc: 77.3 (20.0%)
    NOPAT: $65.7mm (51.4x)
    Note: The medium-term tax rate will be between 15% (the Hi-Tech tax rate, which EDU partially qualifies for) and 25% (statutory rate). I imagine the long-term tax rate will move towards a standard 25%, but I will leave this analysis to you. I will use a 15% tax rate throughout this analysis.
    Until today's Q1 release, management had stated the following multi-year projections:
    Revenue Growth: +30%
    Op Income Growth: +25%
    For FY 2011, management stated that it would achieve 30%-ish revenue growth via: (1) +15% enrollment growth, (2) +7% raw price increases and (3) +7% mix change as students moved to smaller, more expensive classes.
    Focusing on margin, we know several things: (1) The basic business model offers no operating leverage. It is an extremely linear model. More students require more classrooms and more teachers. There are very few overhead costs. This is clearly very different from online education programs in the U.S.; (2) The mix change to smaller classes increases the revenue, but it does not increase the operating margin (as a % of revenue); this makes sense as larger classes have a higher revenue for a given amount of teacher time (cannot charge 20x more for 1:1 tutoting than for 20 student group class).
    One other thing to note is that the raw price increases and mix improvement could not continue forever. Eventually, an equilibrium mix would be achieved and prices could not keep rising significantly faster than inflation (and the competitive environment challenges whether prices can rise at all). At the end of the day, long-term growth must come from enrollment. Thus, putting an enormous multiple on mix growth is an error.
    Thus, even if we believe managment's enrollment projections, we are paying over 50x for a company without any operating leverage that is growing unit sales at +15% (with a one-time hiccup of only 8%). And further, this company operates in an extremely competitive environment. It has limited scale advantages although it does have a brand name due to its size. I would argue that the brand for teaching vocational language skills is not terribly valuable, but this is judgment.
    -
    Today, the company reported Q1 numbers. And remember that Q1 is by far the most important quarter because it includes the summer break, when students take EDU classes. Enrollment was up a disastrous +8%. Management offers several excuses for the low growth, but even the excuses they offer do not explain the entire shortfall from their predicted +15% number (and based on Wall Street revenue predictions, the whisper enrollment growth was closer to +17%). The anemic enrollment growth suggests that demand and competition will continue to hamper growth. This will knock the growth story from the stock and cause a snowball of selling from growth/momentum players.
    The long position has been offered some hope in the revenue number. Although it fell slightly short of the whisper number, the revenue was up 29%, right where management had promised. How can EDU miss its enrollment number by 7% but hits its revenue number?
    Here are the facts:
    - Enrollment up +8%
    - Op Income up +8%
    - Revenue +29%
    How can these three items be reconciled? Management does not offer a complete answer to this obvious question in the press release.
    First, the innocent answer:
    The innocent answer is that management was able to raise revenue per enrollment by +20% via raw price increase and getting students to attend smaller, more expensive classes. And op income only increased 8% due to high expenses preparing for future growth. In particular, EDU over-hired teachers and other staff. If true, then we still have a company that only grew enrollment by 8%. We cannot put a super-high multiple on the mix expansion because this must come to an equilibrium. And can they really keep increasing apples-to-apples prices by significantly more than inflation? So, it seems that the portion of revenue growth that is sustainable is much closer to 10%. A 50x multiple is much too high for this.
    Now, all the difficult questions:
    How did mgmt get it so wrong on call?
    Before this quarter, revenue per enrollment growth had been in the 10% range and management had usually assigned the increase to mix upsell (small classes). In the Q4 conference call, management suggested it would rise to +15% (half from mix and half from apples-to-apples price increases) in FY 2011. This statement was made in mid-July, with Q1 more than half complete. How was management able to dramatically exceed revenue per enrollment and why was this not alluded to on the call? Further, management stated that op income would increase 25% on that call. The reason op income was so low (staff overhiring) would have been known then. 
    Why no margin improvement from raw price increases?
    If we saw only mix improvement, it is possible we would not see any op margin improvement, but if we also see raw price increases far exceeding inflation, we would expect to see significant op margin expansion. And even before this quarter, we have seen no margin expansion. And in a highly competitive environment, we would expect to see pricing pressure.
    How does mix keep improving?
    As well, how can repeatedly see mix improvement due to smaller classrooms. Shouldn't we expect and equilibrium to be reached fairly quickly? How can they keep getting students to take smaller and smaller classes at an increasing rate? It is possible, but it seems unlikely.
    In short, I cannot arrive at an innocent explanation for these questions. I keep coming back to: management padded its revenue numbers by selling classes at large markups (but offering discounts to students) and then passing the discounts through the expense line. I very well could be wrong, but I can come up with no other way to explain the facts as presented by management. Is it possible that even though numerical demand was up only 8%, they were able to upsell (smaller class size) at a higher rate than past quarters and charge more for the same experience? Management dramatically overestimated enrollment while underestimating upsell and price increases. Seems highly unlikely.
    Risk
    The major risk here is that EDU executes its "one stop shop" strategy while improving its brand. At some point, their scale and brand would produce a competitive moat and the growth runway would be there to justify the multiple.
     

    Catalyst

    The near term catalyst is the reaction to today's numbers as well as the next two quarters. Several key elements of growth/momentum are no longer present: (1) Slowing revenue growth, (2) Dramatically slowing unit sales, (3) Price momentum gone, and (4) Operating margin shrinking. I also expect some Wall Street analysts to review their decision once the Q1 conference call is made in October.
    The more speculative catalyst (which I am sure will be asked about on the call) is whether management can explain these seemingly incongruent facts regarding revenue, enrollment, and rapid expansion of spending leading to low margins.
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