Description

For someone who despises CCP as much as I do, it is ironic that I keep writing up Chinese ideas. The latest installment is $TAL which has a somewhat different set-up from most of its Chinese ADR peers with dirt cheap valuation but slow/slowing growth. Current market cap is $4.5B. Net cash is $3.8B. they generated $200m operating cashflow last Q, and by my estimate should have close to $4.5B net cash by end of 2025. Perhaps more important/interesting is that TAL is growing revenue at 50% in ’24 and should continue to grow 30% CAGR in ‘25/’26, and shareholders will get a core education business on track to do $2.5B+ revenue @ 15%+ op margin in 2026. As with most of my recent ideas, the balance sheet hopefully provides enough downside support. So the write-up will focus on the background and key concerns on the stock. Happy to answer questions in the thread as always.

Background: For profit education used to be one of the most beloved Chinese industry groups by foreign investors for good reasons. Unlike University of Phoenix’s of the world in US, Chinese players focus on K12 after school tutoring. Given the nature of the current education system and tradition, Chinese (and East Asian) parents value education for their children over just about anything. Competition to get into good kindergartens, primary school, and high schools to improve the grades of college entrance exam and odds of top universities is otherworldly. I was astonished to learn that almost half of students in Tier 1 cities like Shanghai/Beijing can’t even get into a proper high school (grade 10), and instead can only go to some trade schools, which effectively eliminate their prospects of promising careers/social advances. So demand is extremely inelastic. Reputation of school/teacher and effectiveness of the program (exam result improvements) are the only thing that matters. Margins are good. FCF is excellent as students pay tuition in advance. Even during the current deflationary backdrop, this is perhaps the only industry I am aware that has positive pricing.

But the apple cart was upset in middle of 2021, when out of nowhere, the CCP government decided to outlaw all for profit K9 after school tutoring (up to grade 9). The official explanation was to reduce burden (financial and others) for parents, as the government believes the industry was one of many drivers behind the plunging birth rates. The more likely real reason is the government feels education (and brain washing) needs to be done exclusively by the “system”, and not in the hands of private enterprises.

The regulation annihilated the industry over night. Most of the companies went out of business – according to government paper released recently to “celebrate” the three year anniversary/conclusion of the “reform”, 90% of offline learning centers were gone. The two largest companies EDU and TAL survived thanks to their balance sheet, closed down majority of their campuses, laid off a big chunk of employees (teachers), and experimented with variations of product offerings. But both stocks went down over 90% and traded at a fraction of cash, and even stopped reporting financials for a couple of quarters during the restructuring.

Very importantly, the demand NEVER went away. Small mom-n-pop/single teacher classes emerged and operated in underground grey area. Tuition fees actually spiked for obvious reasons. Also enforcement of the regulation was carried out by each city, and the latitude varies significantly from city to city. EDU and TAL to a lesser extent started offering classes in a different name (no longer by subject like Math or English, but “learning capability” and “writing skills”).

So the government inadvertently created a golden opportunity for the few brave souls who still followed the industry. I got involved with EDU in the summer of 2022, after they resumed reporting. It was sporting a $4B market cap, with $4B+ in net cash and $2B+ of stake in a publicly traded company, operated in the black, and was growing 20%+ (accelerating to 30%+ in 2023/2024). Mgmt sheepishly said “We have robust demand and no competition” on earning calls with no sell side analysts. From the depth of destruction, EDU was a great stock.       

2^nd bite at the apple? Fast forward to today. TAL seems like an interesting opportunity. TAL was hit harder than EDU, as it was more focused on tutoring business and did not have the overseas test prep business of EDU. Their learning centers declined from 1000 near the peak to under 200 at the trough. The core K9 business (“peiyou”) saw sales plunge from $3B in 2021 to $200m in 2022. TAL was more tentative, i.e. “slower” to react to the loosening of the regulation. I surmise it was because EDU is more de-centralized and regional heads (principals of local campuses) have much higher freedom and leeway, and hence reacted faster to changing winds in local markets. So while EDU was growing gangbusters starting in late 2022, TAL was essentially 12-18 months late. Encouragingly, the company did ramp up the expansion pace starting last year, doubling learning center openings and core revenue in recent Qs. It could be even faster if not for teacher recruitment capacity issue (who’d have thought any industry in China today faces labor shortages).

OK, so the story sounds great, but why has the stock gotten cut in half from the peak earlier this year? In addition to the market wide selloff in anything China related, I surmise there are three key issues – regulatory risk, margin uncertainty, and a lack of shareholder return compounded by zero investor communication (sounds familiar to another popular battleground Chinese stock?).

On regulatory risk, I suppose it will always be something investors have to live with. Scars are still fairly fresh. While one can never rule out an encore performance, I think risk is fairly low in the short-medium term. Job creation is now priority #1 for the government, and this is one of the few industries creating white collar jobs for fresh college grads (the most acutely affected group). Facing various technology embargos, the government also realize they need to increase spending in education related to science/technology. They also have to acknowledge that underlying demand was always going to exist, as long as the current college entrance exam system stays in place. A similar crackdown/lift has actually happened in Korea in the not too distant past. Lastly, for those who don’t follow China closely (lucky you), Xi has a penchant for short attention span and losing interest quickly on most of his pet projects – construction of a new Capital, Belt-Road initiative, Beijing stock exchange, and most famously Zero Covid. Most of the projects/initiatives start with great fanfare and end in abject failure, so he and his underlings just bury/eliminate the subject from public view, as if they never happened. Hopefully the Supreme Leader has much more important things to worry about than after school tutoring for kids..   

On margins, TAL’s most recent Q was a big beat, as they generated positive margins in a seasonally slow quarter (revenue is seasonally higher during summer and winter holidays), but they guided for a big YoY decline in the seasonally strong Q2, when every sellside/buyside analyst was expecting huge op margin leverage from almost doubling of revenue in the core segment. Mgmt claimed they are “investing” in core business capacity expansion and AI, but never gave any concrete breakdown of what possibly they could spend on. I think this is more of mgmt. just sandbagging guidance (they did just beat their margin guidance by 800bps last Q). But investor sentiment is extremely skittish, so the stock sold off and never recovered. I take solace that op margins should be fine – 1) gross margin seems quite healthy, 2) all the competitors (EDU and two smaller players listed in HK) are reporting 15%+ op margin in the same business and TAL historically had the highest margin in the industry, and 3) Pricing is very robust based on 3^rd party data and conversations with competitor mgmt. teams, and almost every key cost item in the P&L are favorable – labor, rent, marketing. The more plausible explanation is just mgmt. does not want to show how profitable they are.

This concern and lack of shareholder communication is compounded by the fact TAL does not have any shareholder return despite the huge cash pile -- there is a buyback plan in place, but no actual repurchase in recent Qs’. This looks esp. bad when compared to its direct competitor EDU ramping up buyback recently and paying a special and regular dividend. This sounds eerily similar to PDD, and I think what I wrote in that thread in defense of PDD also applies here. One also has to be cognizant that TAL almost had a near death experience, and hoarding cash is probably reasonable, until they start gushing cash beginning next year – for context, EDU generated $800m+ FCF in each of last 2 years against an EV under $6B. TAL is still run by its founder with a generally good reputation and significant stake in the company.

Valuation is admittedly more back-of-envelope than precise. $3.8B net cash last Q and should be over $4B by year end 2024. TAL should do $2.2B USD revenue in FY 2025/CY 2024. 25% of that revenue is in learning devices (think tablets). The segment is growing nicely but is roughly break-even. I have very little conviction in this segment, so I ascribe 0 value to this revenue stream. The core “learning services” segment should do $1.5B rev (45% growth YoY), going to $2.1B in ’25 and $2.7B in ’26. 15% EBIT margin on $2.7B is $400M EBIT. FCF will certainly be higher due to working capital benefits. 10x EBIT + cash gets me a double from here in two years.

Catalyst

continued growth.

resumption of buyback/dividend.