Summary

This is a time sensitive idea in a relatively illiquid small cap stock.  We recommend both short term traders and long term investors build their positions in China Education Alliance, Inc (CEU) prior to its 2^nd quarter earnings conference call on August 11.  The stock has been sold off due to, in our opinion, an incorrect reset of expectation after two consecutive quarters of slowdown in revenue growth.  Along with a weakness in general market and negative sentiment towards Chinese small-cap stocks, the stock has come down from a high of $7.48 to just below $4.  At these levels, the stock trades at less than 3x EV to FY10 EBITDA and 6.5x PE (3.1x excluding excess cash).  We believe this is an excellent entry point for such a highly profitable company with excellent cash flow generation.  The upcoming 2^nd Q earnings could be a catalyst for the stock price.  Historically, despite the volatilities we’ve seen in its historical quarterly results, CEU has consistently achieved 30%+ top and bottom line growth and we believe it is on track to achieve its stated guidance of 30% revenue growth in FY10.

Background of the Chinese education industry

According to Chinese tradition, education is seen as the foremost factor in achieving success.  In general, only students who pass the numerous examinations, which are given at various stages of the educational process, can obtain better educational opportunities at a higher level.  The one-child policy, which has been in effect for three decades in China, has only increased the parents’ willingness to spend more on their only kids’s future.  As a result, spending on education resources is one of Chinese family’s major expenditures.  According to the United Nations Educational, Scientific, and Cultural Organization, the average PRC family sets aside 10% of its savings for education.  Historically, spending on kids’ education has accounted for about 10-11% of a typical Chinese household’s expenditure.  With rising household income, the amount of spending on education will only increase.  In addition, the government in China has historically under-invested in education, as its spending on education in 2006 was under 2% of overall GDP vs. 6.7% in the United States and an average of about 5% in G7 countries, estimated by the National Center of Education Statistics (www.nces.ed.gov).  This has been gradually changing as government considers education to be of crucial importance for its economic and social development and hence regards education as a priority.  The Chinese government has planned an increase of education expenditures to 4% of GDP in 2010.  Such tradition and the above mentioned trends have created a huge demand for examination-oriented preparatory education services, hence a market for CEU’s products and services.  The target market is estimated to be the 150 million students in 6-18 age range, and $15 billion in size annually.

Company Description

CEU’s business is focused on meeting the education market’s needs by providing examination preparatory materials both on-line or on-site for all major primary, middle and high school examinations, as well providing vocational training for high school and college graduates.

The company mainly operates in 4 provinces in China and has the following three sources of revenue:

1. Online Education - sale of educational and supplemental materials and vocational and certification training courses through its various web portals, i.e. www.edu-chn.com, www.360ve.com.  60% of overall revenue with gross margin historically in the 75%-80% range.
2. Training Center - on-site training and tutoring services at its 36,600 sq ft training center in the city of Harbin. 33% of the overall revenue with gross margin in the mid 70%s.
3. Other revenue – primarily advertising revenue from its websites. 6% of overall revenue with 90%+ gross margin.

CEU owns a proprietary database of 350k exams, test papers, courseware and other copyrighted materials.  Some papers were exams given in previous years and some were developed by the famous teachers/instructors engaged by CEU on an exclusive basis.

In addition to the education resources, the management and sales team of CEU have been in the education supplemental materials business for a long time and developed a close relationship with the regional and local governments’ education bureau/commissions.  Students’ purchase decisions of supplemental materials are typically influenced and even dictated by teachers’ recommendations.  With its close connections to local education commissions and exclusive partnership with most of the famous teachers in the 4 provinces it operates, CEU enjoys a unique advantage in marketing its products.  In the vocational education side of business, CEU partners with the National Vocational Educational Association (a quasi-government entity) to markets its training services.

Since 2005, CEU’ revenue has grown from $3.1 million to $37.4 million, earnings from $1.7 million to $15.6 million in the LTM ending 3/31/10. CEU has an asset-light business model with excellent operating leverage and little capex requirement, so free cash flow has been consistently growing in tandem with earnings, i.e. quality of earning is very high.  Historically, management has been extremely careful with acquisition of other businesses using its cash resources.  In fact, most of the acquisitions done in the past have been small, tuck-in deals.  The management of the acquired companies typically stayed to manage the business.  In addition to steady cash flows, CEU also has a pristine balance sheet with $68 million cash and zero debt to support its growth and expansion into other regions of China.  CEU mgmt is confident it can grow the top line organically by at least 30% in FY10.  The company has also stated it now has plans to have a number of acquisitions completed by year-end.

* Excludes $3.6 million non-cash expense related to derivative securities and warrants.

* FYE09 cash balance included the $24 million secondary offering completed in Sept 2009.  FY10 year end cash estimates based on the FCF est for FY10.

CEU mgmt has been very investor friendly and, at the request of its investors, is starting to make a lot of upgrades to commit to a higher standard, i.e. upgrading to NYSE, and potentially upgrading its auditors and board of directors.

Valuation and risks

Despite the rallies of all other Chinese education stocks, CEU has gone sideways mainly because of the slowing YoY revenue growth it reported over the last two quarters (13.5% in Q4 2009 and 5% in Q1 2010).  At a current price of $4 and 31.65 million shares o/s, CEU has half of its market cap in cash and trades merely at 3.24x EV/EBITDA and 8.3x PE on a trailing basis vs. an average of 16.9x and 31x of its peer (see table below).  Excluding the excess cash on hand, the stock has a PE of merely 3.8x!  In fact, we like CEU’s business model better for its better margins and cash flow profile (high EBITDA to FCF conversion), given similar growth prospects.  If the stock price stays flat, we estimate that by year end CEU would have about $83 million cash on the balance sheet (assuming no acquisitions), an amount representing 65% of its current market cap of $128 million.

* in $ millions.

Historical experience has shown that CEU can have some zigzags in its quarterly results, especially in the online education revenue, as the timing of the students’ purchase of its online education resources can be lumpy.  In addition, Q1 is typically the seasonal bottom due to various holidays in China.  On an annual basis, the company has always achieved at least 30% CAGR in online education revenue.  We believe investors (especially those who have only seen a short history of the company) have incorrectly extrapolated the slowing quarterly revenue growth into the future.  On top of that, a lot of the shares issued in the last year’s secondary offering have been placed in the hands of very short-term oriented investors, who have exited the stock given the two quarters of “let-down”.  We not only believe CEU can achieve its stated guidance of 30% revenue growth with accelerating growth in rest of the year, but also think the upcoming Q2 earnings to be released on Aug 11^th can be a catalyst for the stock price.  As most of the exams are held in June/July, Q2 is typically a busy period for students to study their exams.

Our target price based on a conservative 6.5x multiple to EBIT gets a stock price of $6.5 per share, representing a 60% upside from the current price.

Risks:

1. Expansion outside of its core geographies – CEU has built a dominant position in its current market in the  4 northeastern provinces in China.  There is concern that whether it can replicate its success with the plan to expand into other regions, given the lack of similar advantages locally.  Our view is that the current valuation has more than discounted the possibility of a slowing growth. CEU’s plan is to acquire other local education companies with necessary resources and contact to help expand its online education businesses.  CEU mgmt has been very disciplined and careful when it comes to expansion/acquisitions.  Historically, it has focused on small tuck-in acquisitions and paid no more than 2-3x earnings for only targets.
2. Fraud risk – CEU went public in 2004 through a reverse merger – a process that doesn’t subject the company to the similar regulatory scrutiny as a traditional IPO.  There have been many reverse merger/SPAC acquired Chinese companies that turned out to be fraudulent recently.  We believe there is a implied discount in all small cap Chinese stocks for the possibility of fraud, due to most investors’ lack of resources to conduct detailed, on-site due diligence in the country.  As an early investor in the company, we, through our local team/contacts in China, have conducted extensive check-up on the company’s businesses and members of its mgmt.  We found the mgmt very trustworthy and we are willing to invest alongside with them.
3. China risk – In addition to the various macro events in North America, there has been continuous discussion of the possible slow down of the general Chinese economy from risks such as a burst of real estate bubble, tightening of credit due to banks’ past aggressive lending in economic stimulus etc.  These kinds of macro concerns have more or less weighed on the valuations of most Chinese stocks.  We are not macro-investors and do not have insight about where the economy is going to end up.  We consider spending on education, given its importance, to be largely non-discretionary and insensitive to a slowdown in the economy.  A tightening of credit has minimal effect on the business as most education expenses and purchase of supplemental materials are paid out-of-pocket by parents.  Small companies like CEU had no chance of getting loans from Chinese banks and will not need to borrow money any time soon given the rich cash balance.
4. Foreign Corrupt Practices Act (FCPA) – CEU has a disclosure about the risk of a possible violation of the FCPA in the US.  We think the only shady area of the business could be that possibilities that some of CEU’s sales people or agents might offer certain “under-the-table” payments, i.e. kickback, to teachers for their recommendation of products.  If you have a problem with such risk as an investor, this is not the stock to own.

Disclosure: We are long CEU stock at the time of this write up and may buy/sell stocks without updating the community.  Do your own homework.