New Oriental Education (Ticker EDU) is the leading education brand in China. Since its founding in 1993, the company has built its reputation on providing overseas test prep services, which are offline-based test preparation classes for standardized tests required for studying abroad, such as the TOEFL, GMAT, and SAT, etc. Over the last few years, as growth in the number of students studying abroad slows down, the company expanded their offering into K-12 after school tutoring services, which most recently contributed to 48% of total revenues in the latest quarter that ended on May 31, 2015.
My thesis, in short, is that EDU’s growth is re-accelerating, and therefore its valuation should re-rate to reflect the company’s faster growth profile. Current valuation is attractive at 17.2x forward CY 2015E P/E, implying a market cap of $3.6 billion, of which $1.4 billion or 40% of the market cap is supported by cash on balance sheet. Roughly 1/3 of the cash is restricted. Excluding the remaining 2/3 of unrestricted cash, the adjusted ex-cash forward CY 2015E P/E multiple is only 12.6x.
In comparison, closest peer TAL Education (Ticker XRS), a pure play in the faster growing K-12 after school tutoring services, is trading at 34.2x forward CY 2015E P/E. Recognize that XRS is a pure play, has a faster growth profile off of a smaller base, and has better management execution, I still think the valuation gap between the two players is too wide.
Overseas Test Prep
Volume growth in this segment is slowing down / possibly declining, but it is still growing via ASP increase. EDU’s overseas test prep services are highly differentiated products that have commanded strong pricing power.
Prior to 2013, the number of people studying abroad was growing at a 15-20% CAGR. This growth rate has slowed down dramatically to the low single digit %s, and can potentially even decrease going forward. However, the company’s classes are arguably best in class by a wide margin. In fact, it has more than 60% in market share and has consistently been able to raise ASP by at least 10-15% per year.
In summary, I think this is a great stable cash cow business, and its success has made EDU a household name for education in China.
K-12 After School Tutoring Services
Leveraging the company’s well-known brand, EDU entered the K-12 after school tutoring services space in recent years to seek its next growth driver. Management estimates that this is a US$30 billion market opportunity in China. By this estimate, EDU has only 1-2% market share in a large and also fragmented market. In fact, the combined market share of the three national players is only ~5%, with the majority of the market being serviced by city-level players and individuals, such as teachers and college students.
Unfortunately, EDU has had a number of execution issues. For example, the company introduced bottom line profitability as a key KPI for its city managers only 4 quarters ago. Prior to this, they were motivated mainly by top line growth and opened many centers that were unprofitable. In addition, the company’s K-6 offering Pop Kids had issues with its curriculum such that enrollment growth was under expectations. Both of these issues are behind us now, but nonetheless the company has a track record for poor execution. Even so, I believe the large and highly fragmented market, EDU’s strong brand name, and its low valuation provide an attractive risk reward profile.
We are now seeing strong growth contribution from this segment. In the latest quarter that ended on May 31, 2015, enrollment growth in EDU's K-12 after school tutoring services was 57% yoy. Even in the lagging sub-segment of Pop Kids, enrollment growth was 48% yoy. If this growth momentum continues, the company's overall growth profile will re-accelerate.
New Initiatives in Online Education
Finally, what is also weighing on the stock price is the company's ongoing investment in its online initiatives. As a result, operating margin declined from 17.0% in FY 2014 to 12.1% in FY 2015. It may slip further as operating margin in the latest quarter that ended on May 31, 2015 was only 6.8%. However, the company is seeing impressive early results from its online platform, showing revenue growth of 40%, registered user growth of 110%, and paid user growth of 60% in the latest quarter. Given this strong growth momentum, albeit off of a tiny base, is encouraging, and I’m willing to give management the benefit of doubt for now and continue to monitor their execution.
Longer term, I think EDU’s investment in its online initiatives will differentiate its services as the smaller players do not have the operating leverage and financial resources to do the same. With a differentiated service, the company can continue to command pricing power and take market share from the smaller players.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise do not hold a material investment in the issuer's securities.