New Oriental Education: Massive Upside Potential

On Oct 1, 2021 43

Summary

EDU is trading below net cash. 21% upside if it trades to net cash.
52% upside if EDU trades to its equity value, which is conservative.
75% upside if revenue drops 80% — a draconian scenario.

Since China’s crackdown on for-profit tutoring in China, New Oriental Education investors have been left in the dark to struggle with a highly uncertain situation. However, using the company’s recently filed 20-F and leveraging public information, we can nevertheless draw some educated conclusions on the value of the stock as it stands today, and consider possible outcomes for the future. My analysis suggest that the stock offers 21% to 75% upside from current levels.

For readers who are unaware of the general situation, I recommend you read the works of Larry Cheung, who has provided initial coverage on the stock when the storm hit.

Background

EDU is the leading provider of private tutoring in China, with a diversified portfolio of educational programs, services, and products. The company provides K-12 after-school tutoring, test preparations for overseas and domestic examinations, adult language training, and services in vocational training such as corporate training, marketing, accounting, human resources, IT, and PRC Bar.

The PRC private education industry, especially the after-school tutoring sector, has experienced intense scrutiny and has been subject to significant regulatory changes recently. In particular, the Alleviating Burden Opinion promulgated by the General Office of State Council and the General Office of Central Committee on July 24, 2021, sets out a series of operating requirements on after-school tutoring institutions, including:

All the existing Academic AST Institutions shall be registered as non-profit;
Local government authorities shall no longer approve any new after-school tutoring institutions providing tutoring services on academic subjects for pre-school-age children and students in grade ten to twelve;
Online Academic AST Institutions that have filed with the local education administration authorities will be subject to review and re-approval procedures by competent government authorities;
Academic AST Institutions are prohibited from raising funds by listing on stock markets or conducting any capitalization activities and listed companies are prohibited from investing in Academic AST Institutions through capital markets fundraising activities, or acquiring assets of Academic AST Institutions by paying cash or issuing securities;
Foreign capital is prohibited from controlling or participating in any Academic AST Institutions through mergers and acquisitions, entrusted operation, joining franchise or variable interest entities.

The Current Situation

As of 9/26/2021, in the company’s recently filed 20-F, EDU notes that it remains uncertain as to how and to what extent the administration over academic subjects tutoring institutions for students in grades ten to twelve will be implemented by reference of the Alleviating Burden Opinion, and the company is working closely with the government.

EDU has already ceased providing tutoring services on academic subjects during national holidays, weekends, and school breaks, and in the near future will close some of its learning centers and lay off employees.

I view this as a bullish update. What is only certain now is that the k9 business will likely go away, but the company is working with the government to determine how much of its high-school business could be retained. In my view, any clarity here, unless that business goes to zero, will be a significant positive catalyst for the stock — as we will see in our analysis below.

Net Cash & Investments: 21% Upside or $2.42 per Share (Worst Case Scenario)

As of May 31, 2021, EDU has USD $1.61 billion of cash and cash equivalents, $1.21 billion term deposits, and $3.43 billion short-term investments, which totals over $6.2 billion in short-term financial assets and the bulk of the company’s $10.2 billion total assets. In addition, the company has $538 million in long-term investments, which consists of various education and non-education investments, making it difficult to assess the potential impairment to such investments, as well as $865 million in property and equipment.

EDU has a total liability of $5.1 billion, the largest piece being $1.93 billion in deferred revenue, followed by $1.86 billion in current and non-current operating lease liabilities. The company has very little debt at less than $300 million unsecured senior notes.

In other words, the company’s net cash & short-term investments less operating leases and debt results in around $4 billion, or $2.42 per share, which implies an upside of 21% to the company’s $2.00 share price.

Equity Value: 52% Upside, or $3.03 Per Share (Base Case)

If EDU trades to its equity value of $5 billion, this would imply 52% upside to $3.03 per share. There are good reasons to believe EDU could trade to least to this level.

I expect most of the $1.8 billion operating lease liabilities to “go away” through spin-outs of its soon-to-be non-profit operations, renegotiations with landlords, and offsets from its “pre-paid expenses”, “restricted cash”, sale of “property and equipment” and monetization of its $1.86 billion “right-of-use asset”. While this is a speculative estimate, I believe EDU has plenty of non-financial assets which could be used to reduce its soon-to-be non-operating liabilities such as these operating leases used to expand the business.

Furthermore, the equity value doesn’t capture the company’s significant IP and brand equity since “Goodwill” is only $73 million on the balance sheet.

Bull Case?

Given the highly uncertain situation, I won’t put an exact number on the bull case. With 47% upside on my base case, it is all gravy from here, and I suspect there are substantial gravy coming.

In FY21, EDU generated $3.9 billion in revenue and $334M in net income. Assuming the draconian scenario where 80% of the business goes away, which assumes only the non-k12 business survives, that leaves us with around $800 million in revenue. At 1x multiple, the reminder is worth $800 million in market value, or $0.48 per share. Adding this to our base case, we get $3.51 per share, or 75% upside to $2.00 per share.

This is a draconian scenario because it assumes that all of the k12 business goes away, when it is likely that only k9 will. K9 is 48% of EDU’s revenue which will likely decline to zero, but high-school is 32% of EDU’s revenue and will likely survive under the current regulations. How much of the high-school business will survive is unanswerable at this time, so I will simply leave it to your imagination.

Conclusion

EDU is trading below net cash, although there it has no off-balance sheet liability. The government is prohibiting 48% to 80% of EDU’s business (the range is driven by the uncertainty around its high-school business) and is working with the company for to ensure an orderly transition. There are no talks of fining the company for any illegal activities that I am aware of (let me know in the comment section below if there are!). Given the scenarios in this article, I believe there is between 21% to 75% upside to the stock, with downside risk protected by its net cash value.

Author: Zen Analyst, Seeking Alpha