One of the great challenges of investing in companies in “emerging markets” is valuation. What is a fair price and what is overvalued? Well, for many investors the answer comes too late.
Come on Down …. and get Acquainted with New Oriental Education and Technology Group (NYSE:EDU)
This company offers private education services in China. It runs classes for both schoolchildren and adults, with a special emphasis on teaching English to Chinese adults.
“Historically, our core businesses have been English language training for adults and test preparation courses for college and graduate students. “ EDU – 20-F 10/23/2008
Turning to the numbers, EDU’s backward facing P/E for 2008 is a jaw-dropping 40. Its market cap of 1.85 billion has it valued at a price to sales of over 9:1. This number is so stratospheric there are virtually no cases in recorded financial history of it being sustainable.
Yet, there is no doubt there is demand for education, and in particular, teaching English in China. However, this is a sector with no discernable barrier to entry — the company is not teaching for degrees and therefore does not need accreditation.
In February of 2009, EDU lowered earnings dramatically, and the share price took a 20% hit, showing a slowdown in a business that probably had benefited greatly from crush of business leading up to the 2008 Olympics.
But now, only 2 months later, we believe the story has taken a turn for the worse. True valuation is difficult to pinpoint until a transaction occurs in the space between two reliable parties at arms-length. Just Wednesday, EDU’s pre-eminent competitor was bought, and now everything has changed.
In their filings they state,
We face competition for our “Elite English” program primarily from Wall Street Institute and EF English First, both of which offer English training courses for adults in many cities in China. Wall Street Institute began providing high-end English training courses to adults in major cities several years before we entered this market and enjoys a first-mover advantage.
So here we see that Wall Street Institute is a competitor with equal if not stronger brand recognition. Wall Street Institute’s seller was Carlyle Group, not exactly naive investors who would sell a property for a mistakenly low price.
The Envelope, Please
The transaction price was $145 million cash.
So let’s look at the valuation of this recent and highly relevant transaction.
|Wall Street English||NewMarket Corp (EDU)|
|Recent sale price||$145 million|
|Market capitalization||1.87 billion|
|Sales growth rate||40%||28% to 35% (guidance in 6-K filed February 12, 2009)|
|Price to sales ratio||2:1||Greater than 9:1|
It could also be argued that Pearson “paid up” for Wall Street English, as they are going to add them to an existing business and share all back office services.
Just as a reality check, if EDU were valued at par with this transaction based on a multiple of sales, it would be trading at a share price below $14.25
It has to be noted that Wall Street Institute’s buyer, Pearson, is a $5.5 billion dollar company. They made this acquisition for an obvious reason — to compete in this market space.
Yet, analyst models, on which the company’s nose-bleed price target depend, show the company’s net profit margins actually rising steeply from current levels of 24% to over 32% by 2011. China is the world’s most price-competitive market space. Citron questions whether a valuation that depends on sharply increasing margins as well as hugely increased revenues makes any sense at all …. especially when the barriers to entry in this business are so low.
Crystal Ball Says
EDU reports in a few days, and no doubt it will be a tad better than its lowered guidance announced February. But for extra credit, what will the analysts say about the valuation point on the Wall Street Institute acquisition?
No doubt, they’ll claim it’s not an “apples to apples” comparison. After all, Wall Street Institute concentrates on teaching English to high-end adults, while EDU’s business is broader.
The facts are that the “English to high-end adults” business is the mainstay of EDU’s business – by their own admission it’s been their core business since founding, and is their highest margin sector. Describing in their own words their newer, more diversified offerings:
Some of these operations have not generated significant or any profit to date and we have less experience responding quickly to changes, competing successfully and maintaining and expanding our brand in these areas without jeopardizing our brand in other areas. Consequently, there is limited operating history on which you can base your evaluation of the business and prospects of these relatively more recent operations. EDU – 20-F 10/23/2008
It is Citron’s opinion that the Wall Street Institute valuation metric is indeed very ominous for EDU. We can debate what variety of apples are being compared, but the difference between EDU’s 9x sales and the 2x sales valuation of their primary competitor is a reference point investors will ignore at their own risk.
In the good old days, a “China IPO” incubated by a “prestigious” Wall Street investment brokerage firm, was a ticket to valuations completely detached from reality. New Oriental seems like a throwback to this frothy era.
As an investment, the company could continue to perform in stellar fashion for years to come, but with limited metrics to distinguish “same store sales” vs. “growth by acquisition”, not to mention the uncertainties of overseas company financial reporting, its fantasy-land valuation exposes shareholders to the potential of extreme price erosion, with nothing coming from the company but a stream of good news met by a constantly oozing share price.
Cautious investing to all.
Disclosure: short EDU