New Oriental Education - The Hidden Dragon of China

| About: New Oriental (EDU)

Quite a few prominent investors like Jim Rogers are optimistic about China’s economy, which had reportedly grown at a 10.7% pace in the fourth quarter of 2009, while others like Jim Chanos warn of an impending major Chinese real estate bust. All the noise and often contrary opinions by the experts have outright confused investors who are interested in learning more about China.

I will not attempt to explain everything about China here but I will point out a rare opportunity that is available to investors interested in the Chinese market. After all, good investment opportunities have to exist in an economy as big as China. The investment I am referring to is a stock listed on the New York Stock Exchange called New Oriental Education and Technology Group Inc. (NYSE:EDU).

New Oriental Education and Technology Group Inc., founded in 1993, is the largest private Chinese education and test preparation company. It has 48 schools in 40 cities and 250 learning centers in China. The company’s current market cap is approximately USD$2.64 billion and its total net revenue is USD$292.6 million for the fiscal year ended May 1, 2009. While its P/E appears high at 38, its earnings growth potential must not be underestimated.

Compared to many industrialized nations, the private education industry in China is largely at its infant stage of development. Since Chairman Mao rose to power in 1949 until more than a decade ago, education in China was controlled entirely by the state and private schools were prohibited by law. Even when China declared its intention to open up its education industry in 1993, privately funded institutions were not allowed to be formed for the purpose of making profit. It was not until 2003 that China introduced a new law that allowed non-state schools to prosper as a business. This is an important point to understand when evaluating a company that operates in such a unique market environment.

The China Statistical yearbook in 2009 ranks education as the third highest consumer spending item at 12.1%, behind Food and Transportation/Communications. Education is always a priority for a Chinese family where most parents want their children to have a good education and hopefully someday become a doctor or an attorney. With a population of over 1.3 billion, 19.8% of which are 14 or younger, the demand for education services provided by a company such as New Oriental Education is huge, to say the least. The industrialization of China will also benefit the company as people’s ability to afford better quality education increases. Moreover, the trend of educating a child at a younger age in China will substantially benefit the company’s outlook.

Despite the lucrative potential of New Oriental Education mentioned above, it is not all glory for the company. Its second quarter of 2009 results reveals a drop in profit of 64 percent and its $61.2 million quarterly revenue missed Wall Street expectations of $61.7 million. They are mainly due to the outbreak of H1N1 last year, where concerned parents of their often only child have withdrawn them from enrollments. Fortunately, the H1N1 vaccines that had subsequently rolled out in schools throughout China have decreased the fear. Exogenous events such as a natural disaster or an outbreak of contagious disease will continue to affect businesses in China, and New Oriental Education is no exception. Other risks worth considering when investing in this company include a serious economic downturn, new policies enforced by the government that will negatively affect its operations, and of course accounting discrepancies.

In order to maintain its market dominance and prosper in this industry, New Oriental Education needs to have an effective and rapid expansion plan. As a matter of fact, when it announced its expansion plan on January 19, 2010 which includes a cost of $4 to $5 million, investors cheered the move and its stock price rose more than 10% to close at $79.35. The plan includes the hiring of more than 1,000 full and part-time teachers for its U-Can program. U-Can is a program that was launched in 2008 which targets middle and high school students in China who are preparing for the college entrance examination in China, known as the “gaokao.”. I applaud this strategic move by the company as well.

The state can be your best ally or greatest foe when operating in the Chinese market. Businesses that understand what the state wants and are able to feed it to them will reap enormous benefits while the ones that step on its toes may go belly up in a glimpse of eye. There is no doubt that China wants to bring up the standard of living of its people, and it understands that education plays a crucial role in it. The private sector can lessen the Chinese government’s burden in providing education to its citizens. It allows China to focus its resources on rural children who need the subsidies while the company caters its services to the urban students who can afford private schooling. But of course, given how the Chinese government controls information flow in the country, these private companies must be very sensitive to the type of education that they provide.

While New Oriental Education is a good long-term investment, I would caution investors against investing for short-term gain as the stock has risen about 35% in 2009. A short-term pull back would not be unwarranted.

Disclosure: Long EDU