Last year a Barron’s article titled Beware This Chinese Export said U.S. investors should shun investing in any small-cap Chinese companies, showing a systemic bias against companies from the fastest-growing economy on the globe.
Suddenly every Chinese company was guilty until proven innocent. This environment of fear created a playground for short sellers, amateur analysts and media, who could concoct almost any allegations based on snippets of information and heavy helpings of speculation.
Of course frauds were exposed but to say that every U.S.-listed Chinese company is a fraud is like saying every sheep in the world is black. There are still many good U.S.-listed China companies around with proper corporate governance and accounting.
In June Bloomberg published a list with all U.S.-listed PRC companies that have done reverse mergers. In the initial list it made a minor error which of course can have big consequences for a company in the current anti-China climate.
The company we are talking about is ChinaCast Education (OTCPK:CAST).
ChinaCast Education is not a reverse merger (see 8-K filed June 23, 2011). The company was originally financed by U.S. venture capital investors Intel (INTC) and DirecTV (DTV) and Hong Kong's second largest conglomerate, Sun Hung Kai, in 2000, and have been audited by Deloitte since inception. The company actually came public through a traditional IPO in May 2004 on the Singapore Stock Exchange. In December 2006, the company was acquired via public tender offer by Great Wall Acquisition Corporation, a special purpose acquisition corporation (SPAC) and eventually listed on the Nasdaq Global Market in October 2007.
ChinaCast Education is the only U.S.-listed company that owns accredited degree-granting colleges in the world's largest post-secondary market in terms of students - China. The company has over 32,000 on-campus students and 144,000 online degree students and is well-positioned to take advantage of the attractive growth prospects in the Chinese post-secondary market through its ground and distance post-secondary businesses. Though enrollment is set by the government, the enormous demand for post-secondary education effectively guarantees maximum enrollment, providing excellent visibility into future revenue and earnings growth.
CAST's post-secondary education segment has higher margins and much higher barriers to entry than the language training, test prep, tutoring segment occupied by U.S.-listed New Oriental (EDU) and many other private companies. However, CAST currently trades at a significant discount of 2.5x forward EV/EBITDA ratio of 2.5 versus the 10-20 forward EV/EBITDA ratios other U.S.-listed PRC education companies trade.
The company had another strong Q1, in which revenues increased 43% to $22.8 million and adjusted EBITDA increased 40% to $13.3 million. With $96 million in net cash and $60 million more to come via student tuition payments in the September/October period, CAST has substantial fire power to boost shareholders returns. It commenced a $50 million corporate share buyback recently and insiders have purchased approximately $20 million of stock in the past 18 months. Not many companies, U.S. or Chinese, have done that. Allocating capital at these compelling valuations will enable the company to accelerate earnings per share growth during the coming year. In addition, the likelihood that CAST will announce another accretive acquisition before year end provides a visible catalyst for the stock.
The Traditional University Group (TUG) segment continues to be the main growth driver for ChinaCast. In Q1 2011, total TUG revenues grew by 69% from organic growth of existing schools coupled with contribution from the acquisition of its third university, Hubei Industrial University Business College (or HIUBC). HIUBC not only brings terrific programs and faculty, it also provides another strong growth vehicle which the company intends to leverage over time. Total student enrollment at the three universities now exceeds 32,000, up from 20,400 last year. It continues to see robust demand for four-year degree programs across each of the campuses due to high rankings, career oriented course offerings and excellent job placement rates. The company’s E-Learning Group (ELG) segment currently has over 144,000 students and is targeting 10% organic top-line growth this year with operating margins of 60%. A new e-learning joint venture partnership with one of China’s leading university distance learning programs, China University of Petroleum, should add to this growth starting in the 2011-2012 academic year.
CAST continues to augment its domestic post-secondary degree programs with new programs such as summer exchange and U.S. degree programs, which were launched last year. International degree programs entail foreign students spending a portion of their four years at one of the universities while studying abroad at the campuses of one of its four U.S. university partners - for the remainder of the post-secondary term. CAST anticipates having close to 600 students in summer programs this July and 150 international degree students enrolled by the end of the year. These initiatives provide a platform for steady growth over the next several years.
In addition to organic growth, the company has announced it intends to deploy its large cash balance to acquire its fourth university in the second half of 2011, which could add an additional $0.10 to its annual EPS run rate.
Financial Outlook for 2011
For the full year ending December 31, 2011, the company provided the following guidance:
- Total net revenue will be between $94 million to $96 million (YOY increase of 21% to 23%).
- Adjusted net income excluding share-based compensation, amortization of acquired intangibles and one-time impairment charges (non-GAAP) will be between $32 million to $34 million (YOY increase of 18% to 25%).
- Based on the current weighted average shares and the higher tax rate accrual used in computation, adjusted diluted EPS (non-GAAP) of between $0.64 to $0.68.
- Adjusted EBITDA excluding share-based compensation (non-GAAP) will be between $50 million to $52 million (YOY increase of 20% to 25%).
Currently trading at EV/EBITDA of ~2.5x, and 80% of tangible book value, analysts have a price target of $10 to $15, substantially higher than the $5.41 it currently trades. Furthermore ChinaCast is currently trading at a market value of approximately $150 million (net of its cash balances.) Its ELG business, which generates approximately $20 million of EBITDA annually, would easily be worth at least $75 million dollars at a modest 3.75 x multiple. Therefore CAST's TUG, (traditional university group) which consists of three universities, is being valued at approximately $75 million. CAST purchased each of these three universities for approximately $75 million and they have grown since their dates of acquisition. In other words, a buyer of CAST stock is paying for one university and getting the other two for free at CAST's current stock price. Lastly, CAST is trading at an EV/EBITDA multiple of approximately 1/10th of the multiple ascribed to EDU, even though the company's growth rates are not dissimilar and CAST is in a more protected niche.
If the company were able to utilize the entire $50 million authorization at the most recent closing price, the company would be able to repurchase approximately 7.7 million shares, which would be roughly $0.11 accretive to 2012 earnings per share after accounting for lost interest income.
The stock is down around 32% YTD, caught up not only in the general negative sentiment toward small-cap RTO stocks, but facing allegations of impropriety by short-sellers. The most serious allegations relate to the company's acquisition of three ground universities and whether the amounts that ChinaCast reportedly paid actually went directly to the original seller or whether large portions of the purchase price were (presumably) pocketed by ChinaCast officials.
The company has been as forthcoming as reasonably possible in addressing the issues raised by critics and I find its explanations to be adequate. The simplest reason, however, to discount the short-seller theory is that to believe that management personally benefited suggests the seller would have had to agree to a below-market price even as the company advertised the higher price in its public disclosures.
Given the competitive environment for acquisitions in China, I do not believe there is a seller that would be willing to sell a university at such a bargain price.
Additionally, ChinaCast has several characteristics that are different from the typical profile of a Chinese company accused of fraud.
- A typical company accused of fraud was privately held in China and went public in the U.S. via a reverse merger. ChinaCast received venture capital funding from Intel and Direct TV in 1999, ChinaCast then went public via an IPO in Singapore in 2004, before becoming listed in the United States via a merger with a SPAC.
- Each transaction included yet another round of thorough diligence.
- A typical company accused of fraud has had unknown auditors. ChinaCast's auditor is Deloitte, which in itself is no guarantee against wrongdoing, but should provide some comfort. In addition to Deloitte reviewing all of the company's financial statements and acquisition agreements, management disclosed that its largest shareholder, Fir Tree, hired PWC to review all of the company's acquisitions as well and found nothing improper.
- ChinaCast and insiders have purchased shares. The company recently repurchased 915K shares of stock at an average price of $4.75 under its $50 million share buyback. This is a strong positive sign and it would make little sense for a fraudulent company to repurchase shares. Prior to this repurchase, management and board members had personally bought back over 10% of the company during the past 24 months.