As both a shareholder of Pearson (PSO) and an experienced investor in China, I feel it is my obligation to express my concerns about Pearson's recently announced acquisition of China-based Global Education and Technology (GEDU) for $294m. While I understand Pearson’s stated strategy is to grow internationally, particularly in Asia, Latin America, and Africa, I believe it is imperative for Pearson not to sacrifice its value system and attempt to achieve growth at any cost, and with unnecessary risks to shareholders.
The recent charges made against multiple Chinese citizens by the SEC for insider trading related to Pearson's takeover of GEDU are serious, and have not yet been resolved. In its 17 page complaint document, the SEC provided information linking the insider trading activities to GEDU’s co-founder and Chairwomen Veronica Wang along with her brother-in-law, an Executive Director at GEDU. These facts directly call into question the credibility and ethics of GEDU’s most senior manager and may ultimately lead to criminal charges against her. Insider trading is illegal both in the U.S. and in China; ignorance of the law by GEDU on this matter is not a sufficient explanation. Pearson's recent announcement on December 8th that they do not see these issues as having an impact on the deal and that they are proceeding as planned, do not instill confidence that Pearson has done proper due diligence on GEDU. It is in Pearson’s best interest, and its fiduciary obligation, to postpone the planned acquisition until the SEC investigation has been completed and the matter resolved. In the mean time, we suggest that Pearson spend additional time and resources for enhanced due diligence on GEDU to insure that management’s recent transgression is an isolated incident.
We cannot stress enough the importance of proper due diligence and having trusted management partners for businesses in China. There are numerous recent examples of high profile fraud cases in China that have impacted some of the world’s largest and most sophisticated investors. For example, China Media Express (CCME) defrauded Hank Greenberg’s Star International, while Sino-Forest (SNOFF.PK) reportedly cost hedge fund Paulson and Company an estimated $500-$750m loss.
The investment of time and costs of reviewing local financial filings, conducting background checks and on-site location visits is critical to avoiding headline embarrassments of a failed deal. Can Pearson assure shareholders that they have reviewed all local Chinese financial filings of GEDU and visited each of their 442 operated and franchised locations in 146 cities in China? The accuracy and truthfulness of GEDU’s financial reports must be called into question. Pearson does not even have to take our word for it; just read and observe what GEDU has disclosed in its financial filings about its internal controls and the recent departure of its CFO. GEDU has repeatedly listed in its prospectus and Annual Report both a “Material Weakness” and a “Significant Deficiency.” The material weakness identified relates to the lack of sufficient accounting personnel with appropriate understanding of U.S. GAAP accounting issues and the SEC reporting requirements. The significant deficiency relates to their closing procedures and accounting manual, which required improvement to facilitate preparation of financial statements under U.S. GAAP for financial reporting processes. Given the abrupt resignation of GEDU’s CFO in August 2011, less than 2 years after joining the company, we have little confidence that either the material weakness or significant deficiency has properly been addressed.
Pearson must also consider that the educational services and testing industry in China is characterized by intense competition, fragmentation and low barriers to entry. Here in the U.S. we have witnessed no less than 10 Chinese companies, including GEDU, raise capital to pursue their growth ambitions in China. These companies include New Oriental (EDU), ChinaEdu (CEDU), Tal Education (XRS), Xueda Education (NYSE: XUE), Ambow Education (NYSE: AMBO), ATA Inc (ATAI), China Distance Education (DL), China Education Alliance (NYSE: CEU), and ChinaCast Education (CAST). Please note that compelling evidence has been presented against both CAST and CEU by Kerrisdale Capital that alleges these companies have defrauded investors. We strongly urge people to read the reports made public by Kerrisdale Capital to better understand tactics used by sinister management teams in China to defraud investors.
Taking GEDU’s statements at face value would lead us to believe that they are one of the largest educational service providers in China by total locations. While this may be true (although we are skeptical unless they can convince us that they have visited all 442 locations), having the most locations doesn’t necessarily translate into having a financially superior business model, nor does it attract the attention from competitors. After reviewing each of the 9 filings for the above listed Chinese educational service providers, not a single company even mentioned GEDU as a meaningful competitor. The financial picture of GEDU that emerged after we reviewed their filings does not justify why Pearson paid a rich valuation for the business (more on valuation later). From 2007 – 2010, GEDU’s sales, general, and marketing costs (SG&A) have grown at nearly twice the average annual rate of revenues, enrollments, and new learning centers. Meanwhile, actual cash flow is growing at half the rate of sales despite GEDU’s business being predominately a cash-based business where course fees are paid up front. However, the most striking and unusual aspect of their business is that capital expenditures have on average declined by 42% from 2007-2010 (Note: GEDU does not report quarterly Capex figures).
Pearson should be wondering how sustainable is GEDU’s growth when they are spending increasing amounts on SG&A expense (41% of LTM revenues), while actual capital expenditures are minimal and declining. We wondered about the same question, and investigated the annual trend in GEDU’s sales growth rate and EBITDA margin. Not surprisingly, both metrics have shown steady decline in each of the periods we analyzed.
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We should also question the rationale of GEDU’s recent IPO and abrupt determination to sell the company. According to their IPO prospectus, GEDU raised capital “for general corporate purposes, including working capital, capital expenditures relating to the expansion of our operations, and funding possible future acquisitions.” There is no evidence to suggest this new capital was actually required or used to support any of these objectives. GEDU has reported ample cash from operations to support its growth and did not make any acquisitions.
Why is Pearson paying a rich valuation for a company that no one else appears to want to own? The steep decline by 70% in value from the $10.50/ADS IPO price to a low of $3.00/ADS cannot be explained solely by market conditions. Instead, we believe it indicates both investors’ disbelief that GEDU’s business strategy would be sustainable, and a lack of confidence in their financials. This is especially true given that GEDU’s stock price traded well below their stated cash per share of $5.13/ADS for many months.
Pearson’s offer of $11.01/ADS values GEDU at an enterprise value to LTM sales and EBITDA of 2.4x and 16.2x, and represented a 214% premium to the 30 day average trading price. This ascribes among the highest valuation to GEDU among all publicly trading Chinese educational service providers. Moreover, the 214% premium paid to the traded stock price and 16.2x LTM EBITDA multiple are among the highest ever recorded according to our analysis of precedent deal values with the help of Pearson's merger market. Wall Street analysts that cover GEDU on average expect the company to achieve 19% and 11% sales and EPS growth in 2012. These figures are significantly below peer averages.
These facts leads us to question why Pearson is paying such a rich value for a company with 1) below average growth and margins, 2) unremedied material weaknesses and significant deficiencies with internal controls, 3) no other interested buyers for the business, and most importantly, 4) a CEO and management team with questionable ethics under investigation by the SEC.
In summary, we hope Pearson seriously reconsiders its proposed acquisition of GEDU, and at a minimum, delays moving forward until the SEC investigation has been concluded. This will afford Pearson the opportunity to conduct additional due diligence and evaluate its position further. While we admire Pearson’s aspirations to grow internationally, it should not be conducted at any cost, and by pursuing transactions that subject shareholders to undue risks. The GEDU acquisition will consume nearly 18% of the company’s current cash balance as of H1 2011, but only add a paltry 0.70% to the group’s consolidated revenues and operating income by our estimates. Put in this context, the GEDU transaction does not appear to be favorable for shareholders in relation to the added risks and potential reputational harm involved.
Disclosure: I am long PSO. I have held short positions in GEDU