Muddy Waters has taken aim at another Chinese company: New Oriental Education & Technology Group (EDU). Given the devastating historical impact of Muddy Waters' exposés on the stock prices of Chinese companies, investors may want to seriously consider the affects of the July 18 report recommending a Strong Sell for New Oriental.
Divest On Warning?
Questions of right and wrong, inaccurate or accurate don't matter much if the last one out of the door gets stuck with the check. Muddy Waters has a history of being to Chinese companies what a tanning bed is to vampires.
No Chinese company, or its investors, wants to be under Muddy Waters' magnifying glass. Now that New Oriental has come under scrutiny, let's take a look at the kind of dirt Muddy Waters has managed to come up with.
Caveat: Due to Muddy Waters' terms of service, I will not be supplying any direct quotes or figures. In addition, this article will not be comprehensive (see Disclaimer below).
Now, let's take a look, shall we?
Who Owns The Franchises? What Franchises?
New Oriental's President and CFO Louis Hsieh claimed in an interview back in June that New Oriental owns all of its stores. These stores supply the rational basis for New Oriental's incredible reported revenue growth.
The story is that within China, New Oriental pursues a very aggressive franchising policy. Muddy Waters points to the fact that New Oriental's 2011 audit fee was lower now than it was four years ago, despite an increase in stores over the same time.
Much lower. That means either a very shoddy auditor or less, not more, stores to audit.
Gross Margins Are Too High To Be Plausible
New Oriental reports gross margins in Chinese Tier 1 cities (Cities with total retail sales of more than RMB30bn + RMB11,000 and high per capita retail sales as proportion of income, annual per capita income: Beijing, Chongqing, Shanghai, Tianjin, Changchun (Jilin), Chengdu (Sichuan), Guangzhou (Guangdong), Hangzhou (Zhejiang), Harbin (Heilongjiang), Jinan (Shandong) Nanjing, (Jiangsu), Shenyang (Liaoning), Wuhan (Hubei), Xi'an (Shaanxi), Dalian, Qingdao, Shenzhen, and Xiamen) that are twice as high as the typical gross margins at which Tier 1 generally tops out.
The gross margins for Tier 2 cities (such as Lhasa (Tibet), Nanchang (Jiangxi), Nanning (Guangxi), Shijiazhuang (Hebei), Taiyuan (Shanxi), Urumqi (Xinjiang), Xining (Qinghai), Yinchuan (Ningxia)Changsha (Hunan), Fuzhou (Fujian), Guiyang (Guizhou), Haikou (Hainan), Hefei (Anhui), and Hohhot (Inner Mongolia), etc.) are even smaller.
Muddy Waters observed some Tier 1 city stores that only offered classes one day a week during its investigation in China, which is hardly what you'd expect for a company performing twice as successfully as the competition.
You Are Who You Hang With
New Oriental has a tight-knit relationship with other educational providers in China who shared a pre-IPO string of investors with EDU.
All of these thick-as-thieves education companies are reporting gross margins that are twice Muddy Waters' perceived benchmark of accounting excellence, Xueda Education Company (XUE).
New Oriental Is In The Franchise Business
New Oriental's brand is focused on the parents of young children. In China, that means POP Kids stores. The POP Kids website even has the franchising hotline number under the About Us section.
Muddy Waters also has an EDU employee on tape discussing the franchising setup, conditions and operations. It's a fairly damning piece of evidence that Louis Hsieh is either misleading investors or is himself being misled. (My vote is the former.)
Why Would New Oriental Deceive Investors About Its Franchising Operations?
Muddy Waters has extensive documentation illustrating the nuances, including an illustration of for-profit taxation, background on Chinese taxation policies, and filing discrepancies, but it all boils down to allowing New Oriental to game its cash balance figures, while increased franchise consolidation allows New Oriental to game the confirmation process.
Its All In Mom's Name
New Oriental's Founder, Chairman and CEO Michael Yu's shares are owned by a BVI company that is, in turn, owned by his mother. That's very generous, even for a dutiful Chinese son.
There's much, much more at http://www.muddywatersresearch.com/research.
Maybe Muddy Waters is right about New Oriental, and maybe it's wrong, or maybe it's all just a misunderstanding. (Maybe Miachel Yu just really, really loves his mother. It would be a more heartwarming result than an organized attempt to deceive U.S. Investors). Reading the publicly available research paper yourself at the link provided above is the only way to arrive at an informed conclusion.
My informed conclusion is that the floor of the NYSE is littered with the bones of Chinese companies brought to ruin by Muddy Waters Research...far, far more than have ever survived its scrutiny.
In today's reverse-merger, fraud-wracked market for Chinese securities, it may make more sense to take one look at the iceberg and dive for a life boat, rather than try to remain optimistic that the advertising claims that the cruise liner you're a passenger on is unsinkable are, in fact, true.
Disclaimer: The purpose of this article is to assess the impact of Muddy Waters' report on New Oriental Education & Technology Group, not to replicate its findings, and is protected as such under the "fair use" clause 17 U.S.C. § 107. I strongly recommend downloading Muddy Water's 97-page PDF yourself at http://www.muddywatersresearch.com/research and agreeing to the Terms Of Service for supporting arguments and data. The Report is available for free to the public.