EDU: Getting Ahead of Itself

May.28.08 | About: New Oriental (EDU)

New Oriental Education and Tech. Group Inc (NYSE:EDU) has spent the last year reviewing its service offerings and has come up with more than a few ideas for improvement. The company has traditionally been in the business of teaching English to Chinese students who are on break between semesters.

While EDU has been extremely successful in this business and has developed a well known brand name, management is now looking for ways to leverage this strength into new initiatives. Most recently, the company has decided to enter the preparatory education industry by preparing students for the standardized Gaokao test that is required for college admission.

The current education system requires all students who wish to enter college to take and pass this standardized test. Unfortunately, despite a widespread desire to enter such programs (as evidenced by the rising number of students taking the standardized test), there is only a 60% pass rate. EDU sees this as a ripe opportunity to offer study classes to better prepare students to pass the test.

The company is so confident that this new market will yield profits that it recently acquired Mingshitang (a Beijing private school) in order to roll out its classes. The more traditional schooling will offer several benefits to the company as it will be able to leverage its strong brand name to a new group of students, and cross sell coursework to its existing database. Also, the test preparatory business runs countercyclical to the English classes the company has built its business on.

With all the growth and enthusiasm in the fundamental growth of the company, it is easy to transpose that optimism to a view of the price of the company’s stock. After all, the stock has risen 60% from its low earlier this year. However it appears that the stock is getting ahead of itself and the risk of a significant drop is more pronounced now that the price is nearing the resistance area of $80.

One of the biggest issues driving optimism is the company’s ability to beat its own guidance during the past quarter. As late as halfway through the fiscal third quarter, management was guiding for 22 to 28% revenue growth. When the number came in at 46.9% growth, investors were ecstatic. However, it raises some eyebrows as to why management continued to affirm its guidance when obviously the numbers were coming in much higher.

For the current quarter, management is now guiding for 29-34% growth and is lauding the fact that this guidance is even higher than the previous quarter's guidance. This is causing many analysts to put up extremely high expectation numbers considering the fact that last quarter the company beat by such a wide margin.

An analogy might be a deadly game of chicken where management continues to guide easy numbers that it can beat, analysts continue to see through the charade, until one quarter the company simply meets its own guidance or beats by a small amount. This was seen in the late 90’s and early this decade with devastating results. Stocks which are priced to perfection typically get disappointed at some point and the decline in share price is often swift and punishing.

So what are investors in EDU to do? Does it make sense to close the position and lock in gains? Is it wise to take a short position, betting on disappointment for the masses?

I think that it is probably best to at least close a portion of the position if long. The name is trading at a valuation that makes me uncomfortable. I do not believe it is time to short the stock yet, but it is definitely one I have on my radar. If the overall market continues to deteriorate like we saw last week, and the FXI (China 25 index) rolls alongside, then it would make sense to take a short position and use a stop a bit over $85. These are dynamic times and it pays to take control of risk and find opportunities to make money even if stock prices drop.

EDU Notes

FD: Author does not have a position in EDU.