New Oriental Education (EDU) has recently taken some big hits. On July 17, it took a 34% hit down to $14.62 after the SEC announced it will investigate its accounting practices. The very next day, Muddy Waters wrote a "strong sell" research report that hit the stock another 35% down to $9.50. The company has since recovered all its losses from the Muddy Waters report, to close at $14.92 on September 21st. It looks like it will soon recover from the hit from the SEC investigation news as well.
As of August 31, 15.15 million shares of EDU were short, or about 10% of the total shares outstanding. If the SEC ruling ends up being favorable, it will likely push the stock well into the $20s.
On September 21, Wells Fargo gave a positive report about EDU that caused the stock to rise about 8% to $14.92. Wells Fargo stated:
Wells Fargo expects New Oriental Education's SEC investigation overhang to be resolved favorably and in a timely manner. Additionally, the firm believes expected valuation range is $24-$31 and that the current discount is unjustified. Shares are Outperform rated.
Trace Urdan, senior analyst of Wells Fargo, has specialized in the for-profit education sector since 1998. His conviction on New Oriental implies that Muddy Waters might have overlooked some things in its analysis.
New Oriental says the SEC will determine if there is a sufficient basis for the consolidation of Beijing New Oriental Education and Technology Group, a variable interest entity (VIE) of the company, and its wholly-owned subsidiaries, into the company's consolidated financial statements. The SEC is likely looking at the potential incorrect revenue recognition accounting from the variable interest entities (VIEs), and might require some additional protections for shareholders.
Muddy Waters' Report Might Be Exaggerating
I'm not saying that Muddy Waters is wrong in his report, he might be correct. I'm usually with the short sellers, but it's worth discussing the other side. Enough investors can jump on the bullish EDU bandwagon, and that will push the stock back up before the SEC investigation resolution. Additionally, in my opinion, Muddy made lots of claims about EDU, but none of them by itself conclusively proves that EDU is fraudulent.
Muddy states that EDU's auditor, Deloitte, will likely resign due to fraudulent reporting by the company. I don't think that Muddy showed enough evidence to support such a strong conclusion. However, I do think it's probable that the company will have to change some of its accounting practices, do some minor account restating and/or increase its internal controls as a result of the SEC investigation, but probably nothing as drastic as an auditor resignation.
The following are three accusations that Muddy Waters made, that might have been exaggerated.
1. EDU has numerous franchisees even though its CEO, Louis Hsieh, said that all of its stores are owned by the company.
In the report, Muddy Waters states:
The fact that EDU is lying about whether it has franchises - a fundamental aspect of its business model - implies that franchising is a big problem for EDU. After researching EDU's franchising for six months, including having chilling encounters with China's spy agency, we have our baseline count of franchises; but, our count might understate the extent. Therefore in this report, we are going to prove only that EDU is lying - that it is in fact franchising. We will give EDU the opportunity to come to the market confessional and admit to investors what is really going on. Should we find any inaccuracies at that point, we reserve the right to publicly release more information on EDU's franchise network.
It's interesting that Muddy didn't go into more detail about the franchisees, and hasn't yet done so. Muddy has taken the position of "I'm going to let EDU get on its hands and knees and admit the amount of franchisees it has, or we will further discredit them." What's the point of this? Why not just release the information it has about the franchisees right away? This stance that Muddy is taking makes me a little skeptical about its conviction on the information.
New Oriental responded to the Muddy Waters allegations by reiterating that all 664 of its schools and learning centers were its own. However, it did start a program in fiscal year 2010 that allows third parties to offer its "Pop Kids" English program. But that never exceeded 21 facilities in total, and is immaterial to the company.
It has been over two months so far, and Muddy still hasn't followed up with its threat of further discrediting New Oriental and releasing its franchisee research. However, I do agree with Muddy that New Oriental should've mentioned the franchisee program. It's kind of strange to completely leave it out even if it is immaterial.
2. Its high gross margin isn't realistic.
Muddy claims that EDU's gross margin of 60.1% for fiscal year 2011 is "far in excess of what is possible." Compared to its peers: Ambow Education (AMBO), Tal Education Group (XRS), Xueda Education Group (XUE), and ChinaCast (CAST), with gross margins of 57%, 46%, 29.5%, and 47.9%, respectively, EDU's is certainly a bit higher. However, it isn't that much higher and since EDU is the biggest, and supposedly best, for-profit educational services company of its peers, it's reasonable to think it runs its business more efficiently. I realize that Muddy thinks all those companies are fraudulent with the exception of XUE, however, that is also debatable.
On EDU's Q4 2011 earnings call, Louis Hsieh explained how the company can achieve its 60% gross margin:
"So we're like Wal-Mart but with a Tiffany price. So we offer one thing under one roof for them and so we're doing the same thing now to K-12."
Muddy states that its research as well as that of Credit Suisse have discovered that EDU's prices are really not above its peers. However, Credit Suisse' report from November 2011 still gave EDU a price target of $33.88. It said:
EDU is a solid player but not the best in K12. We initiate coverage on EDU with OUTPERFORM based on: (1) more sophisticated pricing system; (2) efforts to move up the value chain; and (3) the prospect that the MaxEn segment can create a new niche market."
Maybe the more sophisticated pricing system is what makes its gross margin so high.
3. EDU's Beijing operation (which is 35% of EDU's reported revenue) has prepared fraudulent financial statements for 2009-2011.
The Beijing operation reported that it had an exemption from corporate income tax called the enterprise income tax (EIT) exemption. However, Muddy claimed that it didn't really have this exemption and did indeed pay it.
Taxes are complicated in China and are done differently than in the US. I think there is a high probability of a misunderstanding of the situation by Muddy. Muddy states that "a slight but telling inconsistency supports the conclusion that the Beijing operation's financials are fraudulent." I think to say that the entire financials are fraudulent due to "a slight inconsistency" about a tax exemption is a bold statement.
I believe the likely endgame scenario is the SEC will have New Oriental restate its accounting due to the confusion with the VIEs, but nothing major will happen. When the SEC investigation concludes, the stock should bounce back to the $20s.
Some reasons why I'm predicting this is because it has been two months since the Muddy Waters report, and there has been no indication of excess damage. No financial employees have reportedly left, and its auditor hasn't resigned. New Oriental has continued with its growth plans. For example, earlier this month it partnered up with McGraw-Hill Education (MHP) to advance English-language education to Chinese students.
New Oriental is a large Chinese company with a market cap of over $2B, and earlier this year was over $4B. The SEC would only cause a delisting or major restructuring as a last resort. The SEC especially now doesn't want to ruin rapport with China as the country has finally said it would allow "observational visits" from American audit-firm inspectors. This step towards potential joint inspections by both Chinese and US inspectors could start a bull rally among Chinese ADRs since it will restore some trust among US investors. But that is fodder for another article.
Disclosure: I am long EDU.