Ever since Muddy Waters released its report on New Oriental Education (EDU) accusing the company of fraud, there have been many claims that refute the accusation. After analyzing the bullish reports, and Muddy's bearish report, I believe the bullish case is much more convincing. That's why I'm long EDU.
New Oriental is one of the best, well respected names of for-profit education in China. Education is a growth industry in China, and New Oriental has a great business model with expanding schools and learning centers. From fiscal year 2009 through 2011, it had an average annual revenue growth rate of 45.3%. The company has no debt, and an enterprise value/revenues of 2.26. Its current PE is 19.5. With its high growth rate that is sustainable in the near term, most companies would have a PE of 30-40. Because of its fraud accusations, the share price is depressed.
Because of its low valuation and profitability, there isn't much risk of going against Muddy Water's strong conviction that EDU is a fraud. Even after EDU's independent review of Muddy Waters' allegations had turned up no "significant instances of fraud", Muddy's head researcher Carson Block said he: "is more convinced than ever that New Oriental is materially misleading investors". The key word used in the independent review is "significant". Even if there is a small amount of mis-timed revenues, the company has great fundamentals, so there is little downside risk.
Muddy Waters Has A Great Record With Recent Mistakes
Muddy Waters used to have a great track record for sniffing out frauds. Since it had such a strong record for busting Chinese frauds, the reports should be seriously looked at. Although looking at his track record lately, he has been missing the mark.
Looking at the Muddy Waters research page, his last three pieces of research before EDU were on the companies: Fushi Copperweld (FSIN), Focus Media Holdings (FMCN), and Spreadtrum (SPRD). Being a contrarian to Muddy on these stocks would've netted an investor some excellent profits. FSIN and FMCN have since received buyout offers and are now trading at multi-year highs, and SPRD is trading at the high end of its multi-year range.
So while Muddy was a great short picker in the beginning, he is 0 for 3 with his last three picks. EDU is yet to be determined, however, the way the trend is going Muddy will probably be 0 for 4. Just looking at the share price movement tells a lot. The stock reached a low of $9.50 after Muddy's report came out. Now, at $16.60 at the time of writing this, it has almost doubled since then. Will EDU also get a buyout offer and reach a multi-year high like FSIN and FMCN? While it's not likely, it certainly is possible and EDU could end up with a $30+ share value.
Bullish EDU Reports Review
Let's look at a couple recent bullish reports on EDU.
1. Wells Fargo Report by Trace Urdan
On September 21, Wells Fargo reiterated its price target of EDU to $24-$31.
Trace Urdan is a senior analyst for Wells Fargo that has been specializing in for profit education companies since 1998. Before Wells Fargo, he worked for Signal Hill Capital. Here is a 2009 interview with him regarding his sector.
Urdan is familiar with variable interest entities (VIE) in China and discusses their risk in this article. Since this article in July, Urdan has had plenty of time to have a second look at EDU and the risks of its VIEs.
Urdan said: "While increased concern regarding the use of Variable Interest Entities (VIE) is understandable, we think it highly unlikely that the SEC will completely disavow the practice, and believe that the agency will instead require some accommodation that enhances protections for EDU shareholders".
2. Gold Pebble Report by Yifeng Mao and Adnan Gilani
The Gold Pebble report researchers produced a very detailed and extensive study on EDU for public view. It's apparent that they spent a lot of time, and that they are very knowledgeable about New Oriental's business. Their study is more intimate and detailed than the Muddy Water's report is. They:
1. Conducted comprehensive surveys on all of EDU's directly operated 48 schools and 680 learning centers to verify revenue.
- Gold Pebble was able to get an answer from all 48 of New Oriental's schools. All of them showed that their invoice was the same as New Oriental's subsidiary. 35 replied with bank details/postal remittances which verified the funds went directly to New Oriental, and not a subsidiary.
- Gold Pebble was able to get a survey answered by 564 out of 680 learning centers. They all had invoice issuing entities of the same New Oriental school name that represents the city they were in. On questions about franchisees, none of the 564 schools said they were aware of any franchisee operations in their cities.
- Gold Pebble also acquired a list of 21 Pop English franchisees. They got in contact of 18 out of the 21, and of those 18, 3 insisted they were directly owned by EDU, and the other 15 said they were franchisees. Gold Pebble suspects that the 3 that lied about their franchisee status did so because they need New Oriental's brand name to attract students.
2. Using Goldpebble's proprietary algorithms to sift through New Oriental's 107,517 class records and 14,468 opening course records they compared New Oriental's financial with its operating data as well as with other listed private schools, interviewed senior management of other non listed private schools and performed on site visits to private school associations, the Ministry of Education and the Tax Bureau.
To investigate the potential reporting fraud, Gold Pebble programmed systems to replicate EDU's 107,517 course records from its online enrollment website and and checked this database with the major cities' schools and learning centers (using Goldpebble's proprietary algorithm).
Gold Pebble analyzed every number that Muddy Waters said was fraudulent. This includes the franchise issue, high margin issue, and tax issue. Gold Pebble found every issue to be explainable and without fraud. For example, Gold Pebble states that EDU reported a lower than normal tax rate because of revenue recognition timing.
The Importance Of Thorough Digging
A big difference I see between the Muddy Waters report and the Gold Pebble report is in finding the precise answers. For example, the Muddy Waters report looks at the high margin situation and says: "No way. That's impossible!" without looking into it further and figuring out how it might be possible, Muddy just came to the conclusion that EDU is a fraud. Whereas the Gold Pebble report analyzes the numbers and came to the conclusion that numbers do make sense to have that high margin. It helps that one of the Gold Pebble researchers, Yifeng Mao, is Chinese and able to speak directly to EDU's employees. Muddy Waters needs to hire middle men in China to investigate.
Muddy claimed to have done some deeper research as it says in the report:
"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 has been almost three months since Muddy's original report, and he still hasn't released this additional information he says he has. It would be nice it to compare it to Gold Pebble's report to see if there are any controversies or mistakes from either side.
The Gold Pebble Report Is Legit
I believe the Gold Pebble report is accurate and should be heeded. It's apparent that the Gold Pebble researchers worked many long hours on the report, and have they extensive knowledge about New Oriental's business. The report is also professionally written and well-organized. However, this isn't conclusive evidence that they didn't make it up. It's also the only report on their website which might make some people skeptical. However, I believe the report is legitimate.
The reason why I believe this is because the Gold Pebble researchers, Mao and Gilani, have reputations to uphold. As shown on the Gold Pebble website, Yifeng Mao, a CFA, is the head of research at Gold Pebble, and has a long analyst history. Adnan Gilani is a fund manager in New York. I highly doubt that they are going to throw away their future and reputation on a fraudulent report. I found more details on their background on their LinkedIn profiles.
The truth will come out soon regarding EDU, as there currently is an SEC investigation into the company. This is expected to be concluded either this month or the next. If the SEC found EDU to be a fraud, then Mao and Gilani's reputations will be tarnished. I don't think they'd risk tarnishing their reputations on one stock report.
Another reason why I don't think the report is a lie, is I noticed that they didn't flaunt or overtly advertise their report. I follow many different analysts and traders, and I had never heard of Gold Pebble research. The only time I heard of it is when Yifang Mao contacted me after reading my earlier article on EDU.
Finally, the Wells Fargo report comes to the same conclusions that the Gold Pebble report comes to. When two analysts independently come to the same conclusion, it's more likely they are both correct.
In conclusion, holding a position in EDU, long or short, is somewhat of a binary play. Either it will be proven that it's not fraudulent, and it will go up, or it has committed fraud, which will be exposed, and it will go down. And the answer will probably be revealed later this month as the SEC investigation comes to a close. In my opinion, there is much more upside potential than downside for this stock.
Disclosure: I am long EDU.