New Oriental Has Ample Upside

| About: New Oriental (EDU)

Summary

The demand for K-12 after–school tutoring services in China is burgeoning.

EDU stands up well to competition with its online-to-offline (O2O) ecosystem.

EDU continues to grow its revenue at double-digit and expand its operating margin into mid-to-high-teens.

As the leading private education services provider in China, New Oriental Education & Technology Group Inc. (NYSE:EDU) concluded its fiscal year 2016 on a positive note; according to Q4 2016 results, EDU's 2016 revenue of $1.5 billion came in above consensus estimates of $1.0 billion. While EDU is currently trading near its 52-week high, there is still ample upside. Vibrant industry trends and healthy fundamentals could nudge EDU 25% higher toward $55 in 12 months.

My bullish view rests on three points. First, the demand for K-12 after-school tutoring services in China is burgeoning, and it offers EDU enormous market potential. Second, EDU stands up well to competition, as it is uniquely positioned in the market with its online-to-offline ((O2O)) ecosystem. Third, EDU's management has proven effective in balancing topline growth and bottom-line improvement, and it continues to grow the revenue at double-digit and expand the operating margin into mid-to-high-teens.

EDU's test preparation services, particularly the English test preparation courses, are broadly recognized by Chinese parents and students, and used to be the primary revenue source of the company for years. As the English test preparation market became saturated, EDU's growth slackened. To extend growth runway, EDU branched out into the K-12 market in 2008, and recently renovated its K-12 programs to better penetrate the market. In FY 2015, the K-12 segment accounts for 43% of EDU's total revenues and the test preparation segment accounts for 33%; while in FY 2008, the K-12 segment accounts accounted for only 12% and the test preparation segments for 70%. The rapidly growing K-12 segment has evolved into the key revenue driver for EDU going forward.

Supported by increasing China K-12 population and household education spending, the robust demand for K-12 tutoring services bolsters EDU's total addressable market. From 2012 to 2015, the K-12 education market segment had fared well despite the economic slowdown; it registered a 3-year CAGR of 19.6%. In the meantime, EDU's K-12 revenue grew at a 3-year CAGR of 22.7%, outpacing the China K-12 market size growth by three hundred basis points. The momentum is expected to persist. It is also worth mentioning that the China K-12 market is notably fragmented, with market leaders EDU and TAL Education (XRS) together possessing less than 3% of the entire market. As a result, there are plentiful market shares for EDU to capture.

Thanks to a record amount of investment, edtech companies that offer online tutoring services proliferated in the past three years. In the first quarter of 2016, above 50% of edtech investment flowed to K-12 companies that are poised to seize greater market shares. Some investors reckon that edtech companies would churn the K-12 market landscape by drawing students from bricks-and-mortar classrooms to dot-com livestreams. Although Chinese students and parents enjoy the technological benefits from online tutoring venues, they still view face-to-face tutoring as irreplaceable; physical interaction is conceived the most efficient way for students to concentrate, to learn, and to memorize. The O2O ecosystem integrates the online learning tools into EDU's offline offerings, and it bodes well for EDU's competitive positioning against pure online contenders.

The fledging O2O ecosystem reaccelerates EDU's topline accretion. Removing the negative effect of RMB devaluation, EDU notched a revenue growth rate of 24% for fiscal year 2016 versus a single digit for fiscal year 2015. To extend double-digit growth trajectory into fiscal year 2017, the management plans to tap profitable opportunities by adding 30 to 40 new learning centers in existing cities and by entering 1 to 2 new cities. In fiscal year 2013, EDU's undisciplined expansion led to corporate bloat, and its profit margin bottomed. From that point, the management has become more cautious expanding the business, and focused on improving utilization rates, which booked a three hundred basis points increase to 19% in fiscal year 2016. The management expects the utilization rates ascend to 21% in fiscal year 2017.

EDU's operating margin stands at 13.4% for fiscal year 2016 versus 17% for fiscal year 2014. Its intensive spending for building out O2O ecosystem had compressed the operating margin in fiscal year 2015 and fiscal year 2016. The management is sufficiently confident that the operating margin is on track to recover, as it expects reductions in O2O related expenses. In addition, the low inflationary macro-environment in China is expected to lend a tailwind to EDU's margin expansion, as it mitigates upward pressures on teachers' salaries and schools' rents, which together compose EDU's core operating expenses.

Currently, EDU trades for 23.9 times its estimated next twelve month (NTM) consensus earnings, well below the P/Es of its rival XRS, which trades at a multiple of 42.4. The street forecasts for NTM earnings growth averaged 18.2%, which puts EDU's price/earnings to growth (PEG) ratio at 1.31, slightly below XRS's PEG ratio of 1.37. My base-case $55 price target is derived from my discounted cash-flow valuation using an 11% WACC and a 5% terminal growth rate; using fiscal year 2017 consensus earnings, it fetches a P/E multiple of 29.9.

The price target is enticing, but there are a number of caveats. First, a disruptive technology or business model may shape an unfavorable competitive landscape for EDU. Second, a sudden education policy change may affect students' decisions on signing in after-school tutoring classes. Third, EDU's massive organization structure may hinder management's attempt to improve margins. Although the aforementioned risks could dampen growth, the likelihood of those happening is low in the near term.

In conclusion, at EDU's present valuation, the downside is limited, particularly given that K-12 demand headwind is minimal; the upside is meaningful, given that EDU's efforts of equilibrating topline growth and bottom-line expansion is paying off.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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