Puxin Limited: Expected Growth Of The Company Suggests A Potential 203% Upside

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About: Puxin Limited (NEW)
by: Acutus Investment Research
Summary

Expanding demand in China’s education sector coupled with Puxin Limited’s acquisition strategy makes strong business sense.

Business operations has been improving and path towards profitability is clear.

Company is undervalued and does not deserve to trade at a discount against peers.

We recommend buying this company with a target price between $17.30 to $23.6.

Overview

Puxin Limited’s (NEW) share price is currently -32% on a year-on-year basis and is currently trading at $7.78 per ADS. We believe that the company is undervalued due to its improving business performance and sensible acquisition strategy amidst a fragmented market. Additionally, Puxin Limited’s performance will be supported by the increasing demand for quality education in China. Our valuation model suggests that the company should be trading between $17.3 per ADS to $23.6 per ADS.

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Investment Thesis

Given the current expanding education market, we believe that Puxin Limited is well-positioned to capitalize on the growing demand. The company’s strategy to use acquisition as an expedited way to expand market share makes the most sense now given that the company is extremely fragmented.

Unlike most new companies that focus on top-line growth at the expense of their operating fundamentals, Puxin Limited has shown that they have the capacity to optimize their expenses without hurting their growth potential. Moreover, our analysis suggests that the company has a clear path toward profitability. Overall, we are confident in the company’s centralized management system (PBS).

Finally, we believe that the company is severely undervalued. After accounting for a range of realistic yet conservative scenarios, we believe that the current price of the company does not reflect the potential. Overall, we believe that the upside potential is significantly higher than any potential downside risks.

Business Description

Puxin Limited is currently the third-largest after-school education service provider. The company currently offers full-stack K-12 education programmes (students ageing from 3 to 18) and study-abroad tutoring programs. The company has also developed online applications to help increase students’ after-class exposure to enhance their learning experiences.

Puxin Limited’s strategy primarily relies on M&A activities and posit themselves as a consolidator of the after-school education industry. Upon acquisition, Puxin implements their management strategy (PBS) and formulate a detailed 100-day execution plan and set forth 21 post-acquisition milestones for each acquired school covering every key operational aspect, ensuring a seamless integration while meeting key objectives.

Management & Governance

It is to our belief that Puxin Limited has a strong and experienced management team to help leads its operations. We believe that the leaders of the company understand the industry very well and will be able to navigate Puxin Limited to become a successful company.

Yunlong Sha, the Chief Executive Officer and founder of the company is no stranger to the educational industry. He had previously taken up various managerial positions at New Oriental between 2001 to 2014. Overall, he has accumulated more than 21 years of experience in the education industry.

Peng Wang, the Chief Financial Officer is also not a stranger to the educational industry. He was previously a principal of a school under New Oriental between 2010 to 2016. Overall, he has accumulated more than 15 years of experience in the education industry.

Expanding Education Market

The education sector in China has been expanding rapidly over the past five years and growth is expected to persist into the foreseeable future. Education in China is extremely important and is perceived to be the only ticket to secure a comfortable future. As such, families are willing to spend a lot of money to ensure that their children secure good academic scores and placements. In Beijing and Shanghai, it was found that at least 70% of primary school students are receiving extra tutoring.

Based on estimates, the K-12 after-school education and study-abroad preparation market are expected to grow by 33% and 59% by 2022 respectively. Given the current and performance of Puxin Limited, we are expecting to see the company continue to grow its market share and remain as one of the largest companies in this industry.

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[Source: Company’s Presentation]

Consolidation as a Business Model

Currently, the after-school education sector in China is highly fragmented. Based on our analysis, the five biggest education companies, such as New Oriental (EDU) or Tal Education (TAL) take up less than 5% of market share each (ranging between 3% to 5% per company). Puxin Limited currently is one of the leading companies that takes up about 3% market share. In fact, there are currently more than 10,000 small-scale tutoring institutions in China with less than 30million RMB in annual revenue.

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[Source: Company’s Presentation]

Unfortunately, small-scale tutoring institutions are not operating optimally. These companies face problems such as (1) low customer lifetime value due to a lack of resources, (2) lack of recruitment efforts, (3) poor R&D capabilities to stay relevant, (4) limited potential for development, and (5) no expertise to compete against national leaders. Puxin Limited’s management strategy seeks to address these issues by raising retention rates, diversifying channels via online-offline integration, systemizing product development, creating room for development via central management and planning for a nation-wide expansion, and centralize expertise sharing in teaching, marketing, management, and operations.

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[Source: Company’s Presentation]

To grow the company organically and remain as one of the leading players would be extremely inefficient. Given the fragmentation of the after-school education sector, it makes sense for Puxin Limited to aggressively capture market share and expand its operations via targeted acquisitions. By applying a standardized management system (PBS) throughout their school network, Puxin Limited aims to achieve a positive operating margin for their acquired companies within two years.

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[Source: Company’s Presentation]

As of today, the company has made more than 48 acquisitions and is exposed to at least 19 key provinces in China. Overall, given the current fragmentation of the market, we believe that Puxin Limited’s acquisition strategy will allow them to not only potentially create an economic moat but also allow them to establish dominance in the foreseeable future.

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[Source: Prospectus]

Business Model and Financial Analysis:

[Source: Author]

Puxin Limited has two primary business model namely: (1) K-12 Tutoring and (2) Study Abroad Tutoring. A screenshot of a cell phone Description automatically generated

[Source: Company’s Presentation]

Total enrollment for the company has been growing significantly in 2017 and 2018 at 180% and 45% respectively.

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[Source: Company’s Presentation]

It is important to note that despite higher enrollments, ARPU has been deteriorating for the K-12 tutoring segment. However, we do not see this as a huge issue to the company’s growth as it has been offset by a significantly higher growth rate.

[Source: Author]

Based on our analysis, we expect total enrollment base to increase by 39% in 2021, primarily driven by a persisting high growth in the K-12 Tutoring segment. Given the company has indicated that they will continue to acquire more schools for their expansion, it is not hard for the company to achieve 4.5M students’ enrollment by 2021.

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Based on our conservative estimates of the total enrollments, we expect the company to achieve a revenue of RMB 6.75B by 2021.

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[Source: Author]

Apart from sustaining a higher top-line growth, the company, unlike many other tech companies, has been improving its costs and expenses over the past few years. Cost of revenues margin has improved from 61.93% in 2017 to 55.78% in 2018. In fact, the margins for the cost of revenues has decreased to only 53.53% in 1H19. A stark improvement as compared to previous years.

The company has been trying to optimize its expenses over the past few years. Unfortunately, between 2016 to 2018, total operating expenses have been extremely poor. In 2018, total operating expenses (S&M expenses + G&A expenses) had increased very significantly. Operating expenses shot up from 62.97% in 2017 to 72.89% in 2018. However, the 2Q19 recent earnings release suggested that the company has the capacity to bring down the costs without affecting the growth of the company significantly. Operating expenses margin has improved from 85% in 1H18 to only 71% in 1H19. In fact, total operating expenses margin was only 61.88%. This is a significant improvement as compared to the previous years!

Based on the most recent earnings call, the company has announced that they are expecting a profitable 3Q19. However, we believe that consistent profitability by 3Q19 is exceptionally tough. It will take exceptional financial discipline to deliver consistent profitability from 3Q19 onwards. It is still very early for the company to be able to optimize their expenses consistently. Our analysis suggests that the company should be able to deliver a more consistent operating profit margin by 2021 onwards. A screenshot of a cell phone Description automatically generated

[Source: Author]

The balance sheet of the company and cash flow movements currently seem healthy. Given that the company is currently working their way towards profitability through margin expansion unlike many aggressive new companies, we don’t see any significant red flags yet.

Company's Valuation

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[Source: Author, Investing.com]

Puxin Limited is currently trading way below its peers. We don’t see any reason why Puxin Limited should be valued at a discount against many of its peers. It seems clear that the premium valuation is being applied to more established companies such as Tal Education and New Oriental. However, Puxin Limited operates on a similar scale against companies such as Four Seasons (FEDU) and Rise (REDU). Unfortunately, Puxin Limited is currently trading at only 1.96x price to sales (TTM). Given the expected growth of the company, we believe that the company is currently undervalued.

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[Source: Author]

We assumed that a significant P/S multiple expansion for the company is unlikely. We also used Puxin Limited’s 2021 revenues that we forecasted to derive an expected share price for the company. Our analysis suggests that upside potential for the company is huge and downside risks remain limited. Even if we accounted for P/S multiple to contract by 40% and our revenue estimates to be 40% off, our numbers tell us that the company should still be trading at about $7.7 per ADS. Overall, given the upside/downside risks, we think that the company should trade between $17.3 per ADS to $23.6 per ADS.

Conclusion

Overall, given the current education sector is fragmented, we believe that Puxin Limited’s strategy and attempt to consolidate the market will position it to be one of the better education companies in the foreseeable future. We reiterate our recommendation to buy Puxin Limited with a target price of $23.6.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NEW over 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.