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New Oriental: Recovery Is Around The Corner – New Oriental Education & Technology Group Inc. (NYSE:EDU)

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Via SeekingAlpha.com

Investment Thesis

In our previous article, we warned investors against potential challenges that New Oriental (NYSE: EDU) was facing due to the outbreak of the epidemic. EDU’s share price dropped 20% over the past month, which was aligned with the performance of major China-related ETFs. With the situation getting controlled in China, we think the education sector will rebound quickly, especially the offline education services. Our model gives a target price of $132 for EDU, which indicates nearly 20% upside potential based on the current price.

Overview

New Oriental Education & Technology Group, or EDU, offers private schooling services, with a focus on K-12 education. From the demand side, EDU’s services are divided into domestic exam preparation (High School Entrance Exam and National College Entrance Exam, also known as Gaokao), standardized foreign test preparation (TOEFL, SAT, A-LEVEL, GRE, etc), and other services. While the majority of New Oriental’s classes are offered onsite (or offline), the company also has the Koolearn platform, which provides online classes.

EDU’s share price went through three different periods since the outbreak of the crisis:

ChartData by YCharts

  • Period 1: Right after the outbreak of the epidemic, EDU’s share price dropped sharply by 10%.
  • Period 2: As the Chinese government adopted strict control policies, the epidemic situation was quickly improved, and EDU’s share price also rebounded to $140.
  • Period 3: Due to the global pandemic outbreak and market crash, EDU’s share price dropped again by 20%.

The recent price plunge was mainly driven by the concern on EDU’s business associated with foreign tests, as well as the overall market sell-off. However, we think the sell-off is irrational, and EDU should see recovery in the near future.

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Online Education Cannot Take Over The Whole Market

Although many students are using online platforms for classes during the epidemic, it does not mean that they actually liked it. In fact, students and their parents have been criticizing the use of online services. According to a report by Xinhua, parents were worried about the potential distractions for using mobile phones and access to the internet, as well as the damage to students’ eyesight due to long screen time.

Meanwhile, many teachers felt reluctant to broadcast their lectures at home. One potential reason is that online education platforms have to face censorship issues in China. For example, the cultural revolution in history class and human anatomy in biology cannot be fully discussed.

All these lead us to believe that once the situation goes back to normal, the demand for onsite education services will rebound quickly, even to compensate for the losses during the lock-down period.

This can also be proved through EDU’s recent earnings adjustment. On March 3rd, the company trimmed its 3Q20 (ending Feb 2020) revenue guidance in the range of $902.1M-$933.2M (+13%-17% Y/Y) respectively from the prior guidance of $983M-$1,006.4M. The impact of this epidemic on EDU’s revenue implied from this adjustment is relatively small (less than 10%), which should give investors confidence about the company’s operations.

Chart: New Oriental’s Revenue and Cost Chart from Q3 2018 To Q2 2020

Source: Bloomberg

More importantly, the outbreak helped eliminate a large group of New Oriental’s competitors, those small, boutique education companies which have struggled with their cash flows. As the leader in the market, New Oriental’s healthy financials and adequate capital helped them to survive through the crisis, and make further investment and development. During the Lunar New Year Festival, the company successfully expanded its virtual cloud classroom by 10 times. The branding effect was definitely enhanced during the epidemic.

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Projection & Valuation

Now we have to admit that the global pandemic will have some impact on EDU’s business regarding foreign test preparation. Overall, we project the revenue growth in 2020 to be 17.5%, similar to their most recent quarterly projection. This should be considered as conservative since EDU expected its revenue to grow 17% YoY even for the peak quarter of the epidemic.

The revenue growth will likely return to a normal level (~30%) after the crisis. In the long run, we assume that EDU’s revenue growth rate will be the same as its CAGR from the past five years: 26.5%.

On the cost side, we believe the epidemic brought additional costs in the short term due to the expenditures on the online platform. Following 2020, as the company’s operation efficiency improves, its costs shall go back to the normal level. We project the COGS and SG&A cost to go back to the five-year average level by 2024:

Income Statement

2020

2021

2022

2023

2024

Revenue Growth

17.5%

32.52%

30.52%

28.52%

26.52%

COGS(% of Revenue)

43.95%

43.45%

42.95%

42.45%

42.45%

SG&A

45.80%

45.20%

44.20%

43.20%

43.00%

Source: Author’s Projection

Using a DCF method with a terminal growth rate of 4%, we got the target price of EDU to be around $132, which indicates a 20% upside potential based on the current market price.

Terminal Growth Method

Terminal Growth

4.00%

Terminal Value

17,010

Enterprise Value

19,452

Plus: Cash

1,414

Implied Equity Value

20,866

Shares Outstanding, MM

158

Target Price

$132

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Source: Author’s projection

Conclusion

In conclusion, we think the current share price of EDU undervalues the company by as much as 20%. The company has proven its growth and profitability over the past years, and will continuously benefit from the increasing demand for private education in China. Now would be a great opportunity for long-term investors to get onboard.

Risk Factors

  • Coronavirus in the long term: Medical professionals claim the vaccine won’t be ready for at least 12-18 months. Before that, the virus can co-exist with human beings. Although China has largely contained the outbreak, it’s possible there will be another outbreak due to imported cases. (Probability: Low, Impact: Medium)
  • Competition from online education platforms: The outbreak led to the soaring demand for online education. Other large online technology companies such as NetEase (Nasdaq: NTES), Bilibili (Nasdaq: BILI) are also expanding into online education. Besides, some companies that specialize in online education, including GSX Techedu (Nasdaq: GSX), have natural advantages since there is no additional cost for them to switch to online. However, we don’t think the preference of the majority of the students will change from offline to online. (Probability: Low, Impact: Medium)

Disclosure: I am/we are long EDU. 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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