New Oriental Education & Technology Group Inc. (EDU)

Price (07-08-2017)

$79.80

Fair Value range

$78 – 86

Uncertainty

Medium

Enterprise Value

~$11.5b

Consider Buy

$62-69

Economic Moat

Narrow

Stewardship Rating

Exemplary

Market Cap

~$12.5b

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Private Education on the rise in China

Thesis: At the current price of $79.80, a base-case intrinsic valuation of $78 provides no margin of safety, indicating a NO-BUY. We recommend a 20% MOS for New Oriental.

Lay of the Land

The private education industry in China is rapidly growing with an exciting future ahead. Experts say the K-12 after-school tutoring market will be close to $100b by 2020. This is due to a rising population of school-going children, the largest of which are the kindergarten years.

Academic excellence is of serious importance in the Chinese culture. Thus, an expanding middle-class in a fast-growing economy with parents willing to spend more towards education, the private education industry in China has a long runway ahead.

Business Overview

New Oriental is the largest provider of a wide range of private educational services in China, holding 2% of the market share. It operates through seven segments: Language Training and Test Preparation; Primary and Secondary School Education; Online Education; Content Development and Distribution; Pre-School Education; Overseas Study Consulting Services; and Study Tours.

How has it done so far?

New Oriental has an excellent track record over the last 10-years with a rock solid balance sheet. Number of learning centers (schools and other centers combined) grew ~5x – all organically. This grew revenue from $133m to $1.8b (30% CAGR). EBIT and Net margins reduced from low 20s to mid-teens but remain above industry averages. ROIC was highest in FY10 at 41% which reduced to 24% in FY16 (after accounting for Operating Leases). This was because of a reduction in EBIT margin. FCFs have grown ~9x from $41m to $367m. Debt-free ROEs have ranged from ~30%-60%, standing at ~50% in FY16. New Oriental’s economic value creation record has been fantastic. $1 in BV/sh in FY07 has grown to a whopping $6.71 today (21% CAGR). The company is cash rich and enjoys a float.

What’s the moat?

New Oriental’s key competitive edge is customer switch cost leading to some pricing power. We know this because of their high student retention rates (over 85% for kindergarten years, and over 70% for middle and high school years). Also, the three most common reasons to change schools are: (1) dissatisfaction with current school; (2) alternative is significantly better in quality/price; or (3) moving away. Generally, students do not change schools very frequently. The switch costs are high: change in the system, teachers, and peers. Moreover, students have an emotional attachment to their school.

Students are unlikely to switch test preparation providers after passing a test and recommend another provider to their peers, once it has worked for them.

New Oriental’s high retention rates, the quality of their product, and high-switch costs for students are all factors increasing customer loyalty.

Competitors with the same edge are far from stealing customers from New Oriental. For now, there’s enough for everybody to go around.

Other competitive edges include:

  • New Oriental’s brand – +20-year-old company, people like it and trust it.
  • Few other competitors have operations running in all seven segments This brand has breadth in its services.
  • Exclusive rights to sell practice exams for TOEFL through their language training classes and bookstores.
  • Medium-level barrier to entry. It takes years to replicate such a wide network of schools, hire/retain high-quality teachers, and build trust. On the other hand, it is much easier to offer learning services on-line.

Management Analysis

Management has proven to be excellent capital allocators. They have achieved superior results without compromising the balance sheet, prioritizing shareholder interests. They are confident in their product and have a clear view of the company’s future in the private education landscape.

However, the company has twice been accused of fraudulent behavior (2012, 2016). Neither one of the accusations had any material impact on New Oriental’s sales or its reputation.

What does the future have in store?

China is entering a Golden Age of education and this welcomes more competition in an already fragmented industry. This industry allows for rapid growth as can be seen with TAL, New Oriental’s biggest competitor. TAL has enjoyed growth in revenue with a CAGR of 61% over the last 10 years reporting $1b in FY17. In contrast, New Oriental reported $1.8b in revenue in FY17. Other risks New Oriental faces are the uncertainties with operating under Chinese government regulations and the threat of international players penetrating the Chinese education market.

New Oriental intends to grow their number of learning centers by 10-15% in FY18. They plan on continuing their expansion into remote cities within China with their dual-teacher model schools. Establishing a presence in remote areas is key to their growth. Management is aggressive yet prudent with their growth strategy and capital allocation decisions.

Valuation

My base-case assumptions below yield a value of $78 for intrinsic value per share.

  • Sales growth rate: 20% gradually reducing to 12% by FY27.
  • Operating Margin: 16%
  • Cash tax rate: 25%
  • WACC in CAP-period: 9%
  • WACC in steady-state: 9%
  • Inflation: 1.9%
  • Reinvestments grow proportionally to achieve sales growth assumptions.
  • CAP-period: 10 years

EBIT margin assumption of 16% for the next 10 years is conservative relative to their forecasts. They claim to achieve 17-18% for the next few years.

My sales growth assumptions would earn the business $7b in revenue in FY27, a believable figure given the size of the market.

A figure of $78 for intrinsic value per share gives you zero margin of safety. New Oriental is in a highly competitive industry, with a narrow moat, has accusations of fraudulent behavior which may or may not be true, and to top it off, operates in China, making it susceptible to volatile government regulations. Thus, a 20% MOS would be appropriate resulting in a buy price of $62.

Best-case assumptions yield a value of $86 for intrinsic value per share.

  • Sales growth rate: 20% gradually reducing to 14% by FY27.
  • Operating Margin: 16%
  • Cash tax rate: 25%
  • WACC in CAP-period: 9%
  • WACC in steady-state: 9%
  • Inflation: 1.9%
  • Reinvestments grow proportionally to achieve sales growth assumptions.
  • CAP-period: 10 years

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