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TAL, EDU, GOTU – Will China Education Stocks go to $0?

China

Written by:

Zhi Rong Tan

On Friday afternoon, 23 July 2021, hundreds of Chinese education provider stocks began to tumble as an unconfirmed copy of a policy paper began circulating online.

On the day the announcement was made, these popular education stocks took a beating:

  • TAL Education Group (NYSE: TAL): – 70%
  • New Oriental Education & Technology Group Inc (NYSE: EDU): -54%
  • Gaotu Techdu Inc (NYSE: GOTU): -63%

These new regulations intended to relieve pressure on students, parents, and teachers in China’s competitive educational system are a major setback for educational institutions. The ruling will profoundly alter the industry.

Some of us may have positions in these stocks, I share my thoughts on how we should manage our education stocks or even Chinese stocks in general going forward.

The Chinese government’s latest moves are one of the most significant reforms in the education industry to ease the burden of homework and after-school training for students.

Here are the rulings announced:

  • Ban on the provision of tutoring services on academic subjects during public holidays, school breaks and weekends.
  • The establishment of new tuition centres is barred.
  • All existing organisations are to register as non-profits and must follow the fee standards to be established by the relevant authorities.
  • Edtech platforms and services that provide online education will no longer be able to raise funds through initial public offerings.
  • Publicly traded companies and foreign investors are prohibited from investing in or obtaining stakes in education companies that teach school curriculum.
  • Any sort of tutoring, such as English education, for preschoolers, is prohibited under the pretext of “mind training.”

Overall, the new regulation is the appropriate direction to take, which will help ease students and parents stress. Nevertheless, it’s a setback for these educational institutions.

These rulings have effectively wiped away the company’s profit and any projected future expansion.

Why did the Chinese government pull the plug?

Before we ask if there is any value remaining in these education stocks, we have to ask ourselves, why did it come down to this?

The education industry was doing so well, and China continues to produce graduates who are considered one of the brightest in the world.

Well, that is because the whole education environment had become too competitive.

In China, students have to take an annual national college entrance examination aka Gao Kao. Their Gao Kao results determine if they get to enter the university of their choice.

These exams help by levelling the playing field between the rich and the poor. However, it has also resulted in unintended consequences which include a highly competitive and unhealthy study environment for students in China. There have been reports that students have been given IV infusions while studying, ostensibly to aid concentration and focus. And of girls given contraceptive tablets to postpone their periods until after the exam.

Taking advantage of the desire to do well and the fear of failing, the private education industry boomed. It has become a multi-billion industry in China.

Total number of student enrolments in K-12 after school tutoring increased to 325.3 million in 2019. Last year there were also more than US$10 billion of venture capital poured into this space to develop education resources from apps to edtech platforms.

Raising need for tuition has become a concern for China. In the battle against declining birth rates, the increasing cost of raising a child becomes a key factor.

Even though the government has abandoned its one-child policy, many families are deterred from having more children due to the added financial burden. With the population problem being a top priority, the government had no choice but to make such a harsh clampdown.

How to re-valuate Chinese Education now?!

Needless to say, when the report came out, there was a lot of fear in the market. Chinese education stocks crashed and also brought down the overall Chinese market.

The question now is, is this an excellent opportunity to buy the dip? Also, if you had these stocks in your portfolio, what should you do now?

Let us use New Oriental (NYSE: EDU), the largest private education service provider in China, as an example.

New Oriental was founded in 1993, and as of 2020, it had around 64.9 million student enrollments. It currently boasts 1,625 learning centres, 118 schools, 11 bookshops, and access to a statewide network of online and offline bookstores via 131 third-party distributors, as well as over 48,300 teachers in 104 cities.

Under its business, it offers a wide range of educational programs and services which consist of K-12 after-school tutoring, test preparation, language training for adults, pre-school education, primary and secondary school education, education materials and distribution, online education, and other services. 

As seen from the chart below, it has been doing very well over the past 6 years due to this competitive environment.

We can split New Oriental’s business into two:

  1. Educational programs and services
  2. Books and other services

The educational programs and services consist of K-12 AST*, test preparation and other courses, pre-school education, primary and secondary school education and online education. While its Books and other services primarily consist of the sales of educational materials, sales of books, consulting services to students regarding overseas studies and study tours.

*K-12 AST refer to New Oriental Primary and Secondary School All Subjects Program, which currently covers all academic subjects for kindergarten and primary school children, as well as middle and high school students

In the past three years, Net Revenues came in at US$2,477.4 million (2018), US$3,096.5 million (2019) and US$3,578.7 million (2020).

Let’s assume the worst-case scenario where the whole K-12 AST, test preparation, and other courses are removed from the equations. This is a subset of its educational programs and services and is the one that is impacted the most by the ruling.

As expected, New Oriental net revenue from its K-12 AST, test preparation, and other courses accounted for a majority of its revenue at 82.7%, 84.2% and 85.0%, for 2018, 2019 and 2020 financial years, respectively.

If New Oriental lost revenue from this entire segment, the group would have brought in around US$537 million in net revenue in 2020.  Together with a market capitalisation of US$3.3 billion, New Oriental’s Price to Sales ratio is around 5.58, which seems relatively low.

Though not an apple to apple comparison, Mindcamp, an early education enrichment provider in Singapore, has a Price to Sales of 21.34 (EPS of $0.01312 and trading at $0.28), which may indicate that New Oriental seems overly sold.

What should I do as an investor? – buy, hold or sell?

So what should you do now?

If you do not have a position in these education stocks, I recommend avoiding this industry now as the fundamental has changed drastically with the new ruling. The tuition industry will not be the same anymore.

For those that are still holding, there are 2 ways you can play this:

  1. Cut loss and learn from this saga
  2. Hold and wait for a slight recovery

If you believe there is more downside, I recommend you just cut your losses and learn from this saga. Alternatively, if you think the current fear is blown out of proportion and that your stocks are overly sold, you can consider holding for a while more and wait for a slight recovery. Note that the keyword here is slight as we should not expect education stock to recover back to its heyday.

Conclusion

The education industry was doing well before this announcement. While I did not invest in any of the stocks above, I could very well see a strong investment thesis. Looking at how fast the revenue grew year on year, it is no wonder why investors chose to invest in these stocks.

Now, this makes us question if this is what investors should expect when investing in China? Is unpredictability the game to Chinese stock investing?

Well, yes and no.

Yes, it can be unpredictable in terms of what the Chinese government will do next. China is different from Singapore which prides itself on being a place of stability where businesses can predict what will happen 5 to 10 years down the road. In China, a drastic regulation can pop up overnight that change a whole industry.

Nonetheless, we can also view China as being predictable since what it has been doing for the past months has been aligned with the party view on China moving forward. The Chinese government did not clamp down on these industries for the sake of doing so. Instead, it was doing it such that everyone in China is better off.

So moving forward, if you want to invest safely in Chinese stocks, you need to understand the way China thinks.

Before you go, some food for thought

Looking to the future of China stocks, you might want to be thinking about the following.

  • Would the property market be the next, given that there are signs of an inflating housing bubble? A pricey house could be another obstacle for having kids in China, don’t you think?
  • 4 of China top tier cities are now among the most expensive globally. What do you think China will do next?

Lastly, I would like to end by saying, China still offer great opportunities for investors. However, moving forward, investors need to understand the regulation risk and diversify.

There is no telling when this will be over, but we will see the end of the tunnel one day, as with past market crashes.

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