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A Chinese Stock You Shouldn't Be Scared Of

June 13, 2014 | About:
Ross Givens

Ross Givens

43 followers

Like you, I generally avoid international stocks. The only exceptions are rock-solid companies that also trade on US exchanges as ADRs — American depository receipts. Google the term if you're not familiar with it. One that meets these requirements and appears to offer a very healthy upside is New Oriental Education & Technology. The company is a provider of private educational services in China with a primary focus on English as a second language.

Since opening its doors in 1993, the company has seen tremendous growth and expansion. It operates a wide range of educational programs including English, other foreign language training, test preparation courses for admissions, assessment tests, secondary school education and a development arm that distributes educational content software, online education, and other technology.

As of the end of 2013, New Oriental operated 48 schools, 319 learning centers and 25 bookstores. They also employ more than 8,100 teachers in 40 cities. With the exception of a few full-time primary and secondary schools, courses are generally designed to be completed in two to sixteen weeks. As mentioned previously, the majority of their programs are language based and help students prepare for entrance exams to educational institutions in the U.S. and other foreign countries.

While based and operated in China, the stock trades as an American depository receipt (ADR) on the New York Stock Exchange under ticker symbol EDU.

FUNAMENTALS

New Oriental (EDU) is far from a mom-and-pop shop. The company has a $4.15 billion market cap and sees average trading volume of over a million shares. EDU trades at 20 times trailing 12-month earnings which while high for a value stock, is actually reasonable for a grower like New Oriental. Analyst estimates put the forward P/E at just 16.55.

This company has been a freight train of growth over the last decade as seen by the unrelenting uptrends in revenue and profits.

The PEG ratio is 0.89. Since disciplined growth stock investors seek buying opportunities when the earnings multiple is less than the growth rate, PEGs below 1.0 are generally ideal if expectations are for the company to continue expanding at a similar rate. Peter Lynch is commonly credited with setting this criteria.

The balance sheet is beautiful. The company carries zero long-term debt and has $1.15 billion in cash and securities as of the most recent quarter. On a per-share basis, this means that New Oriental holds $7.34 of its $26.32 share price in cold hard cash. And with no creditors holding rights to any of it, that is a big safety net for equity investors.

Deducting the aforementioned cash from the market value of the security puts the P/E ratio at an even more attractive 12.3. This is almost unheard of for a financially sound grower like EDU.

The beauty of this stock is that we really don’t have to dig too deeply with the analysis. Since there are no interest payments to weigh down per-share earnings. the risk of insolvency is extremely low. Selling, general and administrative expenses have adjusted alongside revenues and it appears that the company has no problem adjusting staff and expenditures according to sales. I would expect a decline in revenue to be met with an equal reduction in spending. This is a sign of a nimble company that can survive under varying economic conditions.

And while much speculation exists surrounding the future of the Chinese economy, this sector is relatively protected from a potential decline. With the world’s largest population growing and an accelerating global economy, the need for Chinese citizens to learn second languages seems to be in no danger of decline. In fact, most would expect exactly the opposite. While 319 learning centers across the country might represent near saturation for a smaller nation, it is a drop in the bucket for their population of 1.351 billion—more than three times that of the U.S.

These basic factors paint a convincing argument for not only maintaining the company’s current level of operations but a continued growth of them.

Risk

Given that the company is obviously in no risk from excessive debt or insufficient revenue, the next risk we would want to monitor is that of increased competition and a dilution of market share. The easiest way to find this using fundamentals is to follow the company’s profit margin. If a firm has no moat and competition is forcing it to compete on price, margins will more than likely be in decline. This could create an environment in which sales are increasing but profits are shrinking. Luckily, this does not appear to be the case for New Oriental Education and Technology. Gross margins have remained in the 57% to 61% range for all of the last 10 years. By contrast, an eroding enterprise would have a much wider range and likely be on the low end of the spectrum today.

Entry

The stock is down 14.1% on the year. Given the increasing pressure on fund managers to perform after 2013’s historic run, many are trimming losers that have failed to keep pace with the indexes. This is typically done at the end of a quarter so that the firm’s quarterly report does not include these holdings. This concept is known as window dressing, and the chart below illustrates its effect after first quarter 2014.

The 30 days following the quarter’s conclusion saw a 17% decline in the stock price before a value recovery began. I am expecting a similar but smaller sell-off in the next few weeks that would create an even better entry price for investors.

Buying at today’s prices is in no way foolish. Those seeking a multi-year hold to take advantage of continued growth will likely fair well from a $26 long. Those demanding an even better value, however, may wish to wait 30 to 45 days before pulling the trigger.

A balanced approach would be to buy 50% of ones normal position at today’s prices just in case the pullback does not occur. The other half could be deployed below $23/share should that opportunity present itself. If this does in fact occur, I would expect those prices to be met in mid to late July. Institutions own 80% of the 158 million outstanding shares so a large seller or two could easily apply the forecasted haircut by selling out of their long position.

As with anything in the stock market, this is simply a best guess at what to expect in regard to institutional activity. The current shift by many U.S. funds away from high P/E growth toward low-multiple value could create favor for the underpriced equity and lead to a bidding up of prices. This is the reasoning behind a half-sized entry today to avoid missing the opportunity. But with a long time horizon and an eye on intrinsic value, a few bucks one way or the other shouldn’t make a huge difference in total return for this stock.


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