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New Oriental Education & Technology: A 60% Upside Potential

August 02, 2014 | About:

5972751-14069191945106058-Gordon-Tam--CFSource: Gurufocus.com

New Oriental Education & Technology (NYSE:EDU) is a solid predictable business with 9/10 financial strength and 9/10 profitability & growth based on Gurufocus measurements. In addition to the 22% margin of safety, EDU looks undervalued. My analysis further shows that there is a 60% upside potential. Please continue reading to see why EDU deserves to be part of our portfolio.

Business Overview

For the history of EDU, New Oriental School was established in Beijing on November 16, 1993. In 1995, EDU had about 15,000 enrolled students. After rapidly expansion to difference provinces in China, EDU finally reached 1 million enrolled students in 2007. For more details about the history of EDU, please read the milestones section of the company website.

EDU operates one of the largest networks of learning centers in China by offering language learning, course preparation, and K-12 tutorials. According to my experience by studying EDU's learning material, I see that EDU is the highest quality in education, and its brand is well-known in China. In fact, EDU has an asset-light business model depending on its strong brand to draw customers. As a result, I highly regard the high margin and stable business of EDU.

Furthermore, as Chinese people put strong emphasis on education, the business of EDU is not even susceptible for any adverse economical downturn. In other word, no matter how tight the financial budget Chinese families have, they will always put educational expenses on the top of their priority list.

Management Team

Michael Yu founded EDU in 1993 and has served as the CEO since then. I have watched a movie about how EDU started from one man shop teaching students in KFC stores without any education centers. Growing from almost nothing other than dedicated hearts to pioneer a brand new post-school education industry, Michael successfully institutionalized EDU to become one of the listed Chinese companies in the United State. This is a great achievement for Michael Yu, and I believe nobody knows the industry and EDU better than him.

However, Michael Yu does not have a strong academical background for a typical CEO. Hence, I think that it makes sense to have Louis Hsieh to serve as the CFO of EDU. Louis has experience in investment banking and private equity, together with his academical background as an MBA from Harvard Business School and a J.D. degree from the University of California at Berkeley. I believe that Louis is a good complement to Michael Yu, and they really form a great management team to run EDU.

Why does EDU decline to such depressed level?

The sales expectation of $412 million to $427.5 million for Q1 2015 implied a mid-to-high single digit growth rate. Relative to 20%+ high-growth rate EDU used to enjoy, it is a big disappoint for its loyal growth investors. As a result, I suspected that those growth investors sold their stocks after the below-consensus growth rate. Hence, the supply of EDU stocks drove the share price to 52 weeks low. However, given the current 12x P/E multiple valuation assigned for EDU, the combination of a mid-to-high single digit sales growth and a mid-teen earnings growth will be more than enough to justify for today's depressed valuation.

Financial Strength

EDU is a debt free company. It has approximately $1.1 billion cash. Deducting the cash from the $3 billion market value, the enterprise value of EDU is only about $1.95 billion.

Valuation

5972751-14069196018577328-Gordon-Tam--CFSource: Gurufocus.com

EDU is a high-growth company. From Yahoo Finance, the consensus next 5 years growth is 22.4%. Another perspective to see the growth of EDU is from the company's fact sheet below:

5972751-14069204777330577-Gordon-Tam--CF

Net revenues have been 26.5% CAGR since 2007, and GAAP net income has been 33.5% CAGR since 2007. These are outstanding growth rates for both the top and bottom lines. No wonder that EDU used to sell for a high P/E multiple so as to account for its high growth potential.

Nevertheless, EDU is currently trading for around 12x P/E multiple of expected $1.57 EPS in 2015. As we can see from the Peter Lynch chart above, EDU has been a good buy whenever it touches the "P/E=15 price line" since 2007. If historical pattern of the Peter Lynch chart is any guidance, prospective investors should start to buy EDU.

5972751-14069313937464747-Gordon-Tam--CF

As we can see from the gurufocus chart about the P/E multiple, the historically lowest P/E multiple is about 20x. As a result, I would like to apply 20x PE with $1.57 expected EPS in 2015 in order to come up with my target price of $31.5 per share. This implies in excess of 60% upside potential for prospective EDU shareholders.

Repurchase Program

On July 22, 2014, New Oriental's board of directors authorized the repurchase of up toUS$120 million of the Company's shares during the period from July 28, 2014, throughMarch 31, 2015.

In the latest earning release, EDU announced to repurchase up to $120 million of shares. As one of the great characters of companies I would like to buy, they normally repurchase their own shares when they are depressed by utilizing the free cash flow from operations. As the supply of shares shrink, it is inevitable that the share price will eventually appreciate to reflect the true value of the stock. I believe that the current EDU repurchase program will have such effect to reveal its true value to its shareholders.

Outlook - A Great Strategic partnership with Tencent

Tencent is around $150 billion market cap company specializing on online advertising, internet communication, e-commerce transactions service, etc. Most Chinese should be familiar with QQ and WeChat service provided by Tencent. With a strategic partnership with such powerhouse on the internet industry, EDU can leverage its educational know-how to a much bigger customer base. The potential rewards for EDU shareholders in this partnership can be significant. I look forward to the wild card option of the upside opportunity when the product of the partnership will be launched by the end of 2014.

Risks

First, as people realize how lucrative to run educational centers and provide lectures, competitors, including internet operators, have expanded to offer online tutorials to reach a wide range of customers without the brick and mortal center costs. As more competitors enter the education sector, there will be more price and quality comparison for customers. This is a threat to the business of EDU. In addition, the online expansion of EDU to distribute its service poses risk since whether EDU can succeed online is still an uncertainty for prospective investors. Second, there has been concern in the past about the accounting integrity of Chinese companies. For prospective investors, they should take into account of such accounting risk. Third, forward estimates show steady-to-growth in net incomes and sales, which could end up being aggressive as revenues and margins could decline.

The Bottom Line

Given an attractive valuation, a bright outlook of the Tencent partnership, and an asset-light business model to generate free cash flow for repurchasing stocks, I believe that EDU is undervalued. Before the full value of EDU is reflected in its share price, risk-tolerant investors should consider buying EDU.

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