Now Is Not the Time to Buy These Stocks

What sector of stocks has been among the worst-performing in the U.S. stock market this year? Consider the case of for-profit educators. Because of concerns about the quality of their product, heightened government regulation, and potential enrollment declines, Apollo Group (Nasdaq: APOL  ) , ITT Educational Services (NYSE: ESI  ) , and DeVry (NYSE: DV  ) are all off well more than 20%. Further, high-profile short-sellers such as Jim Chanos and Steve Eisman remain bearish on these stocks.

That performance and sentiment, however, differ enormously from how investors are treating for-profit education on the other side of the world. Three Chinese for-profit educators have IPO'd since August, raising some $300 million, and that country's private education leader, New Oriental Education & Technology (NYSE: EDU  ) , is up more than 20%.

Are the dynamics that govern this space so different in China that private educators there deserve such a rosier outlook? My expectation is no and that investors in Chinese for-profit education today are headed for disappointment.

It wasn't always this way
Let's be clear: There are stark differences between the operations of a company like Apollo in the U.S. and a company like New Oriental in China. While the former generally targets adults who seek professional degrees and access federal loans to pay for their educations, the latter generally targets Chinese youths who need English-language training or standardized test prep services that their cash-rich parents (who have only one child) are more than willing to pay for. This is one reason why New Oriental is a former Global Gains recommendation and why I argued that it was crazy to short New Oriental at a little more than $50 share in April 2009 as some other analysts had proposed.

With New Oriental trading for more than $90 per share today, I'm glad I took my own advice. That said, I suspect that New Oriental's stock has gotten ahead of itself as more and more Western investors have come to embrace the Chinese education story. This not only manifests itself in a valuation that's now more than seven times sales and 30 times EBITDA, but also in the fact that smaller competitors Ambow Education (Nasdaq: AMBO  ) , Global Education & Technology (Nasdaq: GEDU  ) , and China Distance Education (NYSE: DL  ) have been afforded similar valuations. All told, after TAL Education goes public this week, there will be nine Chinese for-profit education services companies trading on the major U.S. exchanges alone, with a number of them being afforded ultra-premium valuations by investors.

Company

TTM Sales

EV/Sales

EV/EBITDA

New Oriental

$429mm

7.3

32.8

Ambow Education

$144mm

7.0

31.0

Noah Education

$100mm

Neg.

Neg.

ChinaEdu

$55mm

1.4

4.6

Global Education & Technology

$41mm

5.6

25.9

China Education Alliance

$40mm

2.6

5.3

ATA

$37mm

1.1

Neg.

China Distance

$34mm

4.2

43.5

Source: Capital IQ, a division of Standard & Poor's.Admittedly, these companies are all small and the market in China is large, but if an investor believes that New Oriental is going to dominate this space (as its current $3.5 billion valuation implies), then the rest of the stocks in the sector should be worth near zero. Investors, however, aren't thinking that way, and my analysis suggests that investors are expecting New Oriental, Ambow, Global, TAL, and China Distance all to grow to the sky.Fat chanceThe fact is that it can't and won't happen that way. Not only are there other international and domestic competitors, but as these companies all grow larger, they will more and more compete with one another. At that point something -- most likely revenue growth or profit margins -- has got to give.In New Oriental's case, this appears to have already started happening. The company reported first-quarter 2011 results earlier this week that showed better than 28% sales growth, yet just 8% operating income growth. One reason for this is that the company's selling and marketing costs skyrocketed more than 50% year over year. That -- spending more to earn less -- is an indication that the industry landscape is getting more competitive, a reality that should only worsen now that Ambow, Global, and TAL have raised $300 million from investors to spend on their own growth this year.Then there's the fact that the Chinese government is actively working to even out the country's development, particularly when it comes to the opportunities afforded to people living in wealthy tier 1 cities such as Beijing and Shanghai versus those living in poorer rural China. How those efforts will affect China's private education industry is at this point unclear, but there's certainly a very real risk that the government could resort to price controls or some such other regulation to create more equal opportunities for all.The global viewWhen it comes to the Chinese education sector today, investors are being asked to pay either an ultra-premium price for sector leader New Oriental or merely a premium price to own one of a gaggle of other smaller, more mediocre companies. Frankly, neither of those is a palatable option, and I suspect that the whole sector is due for a drop as rising competition in the industry weighs on results going forward. Add to that any kind of forthcoming regulatory risk, and the hot money flowing into the sector today will quickly realize that it's made a mistake.Only after that happens should you look to add a company such as New Oriental to your portfolio. Because while the Chinese market will be volatile, it has the potential to be a multidecade growth story that all investors should have at least some exposure to ... at the right price, of course.

Get Tim Hanson's "Global View" column every Thursday on Fool.com or by following him on Twitter.

Tim Hanson
is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Apollo is a former Motley Fool Inside Value pick. New Oriental Education & Technology Group is a Motley Fool Rule Breakers recommendation. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (22)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 21, 2010, at 11:34 AM, TMFMmbop wrote:

    Just to follow up since I filed this article a couple of days ago...

    TAL Education was up 50% in its NYSE debut and ANOTHER Chinese tutoring company, Xueda Education (XUE), announced it will be going public this week. If this isn't additional evidence of a bubble in this space, then I don't know what is!

    Tim Hanson

  • Report this Comment On October 21, 2010, at 12:26 PM, MegaEurope wrote:

    "a premium price to own one of a gaggle of other smaller, more mediocre companies."

    I don't think this statement is really true. CEU and NED are cheap, CEDU and ATAI seem fairly priced. And CEU for example is not mediocre, putting up better ROI, free cash flow, etc. than EDU.

  • Report this Comment On October 21, 2010, at 12:33 PM, TMFMmbop wrote:

    NED is, at this point, totally bereft of a coherent business plan, hence its negative enterprise value. Some of the others you mention don't have scalable business models and/or have been unable to break outside their region.

    Tim

  • Report this Comment On October 22, 2010, at 3:20 AM, curtsms wrote:

    I'm a 20-something girl from Indiana who had the opportunity to work as a spoken English teacher at New Oriental's Beijing office for a year from 2009-early 2010. Allow me to explain a bit about my background and explain why I believe New Oriental has already passed its peak.

    For starters, I began studying Chinese when I was a freshman in university and spent my junior year of college studying abroad at Tsinghua University in Beijing. I developed a good network of friends and by the time I went back to finish my senior year of college, I became something like an older sister to the 100-some full time four year students at my college, DePauw University in Greencastle, IN. I became good friends with several newly-arrived freshman Chinese students. Since I had a great interest in going back to China after graduation and taking up an English teaching job, I asked the students what school they think is the best. Unanimously, every student told me they had studied at New Oriental. One of my close girlfriends from Suzhou (a well-developed international city not too far from Shanghai) even told me that, although New Oriental has a number of offices in hundreds of cities across the country, a number of Chinese students preparing for the TOEFL and SAT exams will go to study at New Oriental in Beijing because it has a better reputation than regional offices.

    After being accepted at New Oriental, I went to Beijing to begin my training with other foreign teachers. Our one afternoon of training included a tiresome presentation about the school and general "teaching guidelines" for the foreign staff. The quality of foreign teachers they recruited was varied at best (during several points of the presentation a middle-aged expatriate made overly-vocal snarly remarks at the Chinese presenter, and at one point began screaming verbal abuses at her for not providing, what were in his mind, adequate living arrangements).

    Classes taught by foreigners for the spoken English segment were 2 1/2 hours each and came at a premium to Chinese students. Based on my experience and the other foreign teachers I spoke to, not a single one of us had any guided curriculum and were told to come up with it on our own. HR did not require their foreign teaching staff to hold the standard ESL teaching certificates, and they gave us no preparation or training in light of this fact.

    Because I have made a point of gaining fluency in Mandarin over the past few years, I was able to communicate on a more personal level with the TOEFL, SAT, GRE, etc. teachers (all of which were exclusively Chinese). The main creed which all teachers at New Oriental are to live by is, "be funny for the students."

    I came to realize that education was a secondary concern at New Oriental. In China, the pressure society puts on its youth is overwhelming and New Oriental classes are there to serve as entertaining babysitting for students, which gives face to parents who feel proud to tell their friends and co-workers "My child studies at New Oriental."

    In retrospect, it should come as no surprise to me that New Oriental poorly equips its students for studying abroad. One key reason I became a sister-like figure to many of the young Chinese during my senior year was because I was an American girl who could communicate with them in their language. I'm sure if you ask any American university student now, they will tell you their Chinese counterparts very rarely break out of their groups and venture to become very close with American classmates. Their poor grasp of English is a large part of the problem.

    In conclusion, New Oriental has deep management problems which have opened up the possibility of new, innovative schools entering into the market.

  • Report this Comment On October 22, 2010, at 1:33 PM, TMFSun wrote:

    curtsms: Thank you for that insightful post!

    I was in Beijing two years ago looking for a job; applied to an English-teaching position at a Kindergarten. Did a phone interview in English, they scheduled a sit-down meeting, and then when I showed up, they were aghast that I was (ethnically) Chinese. The interviewer basically told me that they would hire Russians, Italians, Poles who had no English language skills whatsoever -- they were just looking for a "white face" for the parents. In fact, typically after the "white face" holds his/her 30 min session, a Chinese instructor comes in to actually teach English to the kids.

    I've met a bunch of Chinese students who had or are currently studying abroad and I wouldn't trust any of them to order me a sandwich. These are smart kids but the emphasis in China is on written English. I don't know if this is a good or bad thing, but for context, the entire culture of American-Chinese immigration relationships is changing. It used to be that Chinese students (like my parents) would come to America to do a Ph.D and then they would stay here. Increasingly, the trend is to grab a diploma and go back.

    What English skills, a US diploma, and New Oriental all provide for Chinese students is differentiation. The US isn't the promised land anymore; most Chinese students like being in China and their primary goal is to find a good job in China. I think if you consider EDU as being in the business of offering differentiation, then the case is different than if we only look at them as an education provider and judge them based on those merits alone. In fact, it sounds like they've done a very good job of making themselves an "exclusive" brand (at least seemingly). In the long-run the educational content is going to matter, but the fact that (ostensibly fairly poor) students would fly out to Beijing just to get the New Oriental experience is very interesting.

  • Report this Comment On October 22, 2010, at 1:51 PM, jems2112 wrote:

    Now that EDU is up 2.15% more since the time of this article posting, I might agree that NOW is not the time to buy.

  • Report this Comment On October 22, 2010, at 2:17 PM, langco1 wrote:

    its time to be short the education stocks they have run up far to high..

  • Report this Comment On October 24, 2010, at 4:01 AM, XMFConnor wrote:

    Was there a reason ChinaCast? (CAST) was not mentioned in the article?

    They seem the most promising to me..

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