Share prices of Gaotu Techedu (GOTU -2.81%), the Chinese online education company formerly known as GSX Techedu, surged 26% on Sept. 22 after it posted its second-quarter earnings report.

The company's revenue rose 35% year over year to 2.23 billion yuan ($345.1 million), but its net loss of 918.9 million yuan ($143 million) marked a steep drop from its net profit of 18.6 million ($2.9 million) a year ago. On a non-GAAP basis, it posted a net loss of 763.9 million yuan ($118.1 million), compared to a profit of 72.7 million yuan ($11.2 million) a year earlier.

A student attends an online class on a laptop.

Image source: Getty Images.

Gaotu's top-line growth still looks impressive, but its stock has lost over 90% of its value this year as Chinese regulators cracked down on the country's for-profit education companies. However, Gaotu's stock now trades at less than one times last year's sales. Is Gaotu a deeply undervalued growth play right now, or do the daunting regulatory headwinds make its stock a toxic investment?

Gaotu Techedu was struggling before the crackdown

Gaotu, which went public in June 2019, initially dazzled investors with its explosive growth rates. Its revenue and non-GAAP net income surged 423% and 1,021%, respectively, in 2019. It was also profitable on a GAAP basis. 

its revenue increased another 237% in 2020, but it turned unprofitable (by both GAAP and non-GAAP measures) as it aggressively used promotions, discounts, and free trial classes to attract new students throughout the pandemic.

Gaotu's tactics made it a top target for short-sellers, who claimed the company was inflating its enrollment numbers and earnings. In late March, the meltdown of Archegos Capital, a shadowy fund that held a massive stake in Gaotu (then known as GSX), also emboldened the bears.

But the crackdown pushed Gaotu's stock off a cliff

China's regulators started to scrutinize the education sector in March, claiming that for-profit education platforms put too much pressure on students and widened the privilege gap between poor and affluent families. The government also accused for-profit education companies of using predatory tactics to recruit students and promoting unapproved curriculums.

In late July, the government overhauled the entire sector. Under the new rules, all registered online providers of academic after-school tutoring (AST) services will be required to gain new approvals for government licenses. Licensed education companies will be prohibited from offering AST classes during national holidays, weekends, winter and summer breaks, and after 9 p.m. on weekdays.

They will also be banned from covering core subjects (such as math, science, and history) "in advance of the school curriculum," hiring foreign teachers, engaging in "excessive profit-seeking activity," and using aggressive marketing campaigns. Education companies will also be prohibited from raising funds, going public, and seeking out foreign investors with VIEs (variable interest entities) based in other countries.

In other words, the new policies will likely gut Gaotu's K-12 tutoring business, which generated 94% of its revenue in the first half of 2021. New government limits on tuition fees could prevent it from ever generating a profit again, and the elimination of the VIE structure -- which Gaotu and many other Chinese tech companies previously used to go public -- could render its U.S. shares worthless.

A dim view of the future

Gaotu's second quarter ended on June 30, so its numbers still don't reflect the impact of the new policies, which were introduced in late July. Gaotu didn't provide any guidance for the rest of the year, and management noted that many of the government's new restrictions -- including pricing limits, data security, and qualifications for new learning centers -- had yet to be finalized during its brief conference call.

Therefore, Gaotu still seems to be in the dark regarding its future, and Wall Street's projections for 41% sales growth this year can't be trusted.

It's also doubtful that Gaotu's peers, TAL Education (TAL -2.89%) and New Oriental Education (EDU -1.40%), will meet analysts' expectations for 16% and 17% sales growth, respectively, this year. Both of those rivals also lost about 90% of their value this year, and are trading at less than one times their trailing revenues.

Gaotu has been shutting down education centers and laying off about a third of its staff to conserve its cash. However, it ended the quarter with just 5.49 billion yuan ($849 million) in cash, cash equivalents, restricted cash, and investments, down from 8.22 billion yuan ($1.27 billion) at the end of 2020. That cash burn could accelerate as its revenue tumble in the second half of 2021.

Is Gaotu's stock worth buying?

Gaotu's outlook looks grim, but it believes it can gradually diversify its business beyond its core K-12 AST programs to weather the incoming storm. But even if it pulls off a miraculous turnaround, its VIE shares could still be canceled by new investment restrictions, or simply delisted by U.S. regulators.

Gaotu's stock bounced after its latest earnings report, but it's likely just short-sellers covering their positions. Shares of Gaotu, TAL, and New Oriental haven't bottomed out yet, and they could easily go to zero if these former market darlings can't find new ways to survive the regulatory challenges.