How to Play China's Booming Education Sector

If you had to guess which U.S. university was the largest, what would you say? The University of Florida? Ohio State?

It's actually the State University of New York, with 64 campuses, but in second place is Apollo Group's (Nasdaq: APOL) University of Phoenix, with more than 450,000 students enrolled from over 40 countries.

With barely any debt and gobs of free cash flow, Apollo Group has been able to reward its shareholders nicely over the past 10 years, outpacing the S&P 500 by more than 15% annually. But it's not the only educational provider that's been in the spotlight as of late.

Credit Suisse Analyst Kelly Flynn recently upgraded both DeVry (NYSE: DV) and ITT Educational Services (NYSE: ESI), because observers think the Department of Education may relax regulations that will make it easier for these for-profit universities to enroll and retain new students.

All three of these companies have one very important trait in common -- despite having physical locations, they are all benefiting from their online distribution channels and their lack of geographical restrictions. As globalization increases, online schooling and tutoring is sure to play an integral role in the evolution of the educational process.

So what's this have to do with China?
With well over 1 billion people, China is easily the most populous country in the world. With that many people and with a growing middle class, you would think education would be an essential part of society -- and it is. However, one startling fact jumps out at you when you dig a bit deeper.

The People's Republic of China only spends 1.9% of its GDP on education -- that puts it at 170th place in the entire world. But it's not because the national government doesn't value education -- in fact, it's quite the contrary. China is a very exam-oriented country; passing a specific test can mean the difference between going to college or stopping just beyond secondary education.

In China, families typically spend 10% of their earnings on education. Oftentimes that hard-earned cash goes toward supplemental education -- practice tests, tutoring, and vocational programs. It's for this exact reason that there's been an explosion of educational service companies in China.

With an enormous populace eager to take advantage of vocational classes and tutoring, a bustling middle class, and growth in the online space, education is a great way to invest in China.

Drilling into the competition
So who's playing in this space?

*Data taken from Capital IQ, a division of Standard & Poor's.
**Compound annual growth rate.

New Oriental Education & Technology is certainly the largest company in the group, and it's the only one that focuses primarily on on-site teaching and preparation. In fact, our Global Gains team found and recommended this stock to investors in February 2007 and sold it less than two years later after locking in a 93% gain.

But I'm not just interested in education, but also how the Internet can change education, especially in a country like China.

Because of its ease of access and vast distribution channels, online education can transform an industry by offering millions of people access to resources they've previously been unable to tap. While China has about 300 million Internet users, its penetration rate -- the percentage of the population that uses the Internet -- is only 28%. Within three years, that number is supposed to double, and fixed broadband subscribers should grow by 77% in just four years.

Similar to the way Apollo Group has been able to use the Internet and offer supplemental education, so, too, has China Education Alliance. This company has more than 350,000 courses and exams that it offers through its online distribution channel, where it uses video-on-demand as well as traditional downloadable materials.

In addition, the company has partnered up with China Vocation Education Society to set up a website dedicated solely to vocational training -- and as an extra plus, it offers a platform for career planning and job searching. It has tons of cash and no debt, and it's been growing revenue at a steady but rapid pace.

Sound too good to be true?
As is the case with many small-cap Chinese companies, it was hard to determine the fair value of China Education Alliance. It has $69 million in cash, but we have no way of knowing what it'll do with all that dough.

Which companies can we trust with their cash? The Global Gains team is flying to China in July to find out. Get all of their notes from the field by providing your email address in the box below.