China Education Alliance (CEU):
China Education Alliance, founded in 2004, operates in the online and on site education industry in China. The primary users are elementary and high school students (aged 6 to 18) who wish to receive addition prep and test materials. The company’s website offers a comprehensive database of practice materials written by teachers and purchased by CEU. Students access this information by paying via charge cards sold by the company. Last year CEU sold 3 million charge cards with the average balance being 50 yuan. The company employs over 200 traveling salespeople to promote this business by offering on site demonstrations.
As well, the company offers onsite training to its students as a separate business. Most students sign up for one or two classes at a time in particular subjects, such as math or English. These classes are only offered on weekends. Because of the different amount of classes taken by each student it is difficult to examine tuition paid per student, as management does not report total enrollment. However information can still be gleaned on the health of this business segment by examining the overall sales from this division as well as the gross margin.
Recently the company expanded into offering vocational training which is designed to help students who want a real world education and experience for an immediate job. This expansion has been successful as total training center revenues have increased from 21% of sales in 2007 to 33% of sales in 2009. This growth continued in the first quarter of 2010.
Finally the company earns revenue from online advertising on its main site. This is managed completely out of house by an ad agency with CEU keeping half of the revenue. This segment has not shown any growth in the past few years and thus has become an increasingly less important part of the company.
It is estimated that the online education market in china saw total sales of 1.36 billion USD in 2009. This number is expected to grow between 25-30% over the next 3 years. The vocational market, of which CEU is increasingly involved in, is expected to hit 2.8 billion USD in sales by 2012. The industry is extremely fragmented with many companies yet no big player dominating. Consolidation should continue in the next few years with CEU themselves saying in the last conference call that they are always looking for deals, with 2 potential deals currently in the pipeline. Margins in the industry should continue to be high for the near future along with high rates of return on capital for new investments in online education and onsite vocational education. This can be seen by CEU’s 80% gross margin of the past 2 years and 40% NIM.
Corporate governance practices at CEU are weak. The CEO Mr. Xiqun Yu, is also the Chairman of the board. He has worked at the company since its inception and his background is technology based. The CFO received his CPA and MBA from Universities in the United States and began working at CEU in the summer of 2009. There are 3 independent board members who, in addition to the CFO and CEO, comprise the entire board. The same 3 independent members comprise the audit, compensation and nominating committees. This poses obvious problems, one of which can be seen in the total number of new share issuances and stock option grants over the past few years. However for the year ended 2009 and the first quarter of 2010 the company did not grant any new warrants to its employees and appox. 100,000 warrants remained outstanding (out of 31 million shares issued). The company also granted 442k options to employees last year which will vest over 3 years. The average price of around 3.11$ per share is below the current price. The company accounts for the cost of the options issuance using the black scholes model on their income statement in the year of issuance, yet these dilutive actions are still cause for concern. In regards to further dilution, in Q1 of this year the company issued no options and promised not to issue new shares for the year in response to a question about funding acquisitions.
In conference calls management does not always give reasonable answers to questions. They tend to stick by their original forecasts and promise they will achieve growth numbers without providing ways to accomplish this. In a recent conference call when asked about the 5% y-o-y sales growth in Q1, which was below the management supplied growth forecast, they replied it was due to seasonality of Chinese holidays. Obviously these holidays would have affected the comparable quarter of 2009.
CEU has an immaculate balance sheet. The company has 69.5 million in cash and equivalents along with 2.7 million in prepaid cash (charge cards) comprising current assets and only 1.7 million in total liabilities. Along with 9 million in long term assets the company has shareholders equity of 79.3 million and net cash of about 68 million. This net cash represents about half of the market value of the company and acts as a nice cushion for an absolute bottom. Since this cash position is so large it is probably worth discussing what the company intends to do with the cash.
Uses of cash:
In the most recent conference call, management explained that they have no current plans to issue a dividend or begin a share buyback program in the near future. Instead the CFO explained that they intend to use the cash in the following rough breakdown. 25% for sales expansion (which I assume is marketing and hiring of new salespeople), 25% for new acquisitions, 25% for fixed assets (which I assume is to buy more test material and expand and build new learning centers) and the final 25% to remain as working capital. Management also stated that they currently have a few deals in the works, but note that they will not go past their target of a PE ratio of 7 when buying a new company. This upper limit on the multiple has been restrictive in the past year but with the current correction in the Chinese market management may find more opportunities.
Sales growth rate: Management was very adamant during the Q1 conference call that despite Q1 sales being only 5% higher y-o-y, they will still achieve sales growth and net income growth of 30% in 2010 over 2009. This, coupled with the fact that the entire industry is expected to grow at a rate of 26-30% over the next 3 years led me to use the company’s guidance of 30% for this year and the following 2 years for the education center and 25% for the next 3 years for the online portion of the business. This would continue a trend that has seen the education center become a larger and larger part of total sales over the past 3 years, rising from 21% in 2007 to 33% in 2009. After that I used a growth rate of 15% for 2 years before using a terminal growth rate of 4%, which I consider to be China’s long term GDP growth rate. The previous numbers were used both for the online education and on site education portion of CEU’s business. Advertising revenues were held steady at the same level as 2009. This is because the company has no control over these revenues and they seem to have stabilized from 2008 to 2009.
Gross margin: Gross margin for the past 3 years has been steady around 80% rising from 79.56% in 2007 to 80.08% in 2009. Q1 2010 saw a gross margin of 79.3% and management explained that this number should rise during the year. Therefore I will forecast growth margin to be 80% going forward and for it to continue at this number for the next 5 years.
Administrative costs: These costs have fluctuated greatly in the past 3 years. The main reason for this is the varying degree of expenses due to options granted in the past 3 years. I have used the average cost of 13.3% of sales over the past 3 years as the rate expected to continue into the future.
Selling expenditures: Selling expenditures relate to advertising and salaries of the salesmen who go around promoting the online products of the company along with the salaries of the teachers at CEU’s education center. Therefore this is where much of the organic growth is generated. Management has forecast selling expenditures to be 25-30 % of sales for 2010. I used the high end of the range since it makes sense for selling expenditures growth to be proportional to future sales growth. Therefore 30% of sales is the estimated cost going forward.
Tax rates: The tax rate is a weighted average of 15% on the internet portion of the business and 0% on the education center which is tax exempt. This should continue indefinitely.
Depreciation and Amortization: This number is expected to be constant as a % of sales going forward since the company intends to grow both through organic growth and acquisitions which will require more PPE spending on items such as test papers and opening of new education centers. Last year’s number contained amortization of intangibles but with further acquisitions coming, this should occur again for the foreseeable future. Therefore I have used the average rate as a percent of sales over the past 3 years of 3%.
Other income: Other income is not addressed in the annual reports or by management during conference calls and has decreased significantly over the past 3 years. Thus I will assume after 2009 that it will not reoccur. Interest income is forecast to be 4 times the amount earned in Q1 2010 and then is assumed to not reoccur as management has earmarked this money for expansion and investment in CapEx.
Discount rate: Using 5% as the equity risk premium, 1.88 as the beta and 3% as the risk free rate, the cost of equity is 12.4%. This is in line with findings that the Chinese stock markets in general have equity risk premia of 8-9% so 1.88 x 5% = 9.4% which is within normal. Since this company has no debt financing the cost of equity is the same as the cost of capital. Due to my discomfort with management and their predictions of future sales and net income, I also used a higher discount rate of 15% on net income to come up with a calculation of the PV of the cash flows. Using the discount rate of 12.4% along with the terminal growth rate of 4% we get a PV of 228 million. Using the higher discount rate of 15% we get a PV of 207 million. Both of these estimates are well above the current market cap of 128 million.
Some issues and final thoughts:
There are some reasons why I passed on this company the first time I analyzed it. The company has been pretty liberal in the issuance of new shares in the past. They have used share issuance as a method of paying for their legal work, to acquire new companies, and to pay management. Total shares outstanding grew from 21.9 million at the end of 2008 to 31.6 million at the end of Q1 2010. Finally this quarter management made it clear that they will not be issuing any more shares or options for the rest of this year. I will see if they hold true to this promise and if they break this vow it might be an early warning sign to bigger problems down the road, such as making unrealistic sales and NI growth projections.
This investment is not for the faint of heart. It is unlikely that we will see any sort of distribution of excess cash to shareholders in the near future, so all of the income from this investment will have to come from share appreciation. As well there is no foreseeable catalyst other than increasing earning, but this may be enough to attract investor attention and increase the share price. I ended up buying shares around 4.30 because it seemed cheap enough with enough cash on hand and high growth prospects that I couldn’t pass. But I did use a 15% discount rate due to the above factors. Therefore I will use the more conservative market cap target of 208 million as a price target.