Free NPV

And mostly fails. CEU held a mid-quarter conference call today to respond to the allegations of 2 weeks ago that it lies on its financial statements and is a much smaller company than it claims to be.

Many of the prepared responses given by management were unsatisfactory. In reply to investor requests to switch to a big 4 audit firm, the CFO stated that their current firm has always done timely and accurate work in the past and they will consider switching but do not need to do so now. If I was the CEO of an honest company facing allegations of fraud I would do everything in my power to demonstrate that my company is legitimate. If all that took was to switch to a more respected auditing firm, that would be the first thing I did. Given that the company is not willing to do something this easy to alleviate investor concerns is extremely troubling.

The company also reported that the reason many of their links on the website do not work is because the servers are located in China, implying that the distance is responsible for the errors. This is unlikely to be true and a weak excuse. They also said that maintenance is done on the site during Chinese off hours which is why when we navigate it in North America we experience problems. In fact, the investors who wrote the initial report experienced the same problems in China.

The only positive is that CEU announced a new share buyback program today, with authorization to buy up to 10 million worth of shares. However, in 2008 they also announced a share buyback program but did not actually buy back any shares. So this could just be a response to the share price drop after the call ended yesterday, with no real intention to buy back shares.

Overall, a disappointing call that made CEU look more like a fraud than anything. It will be worth checking back on this story when they report earnings in two months, as if the company is on the level it is now an incredible bargain. Yet that seems to be less and less likely with each weak reply by CEU.

for those that are interested, a link to the transcript can be found here

I just sold out my shares in CEU for a loss of around 40% on my initial position and down around 25% since I recommended it here. It is currently trading around 2.90. The blog Zero Hedge posted a research report (link here) that attempts to prove that the training center is much smaller than claimed and the website is generating much lower traffic and revenue figures than the company claims. So for now the best approach is to sell out, sit back and wait until we get some answers.

Generally Wall Street hates uncertainty and it is smart to buy during those times but when the uncertainty is around fake financial numbers instead of general business uncertainty I just don’t want to be involved from a value standpoint (cski options while shorting the underlying is a different matter entirely, where I don’t care if the company is proven to be a complete sham, as I am exploiting options mispricings). In regards to that, I took a look at ceu options but nothing jumped out at me as being underpriced.

China Education Alliance (CEU), up 35% since initially recommended on July 5th, recently reported solid results for the 3rd quarter. CEU saw sales growth of 40% and net income growth of 25% compared to the same quarter in the prior year. The decrease in net income margin can be attributed to a large increase in selling expenses which rose to 36% of sales from 30% in the prior year. Management said on the conference call that most of this increase was a result of higher commissions paid to CEU salesmen, and that they will try to control selling costs better and keep it closer to 30% of sales.

For the 9 months, sales are up 27%, and CEU should hit its target of 30% sales growth for the year. Net income for the 9 months is up 23% and will most likely fall slightly short of the 30% target. This is due to very low selling expenses as a percentage of sales for 2009 which positively impacted margins. For the first 9 months of 2010 selling expense has been 32.2% of sales which is closer to the 2007 and 2008 number of 30% and much higher than the 2009 number of 25%. So far in 2010 online education and training center revenues are growing at roughly the same pace of 31%, with advertising revenues (which make up a small percentage of total sales) down 26%.

CEU also announced its plans for aggressive growth by opening 50 tutoring centers in the next 3 years. The company has already completed 1 facility in Beijing and will have 3 more open by early 2011. This is important as the company feels it needs to establish a physical presence in a community before it offers its online products. Thus in the conference call management stated that they will not expand their internet business outside of the 4 territories that the currently operate in until they open more tutoring facilities in new territories. As well, management also said that each new facility can bring in 7 to 10 million in revenue per year when it is fully operational. This would mean 350-500 million in revenues in 4 to 5 years time, quite high when considering the company only had revenues of 33.8 million in the first 9 months of 2010. However, this goal is congruent with this article on seeking alpha, where a hedge fund manager reports on his conversation with the CEO of CEU. I will not change my model to reflect this astronomical growth potential, but will leave it unchanged at 30% growth this year, 27.5% growth in 2011 and 2012 before tapering off to the long run average. If this growth materializes it would obviously be great, but it is impossible to speculate or comment on until we see some signs of development. Hopefully we will get a better view by Q2 2011 when the first 4 centers should be operational.

Management also said it plans on using a large amount of the cash on hand for this expansion, along with the building of 2 new vocation centers. They did not express interest in share repurchases at this time. As well, they have not issued any new warrants or options this year, preventing the dilution that has gone on in the past at CEU. Also, there was no discussion or questions on switching to a big 4 auditor, something that would bring many investors peace of mind.

Overall, a successful quarter, but one in which management makes some very grandiose goals. Even if CEU does not grow at that rate but still continues its current trend, it is a very undervalued company. My valuation of 240 million is still far below the current market cap of 165 million.

China Education Alliance (CEU) had a very strong quarter, with revenue up 33.7% vs the comparable quarter of 2009. This was driven by 35% growth in the online education segment and 45% growth in the training center segment. The revenue from the advertising segment, which is outsourced to an ad agency, fell 16% yoy. Management has said that they expect revenues from advertising to remain steady for the indefinite future. For the 6 month period, revenues were up 19% yoy. This weaker growth is due to the Q1 weakness that saw revenues up only 5% yoy.

Gross margins were very strong for the quarter at 83.5%. Management explained in the conference call that margins are driven by class participation rate, ie. If the classes at their training centers are full, they still pay the instructor the same amount hence higher margins. The same applies in their online business, where higher sales don’t necessarily translate into higher materials cost. Management has guided that gross margin should be closer to 80% in the future but might come in higher, as it did this quarter.

There were some changes to operating expenses during the quarter. Selling expenses, which include commissions to salesmen and marketing costs, were 32% of sales for the quarter up from 23% a year ago. This is caused by a new marketing push. Administrative costs actually decreased yoy. This is because the company accounts for the cost of options grants in this segment. Last quarter management promised no new options grants this year or issuance of stock warrants. If you remember, I was concerned that they would not hold true to this promise and investors may face further dilution. I am happy to see that management has been faithful to their promise so far this year .

Therefore net income is up 30% yoy for the 2nd quarter, and up 21% for the first 6 months of the year. This is positive as management had previously stuck to their forecast for 30% revenue and NI growth for 2010. They still maintain this forecast and it appears that they may be able to pull this off, despite the handicap of the slow growth from Q1 this year. To accomplish this goal, sales will need to grow 38% yoy in the second half of the year. With all the additional cash spent on marketing in the 2nd quarter, it makes sense that this will result in higher sales growth in the next few quarters.

In other new developments, they are currently constructing new training centers, with 2 set to open in the Beijing province in September and the other 2 expected to be complete within 9 months. This will be in addition to the 10 training centers for exam preparation CEU currently has running in northern China. This will require small amounts of cap ex, as each training center costs about 0.5 million USD to open.

CEU currently has built up a large cash position of about 75 million USD and much of the conference call focused on CEU’s intentions for this cash. Management has indicated that they will use a small amount for the cap ex noted above, and the rest they would like to keep on hand for acquisitions. They still maintain that they will only do acquisitions when it is favourable for them, at a multiple of about 7 times earnings. Right now most Chinese education companies are going for about 15 times earnings, so acquisitions may not be executed soon, though management claims to be actively looking.

There was a notable change in response to a question concerning share buybacks. In the past, management has said that they would like to keep their cash on hand for expansion and growth. However, this time they finally said that they agree the share price is very cheap and they have been talking internally about the possibility for a share repurchase plan. This is a good step and could act as a catalyst should management decide to initiate a share repurchase plan. Finally, when asked if CEU would consider switching to a big 4 auditing firm, the CEO stated that he recognises how switching to a big 4 firm could increase value, so they may consider it, but he would not like to discuss this on the conference call. This struck me as very positive, as if they company had something to hide or had no plans to one day switch to a more respected auditor, they would have disregarded the question by answering that they don’t need to because everything is ok.

All in all, this was a very successful quarter for CEU. Sales increased, net income increased, the company indicated that it is listening to shareholders in regards to auditors and share repurchases, and management kept their promise about not being dilutive to shareholders. I am more bullish on the company than I was in the past, and maintain my valuation of around $210 million, a 55% premium to the current price.

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.

Industry Analysis:

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.

Management Analysis:

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.

Balance sheet:

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.

Valuation:

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.