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.