New Oriental Not Too Cool For School

By Stephen D. Simpson, CFA | July 17, 2011 AAA

Sometimes a little perspective is in order. New Oriental (NYSE:EDU) gets well-deserved plaudits for being the largest private education provider in China, and yet the company's revenue is about one-tenth that of Apollo Group (Nasdaq:APOL), the operator of University of Phoenix and the largest for-profit education company in the U.S. And yet, Apollo's enterprise value is only about 50% larger than that of New Oriental. That raises some interesting questions about the sort of growth potential New Oriental has, as well as how much of that growth has already been put into the stock by enthusiastic new shareholders.

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A Strong End to the Fiscal Year
New Oriental certainly gave out a graduation present of its own as it closed its fiscal year. Revenue rose 59% for the fourth quarter, handily beating even the high end of the analyst range. Given that enrollment was up about 12% for the quarter, it is pretty clear that New Oriental is seeing some strong trends with its pricing and mix.

At the same time that revenue is growing by double-digits, the company is doing a good job of managing expenses. Gross margin jumped almost eight full points (to nearly 59%), while reported operating income rose more than 185%. Non-GAAP operating income growth was likewise sound, as income by this accounting rose 122%.

Can the Big Get Bigger?
New Oriental has leveraged a first mover advantage and sensitivity to customer preferences into incredible mind-share in the Chinese market. Consequently, rivals like Ambow (Nasdaq:AMBO), Xueda (NYSE:XUE), Global Education (Nasdaq:GEDU) and China Distance (NYSE:DL) are experiencing solid growth in their own right, but not really impinging on New Oriental's growth in any meaningful way.

To that end, New Oriental saw better than 15% enrollment growth for the full fiscal year, while expanding its footprint of schools and "learning centers" to 54 and 433, respectively. The company is also not resting on its laurels, launching new programs like POP Kids and U-Can to not only serve a broader potential customer base but get more of the available customer dollars (or yuan, if you prefer).

This growth is not going to continue without some challenges, however. For starters, finding teachers who meet the company's standards for qualifications and in-classroom skills is becoming increasingly difficult. Second, there are only so many prime locations for the company - this is a company whose products appeal to more aspirational families (where speaking English and/or preparing to study overseas is seen as critical) and that constitutes a relatively concentrated market in today's China.

Most of the Risks Are Macro
No company is immune from the risk of a "lightning strike." New Oriental could find itself in the midst of an accounting scandal or some sort of dust-up related to the true efficacy of its courses. Unfortunately, those risks are largely unavoidable for most investors.

What investors may want to consider, though, are risk factors like the health of the Chinese economy, the possibility of government intrusion in the for-profit education sector, and the risk that the U.S. will be less welcoming to Chinese students wishing to study at U.S. schools. Those all seem like relatively minor issues today, but investors should at least give them a bit of thought. In comparison, the risk that companies like Washington Post (NYSE:WPO) or Princeton Review (Nasdaq:REVU) grab major share from New Oriental seems entirely manageable.

The Bottom Line
New Oriental sports hefty backward-looking valuation ratios, and some investors may assume that the valuation is way out of line with its probable growth trajectory. While it is true that today's valuation assumes better than 20% revenue growth for the next few years, and a decade of better-than double-digit free cash flow growth, that does not necessarily seem outlandish for such a small and fast-growing company.

Though investors should be very attentive to the trends in enrollment and margins, New Oriental is in a leading company in a fast-growing industry. That is often music to the ears of growth stock investors and it should not be all that surprising if New Oriental's earnings momentum pushes those already-high valuation metrics even higher still. (For additional reading, check out Investing In China.)

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