Monday, December 17, 2007

Profit from a busted Chinese IPO

Noah Education (NED) is a high growth Chinese company in an attractive market, trading at value prices. With nearly half their stock price in cash ($3.65/share), the company is trading at an ex-cash trailing P/E of 12. Though some short term risks exists, I believe NED offers an incredibly attractive risk/reward here, and a surprisingly affordable relative and absolute value for a Chinese company.

Company Overview
NED IPOed in October, selling 9.8M shares for $14/share. Please note that the proceeds from the IPO (~$130M) are not reflected in the most recent financial statements, which are for the quarter ended September.

NED primarily produces learning devices and content for children aged 5-19. The companies' primary product, their DLD (~80% of revenues), is a handled device preloaded with over 30,000 courses on a variety of subjects. Though there are competitors, NED is the current leader in the space, and their product is generally considered superior to competitor's products. There are about 233M school children in NED's target. With total DLD sales to date estimated at 6mm, there is plenty of potential for increased penetration as prices eventually come down. Current estimates call for DLD unit growth of 20% annually through 2009.

The company also sells an e-dictionary product (~20% of revenue) which has become commoditized and should not be a significant driver of profits going forward.

Though the majority of NED's revenue currently comes from the DLD device itself, it's worth noting that NED is building an extremely valuable library of learning content that, to date, it is mostly monetizing through its DLDs. NED's content was largely compiled by a network of over 250 teachers, and has received strong endorsement from the Chinese government, as well as from users. The company plans to continue to build on and monetize this content in the future through other channels (e.g. the web, cell phones, etc.).

The companies' main growth initiative is its focus on building out after school tutoring centers, targeting school children in the 5-19 year old range. The largest provider of tutoring services, New Oriental (EDU), tends to target a slightly older audience, from senior secondary students to adults. Noah is in a fantastic position to leverage its strong brand and to potentially become a dominant player in the space. This market has attracted lots of attention due to EDU's success, but I think NED's strong brand and existing content should give them a leg up on the emerging competition. This is also an incredibly large market, and there should be plenty of room for multiple large players. NED will also benefit from enormous cross-marketing opportunities. They are in a great position to drive current DLD users to their tutoring centers, and to promote their DLDs to their tutoring customers.

It's also worth emphasizing just how important education is in Chinese households. The Chinese education system is incredibly competitive, and success in school, as well as English language skills, are incredibly important to career success. Due to China's 1 child policy, parents will often invest heavily in their children's education to ensure that their children have the best opportunity to get ahead as possible. NED is a great way to play the rapidly growing income of Chinese families, as its revenue going forward should be highly levered to the prosperity of the Chinese consumer.

Risks:
So, how did this get so cheap? The company received a lot of negative press after one of its manufacturer's forgot to put a warning label on one of its products. Though this was in actuality not a big deal, the local media overblew the situation, and NED received a lot of bad press. The company has increased its marketing and taken efforts to restore its brand, but it is likely that--at least in the short term--the companies' reputation has been damaged. The news wiped out roughly 60% of NED's enterprise value, which I believe was a strong over-reaction. That said, it is possible that the negative press damages sales going forward, even beyond the next quarter or two.

An additional risk is pricing pressure and eventual commoditization of DLDs. Though the products are currently differentiated significantly, it is possible that NED will lose its edge as its competitors build out their own proprietary content. I think this is a long-term risk, but given strong pricing trends and NED's recent market share gains, this issue seems like it still may be some time away.

Valuation:
Adjusting for cash, NED trades at a P/E of only 12, with incredible growth prospects both in its interactive education content and tutoring business. It's worth noting that the market places a much higher value on tutoring and online education services than it does device manufacturers. EDU has a trailing P/E of 70; though I think that we'll see that come down eventually, I would do think a 25-30 P/E could be reasonable on NED's earnings from its tutoring business when it starts generating significant income. At today's prices, you are getting the interactive education business, which is anticipated to grow 20-30% annually for the foreseeable, at bargain prices, not to mention a free call option on what could be a highly profitable tutoring and education content business, which could allow for multiple expansion as NED transitions from a device company to an education company. With $3.65 in cash providing a nice downward cushion, I believe NED offers an incredibly attractive risk/reward opportunity, especially for a Chinese stock. Though I have no specific price target, I could easilly see this being a multi-bagger of the next few years if the tutoring initiative is successful, and if NED reaches the lofty valuation multiples achieved by education companies in the US or China.

Note: Author is long NED.

5 comments:

Wesley R. Gray said...

im confused on your 3.5$ cash per share? are you confusing the currency? im lookin on capital iq right now a nd they got 77.5mil yuan in cash and 21.5mil shares so 3.6mil yuan per share...at 0.1355 USD/CNY you get the 10.5mil USD per share or roughly 10.5/21.5mil ~50cents$ per share...
am i crazy? i've made similar mistakes in my own work more times than id like to admit..perhaps im off base but if im not this might make your assessment change...

Wesley R. Gray said...

sorry, i meant 77.5mil yuan and 21.5mil shares so 3.6yuan per share (not 3.6mil in the post) which is close to your 3.5$ dollar per share figure...

Research Intensive Investing said...

Capital IQ is incorrect--I ran into the same issue when I was originally researching this. The company IPOed in late October, and issued financial results for the quarter ended September 30th in November. Because the cash posted sometime in October, the cash did not appear on the September balance sheet. Proceeds from the IPO were about $140M.

For what it is worth, I've actually been burned by issues with capital IQ before, so I generally always like to double check with analyst reports and my own calculations from sec filings.

Eric

Wesley R. Gray said...

that is very nice to know...ive ran into issues with factset as well...all the money that goes into those damn things and the best place to STILL get the facts is from the sec.gov...

okay that makes me more comfortable looking at this name. thanks!

great research by the way..as usual

john said...

Eric,

Nice piece on NED, looks like you have some other good stuff going on here. I am adding you to my blogroll
feel free to do likewise.

John Bougearel

successfultradingtips.com