BUY OR SELL-New Oriental: Best in Class or Could Do Better?

Mon May 2, 2011 11:23am EDT

* Market leader "priced to perfection", or expensive?

* Strong brand attracts a premium ...

* But aggressive expansion has eaten into margins

By Megha Mandavia

BANGALORE, May 2 (Reuters) - When Chinese have money to spend, their top discretionary item is education, spawning a $20 billion tuition industry that is attracting a steady stream of new kids in class.

Market leader is New Oriental & Technology Group Inc , which has ballooned from a small night school less than two decades ago, and whose stock has risen 30 percent in the past month to trade at more than 50 times forecast earnings.

In the past year, the competition has become tougher with Xueda Education Group , Tal Education Group , Ambow Education Holding Ltd and Global Education and Technology Group listing in the United States and posing a threat to New Oriental's student and teacher base.

New Oriental, founded in 1993 by Minhong Yu, born of farming stock and a recent addition to the Forbes list of billionaires, has more than 1.8 million students on its books and is one of the most trusted names in Chinese education.

Some analysts still see value in the stock, but others are looking to invest in newer, and cheaper, rivals in a fast growing but highly fragmented Chinese education market.

QUALITY TEST

"There's a fight for quality," said Jeff Lee, analyst at Signal Hill, noting many Chinese companies are tarred with the brush of less-than-accurate accounting.

"Investors are willing to pay a huge premium in a company where they know they can really trust management, brand, auditors and the financials," he said.

New Oriental, which listed on the New York Stock Exchange in 2006, has seen its revenue triple since to close to $400 million, while its stock price has risen six-fold.

The company, valued at close to $5 billion, offers English language tuition and test preparation courses in China, as well as after-school tutoring for elementary, middle, and high school students.

"Education is the number one in discretionary spending. Given all the economic improvements and rising domestic consumption power, Chinese people will continue to spend on education," said Oppenheimer & Co analyst Ella Ji, who has a "buy" rating on New Oriental stock.

William Blair analyst Brandon Dobell said New Oriental shares could remain firm in the near term, but were unlikely to gain much given the fickle nature of the Chinese market and the stock's recent rally.

MARGINS SQUEEZED

Analysts see big growth potential in China's education market, and point out that New Oriental has no more than a 1 percent share of a market that is home to thousands of small mom-and-pop learning centres.

In recent months, New Oriental has aggressively expanded its learnings centres and taken on more teachers to stay ahead of competition -- it now has 52 schools and more than 400 learning centres in China -- but this has taken a toll on its margins, which have dropped to around 20 percent in the first 9 months of this fiscal year from almost 25 percent a year ago.

"The near-term challenge for the company is capacity utilisation and better control of marketing and staff costs," said Morningstar analyst Dan Su, who has a 'hold' rating on the stock.

"New Oriental is priced to perfection right now given the growth. If there's any hiccup in growth, you're going to see the stock price come down," said Signal Hill's Lee.

Tal Education, Xueda, Ambow and Global trade at multiples of 11 to 37.

"These companies have growth rates similar to New Oriental's, but are trading at half the multiple," Lee said. (Reporting by Megha Mandavia in Bangalore, Editing by Ian Geoghegan) (megha.mandavia@thomsonreuters.com; within U.S. +1 646 223 8780; outside U.S. +91 80 4135 5800; Reuters Messaging; megha.mandavia.reuters.com@reuters.net))

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