With New Oriental & Technology Group (EDU) looking to ramp up the development of its online-emerging-offline (OMO) businesses alongside a ~20-25% capacity expansion into FY21, the company looks well-positioned to gain market share going forward. Given the prospects for industry consolidation post-COVID-19, I see a clear path toward multi-year margin improvement for EDU.
The stock currently trades at ~1.0x PEG, which is reasonable relative to the >30% YoY earnings growth trajectory, strong cash generation, and the optionality from Koolearn. As a long-term investor, I remain bullish on the stock, particularly with an upcoming catalyst (potential HK secondary listing) ahead.
COVID-19 Headwinds Weigh on 1Q21
Revenue in 1Q21 fell ~8% YoY to $986 million, ahead of the prior guidance for an ~11-15% YoY decline. The modest dip in revenue was mainly down to COVID-19-driven one-offs, including delayed enrollment, the curtailment of summer holidays, as well as the delayed resumption of offline operations (e.g., in Beijing, which suffered a second COVID-19 outbreak just before the summer). No surprises, then, that total student enrollment growth was below par at ~13.5% YoY to 2.96 million.
Gross margins were also down ~6.1% points YoY to 52.9% due to revenue declines, higher teacher compensation, and one-off expenses stemming from the capacity ramp. Non-GAAP operating margins were also down a steeper ~7.2% points YoY to 16.8%, while non-GAAP net profit declined ~19.8% YoY to $185 million, improving from the ~49.0% decline in 4Q20.
(Source: Earnings Release)
2Q21 Set for Return to Growth
Going forward, the company’s financial performance is guided to rebound as soon as the next quarter – 2Q21 revenue guidance is set at +10-13% YoY. This seems very strong, but excluding the impact of FX fluctuations, 2Q21 revenue guidance moves closer to ~7-10%. Driving the revenue guide is an ~25% YoY growth for K12, a ~35% YoY decline in overseas test prep, and a ~5% YoY decline in overseas consulting.
K12 Leads the Recovery
The key take, in my view, from the latest guidance is the recovery potential in the K12 business, which appears well on track to bottom out after the summer promotions. The guided revenue reacceleration to ~25% YoY in 2Q21 (from ~8% YoY in 1Q21) is particularly impressive given the shortened summer and delayed reopening of learning centers in Beijing.
The 2Q21 strength also comes on the heels of a ~21% YoY increase in its K12 student enrollments for 1Q21, well exceeding the most optimistic Street estimates. The ~31% YoY growth in summer promotion enrollments was also very impressive, partially down to the OMO initiatives in some piloting cities. Going forward, I feel comfortable underwriting further pick-up in enrollment growth in Beijing towards the 2021 winter holiday, which should entail continued YoY acceleration in 2H21.
Capacity Expansion Plans on Track
As of 1Q21, the number of schools and learning centers increased by 17% YoY to 1,472, with seven schools opened in new cities. This translates into total square meters of classroom area rising ~23% YoY, in line with prior guidance for 20-25% YoY growth in FY20-21. In tandem, management has maintained the 20-25% capacity expansion target for FY21 as well.
That said, I think the shifting of some capacity from the overseas and domestic test prep businesses and the OMO model could lift the revenue growth potential for the K12 business beyond the planned capacity ramp. On that basis, I see further tailwinds for K12 revenue growth heading into FY22.
Margin Expansion Also on Track (Despite Koolearn)
While the offline business is on track for a strong recovery, management also highlighted the additional investments required on the online side (i.e., Koolearn). But even with the headwinds from Koolearn, the low-cost conversion rate of online should continue to improve into the winter enrollment.
And with revenue gaining momentum, the margin pressure from online, as well as the operating deleverage on overseas test prep and consulting, should ease in the coming quarters. Ongoing OMO initiatives should also improve K12 profit margins in the long run, given the low customer acquisition costs and leverage on rental expenses. All in, I see the long-term operating margin target of 17-18% by FY22-23 as well within reach.
Quality Compounder with a Long Growth Runway
On balance, I remain bullish on New Oriental’s prospects as a quality compounder in the Chinese education space that can sustainably grow profits for years to come. The post-COVID-19 environment has further accelerated consolidation in offline K12 tutoring, which should drive further revenue growth and, by extension, a multi-year margin improvement.
From current levels, I see room for non-GAAP operating profit to inflect higher into FY23 as margins expand along with the revenue recovery. Thus, valuations are not at all demanding, in my view – the stock is trading at ~1.0x PEG relative to a >30% YoY earnings growth trajectory. Downside risks include slower-than-expected capacity ramp-up and increased regulation, while a potential HK secondary listing ahead is an upcoming catalyst to look out for.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.