China Education:Quarterly wrap up,a triangle puzzle,growth,capacity and margin

Top-line beat; K12growth is all we care; another strong quarter

    TAL and EDU have reported their quarterly Sept.-Nov. 2017results. The toplineof both TAL and EDU beat consensus estimates. K12, the mainrevenue/profit contributor, maintained the strong growth seen in the previousquarter (U-can +45%; Pop Kids + 51%; and Peiyou + 52%). Deferred revenue ofTAL rose 49% while that of EDU increased 58%, suggesting the revenuegrowth outlook for the next winter and spring seasons should also be strong.Overall, investors are positive on growth delivered by the two companies.

    Guidance: accelerated or decelerated for next quarter?

    From a forward-looking perspective, EDU’s top-line growth guidance is stillaccelerating at 35-38% (in USD terms) for 3Q (2Q growth was 36.9%).Management believes 35-38% is not aggressive and has the confidence todeliver at the high end of the guidance. On the other hand, TAL guided 50-52%for 4Q (3Q growth was 66%). This suggests growth deceleration in the nextquarter, but management explains it is mainly due to impact from a lateChinese New Year (1-2weeks). If 1-2weeks of revenue is added to 4Q18,management believes the growth rate should accelerate.

    Margin, growth and capacity, triangle puzzle

    We analyze the relationship between top-line, capacity and OP margin. Webelieve OP margin is related to the speed of expansion/penetration in China,which helps to boost growth. Therefore, it is inevitable for margin to decline ifcapacity expansion is overly aggressive. We observe margin has a correlationwith the difference between revenue and capacity growth (figures 7-8). If thedifference between revenue/capacity growth starts to accelerate (revenuegrowth outperforms capacity growth to a certain point), we believe marginwould also improve. Similarly, if capacity growth accelerates and it fails topass through to revenue growth, margin would likely decline. As such, we donot worry about a short-term margin decline as long as top-line growthremains strong.

    Valuation/Risk

    We have Buy ratings on EDU (New Oriental) (target price USD115) and TAL(target price USD36). EDU and TAL are leaders in the K12tutoring market butthey account for a less-than-4% market share in total. We expect them to growshare robustly, and believe they will penetrate into lower tier cities to increasetheir total market share. Our valuation is based on DCF, because K12-tutoringis a strong cash flow business with visible and stable growth. Risks include: 1)change of policy; 2) disease outbreak; and 3) aggressive network expansion.