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Three Better Stock Picks than New Oriental Education


EDU is overvalued, and investors are better served in the domestic market.

I made a lot of presumptions about China and its people before coming here. If there's one that's proven true, it's their dedication to education. While the Chinese may not always be able to think outside the box or generate creative ideas, as I discussed a few days ago in A Tale of Two Chinas, they're fixated on education.

After all, with 1.2 billion people, the competition for jobs is fierce. Some of my local Shanghainese friends have told me that getting a low-paying cashier position at KFC (YUM) or Starbucks (SBUX) is highly competitive. Thus, top-notch education is a must for those that want even average jobs.

Parents want nothing more than to see their only child succeed and take advantage of the opportunity to have a life that they couldn't due to China's past. On average, they shell out 11% of their income on additional classes outside of everyday school. In terms of priority of categories where income is spent, only food and housing are more important.

It's no surprise then that China's largest private education provider New Oriental Education (EDU) has been a hit with Wall Street. The stock has, on average, returned 46% annually the past five years. This year alone it's up 34%.

Last week, the company announced another solid first-quarter earnings report. Revenue increased 26.3% and GAAP earnings rose 27.1%. Student enrollments grew 18.7% to 657,500 and continued investments were made in promoting and advertising the brand. In addition. a new concept was officially launched to offer smaller classes and one-on-one tutoring, which should translate into higher margins in the future.

Investors, however, were not impressed. The stock fell 11% as the spreading of the H1N1 virus has impacted near-term results, causing management to warn analyst estimates were unachievable.

Personally, I've been quite bullish on New Oriental for some time. Its rock-solid balance sheet boasts nearly $10 per share in cash and no debt. The brand name is recognizable throughout China as a premier education provider. Its comprehensive portfolio of service offerings cover nearly every stage of learning. And with a fresh US veteran investment banker heading up its business development department, new acquisitions can be expected to supplement organic growth.

From a fundamental standpoint, my only concern for the New Oriental is the fact that several local acquaintances have suggested that the company's rapid growth has actually diluted the brand. From their experience, New Oriental's service quality has begun to deteriorate. This is, of course, a very small sample size. But it's a problem that warrants further investigation.

My main concern with New Oriental -- and the reason I've been apprehensive to purchase the stock -- is its valuation. Even with its hasty growth rates, the stock is richly valued. Wall Street Institute, majority-owned by Carlyle Group, sold its Chinese subsidiary for $145 million, two times this year's expected sales, which have been growing at 40% the past few years. New Oriental sells at seven times this year's expected sales. And in comparison to US private education companies Apollo (APOL), DeVry (DV) and newly IPO'd Education Management Corp (EDMC), New Oriental sells at a far higher P/E ratio.

Sure, the US-based companies may not have quite the growth potential that New Oriental does in China, but they're benefiting greatly from the fact that people are heading back to school in droves due to the recession. Expected growth rates are impressive and therefore New Oriental doesn't deserve such premium multiples.

Even after the stock's price correction this past week, I think New Oriental is overvalued. For now, traders seeking to invest in the education sector would be better served sticking to the domestic market. That said, New Oriental is a phenomenal company operating in a country where growth can sometimes be limitless. At a more attractive price, the stock may just find a spot in my portfolio.
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