Investment Summary
China’s education market is enjoying full-blown demographic, social and policy tailwinds that are favourable to sector growth. China’s large population and limited education resources have created some significant imbalance in education infrastructures. The relaxation of one-child policy from January 2016 further widens the gap. In response, the government has stressed on improving education’s quality and penetration, while private capital is now more encouraged to operate education business to complement the public-sector supply. From a social perspective, the low admission rate to tertiary education (only 37% in 2014) and competitive job market have placed a strong emphasis on examination results. This enforces parents’ anxiety over their children’s academic performance therefore boosting the demand for K-12 after school tutoring. Meanwhile, China’s rising disposable income will continue to support the increase in average spending on education.
Frost & Sullivan estimates the K-12 after-school tutoring service in China to grow at 10% CAGR from RMB354bn in 2016 to RMB564bn in 2021E. K-12 tutoring is highly fragmented as the curriculum varies across provinces and cities. The top two leading players, namely TAL Education (TAL US) and New Oriental Education (EDU US), only accounted for ~3.5% of total market in 2016. We expect these two leaders to gain their market share amid 1) increasing use of national standardised examination paper across provinces (same set of well-researched materials can be deployed in more regions); 2) parents’ increasing awareness on brand names and track record, 3) the duo’s network expansion to lower tier cities, which will drive mom-and-pop tutors to exit the market; and 4) their extended coverage to all K-12 subjects.
We expect TAL and EDU to grow faster than industry and expand their aggregate market share to 8% in 2019E. In terms of stock pick, we prefer EDU to TAL given its cheaper valuation (trading 28x FY19 P/E vs TAL’s 44x), diversified offering (EDU is also strong in language classes and overseas test preparation), and more imminent margin recovery. As EDU increase exposure to the rapidly growing K12 market, it valuation gap against TAL should narrow, in our view.
BRIEF INTRODUCTION OF CHINA’S EDUCATION SYSTEM
China’s education system can be broadly divided into two segments, namely formal and informal education. The key difference is that the formal system enables students to obtain official certificates from the PRC government, whereas the informal system merely enables students to obtain completion certificates, which may not be officially recognised.
Formal education includes fundamental education (three years of pre-school, nine years of compulsory education at elementary and middle school, and three years of high schools), secondary vocational education (e.g. IT, languages), higher education and adult education. The Gaokao ( 高 考 , higher education entry examination) and Zhongkao (中考, high school admission examination) are the key events for high school and universities in China. Informal education includes after-school tutoring, test preparation courses, as well as licenses and certificates preparation. Compulsory education is closely regulated by the Ministry of Education (MOE) while pre-schools and high schools operate with a greater degree of flexibility. Informal education generally faces less stringent regulatory requirements despite its nationwide exposure.
Population of school-age (6-18) children contracted to 181 million in 2014 chiefly due to China’s one-child policy. But a reversal is happening. Following the policy relaxation in Jan 2016, the number of new born babies increased from 16.6m in 2015 to 17.9m in 2016. Further increase in birth is set to lead to an even fiercer competition among Chinese students over the limited educational resources. This backdrop, coupled with the rising household income and stronger parent awareness, will drive up the average spending on children’s education.
After-School Tuition Service to Blossom in Next 5-10 Years
Chinese parents are well-known for their commitment to children’s education and admission tend to be exam-oriented. The low admission rate to universities, particularly the top-tier ones, and a lack of good job opportunities further compel the “tiger parents” to spend more on after-school tuition. In 2014, only c37% of college-entry-age youths were admitted to higher education institutes, a level lower than other developed countries. The admission rate to key top tier universities in China was lower at only 3% in July 2015.
The anxiety over getting good education is further compounded by job market headwinds. According to a Frost & Sullivan report, fresh higher education graduates represented around 45% of China’s unemployed youths from 2011 to 2015, rising from around 35% in 2005. This highlights the increasing challenge for fresh higher education graduates to seek meaningful employment.
These factors combine to prompt parents to increase their investment in education, boosting the demand for after-school tutoring service as well as occupational test preparation. Indeed, the demand is so prevalent, after-school tutoring is often viewed as mandatory in China.
Frost & Sullivan estimated the market size of K-12 after-school tutoring at RMB354bn in 2016, which may grow at 9.7% CAGR to RMB564bn in 2021E. We believe this growth trend will be driven by the increase in average spending per student and student enrolment rate.
Since the issuance of the “Outline of China’s National Plan for Medium-and-Long-Term Education Reform and Development (2010-2020)” (国 家 中 长 期 教 育 改 革 和 发 展 规 划 纲 要 （ 2010-2020 年 ）) in 2010, the government has been encouraging private capital to operate educational business in China. Technological advancements, e.g. online platform, mobile apps and performance trackers, have further pushed the penetration of K-12 education across the country.
Consolidation of the Education Sector
China’s education sector remains highly fragmented. Formal education is usually regional and difficult to expand across country because of the strict regulation and close tie with local government. Although K12 after-school tutoring market is more flexible than formal education, the top operators, namely TAL Education (TAL) and New Oriental Education (EDU), only accounted for 1.8% and 1.6% of market share respectively in 2016. With more provinces using the national standard exam paper (全国统一命题试卷) in Gaokao (from 15 provinces in 2014 to 26 in 2016), leading players can introduce same set of teaching materials in more provinces. The increasing demand for higher quality course contents and curriculum formats should also favour the leading players. As these trends unfold, the scale advantage of big tutoring service providers could translate into operating leverage.
With TAL and EDU deepening their market penetration while media actively monitors the industry, individual tutors who find it too costly to compete with the established players may be forced to exit the business. Companies like TAL and EDU possess the research capabilities to enhance teaching qualities, and their enriched questions bank is unmatched by the smaller players. The better track record and their consistent investment in technology further strengthen their leading position. Consolidation in the education and tutoring business may become the new sector norm.
Education technologies to aid penetration
To improve their efficiency and market penetration, the leading players have consistently invested in education technologies and innovations. Online teaching tools and live-streaming models are emerging to extend the lessons beyond the classroom. The flexibility in providing pre-recorded lessons online or live lessons in offsite locations provides great value-add to student engagement.
TAL and EDU have also been rolling out a dual-teacher model at their schools, to establish a stronger hold in the lower tier cities. Under this model, TAL/EDU will operate learning centres in the lower tier cities where students attend lessons provided through live broadcast by famous tutors teaching simultaneously in another city. A teaching assistant will still standby in the classroom to answer questions. The emergence of this dual-teacher model has not only improved teacher utilisation (i.e. student-to-teacher ratio) but also lowered the fixed cost at learning centres.
Technology further allows teachers/parents to better gauge and analyses student feedback to track the teaching progress. This performance analytic and research capability is another key differentiator between the leading industry players and the local mom-and-pop tutors.
Increasing brand awareness favour established leaders
In the era of overflowing information, particularly on the internet, a tutor’s track record and brand name matter more in attracting and retaining students. For example, before expanding into a new city, TAL will promote among parents and schools, mostly via online discussion forums. Some tuition centres carefully select their admitted students to ensure better examination performance and overall track record.
We believe the increasing use of national standard exam paper will trigger a shift of student population to leading tuition centres that have a national track record and abundant research capabilities. TAL and EDU, with strong established brand names, are key beneficiaries.
Renowned for K-12 mathematics (TAL) and English overseas test preparation (EDU) respectively, TAL and EDU are actively expanding coverage to all K-12 subjects. TAL acquired Firstleap (offers classes across all K- 12 subjects in English) and Shunshun Bida (overseas studies consultancy) in 2016 to complement its service offerings. On the other hand, for EDU, contribution from K-12 also increased rapidly from 25% of sales in FY09 to 55% in FY17. Their rapid expansion across K-12 subjects is likely to drive further market consolidation.
The two also has different strategy in student acquisition, with TAL acquiring students at a younger age. Primary school students accounted for ~65% of its student enrollment. As a result, students tend to stay with TAL longer and lower the need/cost for student replenishment. Meanwhile, EDU tends to attract more senior students because of its strength in overseas test preparation (27% of revenue in FY17). With high school students accounted for 35% of total enrollment in FY17 (vs TAL’s 10%), EDU would need to replenish its student population more often than TAL. However, as EDU rapidly catches up on the K-12 business, the gap against TAL is narrowing.
Multi-year growth story; prefer EDU over TAL
Considering our positive view on the K-12 after-school tutoring market, we initiate coverage of New Oriental Education and TAL Education, with a BUY rating. Their key earning drivers include robust student enrolment growth, price increases, active ramp-up of online platform, and market consolidation.
Recent share prices pullback post Jun-August quarter results were largely due to the concerns of margin pressure. Operating margin of TAL and EDU dipped 3.7ppt and 3.9ppt respectively in the quarter ended in Aug-17. In our view, this was largely due to 1) the faster expansion pace over the past 2 quarters – TAL added 76 learning centres (15% network expansion) and EDU added 91 learning centres (12%), which lowered the utilization; and 2) larger scale of summer promotion this year.
As these new learning centres ramp up and both companies guided a milder expansion in rest of fiscal year, we expect the utilization to pick up gradually. Usually more than 50% of students acquired in summer promotions would then sign up for subsequent program with lesser or no discount. This should also help normalizing the margin in subsequent quarters. EDU may see margin to rebound faster because of less aggressive expansion over the past two quarters compared to TAL and resumed growth at higher margin overseas test preparation courses. Accordingly, between the two, we prefer EDU over TAL for its cheaper valuation and more imminent margin recovery.