TAL Education Group (XRS) – Expensive Chinese K-12 Education Provider but We Believe it Could Go Higher

TAL Education Group: Chinese K-12 Tutoring at an Expensive but Worthwhile Price

“As an educational company, if we do not teach our students well, that is no different from robbing and stealing from them.” ~ Zhang Bangxin (XRS founder, Chairman & CEO)


We recommend buying and holding TAL Education Group (NYSE: XRS). TAL is the market leader in traditional offline K-12 tutoring in China, has a long runway for growth, and is growing “owner earnings” at 20-30% p.a. Expensive valuation, but rock solid balance sheet (net cash), strong cash flow, smart management (37% stake), excellent track record, and optionality with online investments justifies current valuation. Chinese culture places strong priority on education – a cultural element foreigners often don’t appreciate. Stock could easily trade over $110 (75% upside) with 2 years.


Education is one of the most core elements of Chinese culture, dating back centuries since the foundation of the “Central Kingdom” itself. Career promotion and societal prestige were based primarily on examination scores since the Yang dynasty more than 1,500 years ago.[1] Since the “one-child policy” in 1979, education became even more important to parents as everyone wanted their kids to have a brighter future in China’s ultra-competitive economy. Education spending makes up an increasing proportion of most family’s expenditures – as high as 1/3 to ½ in some cities (and increasing in lower-tier cities and rural places).[2] Spending on after-school tutoring, extracurricular lessons, and other non-school education activities is on the rise and should continue to grow for many years to come.

Parents’ strong reluctance to take risks with their child’s education lies behind our long thesis for XRS. TAL Education Group is China’s leading K-12 extracurricular tutorial education company, offering comprehensive tutoring services to K-12 students covering core subjects, including math, Chinese, English, physical, chemistry, biology, history, geography, and political science. The company is better known in China as Xue Er Si (Chinese: 学而思 – “Learn yet Think”), after a well-known Confucius saying. In 2013, it officially changed its name to Hao Wei Lai (Chinese: 好未来 – “Bright Future”).

XRS provides tutoring services offered through 1) small classes done primarily under the “Peiyou” brand (85% of sales), 2) personalized premium one-to-one sessions under the “Zhikang” brand (11% of sales), and 3) online course offerings at xueersi.com and haibian.com (4% of sales). Small classes usually range from 15-35 students and typically meet on weekends or after-school hours on weekdays. XRS started investing in online offerings in 2010, but while online education is a huge emerging market in China, our research suggests that XRS’s core K-12 small class offering is difficult to duplicate online. XRS conducts its small class and personal tutor sessions across the years throughout 363 learning centers and 292 service centers in 25 cities in China. XRS started out in Beijing and its expansion in the past 5 years has been primarily in larger cities. We believe the white space in both existing markets and newer markets is tremendous.

Unlike its larger rival New Oriental (EDU), XRS’s bread-and-butter is the domestic Chinese K-12 curriculum, especially in mathematics, physics, and chemistry (math and science offerings make up 80% of its revenue). The brand is well-known and extremely well-trusted by Chinese parents, which makes it extremely sticky and de-risks expansion into new cities or towns. According to a brand survey by Brandz in 2015, XRS was ranked amongst the top 100 brands in China and the #2 education brand (only behind more recognized New Oriental).[3] EDU’s strength is in its English language curriculum and English-based tests like the SAT, GRE, or TOEFL.

EDU is also another interesting investment but we believe it’s focus on overseas test prep, while a growing market, isn’t as “safe” as XRS’s focus on the domestic Chinese K-12. If there was a sharp decline in volume of Chinese students seeking to study abroad, or a government legislation discouraging studying English or abroad, EDU would be affected far more than XRS. The chance of something negative affecting the development of China’s K-12 curriculum is far lower and that plays to XRS’s strengths.

TAL Education Group

XRS was founded in 2005 by Chinese by current Chairman and CEO Zhang Bangxin. XRS started with only a few learning centers which tutored students on Olympiad-level mathematics (a very popular course offering in China because those who excel in local or national math contests have far greater chance of admission to top universities). This is very different from EDU which started out as an English tutor. XRS is as local as you can get – it quickly expanded from covering just mathematics to physical, chemistry, and other subjects, including English later on. And while EDU tended to appeal more to high-schoolers and adults, XRS focused on tutoring kids starting from elementary school up to high school. XRS went public on NYSE in October 2010 at $10/ADS (2 ordinary shares per ADS). The stock is $63 today, representing a 5-year CAGR of 45%.

But at an only $5B market cap, we believe there is much more growth in store for XRS. XRS earned $1.12 per diluted EP-ADS in the year ending Feb 28, 2016, and we are aware it trades at a “scary” 55x trailing P/E. But high quality gems don’t come cheap and if you truly understand XRS’s growth potential and the industrial tailwinds, you will realize that the valuation can easily grow into rapidly-escalating earnings. Moreover, FCF/share averages 1.4x GAAP EPS and the stock trades at a more reasonable 30x 2018 P/FCF and 20x 2019 P/FCF for 30% long-term growth.

XRS founder

XRS founder Zhang Bangxin

We’ve translated Zhang’s 2016 address to XRS’s employees at the company’s HQ (attached at end) – we encourage you to read this carefully to get a sense for the founder’s long-term focus on winning not the next few years, but the next decade. We think not many investors appreciate Zhang’s longer-term vision. Note Zhang’s religious focus on service, delivering value to the customer, and self-innovation. His belief that “if XRS doesn’t teach students well that is equivalent to robbing or stealing from them” is setting the standard in education in China.

At Golden Harbor, we love to spend time appreciating the soft, cultural things that make a company tick and differentiate it from competitors. Our experience is that visionary leaders who focus deeply on customer satisfaction and having a clear mission tend to outperform over time and consistently do so. Zhang’s ambition, humility, and focus remind us of other visionary leaders like Jeff Bezos (Amazon), Jack Ma (Alibaba), or Richard Liu (JD.com) who, through their sheer determination and long-term thinking often not only dominate existing markets but create new ones.

The scope of Zhang’s ambitions for XRS over the next decade is extremely impressive to say the least – this is type of bold, focused leader we are comfortable investing along-side with for many years – even if the stock is optically expensive. And Zhang has his money where his mouth is – he owns 36.8% of the shares and has 74% voting power. Directors and officers own another 7.4%, making total insider ownership at a healthy 44% (88% of the voting power). We don’t mind the lack of voting power and want to be along for the ride. Zhang has mentioned in the press many times recently that he will not sacrifice high-speed growth for quality of growth. One of the XRS’s core values is “full customer satisfaction”. Zhang will not grow the company at a pace where thing start falling apart in any way.[4] So far, he has proven that 40% growth in enrollments and student count is a comfortable pace. We believe XRS will continue to deliver.

From 2005 to 2010, XRS was basically only in Beijing and Shanghai. The company didn’t start its China-wide expansion until the last five years (2011 – present), and we believe the growth is just getting started. In 2011, XRS operated 132 learning centers and 108 service centers in just six cities in China – with the majority of revenue (96%) still coming from Beijing and Shanghai. By 2016, XRS had grown to 363 learning centers and 292 service centers in 25 cities in China, with only 54% of revenue from the top 5 cities (Beijing, Shanghai, Guangzhou, Shenzhen and Tianjin). In 2015, XRS entered several second-tier cities such as Luoyang, Nanchang, Ningbo, Wuxi, and Fuzhou, and it entered Hefei (Anhui Province) in 2016. Over 5 years, the total number of learning and service centers increased by a 22% CAGR. The total number of students enrolled increased from 486,000 in 2011 to 2.31 million by end of 2015 – a 37% CAGR. Total revenue (reported in USD) increased from $111 million in 2011 to $620 million by FY2016 – a five-year CAGR of 41%. RMB-denominated revenue (which shows true growth) compounded slightly faster. Students enrolled per city has increased by about 17% p.a. for the past two years – suggesting that XRS’s expansion isn’t coming at the expense of quality on a per-city basis.

Geographically, XRS is just getting started. China has 62 cities with over 1 million people and 352 cities with populations between 100,000 and 1 million.[5] XRS is currently averaging 92,000 students per current city (only 25 so far). For cities with populations over 1 million, 92,000 students amounts to < 9.2% of the population. While this sounds high, keep in mind that many of these cities have far more than just 1 million.

The table below is illustrative. There are 62 cities in China with populations over 1 million. Together, the total population of all 62 cities is 262 million, or about 19% of China’s 1.4 billion population. Of those 62 cities, we’ve highlighted the 25 that XRS is currently in (in yellow) (note that XRS so far has only expanded to these >1 million population cities). We’ve made an educated guess that of the total 262 million people, 10% are K-12 age kids (say from 5 to 18 years old) that represents XRS’s target group. Personally we feel 10% is too conservative. We don’t factor in China’s recent elimination of the one-child policy which could give tailwinds to this estimate in next few years as babies grow into school-aged children. Even at 10%, that’s 26 million K-12 aged kids that XRS could tap into. XRS reported 2.3 million students at the end of FY 2016 – that’s only 8% of the addressable market. Even if you only take the cities that XRS is currently in, the total population is 165 million. Assuming again the 10% K-12 ratio, that’s 16.5 million K-12 in XRS’s existing markets. XRS’s latest 2.3 million students would only be 14% of this smaller addressable market.

XRS market analysis

Growth in revenue is driven by students enrolled. The company is guiding 40-50% annual growth in student enrollments for the many years to come. The population analysis allows us to sanity check this metric. XRS has only mid-teens market share in its existing markets – and that’s not even accounting for the 37 additional cities with greater than 1 million population that XRS has yet to expand in! And that doesn’t even include the remaining 80% of the Chinese population in over 730 cities with populations < 1 million! Given XRS is a leader in the K-12 space and kids can sign up for multiple classes (many take as many as 4 classes per year), that suggests that the white space for XRS is enormous. It could literally double the student count without expanding into any new cities and still double the revenue, EBIT, and net income of the business.

XRS has been net cash since its 2010 IPO. As of Feb 28, 2016, XRS had $247 million in net cash, or about 4% of the market cap. That’s puts TEV at $5.4 billion.[6] Dividing by the 2.3 students enrolled in FY2016 we get an EV/student of $2350. While that may seem high given the average student pays about $268 in tuition in 2016, we believe that figure will come down rapidly when XRS continues to add enrollment at the 30-40% clip for the next five years. At 35% uniform growth in enrollment, XRS will have 10 million students by 2021, and current TEV per student over 2021 estimate falls to $600, which is a bit more than 2x annually per student spending on tuition. New Oriental, with 3.6 million enrolled students and a $6.2 billion TEV, trades on a TEV/student of ~$1,709, but student enrollment is growing slower at 25% or so. While we’re not making judgments on whether this is reasonable valuation metric, our point is given that an average XRS student is far stickier than students of any other publicly-listed company, we feel there is room for the valuation to go up. Even at 10 million students, that’s not even 50% of the entire addressable market (> 26 million) in China’s 62 most-populous cities. And that doesn’t even include the 730 lower tier cities that XRS has yet to penetrate. Whatever the specific numbers are – we believe the market for XRS, the market leader with a market leading and well-trusted brand, is HUGE.

Keep in mind there is also room for ASP per student to go up. Currently, the average student spent $268 in FY2016 (ended Feb 28, 2016) for tuition at XRS courses. ASP for courses, on an apples-to-apples comparison, have increased about 5-7% per annum – in line with inflation. Overall ASP growth, at about 3-5%, b/c of mix shift (online courses, which are growing faster, have 50% lower prices than in class courses, and 1-1 tutoring is more expensive than small-class offerings). Management typically offers summer promotions (1 Yuan classes) to sign more students up (and students typically are sticky for several years) which depress pricing somewhat, but that is more than made-up when students elect several courses in the future at the full price.

As the chart below shows, the average family annual income in 2015 in large cities such as Shanghai was about $6,000 USD, whereas it was about 50% lower for more distant, western places like Gansu Province.[7] At $268/yr, the average tier 1 city family would spend 3-4% of annual income for XRS classes (per child), whereas families in less prosperous places would be spending about 7-10% of annual income (I do assume wages in lower-tier cities are growing faster than wages in first-tier cities). Education is an all-important investment for parents, and these figures, while high, are very reasonable in China. Parents also save for many years to pay for these services so they are definitely affordable, even though expensive.

XRS analysis 2

Although management has said that it can increase prices almost anytime (even in mature cities like Beijing and Shanghai where enrollment is growing mid-teens rather than 40%), Zhang prefers to play the long-game. Even without price increases, revenue can continue to grow at healthy 30-40% for many years. We don’t assume any price increases for our 8-year projection period.

Hiring and training great teachers is XRS’s biggest asset. Remuneration to teachers makes up its largest single cost bucket at ~50% of COGS. XRS hires graduates from China’s top universities (including Peking and Tsinghua Universities) and teachers undergo a 6 month training process before they are certified to lead classes themselves. Teaching expenses don’t appear to be scalable. From 2011 to 2016, the number of full time teachers increased from 1,169 to 6,594, a 41% CAGR. That lines up squarely with the 41% CAGR in revenue over the same period and shows that additional teachers will need to be hired to accommodate future increases in students (small classes disallow much cost leverage but increase student learning results because they get more 1-1 attention from teachers). We don’t mind this and actually think it’s a good thing that XRS hires more teachers to preserve the small-class feel that made its brand so trusted and well-known in China. We would actually be concerned if XRS skimped on hiring teachers and tried to conduct bigger classes. It turns out that the single digit ASP increases in student tuition are partially offset by single digit increases in teacher salaries, so we expect teaching costs to be neutral from a gross margin POV.

According to Jefferies research, the quality and experience of teacher is the single most important factor that parents consider when choosing education companies.[8] A natural question is whether or not XRS will run out of good teachers to hire – this may be an issue but neither the company nor its competitors have stated that top quality teachers are getting incrementally more difficult to hire. XRS actually tries to reduce its reliance on teacher quality per se by focusing on standardizing its teacher training programs so that it isn’t overly reliant on a few dominant teachers (who may leave and start their own start-ups!). XRS’s has an internal system to ensure that each teacher is trained up to rigorous standards and is well-paid and motivated. Teacher metrics are based on student success on examinations – very results driven. Teachers who perform well are promoted to larger cities and eventually corporate management positions. XRS doesn’t skimp on paying its most valuable employees and in return teachers provide students with above-and-beyond service. The teacher retention rate at XRS is over 90% – the highest in the industry.

XRS analysis 3

XRS rents nearly all of its classrooms in the 25 cities it is in. Interestingly enough, rent tends to go up yearly, and XRS’s total rental expenses CAGR’ed at 41% from 2011 to 2016 – exactly in line with revenue and teaching expenses. Given its “small-box” model, we expect no rental cost leverage and expect rental expense to hover at about 27% of total COGS. The company has not mentioned that space for expansion is an issue – but we will keep an eye on this.

The average learning center is about 750 square meters and this size has gone up over the past 5 years. We believe that XRS is opening up larger learning centers and hosting more classes in these centers to get operating leverage. Classes operate at only 20-25% utilization capacity because most courses are conducted on weekends.[9] We believe there is some room for capacity utilization (and margin) improvements but time will always be limited on the weekdays as students attend full-time school.

Other COGS includes small amount of stock-based compensation expense, course materials production cost, and depreciation of owned HQ building in Beijing. Given XRS is well-known for its high quality and proprietary course materials, we don’t think these expenses will come down as % of sales over time as they are fairly crucial to protecting XRS’s moat.

Since XRS’s 2011 IPO, gross profit margin has improved slightly from 49% in 2011 to 51% in 2016. We forecast future gross profit margin at 50% to factor in annual increases in teacher remuneration, lease costs, and more investment in developing better course materials. Gross profit grew from $54 million in 2011 to $316 million in 2016, a 42% per annum CAGR. We think continued expansion in student enrollments will continue to drive at least 30% p.a. gross profit margin growth going forward for the next 5 years at least.

While XRS says it relies on word-of-mouth as its sole advertising tool (which we feel is quite impressive), selling and marketing (S&M) expenses still make up ~12% of sales and has increased as a % of sales from 9% in 2011. XRS says this is due to increases in number of “sales and marketing personnel” and increased salaries per worker – in all honesty the company probably does a small amount of advertising – especially in new markets. Someone has to print the flyers and ads! In any case, we don’t expect any leverage from S&M expense going forward and keep it at 12% of sales (with room to come down).

G&A expenses went from 17% of revenue in 2011 to 26% in 2016. Most of this is due to XRS’s investment in content development and online education xueersi.com platform. Given XRS is in active investment mode in building out its online platforms (xueersi.com and haibian.com) and coming up with new courses and content (all proprietary), we expect this cost to remain elevated for the next 2 years at the very least (28% of sales) and gradually coming down as XRS reaps the results of its investments in the latter years (2019 and beyond).

Online Education – Peripheral, not Core

Over the past few years, there’s been a lot of discussion about China’s rapidly rising online education and its impact on traditional off-line operators like XRS and EDU. Pundits have offered spectacularly large market predictions for online education (some sources cite an RMB 200 billion market (30B USD) in 2015 and reaching almost RMB 700 billion (107B USD) by 2020) and spectacular growth rates exceeding 30% per annum.[10] Online education usually is in the form of pre-recorded lectures, or in recent years, live broadcasting by small number of teachers to larger number of students with interaction. Many tech companies are starting to invest in this field, including Baidu, Alibaba, and Tencent.

We think XRS is fairly well insulated from the online model (but we will be monitoring the ecosystem for potential disruptors). The first reason is that surveys show that parents are unwilling to consider online courses for core extra-curricular K-12 tutoring. Many students below the age of 18 lack discipline to “self-study” and given how important doing well in school and examinations are, parents won’t take the risk of allowing their kids to “slack off” with online-only programs.[11] Surveys show that while 44% of students have tried some type of online offering, 88% did not complete their online offerings, citing lack of motivation (36%) as the primarily reason and lack of proper learning atmosphere (aka classrooms and live teachers) as the second most important reason.[12] Online programs are usually more popular with adults who are more disciplined and know exactly what they want – it is not suited for students in the K-12 cohort. Secondly, core learning in K12 is mostly skill-based, and in-class environments are still the best for student-teacher and student-student interaction. Thirdly, the quality of many online-only players is often unproven and inconsistent. Online education start-ups don’t have the resources to hire and retain the best teachers.

Remember, it’s the parents that make most of the decision and surveys show that for them, the most important factor is instructor experience, and the second most important is learning environment. In fact, only 10% of parents (according to Jefferies survey) consider price to be the determining factor.[13] For many K-12 classes, the aim is partially to learn, but more importantly to pass the crucial examinations. Parents won’t skimp on testing out an unproven brand – they would still prefer established brand like XRS even if it’s more expensive. As disposable incomes rise in China, we believe the pricing power will work even more in XRS’s favor as consumers become even less price sensitive, but more brand-sensitive, in education spending.

Over the past two years, larger internet companies have tried to introduce educational offerings to broaden their categories. For example, Netease recently introduced a “cloud classroom” education offering tailored to professional learning for adults. For K12 Netease introduced their own “problem database” that users can access online. Baidu is focusing on introducing “problem databases” to allow students to download new problem sets. Tencent is taking a different approach and focusing on apps to allow students and teachers to organize education-related events (social networking is obviously Tencent’s core competency). Alibaba is introducing an “education platform” where teachers can sell services and problem sets, all replete with discounting and perhaps even haggling.[14] Even New Oriental’s Koolearn.com, the recipient of a $50M investment from an affiliate of Tencent back in Feb 2016, focuses on vocational training for adults.[15]

We are not worried about the recent IPO of $400M market cap online English-learning platform China Online Education (COE) either. COE, founded in 2011, is an online conversation-based English platform – if anything, we think COE’s model would be more of a threat to EDU than XRS. XRS derives over 80% of revenue from non-English subjects and isn’t dependent on English offerings as EDU or COE would be.[16]

We believe XRS will continue to growth amidst all this competition. Many of these competitors, while better capitalized, have corporate cultures better suited for their core specialties rather than education. Baidu’s core competence is search and advertising, Tencent’s is social networking, and Alibaba’s is commerce. Their education offerings seem too haphazard and distracted because it isn’t who they really are. Baidu is constantly thinking about how to make money off of advertisements on their education platform. Tencent is too focused on accumulating user volume on their education offerings. Alibaba seems more comfortable debating how to best monetize their “education supermarket” – commissions or advertisements? We prefer XRS (and even EDU) because “teaching students effectively” is hardwired into their DNA. They aren’t distracted, whereas education is at best a side-distraction for these larger competitors. They are unlikely to be putting their best people into developing an education offering, whereas XRS (and EDU) will be. Despite all of the investments that Baidu, Alibaba, and Tencent seem to making, none actually discuss education in their latest quarterly earnings calls. No mention at all! We also remember back in 2013 when YY.com was talking about making a big splash in online education thru their 100.com online education platform. Investors feared that this would be end of New Oriental and XRS.[17] Talk on 100.com lasted about 2 quarters and YY never mentioned it again. We think once this hullabaloo with online education calms down and XRS demonstrates consistent growth, the stock will go higher.

It’s not like XRS isn’t making its own moves in online education. XRS’s online strategy is to move slowly, leverage its core K-12 offline brands, and invest in other companies that are ancillary to XRS’s core strengths. XRS operates two core websites: xueersi.com and haibian.com. About 14% of its students, or about 300K, use these platforms. Xueersi.com focuses on pre-recorded video lessons and some live broadcast lessons, and haibian.com (the smaller of the two sites) focuses only on live broadcast lessons with interaction with the teachers regarding homework, problems, and other topics. Haibian.com has 20,000 students. XRS requires students using its online programs to respond within 15 minutes or otherwise it alerts parents. Although 14% of students at XRS use these online offerings, revenue from courses online makes up only 4% of XRS’s revenue – due to the lower pricing for online courses.[18] While XRS has said they are ramping up hiring of teachers in 2016 and 2017 (a margin drag) to beef up its online offerings (when developed, online should allow for some leverage because one teacher can broadcast to many students), we still feel that online will be at most complementary to the core off-line class setting. These online sites would be a great way for XRS to sign up students in cities it has not reached yet and get them to sign up for full-classes when XRS actually reaches those cities offline.

Besides its own online offerings, the table below shows XRS’s current online education portfolio. XRS has at least 10 more undisclosed investments beyond what is shown. We believe that even if online education were to take-off, brand still matters, and that the most reliable or trusted brand would be the most coveted online. We feel XRS is actually best positioned to take advantage of any upside should online education all of a sudden catch fire.

XRS analysis 4

Source: Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 79.

Financials & Valuation

We expect core operating income (EBIT) and EBITDA to compound in the 30%+ per annum range for the next 6 years at least, driven by strong execution, increase in enrollment, and penetration into new cities. At current $63 price tag and 4% of market cap in net cash, the stock trades at 47x forward EV/EBITDA for FY 2017 but for longer-term compounders we aren’t discouraged by this. The EV/EBITDA will quickly come down to 23x for FY2019, 17x for 2020, and 14x for 2021. By then, XRS won’t have even finished expanding in the top 62 cities in China yet and probably won’t even have started penetrated the remaining 80% of the population in lower-tier cities and countryside. Since its 2010 IPO, XRS has averaged 30x EV/EBITDA and 38x P/E over the past 6 years.

XRS analysis 5

One of the “wonderful” characteristics of XRS (as well as its peers) is that cash is received up front and expenses paid later. Expenses to teachers, staff usually take over 30 days to settle while cash is received several months in advance of when courses are offered. This item is usually booked as “deferred revenue” – a liability. By looking at changes in deferred revenue, we can actually estimate the growth in revenue 1-year out. XRS booked 289 million in deferred revenue by end of FY2016, a 63% increase over the 178 million booked at end of FY2015. If history is any guide, that means we could possibly be seeing 50-60%+ revenue growth for this coming year, well in excess of our 35% forecast.

XRS analysis 6

The negative working capital cycle allows XRS’s cash from operating activities to substantially exceed its net income. From 2010 to 2016, cash from operating activities was on average 2.12x net income. We model similarly strong cash flow conversion going forward. Capex has traditionally been 3-5% of sales (expect for 2012 when XRS spent $63 million purchasing a new Beijing headquarter). Capex is mainly used for purchase of computers, call center equipment, and other PP&E upgrades (remember, XRS leases all of its schools). We forecast capex as 5% of sales going forward and forecast forward FCF to average 1.4x of net income (XRS is unlevered). We expect FCF, or what some call “owner’s earnings”, to compound easily at 20-30% p.a. for the next 5 years.

For some who shudder at XRS’s 50+ P/E, let us say that the cash flow valuation looks a lot better, although it still might be very expensive for some. XRS did $145 million of trailing 12M FCF, which is a not-so-bad 2.7% yield on current TEV. Even at this valuation, with 2.7% yield and 20-30% growth in “owner earnings”, we believe buying XRS at $63 can work out if you have patience and a 3-5 year horizon. The stock went up 6x from 2011 to 2016 and we don’t see why the stock can’t go up 30-40% p.a. even at this valuation. We believe XRS can easily grow its student enrollment at 40%+ rates for many more years to come and that should drive the stock to go higher. Our FCF two years out yields 5% on current TEV and 3 years out yields 7%. While you may be able to get XRS at a cheaper price upon some type of sell-off, our experience tells us timing the market is utterly useless and over the long run it’s better to pay a bit more for a quality business than to pay less for an inferior-quality company. Based on our estimates, we wouldn’t bet against the stock reaching $100 / share within 2-3 years. A $100 price target corresponds to 25x our forecast of $4.00 FCF/share by FY2020.

Moreover, a TEV of $5B isn’t extraordinary if XRS successfully uses technology and its online investments to increase offline student stickiness. It is slightly smaller than EDU ($6.2B TEV) but if the recent New Oriental – Tencent collaboration could foreshadow further collaboration between tech companies and core education companies to come. It isn’t outside the realm of possibility to see XRS do a deal with one of the BAT[19] companies to fuse technology and education, or perhaps become a take-out target (given its strong cash flow, Fort-Knox balance sheet) altogether.

One interesting example of this “partnership optionality” is that between XRS and Didi Chuxing (China’s Uber) announced Jan 2016. XRS would provide up to $4.5 million (30 million RMB) worth of free education services and materials to the sons and daughters of Didi drivers as part of XRS’s public program to provide quality education to as many kids as possible. Over 90% of Didi drivers do not have time to tutor their children, especially on weekends when drivers are most busy and kids are not in school. Over 95% of Didi drivers say they would support these XRS gifts.[20]

It is interesting to note that although the shares have increased nearly six-fold since its 2010 IPO, Zhang has yet to sell a single one of his 59.55 million ordinary shares he held since the IPO (other officers have sold a little but insider ownership remains at 44.2% – down from 49% at the IPO).[21] This gives us extra conviction that Zhang feels bullish about the future. Zhang is only 35 – he has plenty of fight in him and plenty of time to see his vision play out.  

For those who are die-hard value investors, we would encourage waiting for XRS to pull back to $50 or below (which would be about 30x FY2017’s EPS of $1.50 and a 20% drop from today’s levels). Anything lower than that would be truly a gift – while we would welcome it with open arms, we don’t count on it.

Optically, the barrier to entry is low. Anyone can set up shop and offer tutoring services. According to iResearch, there are over 100,000 companies or institutions that provide extracurricular tutorial services in China.[22] But being able to replicate this model on a multi-city scale needs significant investment in content, quality teachers, and impeccable reputation – especially in K-12 segment. Zhang explained in a recent interview with the Chinese press that the education market is bigger, but completely unlike e-commerce or search, where scale allows duopolies or oligopolies to form (think of Alibaba – JD splitting B2C e-commerce, Ctrip and Qunar splitting OTA travel before they merged, or Baidu and Qihoo 360 splitting search).[23] In education, the addressable market is actually larger than a market like search, but it is composed of several smaller, vertical “niches” that cannot be tendered to by one big platform. There are many students with many needs, but you can only specialize in a few niches at once. There is core K-12 cohort. There is the English-learning and test-taking cohort. There is the professional education (for adults) cohort who want to learn specialized skills in IT or trade. It’s very hard for an education company to create a “platform” and take the whole market – the interaction with customer is not one-off as in buying a product, but over a period of months and even years. Teachers cannot be “jack of all trades” and must specialize.

We believe XRS’s strength lies in identifying this reality and focusing all its attention on optimizing its K12 product – its bread and butter. Zhang openly acknowledges that New Oriental is superior to XRS in foreign languages and that Tarena (TEDU) is more dominant in IT education for adults, but XRS knows where its strength lies. Every single initiative the company undergoes, from training its teachers to investing in other education companies, is done to strengthen this advantage. Fortunately, we believe K12 is also the largest market, has the stickiest customers, has strong pricing power, and offers the most room for XRS to expand. We do not find it surprising or unrealistic that XRS will, as Zhang delivers to his employees, be in over 100 cities over the next decade, from 25 today. The market is big enough and allows for scalability if you excel in your niche.

Parents won’t take risks with their child and send to potentially-inferior tutors just to save a dime (probably negative NPV investment from the parent’s view). Tutoring, and education, in China is about as delicate as infant formula – one wrong move and the child lags his peers and can’t catch up. Competition is seldom based on price. XRS is by far the nation’s most trusted K-12 brand and because of this we believe will continue to win market share. The stronger XRS becomes, the more it will be able to hire the best teachers (often stealing them from smaller, less well capitalized, localized tutoring shops). That in turn will lead more parents to pick XRS because it becomes the “low risk option”.

This virtuous cycle is further reinforced by the larger companies’ abilities to use technology to develop personalized data tracking for students. This will only increase user stickiness and increase switching costs. If a student who has been studying with XRS for a few years decides to switch, all of a sudden he/she loses all that data charting her progress for the past few years. Switching costs should only go up over the coming years.

New Oriental will probably do well over time too but we believe XRS’s model is more stable because K-12 is basically the backbone of China’s education system and essentially the nation’s future. That’s why we’re happy to compromise a bit on the valuation and ride the growth. Of course, at today’s valuation, there’s nothing wrong with buying a small stake and waiting for a pull-back to buy more.


Zhang Bangxin’s 2016 Address to Employees[24]

10-year Plan:

In the next 10 years, we will open offline schools in over 100 cities, with over 1,000 service centers and 10,000 classrooms. We will have over 100,000 plus full time employees. We will train over 1 million full time teachers. We will service over 20 million students offline alone, and combined with online, we will service over 100 million students. We will deliver over 1 billion lessons annually, which will exceed over 10 billion course hours. Our revenue will exceed 100 billion RMB (15 billion USD), and we will have over 10,000 recorded lessons on file.

Over the next 10 years, XRS won’t undergo just a simple change, but rather a fundamental transformation.

  • We will transform from a tutoring organization to an education organization. Over the past 12 years, XRS has accomplished many things, but we have focused on providing tutoring on weekends and in evenings on weekdays. But the future XRS will seek to penetrate deeper into the schooling system.
  • We will transform from an off-line business model to a technology-focused company.
  • We will transform from a Chinese company to a global company.
  • In the next 10 years, we will transform from an operations-driven company to a data-driven tech company

XRS’s strategic investments:

  • Toddler education – such as Baby-Tree, Xiao Ban Long, Heiha Technology, and Shark Park
  • Products in the K-12 space, including Xueke Net, Homework Box, and Qing Qing Home Tutoring
  • English products, including Shunshun Liu Xue, Li Bu English
  • Leading tech education companies overseas, including Minerva College, LTG, and game-oriented education products like Enuma

XRS has made many strategic investments over the years, but we won’t try to be everything at once. We hope to deepen and strengthen our core offerings, and leave the remaining to working with our investment partners to win-win.

3 Parables

The theme of my speech today is “Connecting You-Me in the Future”. I will first share 3 stories with everyone.

First off is a girl called Liu Zhixin. Liu grew up in Shandong province and came with her parents to Beijing during her first year of middle school, where she attended school near Renmin University. She also attended XRS’s Peiyou classes outside of school. She attended Peiyou for 6 years, where she took 3 subjects. She became the top scorer in 2015 college entrance examination in Beijing, and she was admitted to Peking University.

The second child is called Yuan Beibei. More than 10 years ago, when XRS only had tutoring classes in Beijing and only 2,400 students. That’s when Yuan came with her mom to sign up with us. She didn’t receive the top honors upon graduating high school, but she later was admitted to Berkeley University. She has not yet graduated, but she already has offers to work at Goldman Sachs and other prestigious organizations. Her mom followed XRS’s progress for many years and took a pay-cut to join us – becoming my first executive officer. Today, she is our VP Cai Yuli.

The third child is called Li Yige. She was a student of Beijing’s #4 Middle School. She didn’t end up going to Peking University, Tsinghua, Stanford, Harvard, but rather she was China’s first student to be attend Minerva. Minerva is a revolutionary type of college, founded by Harvard’s former principal, professors, and Stanford professors. The admission rate there is 2.9%. Many US students turn down other schools to attend Minerva.

Minerva uses the power of the internet to facilitate communication between teachers and students. Classes are conducted over 7 cities across the world through four years – the concept is very innovative. In 2014, XRS invested in this forward-facing university.

The reason I wanted to share with everyone these three stories is to show that the XRS today, compared to 10 years ago, isn’t just a tutoring organization helping students progress from elementary school to middle school and then to high school. Our students have demonstrated excellence not only in China but across the world.

We have focused resiliently on providing every child top quality education from 2003 to 2013. While our students have gone on to do great things, but we are always cautious. We must all remember these core three principles.

  • If we don’t teach students well, we are no different from stealing their money. 12 years ago, when we first started, we provided free trial classes for students and parents to test the courses out. We allowed refunds. This is not to say how good our business model is, but we started out on Day 1 by promising that we will not be a company that steals from customers. Parents are sending their kids to our organization, if we don’t teach them, we are essentially stealing their money. This philosophy sticks with me to this day and will continue to drive me going forward.
  • Secondly, we won’t earn respect if we don’t get students by word-of-mouth. China has many tutors, we have plenty of competition. Whenever we enter a new city or market, if we can’t provide students and parents something new and differentiated, why would we enter in the first place? We will focus on growing over the next few years, we are already in 19 cities, and we will enter several new ones this year.
  • Thirdly, a school that isn’t close with customers, doesn’t have a bright future. If we just focus on our business, profits, and not really understand the customer, spend time with them, understand their needs thoroughly, we will not have a bright future. We have worked on this for the past 12 years and want to continue improving in the future.

Let me share another story with everyone. Back in December 2013, when it was sign-up period at Shanghai’s winter XRS Peiyou classes, many parents waited in line until 11 – 12PM at night. At that time, one of our principals Yang Fuguang sent out a Wechat message to us showing a parent-packed picture – he said, “Parents are working so much to get their kids to sign up – we should have better action to show our appreciation for their trust.” I was thoroughly touched to see our products and services so welcomed by parents. Thinking back, this phenomenon also happened back in 2007 in Beijing. XRS sees over 90% signup rates for classes whenever it enters a new city – many people can’t even sign up. XRS still has many problems today, and many issues we need to fix. For one, we must find a way to provide our services and products to more cities to fulfill the great demand.

It’s going to be a long and arduous process. But we could at least consider ways to save parents the hassle of waiting in line till midnight. Last year, we introduced the XRS app, which has given students and parents more benefits.

We must create more competition for ourselves

Over these few years, what surprises me the most is, we are always striving to exceed ourselves. 3 quick examples – firstly, our Peiyou and Mobius classes. XRS Peiyou is the leader in K-12 education. Many of the teachers of our other brands come from their experience teaching in Peiyou. Over the past 7 years, we have continued to ponder, whether there will be a product that will exceed Peiyou in some or all respects?

Over the last five years, we have often wondered whether xueersi.com (our online platform) will exceed Peiyou. Will we even need off-line education? We eventually realized, that online education and offline education weren’t the same thing. Then, what will off-line education look like in 5 years?  We created Mobby.com, which uses iPads to teach students, using many new technology. Later on, under competitive pressure, XRS’s Peiyou wasn’t just not defeated, but it grew even stronger. Our work with Mobby allowed us to gain better perspective, to understand how to connect our product with technology better. We are always trying to give exceed and reinvent ourselves.

Another example is Le Jia Le and Li Bu. XRS started as focusing on the sciences, but 7-8 years earlier we entered the English market for young kids. Le Jia Le is becoming a national level English brand under the Peiyou umbrella. Last year, we acquired Li Bu English – which is focused on students who want to study abroad or attend international school. Along with our other English product offerings – Le Wai Jiao and Shun Shun, we have a complete English product offering.

The third example is our xueersi.com online school and Haibian direct broadcast offering. Our online school is a core pillar of our brand and growth strategy. Seven years ago, when we started our xueersi.com online offering, we looked up to our Korean peer Megastudy, which did very well in Korea but was overtaken by us in China. Xueersi.com was the first in China to use high-definition broadcasting of lectures and later on introduced direct broadcast in addition to recorded lessons. Over the past few years, our combination of recorded lectures and new innovations in direct broadcasting has become a global standard and first.

Even in spite of this, over the past three years, we also incubated yet another online product – Haibian (Chinese – “Seaside”) direct broadcasting. Haibian uses direct broadcasting plus service to help parents and earn good results and reputation. Xueersi.com and Haibian.com compete but also complement each other. They learn from each other and compete with each other, taking each other’s technologies and lessons learned.

Past several years, in addition to perfecting our core K12 product, we have used M&A to expand our horizons. We have invested in many education technology companies, most are #1 in their respective fields. For example, Baby Tree is #1 in the maternity category.

In sum, XRS will continue to expand its assortments with K-12 as the core. We will enter baby and young child market via Baby Tree, Xiao Long Ban, Hei Ha Tech, and Shark Park. We will expand in our core K12 offering, with brands like Xue Keji, Homework Box, Qing Qing Tutor. We will also expand in English and foreign language offerings with brands like Shun Shun, and Li Bu English. We will invest in the leaders of education abroad, such as Minerva, LTG and Enuma.

Data Technology

Education is about to welcome the data technology age. What do I mean by this? Everyone is aware that big data has ushered in rapid developments in society. The future of education sector will be predicated on big data. We have realized that the internet and information age are transforming the education sector, but everything revolve around service. In the age of education 1.0, everything revolved around teachers. In 2.0, everything revolved around the student, with a focus on motivating and encouraging students.

The education industry of today has its roots in service. Will big data change this? Actually, when service meets content, service is the core, the content is the ancillary. When service meets tools, service is still the core, tools are the ancillary. When service meets direct broadcast, service is still the core, broadcast the peripheral. But in the next decade, besides service, there will be big data. Data will complement service as the core of our business.

Why is data so important? Data helps us make education more individualized. Current education treats humans like machines – regardless of a student’s capabilities or interests, we feed him/her the same thing. This is a very low-efficiency way of doing things. In the world driven by data, a 20-year old of the future can get a Master’s Degree – won’t need to wait until she is 28 or 30. Hence, data and analytics will underpin the direction of the education sector for the next decade. We have just invested in a global-leading self-adaptive learning platform called Knewton. Knewton has one of the world’s most comprehensive databases – we’ve also signed service contracts with them.

In the past, teachers and tutors had always been paid by the hour. To some degree, we also paid by time taught today, similar to barbers and nail artists. In the future, education will be measured by effectiveness and results. Those organizations who can allow students to improve the most will be the winners.

Looking even future, we may even measure success in education based on unleashing the student’s potential and longer-term growth. We may be able to earn our tuition only if we help a student achieve success in society, maybe if they become an expert in some industry or practice. That will be the true value of education and how we should progress.


[1] http://www.chinahighlights.com/travelguide/ancient-education.htm

[2] http://www.eastasiaforum.org/2014/03/15/education-chinas-most-important-economic-weapon/

[3] https://www.millwardbrown.com/docs/default-source/global-brandz-downloads/china/BrandZ_2015_China_Top100_Chart_EN.pdf

[4] http://www.duozhi.com/leader/201501272754.shtml

[5] http://worldpopulationreview.com/countries/china-population/major-cities-in-china/

[6] Note that XRS’s basic ADS outstanding is 80M and diluted ADS outstanding is 91.5M. We use diluted metrics to get more “conservative” calculations.

[7] Extrapolated from 2012 survey numbers as reported at: http://www.nytimes.com/2013/07/20/world/asia/survey-in-china-shows-wide-income-gap.html

[8] Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 9.

[9] JP Morgan report on XRS (Leon Chik & Christine Wang): “Lifting PT to $70 – Tech savvy for better growth.” 23 June 2016.

[10] Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 13.

[11] According to a Sohu survey in Nov 2015, where some 200,000 respondents participated, results show that while 83% of students participate in extracurricular courses, 68% of parents say they would not consider online tutorial courses for children – see Jefferies report pg. 16.

[12] Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 19.

[13] Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 17-18.

[14] http://www.huxiu.com/article/136930/1.html

[15] http://www.prnewswire.com/news-releases/new-oriental-announces-tencents-investment-in-xun-cheng-and-xun-chengs-proposed-ipo-in-china-300212652.html

[16] JP Morgan report on XRS (Leon Chik & Christine Wang): “Lifting PT to $70 – Tech savvy for better growth.” 23 June 2016.

[17] http://technode.com/2014/02/25/yy-launches-a-separate-online-education-platform-100/

[18] Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 37.

[19] BAT stands for China’s three largest technology / e-commerce companies: Baidu, Alibaba, and Tencent.

[20] http://edu.sina.com.cn/zxx/2016-01-13/doc-ifxnkkux1264295.shtml

[21] See “Share Ownership” in XRS 20-F.

[22] Jefferies report by Johnny Wong and Kevin Zhao: “Education: Powering Ahead: Assuming Coverage of Chinese Education Sector.” 8 July 2016. Pg. 9.

[23] http://www.duozhi.com/leader/201501272754.shtml

[24] http://tech.sina.com.cn/i/2016-01-20/doc-ifxnuvxh5029913.shtml


Author: goldenharborinvesting

Global investing across the capital markets.

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