INTERNET: Online Education Looks Good in Principle

Bottom line: The online education sector is currently in a teething phase that could last for the next two years, but could offer big potential for investors who can separate the wheat from the chaff. 

Today I thought I’d look at some of the major online education stocks to hit the market over the last two years, most turning in a decidedly negative performance that may or may not be justified. The latest of those, Koolearn (HKEx: 1797) stumbled out of the gate late last week with a flat trading debut, and since has posted some minor gains that probably don’t mean too much. (English article)

Koolearn’s anemic performance actually looks quite strong when compared with some of the others that have floated shares over the last two years. Most of those are down moderately to sharply over the last 52 weeks, led by a 67 percent plunge for one called Puxin (NYSE: NEW) and a 55 percent slide for another called Sunlands (NYSE: STG).

There are quite a few moving parts here, the two biggest being regulatory uncertainty surrounding this emerging group and also questions about their boasts of using artificial intelligence (AI). Then there’s the more fundamental question of the actual potential for this group, which theoretically could be quite big due to online technology’s ability to overcome many physical barriers.

Let’s begin with some big-picture thoughts, led by the fact that Chinese put a huge value on education and are often willing to spend lavishly on related products for both themselves and their children. In particular, Chinese children can be found bouncing from one extracurricular class to another in much of their spare time, when they’re not doing homework of course. That’s because their parents are always looking for every possible competitive advantage to get them ahead of their peers in this highly competitive society.

That broader reality leads nicely into the next issue facing the industry, namely the potential for regulation of this group that has so far mostly escaped such scrutiny. China’s education minister said last month that such regulation was coming (English article), which most believe is in response to concerns that children are getting saddled down with too much extracurricular work.

Against that backdrop, let’s look at some of the big figures coming in from these firms, which look sort of impressive and yet also not so impressive considering the big potential of the market. Of the five I looked at, the largest in terms of revenue is OneSmart (NYSE: ONE), which notched about $430 million in revenue last year. That figure is certainly nothing to sneeze at, but also isn’t extremely large, meaning there’s plenty of room for growth.

But finding that growth looks a little more problematic. Of the five I companies I examined, which also includes one called Rise Education (Nasdaq: REDU), four are posting revenue growth in the 25-45 percent range. That hardly looks exciting for firms that are tooting their horns so loudly on the potential of online learning.

Uninspiring Profits

Things also don’t look too exciting in terms of profits either. While three of the five are profitable, Koolearn has said it expects to slip into the loss column this year as it pursues growth over profits. Another profitable player, OneSmart, saw its profit actually slip 5 percent last year. The lone standout in terms of profits was Rise, which became profitable last year to the tune of $21 million. So  perhaps that’s why shares of Rise and OneSmart took the least hammering over the last year, with their stock down just 25 percent.

All the companies actually look quite similar in terms of student enrollment, with growth now in the 35-45 percent range. The one exception is Koolearn, whose student body is currently roughly doubling each year. But with that exception, it’s really hard to get excited about those kind of growth figures, even though they would be impressive in many other sectors.

One of my contacts told me his firm previously looked at some of the companies, but was put off by questions about the reliability of claims of using of artificial intelligence. Anyone who lives in China knows that AI is one of the current flavors of the moment, in no small part due to government encouragement. The result is that anyone who has anything computer-related in their business automatically boasts of AI prowess, even though they may simply be running very basic software.

At the end of the day, I personally feel there’s big potential for this group, despite all the drawbacks and uncertainties I’ve just mentioned. The big issue is separating the wheat from the chaff, which is probably easier said than done with such big-talking Chinese firms. I haven’t done any of that deeper spade work to give an informed opinion on any of these names, though Koolearn’s ties to leading traditional education services veteran New Oriental (NYSE: EDU) could perhaps give it a leg up on some of its rivals.