SMALL CAP FOCUS: Hailiang Banks on China’s Education Obsession

Bottom line: Hailiang looks well placed for growth due to its small size, a major new expansion and positioning in the recession-proof education space, which could help to boost its shares that look quite cheap at current levels.

After a period of neglect due to their low-tech image and overly eager expansion by some, Chinese education stocks appear to be coming back into vogue on growth that looks solid, if not spectacular. On the heels of solid quarterly reports by 2 sector leaders 2 weeks ago, the much smaller and recently listed Hailiang Education (Nasdaq: HLG) has just released its first post-IPO earnings report that shows similar respectable growth. But more intriguing is the potential for growth acceleration, as the company launches a massive new campus and starts to expand its well-regarded brand as one of China’s leading private educators.

As a regular China IPO watcher, I’ll admit that Hailiang didn’t make it onto my radar screen in July when it made a small offering using the relatively low-profile “best-efforts” method. That’s not too surprising, since China’s markets were in free-fall at that time after a spectacular run the previous year, and their downward spiral was infecting most of their US-listed Chinese cousins.

Since making the IPO in that volatile time, Hailiang’s stock has defied the downdraft and actually is up by about a third from its offering price of $7. (IPO announcement; IPO prospectus) By comparison, shares of the 2 biggest US-traded Chinese education stocks, New Oriental (NYSE: EDU) and TAL Education (NYSE: XRS), are also up but by a more modest 19 percent after a recent sector rally.

It’s not difficult to see why Hailiang has outperformed, since the company’s stock is still valued significantly lower than its peers. But Hailiang’s model of focusing on traditional K-12 schools, along with its relatively small size, makes it look like an interesting bet for the longer term. That stress on primary education contrasts sharply with most of its US-listed Chinese rivals, which typically operate extra-curricular schools often known as “cram schools” for adults and children.

New Mega-Campus

Hailiang’s small size also makes it look interesting due to the big potential for strong growth with even modest additions. Such growth looks almost certain to come over the next few years, following the recent opening of a new mega-campus in eastern Zhejiang province, which has boosted the company’s capacity sharply. What’s more, Hailiang has plans to make new acquisitions, as it seeks to expand beyond its home based in an area of eastern China that was historically famous for churning out academics.

Last but certainly not least, education is relatively recession-proof, even if it’s not nearly as glamorous as China Internet stocks that were attracting all the interest among US investors until recently. China’s strong traditional focus on education means that people are less likely to skimp on such spending even during economic hard times, and may even spend more to boost their own competitiveness. What’s more, Chinese are famous for spending heavily on their children, which is Hailiang’s main focus.

Hailiang’s biggest drawback, which is really a drawback for everyone, is the potential for crackdowns in the sensitive education sector. It’s hard to know if and when such clamp-downs could be coming, and they occur quite regularly in the Internet sector that I cover more regularly. But as China’s economy slows and the need for private schools grows with the mass migration of Chinese to major cities, it really seems unlikely the government can afford to clampdown on entrepreneurial companies like Hailiang that provide a much-needed service and also create thousands of jobs.

Low Valuation

All that said, let’s take a closer look at some of the financials for this modest-sized company, whose market value of just over $200 million makes it a good candidate to kick off my new Small Cap Focus series. The most glaring factor setting Hailiang apart from its peers is its price-to-earnings (PE) ratio, which the company set quite low at the time of its IPO and still remains low at about 10. That’s about half the level of New Oriental, a third that for Tarena International (Nasdaq: TEDU) and also a third of that for TAL Education, which are 3 of Hailiang’s biggest US-listed peers.

Then there’s the company’s latest earnings report, which showed that Hailiang’s business picked up in its latest fiscal year that ended in June, as it prepared to launch the new mega campus in its hometown of Zhuji. Revenue for the 12 months through June grew 11 percent to 515 million yuan ($83 million), doubling from the 6 percent growth the previous year. (results announcement; annual report) The company’s gross profit increase of 11 percent marked a slowing from the previous year’s 14 percent growth, as costs rose due to higher labor costs.

But the most intriguing thing about Hailiang is its future growth potential. I recently visited its massive new campus in Zhuji, about 1 hour by high-speed rail from my home in Shanghai, and have to say it looked more like a university than a K-12 complex. (company announcement) The campus just opened in the current academic year, and is so large it includes its own hospital, supermarkets and full-sized sports stadium, among other things.

The addition of the massive new campus boosts Hailiang’s capacity sharply, meaning presumably we should start to see a return to solid double-digit revenue growth in the near future, marking a nice acceleration from current levels. That said, it’s also quite possible the build-up could put some short-term pressure on profits, as Hailiang spends to boost enrollment and seeks out new acquisitions.

At the end of the day, the biggest selling point on Hailiang has to be its very low valuation, and also its almost certain potential for big revenue growth with the opening of its new campus. I also like its positioning in the relatively recession-proof education space, and its status as a big name and one of the major early arrivals to China’s nascent private education sector that is almost certain to see big growth over the next decade.

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Disclosure: Companies profiled in the SMALL CAP FOCUS series have provided direct input and other financial support for the related articles, but Young’s China Business Blog doesn’t own or plan to invest in any of their stocks. To more investor information on Hailiang, click here.