HK/China Equity Long-Short

Osbert Tang, CFA

Thematic (Sector/Industry)

In Sep, various ministries and local governments have announced detailed regulations or opinion-seeking drafts for the implementation of central government's "Double Reduction" Opinions. The areas that covered by these regulations range from the qualifications of tutors to the advance collection of tuition fees. While this should be anticipated, we think there is risk of regulatory overshoot which will put further pressure on the after-school tutoring companies like <a href="https://www.smartkarma.com/entities/new-oriental-education-technology-group" target="_blank" data-smartkarma-citation="entities:32210:1" rel="noopener">New Oriental Education &amp; Technology Group (9901 HK)</a>, <a href="https://www.smartkarma.com/entities/tal-education-group" target="_blank" data-smartkarma-citation="entities:1124:1" rel="noopener">TAL Education (TAL US)</a> and <a href="https://www.smartkarma.com/entities/gaotu-techedu-inc" target="_blank" data-smartkarma-citation="entities:28069:1" rel="noopener">Gaotu Techedu (GOTU US)</a>.We can see that the regulations are all targeted on off-campus after-school tutoring but not on the higher and vocational segment. In this regard, we believe <a href="https://www.smartkarma.com/entities/china-education-group-holdin" target="_blank" data-smartkarma-citation="entities:18218:1" rel="noopener">China Education Group (839 HK)</a>, which focused on higher education, and <a href="https://www.smartkarma.com/entities/china-east-education-holdings" target="_blank" data-smartkarma-citation="entities:27843:1" rel="noopener">China East Education (667 HK)</a>, which focused on vocational training, are better positioned in this wave of regulatory crackdown.

In Sep, various ministries and local governments have announced detailed regulations or opinion-seeking drafts for the implementation of central government's "Double Reduction" Opinions. The areas that covered by these regulations range from the qualifications of tutors to the advance collection of tuition fees. While this should be anticipated, we think there is risk of regulatory overshoot which will put further pressure on the after-school tutoring companies like New Oriental Education &amp; Technology Group (9901 HK), TAL Education (TAL US) and Gaotu Techedu (GOTU US).We can see that the regulations are all targeted on off-campus after-school tutoring but not on the higher and vocational segment. In this regard, we believe China Education Group (839 HK), which focused on higher education, and China East Education (667 HK), which focused on vocational training, are better positioned in this wave of regulatory crackdown.

China Private Education: More Regulations Rolled Out Backing "Double Reduction"

Equity Bottom-Up

We take the recent newsflow on business development at <a href="https://www.smartkarma.com/entities/china-education-group-holdin" target="_blank" data-smartkarma-citation="entities:18218:1" rel="noopener">China Education Group (839 HK)</a> positively. While the market may still skeptical towards the company due to the sector's regulatory worries, CEG is standing in a better position than many of its peers given its focus on the vocational and higher education segment. In our view, the beaten-down performance of CEG's share price is not justified, and it is an interesting time to look at its long-term promising outlook now.   The 58% increase in approval higher education enrollment quota for 2021/2022 academic year, upside from contribution of the newly added Chengdu Jincheng College, support from banks and IFC through provisions of seven-year loan facilities at low pricing, rapid execution of M&amp;A and further potential pipeline acquisitions all lend support to CEG's business prospects amid a turbulent time. Our belief is that at 13.5x PER for FY22, CEG is inexpensively priced relative to growth.

We take the recent newsflow on business development at China Education Group (839 HK) positively. While the market may still skeptical towards the company due to the sector's regulatory worries, CEG is standing in a better position than many of its peers given its focus on the vocational and higher education segment. In our view, the beaten-down performance of CEG's share price is not justified, and it is an interesting time to look at its long-term promising outlook now.   The 58% increase in approval higher education enrollment quota for 2021/2022 academic year, upside from contribution of the newly added Chengdu Jincheng College, support from banks and IFC through provisions of seven-year loan facilities at low pricing, rapid execution of M&amp;A and further potential pipeline acquisitions all lend support to CEG's business prospects amid a turbulent time. Our belief is that at 13.5x PER for FY22, CEG is inexpensively priced relative to growth.

China Education (839 HK): More Flows of Positive Development

Forensic Analyst

Jason Yap, CFA

Forensic Accounting

The “double reduction” crackdown on K9 after school tutoring ("AST") that covers primary and middle school curriculums has inflicted major pain on the USD38 billion industry. With the original aim of easing student pressure inside and outside school, it has led to unintended consequences of tutor layoffs, early lease terminations, and fresh anxiety among parents on how to occupy their children's available after school time.
The regulations also shook the confidence of AST investors and enterprises. Weak hands folded by shutting operations, filing for bankruptcy and/or exiting investments while industry leaders with a stronger cash position frown over the best approach to pivot operations.
For industry leaders like <a href="https://www.smartkarma.com/entities/new-oriental-education-tech-grp-adr" target="_blank" data-smartkarma-citation="entities:531:1" rel="noopener">New Oriental Education (EDU US)</a> and <a href="https://www.smartkarma.com/entities/tal-education-group" target="_blank" data-smartkarma-citation="entities:1124:1" rel="noopener">TAL Education (TAL US)</a>, revenues generated from K9 academic tutoring comprise between 50% to 80% of total revenues. Hence, there is a direct material impact on forward revenue and earnings.  In addition, they will incur one-time costs for, amongst others, staff severance, early lease terminations, and refund liabilities for K9 courses that can no longer be administered.  
In August 2021, Beijing education authorities <a href="https://www.caixinglobal.com/2021-08-16/cover-story-whats-next-for-chinas-after-school-tutoring-industry-101755589.html" target="_blank" rel="noopener">extended</a> an olive branch, highlighting that AST companies may switch to sectors that aren’t affected by the new regulations, such as high school tutoring, vocational education, all-round education and adopting hybrid business models. A similar stance might by adopted nationwide and signals (at least some) policy support for the embattled AST sector.
Using TAL Education as a bellwether for the AST sector, we examine the financial and accounting concerns that arise as a direct result of the new regulations. In addition, we analyse the recent exit of a key Convertible Notes investor, who has essentially capitulated in the face of execution uncertainties of TAL's pivot strategy.  Should other investors follow?

The “double reduction” crackdown on K9 after school tutoring ("AST") that covers primary and middle school curriculums has inflicted major pain on the USD38 billion industry. With the original aim of easing student pressure inside and outside school, it has led to unintended consequences of tutor layoffs, early lease terminations, and fresh anxiety among parents on how to occupy their children's available after school time.
The regulations also shook the confidence of AST investors and enterprises. Weak hands folded by shutting operations, filing for bankruptcy and/or exiting investments while industry leaders with a stronger cash position frown over the best approach to pivot operations.
For industry leaders like New Oriental Education (EDU US) and TAL Education (TAL US), revenues generated from K9 academic tutoring comprise between 50% to 80% of total revenues. Hence, there is a direct material impact on forward revenue and earnings.  In addition, they will incur one-time costs for, amongst others, staff severance, early lease terminations, and refund liabilities for K9 courses that can no longer be administered.  
In August 2021, Beijing education authorities extended an olive branch, highlighting that AST companies may switch to sectors that aren’t affected by the new regulations, such as high school tutoring, vocational education, all-round education and adopting hybrid business models. A similar stance might by adopted nationwide and signals (at least some) policy support for the embattled AST sector.
Using TAL Education as a bellwether for the AST sector, we examine the financial and accounting concerns that arise as a direct result of the new regulations. In addition, we analyse the recent exit of a key Convertible Notes investor, who has essentially capitulated in the face of execution uncertainties of TAL's pivot strategy.  Should other investors follow?

TAL Education - Key Investor Capitulates, Should the Rest Follow?

China and US Equity Analyst

Roger Xie

Cross Asset Strategy

<ul>
<li>China’s tech sector has been in the spotlight in recent days. Beijing has released a series of rules aiming to remake private education and tech sectors. to curb cost pressure and better serve ordinary people.  we believe the magnitude of policy change on private education sector is unprecedent, which could surprise investors. This negative sentiments further spurs the fear of  anti-trust and unfair competition scrutiny on China Internet sector. It has led to capital flight from China tech sector. <a href="https://www.smartkarma.com/entities/hang-seng-tech-index" target="_blank" data-smartkarma-citation="entities:31367:1" rel="noopener">Hang Seng Tech Index (HSTECH INDEX)</a> has declined 40% from its high in February this year.</li>
<li>In the newly released policy, the State Council banned foreign capital from investing in education institutions through any approach, including VIE (Variable Interest Entity) structure. This has led to investor concerns whether the ban on foreign investments through VIE will be extended to other sectors. VIE is considered to be the foundation of offshore China ADR listing structure. Our assessment shows that the VIE structure will remain to stay, but the new oversea listings could face more scrutiny from regulators. The paradigm shift could fundamentally benefit <a href="https://www.smartkarma.com/entities/hong-kong-exchanges-clearing" target="_blank" data-smartkarma-citation="entities:490:1" rel="noopener">HKEX (388 HK)</a> as the preferred listing venue for offshore China ADR. And the dual-listing status for many China tech giants will remain. </li>
<li>China central bank lowered bank reserve requirement ratio early this month and free up US$154bn from the system. The benchmark 10-year treasury  yield hovered around 2.9%  past few weeks indicating plenty of liquidity. Investors have been speculating that LPR (Loan Prime Rate) might be cut further to stimulate the growth. We believe structural monetary policy operations will continue. Likely, more support will be provided toward green energy, innovations and industry upgrade, but it might remain tightening for property and overcapacity sectors. The upcoming Politburo Meeting in end of July could give more hints about monetary policy stance. More than 40% of China A-share companies have released their 1H earning preview, which delivered 120% year-over-year growth (due to low base by pandemic in 2020). We remain sanguine on China equity market outlook in 2H 2021, but would recommend more clarity on policy for China tech giants.</li>
</ul>


China’s tech sector has been in the spotlight in recent days. Beijing has released a series of rules aiming to remake private education and tech sectors. to curb cost pressure and better serve ordinary people.  we believe the magnitude of policy change on private education sector is unprecedent, which could surprise investors. This negative sentiments further spurs the fear of  anti-trust and unfair competition scrutiny on China Internet sector. It has led to capital flight from China tech sector. Hang Seng Tech Index (HSTECH INDEX) has declined 40% from its high in February this year.
In the newly released policy, the State Council banned foreign capital from investing in education institutions through any approach, including VIE (Variable Interest Entity) structure. This has led to investor concerns whether the ban on foreign investments through VIE will be extended to other sectors. VIE is considered to be the foundation of offshore China ADR listing structure. Our assessment shows that the VIE structure will remain to stay, but the new oversea listings could face more scrutiny from regulators. The paradigm shift could fundamentally benefit HKEX (388 HK) as the preferred listing venue for offshore China ADR. And the dual-listing status for many China tech giants will remain. 
China central bank lowered bank reserve requirement ratio early this month and free up US$154bn from the system. The benchmark 10-year treasury  yield hovered around 2.9%  past few weeks indicating plenty of liquidity. Investors have been speculating that LPR (Loan Prime Rate) might be cut further to stimulate the growth. We believe structural monetary policy operations will continue. Likely, more support will be provided toward green energy, innovations and industry upgrade, but it might remain tightening for property and overcapacity sectors. The upcoming Politburo Meeting in end of July could give more hints about monetary policy stance. More than 40% of China A-share companies have released their 1H earning preview, which delivered 120% year-over-year growth (due to low base by pandemic in 2020). We remain sanguine on China equity market outlook in 2H 2021, but would recommend more clarity on policy for China tech giants.


China Equity Strategy: Tug of War, Policy Uncertainty and Plenty Liquidity

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<h2>Headline Developments</h2>Another bad week for Didi (DIDI) , with the stock plummeting a further 21% after Bloomberg reported that Chinese regulators were weighing up “serious, perhaps unprecedented penalties” which may include a hefty fine (&gt;$2.8b), enforcing a state-owned investment or delisting the company from the NYSE.

Headline DevelopmentsAnother bad week for Didi (DIDI) , with the stock plummeting a further 21% after Bloomberg reported that Chinese regulators were weighing up “serious, perhaps unprecedented penalties” which may include a hefty fine (&gt;$2.8b), enforcing a state-owned investment or delisting the company from the NYSE.

China

TAL Education Group provides educational services. The Company offers comprehensive tutoring services to students covering core academic subjects such as mathematics, English, Chinese, physics, chemistry, political science, history, and biology. TAL Education Group serves students in China.

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TAL Education (TAL US)

China Private Education: More Regulations Rolled Out Backing "Double Reduction"

More detailed regulations on after-school tutoring have been rolled out by various ministries and local governments in Sep. The higher education...

Osbert Tang, CFA

China Education (839 HK): More Flows of Positive Development

Good enrollment quota growth, confidence from banking community and IFC and rapid execution of M&As are driving FY22 outlook for CEG, and this...

Osbert Tang, CFA

TAL Education - Key Investor Capitulates, Should the Rest Follow?

The “double reduction” crackdown has inflicted major pain on the USD38 billion AST industry. Weak hands have folded but TAL strives to pivot....

Jason Yap, CFA

China Equity Strategy: Tug of War, Policy Uncertainty and Plenty Liquidity

We remain sanguine on China equity market outlook in 2H 2021 given the earning growth and plenty liquidity, but would wait for more clarity on...

Roger Xie

Weekly Innovation Review (WIRE) #42

Headline Developments: Another bad week for Didi (DIDI) , with the stock plummeting a further 21% after Bloomberg reported that Chinese regulators...

Granite Bay Capital

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