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jpmorganmarketsAsia Pacific Equity Research11 March 2020China EducationOnline feverChinaHead of Asia Gaming, Leisure and EducationDS Kim AC(852) 2800-8597ds.kimjpmorganBloombergJPMA DSKIM Jeremy An(852) 2800-8512jeremy.anjpmorganDerek Choi, CPA(852) 2800-8744derek.c.choijpmorganJ.P. Morgan Securities (Asia Pacific) LimitedSee page 60 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.We missed the rally in online K-12 pure-plays. We significantly underestimated the extent that narrative and momentum would turn in their favor, against earnings revisions and what we (once) thought as fair multiples. Admittedly, extremely disruptive events such as COVID-19 lead to many changes, some short-term, some structural we thus raise our forecasts (reflecting behavioral changes among students) and target multiples (reflecting investors growing appreciation of the story) to reflect this viewpoint. Despite this, we struggle to bring ourselves to chase here given risk/reward, knowing the easy part of rally (story-led re-rating) is behind us, with fundamental analysis giving us no margin of safety. We thus keep our ratings and stock strategy unchanged: we recommend TAL (OW) to play online K-12 in a sustainable way, while we prefer GSX (N) over Koolearn (UW) for anyone eager to ride on momentum Its been a wild ride. The share prices of online K-12 operators, such as GSX, Koolearn and Youdao (DAO US, not covered), have been on a remarkable run, rallying +93%/+65%/+57% YTD (vs HSCEIs -9% or TALs +13%). The narrative is simple: mandatory homeschooling amid school closures push students to engage in online education via free courses, in turn enablingoperators to save marketing dollars (near term) and to grow faster with a boost in penetration and conversion to paid-students (long term). How sizable and sustainable benefits from COVID-19 disruption would be is still moot (discussed inside). However, it is admittedly a story that resonates and has led to a substantial re-rating. How far can this rally extend? Koolearn and GSX now trade at 17x and 12x P/Sales on CY20E, two of the highest multiples in the entire China internet space. We find it tough to establish a ceiling for these stocks as they arent really driven by results or valuations, and we dont see imminent events that could derail momentum (perhaps not until summer break, when online promotionsmay yet heat up again). Regardless, this note introduces a valuation framework that we think could be useful when the hype fades, from both relative (fair P/S multiple?) and absolute (reverse DCF) standpoints. Spoiler alert: these stocks are not cheap. TAM conversion. We estimate Chinas K-12 tutoring market to be RMB508B in 2019, 8%+ of which (RMB43B) came from online. We now model online penetration can double to 19% in three years and triple to 26% in five years, driving online K-12 revenue to grow at a +38% CAGR to RMB214B in 2024E. However, we note this is an aggressive target, if we consider online ASP is half of offline levels, i.e., our numbers imply 40%+ of tutoring enrollment/students will be purely based on online by 2024E, up from about 15% today. See inside for details. Raising price targets, but . Were now giving the full benefit of the doubt, ascribing bull-case multiples (7-10x forward P/Sales) on bull-case forecasts (industry and market share). Yet, theyre still not giving us any upside, hence we stick with our ratings: Neutral on GSX and UW on Koolearn, versus OWs on TAL and New Oriental (EDU).Table 1: JPM ratings and PTsSource: J.P. Morgan. Price as of 10 March 2020.JPM PTRating (LC)TAL OW 64.0 18%GSX N 40.0 (5%)Koolearn UW 22.0 (28% )EDU OW 160.0 25%Upside2Asia Pacific Equity Research11 March 2020DS Kim(852) 2800-8597ds.kimjpmorganOther key points (contd) How to play the sector? GSX for momentum chasers. We do believe the key recipe behind its stock surge will remain intact for a couple more quarters that is, a strong revenue beat led by conservative guidance and growth-at-any-cost strategy (higher marketing spend to boost the top-line), in turn driving Street upgrades on revenue/enrollment (probably the only metrics that matter for these stocks), hence, price targets. We believe the first major test will be its 3Q trends (following Gaokao and summer promotions), until which time momentum investors may bid up shares regardless of valuations. However, we rate the stock Neutral on valuation, as well as our lack of strong conviction on the long-term viability of its key strategies (e.g., star-teacher model, aggressive viral/SNS marketing). How to play the sector (sustainably)? TAL still our preferred way. As the industry evolves into a product-driven market in the medium-term (from a promotion-driven one today), we believe TALs moat will increasingly bear fruit, such as its unparalleled brand equity and high-quality curriculum, supported by its best-in-class management and relentless R though definition of enrollment can be different across companies). The sheer scale of user data should help to save significant amounts of traffic acquisition costs. Our checks on search queries on both web (mobile + PC) and WeChat do indicate a surge in interest for most of major companies. Its also interesting to see some players have garnered much more attention than some others. The pictures say a thousand words see below. 6Asia Pacific Equity Research11 March 2020DS Kim(852) 2800-8597ds.kimjpmorganTable 3: Summary of managements commentary from calls/mediasSource: Company data, China TimesFigure 5: Wechat Index: comparison between online AST playersSource: Wechat Index. Note: WeChat index reflects the popularity of different key words on WeChat. It integrates both search and browsing behavior data on WeChatpany Comments Date SourceGSX“Right after the Coronavirus broke out, we instantly took actions and thanks to our strong organizational capabilities, we have launched free live courses on multiple platforms, and we have attracted nearly 15 million in enrollments“18-Feb-20 4Q19 earnings callYoudao “There have been over 10m free course enrollments, since we launched the campaign on Jan 24“ 27-Feb-20 4Q19 earnings callEDU (Koolearn) “We have acquired more than 10m enrolment via Koolearn free online courses offering so far“ 02-Mar-20 Business update call TAL “We saw strong free enrollment traffic and incremental online revenue of a few hundreds million RMB for the winter semester since the COVID-19 outbreak“ 02-Mar-20 Business update call Yuanfudao“On February 3, the first day of our free live broadcast courses, we saw in total 5m of primary and middle school students attended the course on the single day. As of now, there have been more than 20m enrollments for our free courses“06-Mar-20 ChinaTimesZuoyebang“At present, we have served more than 30 million free course enrollments, the highest in the industry; meanwhile, we have served more than 1.1 million regular-price winter students.Most of the free class students are new users.“06-Mar-20 ChinaTimes7Asia Pacific Equity Research11 March 2020DS Kim(852) 2800-8597ds.kimjpmorganFigure 6: Baidu Index: comparison between online AST playersSource: Baidu Index Note: Baidu index reflects the popularity of the key words via Baidu search. The Y-axis shows the daily search volumes of certain key word via Baidu on PC and mobile.Figure 7: Sougou Index: comparison between online AST playersSource: Sougou Index. Note: Sougou index reflects the popularity of the key words via Sougou. The Y-axis shows the daily weighted average search volumes of certain keywords via Sougou.Positive #2. Another unquantifiable benefit was the behavioral changes among students and parents. Our view is that the COVID-19 outbreak provided online K-12 operators an opportunity to showcase how their courses “could actually work” and is a potential driver for accelerating penetration. More on TAM later in the note. Positive #3. Perhaps most important, in our view, could be that a big chunk of new users came from low-tier cities. Recall, low-tier cities have been the toughest area to crack for online K-12 operators, similar to most other internet verticals, due to relatively low online/mobile adoption rates, higher traffic acquisition cost, and competition from local and low-cost players. Put differently, the COVID-19 disruption seems to have expanded the serviceable addressable markets (at least temporarily), which wouldve otherwise taken much longer or cost heavy sums of marketing dollars in our view.8Asia Pacific Equity Research11 March 2020DS Kim(852) 2800-8597ds.kimjpmorgan but there exist a great deal of uncertainties, too. All that said, this does notnecessarily mean online K-12 companies could enjoy a big jump in revenues/profits as cautioned by operators themselves. Its too early to assess the quality of new enrollments, i.e., we do not yet know how difficult or costly it will be to convert them into paid users, which requires a few challenging steps. First, operators will first need to keep/engage students in free broadcasting classes until course completion. Second, theyll then have an opportunity to convert them into short-term/promotional course users. Lastly, operators will need to entice them to enroll and pay for full-priced normal courses. Its difficult for us to estimate accurately such quality (thus the scale of benefit) at this point, without access to actual trends (such as attendance rate, drop-out rate, early conversion rate, etc.). But we do think that the conversion process could prove relatively more challenging than that seen in the past given two potential issues. Quality of traffic. Many (if not most) of users are likely double counted across different platforms, considering how easy and accessible it was to enroll for such courses. Not only that they were free and readily available across different media/channels, all major K-12 players offered essentially the same type of products of similar quality, at the same time, for the same purpose. Many parents (your author included) have used the opportunity to try out different platforms but we would simply caution against extrapolating too much from current levels of traffic and being overly bullish. 9Asia Pacific Equity Research11 March 2020DS Kim(852) 2800-8597ds.kimjpmorganA TAM conversationIt is not easy to assess the size of the AST industry, let alone online AST, given its fragmented nature and varying statistics from different sources and institutions. That said, based on figures from consulting firms (e.g., Frost Note*: AST excluding extracurricular activitiesFigure 10: Korea AST:Participation rates based on studentsSource: KOSISLast but not least, notwithstanding clear advantages of online (much better accessibility and affordability), we are of the view that offline-based products still offer meaningfully superior quality than online, when it comes to efficacy of delivery (i.e., the level of attention and engagement) and teaching content (more localized curriculum for offline, vs nationwide/standardized online courses). We strongly believe online-offline is not mutually exclusive in education; we expect online and offline tutoring to co-exist in any foreseeable future, complementing each other to tap into the huge pool of Chinese students. Please refer to our in-depth report, “China Education: Whats Better Than Learning?” (pages 14-31) for our detailed analysis and discussions on online vsoffline market and products. 1.6% 1.5% 1.3% 1.3% 1.1% 1.0% 1.1% 2.3% 2.3% 2.7% 3.1%Online penetration17.6 16.9 16.215.6 14.9 14.4 13.913.5 13.6 14.315.417.3 16.7 16.0 15.4 14.7 14.213.7 13.2 13.3 13.9 14.9-8%-4%0%4%8%12%051015202009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019(Won T )Offline Online Y/Y gr owth75.0% 73.6% 71.7% 69.4% 68.8% 68.6% 68.8%67.8% 71.2% 72.8%74.8%3.7% 3.7% 3.0% 2.8% 2.5% 2.4% 2.2% 5.1% 5.2% 6.0% 7.5%0%10%20%30%40%50%60%70%80%2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019AST total Online courses
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