Now Is Not the Time to Buy These Stocks

What sector of stocks has been among the worst-performing in the U.S. stock market this year? Consider the case of for-profit educators. Because of concerns about the quality of their product, heightened government regulation, and potential enrollment declines, Apollo Group (Nasdaq: APOL), ITT Educational Services (NYSE: ESI), and DeVry (NYSE: DV) are all off well more than 20%. Further, high-profile short-sellers such as Jim Chanos and Steve Eisman remain bearish on these stocks.

That performance and sentiment, however, differ enormously from how investors are treating for-profit education on the other side of the world. Three Chinese for-profit educators have IPO'd since August, raising some $300 million, and that country's private education leader, New Oriental Education & Technology (NYSE: EDU), is up more than 20%.

Are the dynamics that govern this space so different in China that private educators there deserve such a rosier outlook? My expectation is no and that investors in Chinese for-profit education today are headed for disappointment.

It wasn't always this way
Let's be clear: There are stark differences between the operations of a company like Apollo in the U.S. and a company like New Oriental in China. While the former generally targets adults who seek professional degrees and access federal loans to pay for their educations, the latter generally targets Chinese youths who need English-language training or standardized test prep services that their cash-rich parents (who have only one child) are more than willing to pay for. This is one reason why New Oriental is a former Global Gains recommendation and why I argued that it was crazy to short New Oriental at a little more than $50 share in April 2009 as some other analysts had proposed.

With New Oriental trading for more than $90 per share today, I'm glad I took my own advice. That said, I suspect that New Oriental's stock has gotten ahead of itself as more and more Western investors have come to embrace the Chinese education story. This not only manifests itself in a valuation that's now more than seven times sales and 30 times EBITDA, but also in the fact that smaller competitors Ambow Education (Nasdaq: AMBO), Global Education & Technology (Nasdaq: GEDU), and China Distance Education (NYSE: DL) have been afforded similar valuations. All told, after TAL Education goes public this week, there will be nine Chinese for-profit education services companies trading on the major U.S. exchanges alone, with a number of them being afforded ultra-premium valuations by investors.

Source: Capital IQ, a division of Standard & Poor's.

Admittedly, these companies are all small and the market in China is large, but if an investor believes that New Oriental is going to dominate this space (as its current $3.5 billion valuation implies), then the rest of the stocks in the sector should be worth near zero. Investors, however, aren't thinking that way, and my analysis suggests that investors are expecting New Oriental, Ambow, Global, TAL, and China Distance all to grow to the sky.

Fat chance
The fact is that it can't and won't happen that way. Not only are there other international and domestic competitors, but as these companies all grow larger, they will more and more compete with one another. At that point something -- most likely revenue growth or profit margins -- has got to give.

In New Oriental's case, this appears to have already started happening. The company reported first-quarter 2011 results earlier this week that showed better than 28% sales growth, yet just 8% operating income growth. One reason for this is that the company's selling and marketing costs skyrocketed more than 50% year over year. That -- spending more to earn less -- is an indication that the industry landscape is getting more competitive, a reality that should only worsen now that Ambow, Global, and TAL have raised $300 million from investors to spend on their own growth this year.

Then there's the fact that the Chinese government is actively working to even out the country's development, particularly when it comes to the opportunities afforded to people living in wealthy tier 1 cities such as Beijing and Shanghai versus those living in poorer rural China. How those efforts will affect China's private education industry is at this point unclear, but there's certainly a very real risk that the government could resort to price controls or some such other regulation to create more equal opportunities for all.

The global view
When it comes to the Chinese education sector today, investors are being asked to pay either an ultra-premium price for sector leader New Oriental or merely a premium price to own one of a gaggle of other smaller, more mediocre companies. Frankly, neither of those is a palatable option, and I suspect that the whole sector is due for a drop as rising competition in the industry weighs on results going forward. Add to that any kind of forthcoming regulatory risk, and the hot money flowing into the sector today will quickly realize that it's made a mistake.

Only after that happens should you look to add a company such as New Oriental to your portfolio. Because while the Chinese market will be volatile, it has the potential to be a multidecade growth story that all investors should have at least some exposure to ... at the right price, of course.