China Education Alliance: Still worth watching

It might be the most dramatic trading week that China Education Alliance (CEA; CEU.NYSE) has ever experienced. The company, which provides online and on-site guidance to Chinese students preparing for examinations, saw its share price plunge 34% to US$2.93 on November 30 after being branded “a hoax” in a research report by Kerrisdale Capital.

The central claim in the report – that CEA’s "revenue and profit are highly overstated in its SEC [Securities and Exchange Commission] filings” – was fervently denied by the company.

Since then, CEA’s share price has begun to rebound, reaching US$3.45 on December 3 as the company issued a statement saying that its auditor Sherb & Co had confirmed most of its bank balances in China. An investor conference took place on December 7 at which CFO Zack Pan answered all questions regarding the company’s business.

SinoSage thinks the following three takeaways are of particular importance.

First, contradicting CEA’s SEC filings, Pan said the company’s onsite teaching facility, Heilongjiang Zhonghe Education Training Center was not fully operational, but closed for maintenance. As CEA’s largest single training center, it will be used for tutorials of college entrance examinations based on some cooperation with local universities and vocational training after the renovation.

Second, Pan said that the inconsistency in CEA’s financial reporting – it told the State Administration for Industry and Commerce (SAIC) that its revenues were RMB4.2548 million (US$639,000) in 2008 while the SEC was told US$24.9 million – arose partly because of differences in Chinese and US accounting standards.

In China, the parent company and its subsidiaries are not required to consolidate financial reports and cash balances held overseas do not have to be disclosed. This could potentially wipe considerable value off the financials submitted to the SAIC.

Furthermore, filings submitted to the SAIC are part of the annual routine through which Chinese companies renew their business licenses. As such, they are generally treated with less care than stock exchange filings. Firms often neglect to submit audited financial reports and, in some cases, minimize their disclosure to avoid information leak to competitors.

Last but not least, Pan insisted that all financial reports submitted to SEC were accurate. He told investors an October review by the SEC of the company’s financial reporting did not find any significant misconduct.

However, the conference call appeared not to ease investors’ concerns. Once the stock resumed trading after the call, it plunged another 28% to US$2.34, losing most of its gains since the price rebound late in the week.

On December 8, the CEA board announced a share buyback program up to a value of US$10 million. The offer, under which the company’s common stock will be repurchased, is valid till December 1, 2011. CEA’s stock responded by bouncing back 15.38% to US$2.70.

Questions may be asked of Sherb & Co, a relatively unknown operation that doesn’t fall within the top 100 accounting firms globally. SinoSage consulted the Public Company Accounting Oversight Board and was encouraged by its findings: Sherb has been hit with one charge of signing off on alleged revenue fabrication, but the case never went to trial and the firm emerged with its reputation intact.

So, if investors can be confident in the quality of CEA’s auditing, then what about its business model?

The company reported a 41% year-on-year jump in revenue for the last quarter, while net income rose 30.41% to US$5.3 million. In its primary market of Inner Mongolia, CEA is currently serving 500,000-600,000 students – only 5% of the 10 million strong target audience. Each student spends about US$28.76 per quarter (US$9.60 per month), which makes for a clear source of cash.

Should CEA succeed in expanding its operations to cover China’s four northeastern provinces, the target market of students aged between six and 18 widens to approximately 150 million.

Based on all the available public information and evidence, SinoSage doesn’t think there are sufficient grounds to label CEA a fraud. The company has a clean auditor and management has responded constructively to the recent crisis. Given the strong growth prospects for its business, CEA remains a stock worth watching.