Introduction

China Online Education (COE) is a Chinese company that specializes in cross-border educational instruction services between young Chinese students and native English speakers. The company caters to strong demand from Chinese parents who want to ensure that their children grow up with good English language ability, which is widely viewed as a necessary skillset for success in today's global, multi-cultural world.

Shares of COE have struggled in recent years due to slowing growth and large operating losses, as well as intense competitive pressures. Although some may view share price declines as a buying opportunity, we would recommend staying on the sidelines until the company can demonstrate sustainable profitability and continued top-line growth.

China Online Education trades on the NYSE as an ADS (American Depository Share) under the ticker "COE"; each share represents 15 ordinary shares. We will use the ADS and USD-denominated figures in this article.

Business Segments

China Online Education runs two businesses:

51Talk - 51Talk is an online service that connects Filipino and North American English teachers to K-12 students and working adults in China. Classes taught by Western teachers are more expensive than those taught by teachers in the Philippines. Online instructional services are provided on a one-on-one basis, with classes offered in 25 and 45-minute segments.

HAWO - COE also offers online group classes (six students paired with one instructor) through its HAWO brand, which was launched in March 2018.

Other Notes

Financial overview (in millions USD)

Share Price

7.06

Shares Outstanding (in millions)

20.45

Market cap

144.38

Debt

Cash

84.08

EV

66.52

(Source: CapitalIQ)

COE has grown quickly over the past few years due to strong demand in China for English educational services - revenues have increased from 60 million in 2016 to $167 million in 2018, although percentage growth has slowed considerably during that time.

The company is still unprofitable due to very high sales and marketing expenses (as a % of net revenues) but this figure has declined steadily in recent years and quarters. Sales and marketing expenses as a % of revenue in 2Q 2019 hit an all-time low of 53%, a positive sign that management is working towards operating profitability.

(Source: COE 20-F SEC filings)

We expect sales and marketing expenses as a % of revenues to continue trending down given historical trends and the fact that COE should begin to realize positive network effects from its service (e.g. paying students and their parents may recommend COE's services to friends and family members).

If COE can manage to continue cutting operating expenses and slightly increase gross margins (which have been on an upwards trend), we see a path to operating profitability within two or three fiscal years. A 1% operating margin on ~$300 million in sales and $5 million in annual depreciation and amortization expense imply annual EBITDA of ~$35 million, which at a 5x multiple leads to a EV of $165 million (more than double current EV). Of course, this is a speculative estimate based on management's ability to execute and continue growing sales while managing expenses.

The aforementioned slowdown in sales growth is likely attributable to the fact that the number of paying students actually declined YoY from 2017 to 2018:

(Source: Page 45 of 2018 20-F)

COE offers free trial and live broadcasting lessons in order to market its services, which is why growth in the number of active students has outpaced the number of paying students in recent years. However, average spend per paying student has increased substantially during the same period, which is a good sign of the company's pricing power.

An investment in China Online Education is highly speculative and carries a number of risks for the following reasons:

Although we believe that COE shares have a reasonable valuation and that the company has a long-term path to profitability, we have elected to stay on the sidelines for now given the risks described above. Becoming profitable will be a difficult task since the company needs to spend in order to drive new customer acquisitions and faces additional personnel and technology-related expenses as it grows.

However, we will consider initiating a long position in COE if shares show continued weakness since the company does have significant growth potential and a path to profitability if management can keep expenses under control. We will continue to monitor the company's progress and keep readers updated via articles on this site. Thank you for reading and please feel free to reach out with any questions or feedback either via the comments section or email (email address is located in our SA bio).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

See more here:
China Online Education: Sitting On The Sidelines - Seeking Alpha