research.hsbcDisclosures we see TAL and EDU as the most defensive China growth stocks amid trade tensions Online education offers students in smaller cities greater opportunities, and for education providers, scalability; online investment will translate into more sustainable long-term growthWe initiate on the two market leaders, TAL and EDU, with Buy ratings; we prefer TAL due to the faster ramp-up of online business and earnings recovery aheadSPOTLIGHT1 Equities Hong Kong / China August 2019 Top marks Investors in search of a strong domestic growth story in China with no exposure to fractious international trade relations should look no further than the countrys thriving after-school tutoring market. Education is a powerful cultural force, as illustrated by the strong desire of many parents for their son or daughter to excel in the feared gaokao, the college entrance exam that determines which university you go to. And despite efforts by the government to reduce academic pressure on stressed out pupils, demand for extra classes continues to grow. Its easy to see why. University acceptance rates in China are lower than in the US and the penetration rates of after-school tutoring (AST) remain far below other Asian education hothouses such as Hong Kong and South Korea. In this report we explore this highly fragmented industry and identify the powerful forces that will give growth the next push. One of the most important is the huge appetite for online courses in smaller cities and rural areas, where access to quality teaching is often limited. Online classes are good for revenues, too, as they can cater for as many as 1,000 students simultaneously, far more than traditional courses in classrooms. The charts on the following two pages illustrate what we believe is a compelling growth story. We initiate coverage of the two largest after-school tutoring operators in China, TAL Education Group (TAL) and New Oriental Education (EDU). Over FY19-22e we forecast a 33% revenue CAGR for TAL and 23% for EDU, as TALs online model has a better growth trajectory. Although competition is increasing online giants such as Bytedance, Tencent, Baidu and NetEase have entered the market we believe TAL and EDU are well equipped to maintain their leadership positions due to their industry know-how and brand strength. As in many other industries in China, we see tighter regulation as the main risk. Indeed, in the last year the share prices of both companies have been highly sensitive to regulatory announcements made by the government. However, in the long term we think tighter regulation will only serve to increase the market share of industry leaders like TAL and EDU as the sector consolidates. Why read this report? After-school tutoring in China is being driven by rising pressure on children to succeed academically; we see TAL and EDU as the most defensive China growth stocks amid trade tensions Online education offers students in smaller cities greater opportunities, and for education providers, scalability; online investment will translate into more sustainable long-term growth We initiate on the two market leaders, TAL and EDU, with Buy ratings; we prefer TAL due to the faster ramp-up of online business and earnings recovery ahead Binnie Wong* Head of Internet Research, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited binnie.wonghsbc.hk +852 282 22590 * Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations THIS CONTENT MAY NOT BE DISTRIBUTED TO THE PEOPLE'S REPUBLIC OF CHINA (THE “PRC“) (EXCLUDING SPECIAL ADMINISTRATIVE REGIONS OF HONG KONG AND MACAO) Equities Hong Kong / China August 2019 2 Focus charts Exhibit 2: thanks to Chinas rising K12 tutoring penetration rate Exhibit 3: and ample upside potential given the large gap between China and other Asian countries Source: Frost POP Kids (泡泡少 教育 ) for 5-12 year-old after-school tutoring, and U-Can (优能中学教育 ) for 12-18 year-old after-school tutoring. It also operates online platforms Koolearn (新东 在线 ) and DFUB (东方优播 ) for overseas studies/test preparation/language learning and after-school tutoring. We estimate that the online business, which has a bigger addressable market, only contributes c5% of total revenue in FY19. We forecast 23% revenue CAGR for EDU for during FY19-22e, driven by 28% revenue CAGR in its K12 segment but dragged down by slower test preparation growth (c8% CAGR). Thanks to an improving offline utilisation rate, stringent cost control and absence of one-off investment losses, we believe EDUs margins are likely to improve and contribute to its 42% non-GAAP net income CAGR during FY19-22e. Although we like both companies, we prefer TAL due to its greater exposure to online after-school tutoring and strong focus on the K12 market. We believe this provides a better growth trajectory, as EDUs top-line growth had been slowed by its overseas test preparation business. More importantly, though TALs online investment will impair its margin in the short term, we believe this is only temporary and will translate into better scale and operating efficiency in the EDU has been in business for 26 years and TAL for 16 Our USD40 target price for TAL implies 22% upside Our USD117 target price for EDU implies 12% upside 9 Equities Hong Kong / China August 2019 future. Lastly, TALs stock price declined by approximately 13% after its 1QFY20 results due to weak margin guidance, which we think creates a buying opportunity given its compelling domestic long-term growth story. Key drivers The key share price drivers of these companies which we explore in detail in the company write-up are, for TAL: 1) standardisation; 2) dual-teacher model ramp-up; 3) online business growth; and 4) margin expansion, while for EDU we think the key drivers are: 1) offline enrolment growth; 2) cross-selling opportunities; and 3) margin recovery. Strategic investments and M&A opportunities TAL and EDU have both been active investors in order to identify new opportunities to complement their current operations and drive long-term growth. Based on past records and our discussions with management, we believe they prefer strategic investment over M&A. The main reason is that most small education companies are at the development stage and are yet to mature operationally and financially. This makes it difficult to develop or integrate companies after M&A is complete. Although TAL and EDU have different investment appetites, they both aim to complement their present services rather than invest in a peer company with a similar model. One reason for this is the incremental cost of making changes to bring the new company up to their standards. According to their earlier investment records, both TAL and EDU have invested heavily in education IT systems and AI technology. This strategy is in line with their efforts to improve teaching quality and develop online education. Another popular area of investment is related to K12 STEAM science, technology, engineering, arts and math a programme which is being encouraged by the government to cultivate well-rounded individuals instead of ace test takers. TAL also focuses on education-related community forums and pre-school early education, while EDU prefers adult education companies to create synergies with its domestic/overseas test preparation segment. Please see the Appendix at the back of this report for detailed tables showing the lists of entities that TAL and EDU have invested in. Why the stocks have rebounded In the past year, the share prices of both companies have been volatile, largely due to government announcements about regulation. On 22 August 2018, the government released a policy entitled “Opinion to Regulate After-School Tutoring Development (国务院办公厅关于规范校外培训机构发展的意见 )”, putting in place stricter operational requirements. By the end of 2018, TALs stock price was down 36% and EDUs 43%. On 9 January 2019, the Ministry of Education announced that the national campaign to regulate tutoring institutions was mostly complete. In the first half of the year, TAL rose 43% and EDU 76%. TAL and EDU favour strategic investments rather than acquiring direct competitors The stock prices of TAL and EDU are highly related to regulation changes