• FY2Q2021 results and XRS online growth fell below consensus expectations. However, revenue growth rose above 20% year-on-year, reaching USD 1.1 billion.
• In 2020, the overall online K12 education market size in China reached approximately CNY 89 billion, with a year-over-year increase of 37.6%. It is expected to further grow in the coming years.
• Compared to its peer, New Oriental, TAL's amount of investments into other firms has decreased by 22 companies since 2016.
• With COVID-19 shaping the potential of the market, tech giants have started to make big moves into the industry.
• We do not see the company handling the upcoming tough competition within the industry but are rather optimistic about its business capabilities and steady growth.

Tomorrow Advanced Learning (TAL) is an education company that focuses on K12 students in China. It also has business segments in adult education, early education & parenting and education informatization. The firm takes quality education and extracurricular tutoring as the carrier system to serve on a global scale. Founded in 2003, it went public on NYSE in 2010.

In China, TAL competes with New Oriental (EDU), a company founded back in 1993. It can be said that both firms are leading China's education industry; for one, the market coverage of the two is evenly matched. From the latest information, New Oriental has active businesses in a total of 98 cities in China and one foreign city (Toronto). TAL has laid its business in a total of 90 cities across China.

As parents in the fast-growing country pay more and more attention to their children's basic education and e-learning is increasingly popular, the vast field of primary and secondary education and online education has eventually become a battleground for companies.

Decent financial results 

TAL's 2Q 2021 financial results weren't very impressive, as the firm earned USD 1.10 billion (up 20.8% year-on-year) compared to analysts' expectations of USD 1.12 billion for the quarter. However, Although it reported USD 0.08 earnings per share for the quarter, beating analysts' consensus estimates of USD 0.05 by USD 0.03. TAL Education Group had a return on equity of 0.21% and a net margin of 1.35% compared to 8.97% in 1Q 2021 due to strong competition presented in the primary education segment. It includes local pure online education companies such as Yuanfudao and Zuoyebang that recently completed mega-rounds of investment. Meanwhile, the non-GAAP operating margins were down to -1.1% compared to 9.8% in 2Q 2020 as customer acquisition costs rose backed by the fierce competition.

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New market opportunities

In the past five to six years, with the support of the state, the development of technology, and the inflow of capital, China's online K12 education industry has undergone rapid development. In 2020, the overall online K12 education market size in China reached approximately CNY 89 billion, with a year-over-year increase of 37.6%.

In 2019, the penetration rate of K12 online education in China was about 15%. As COVID-19 struck during the beginning of 2020, the advantages of online education have been very apparent. The penetration rate of online K12 education reached its peak in March 2020. Although the industry is still in the stage of consumption popularization in China, there are obvious trends. This field consistently demonstrates a long-term massive demand as an emerging way of obtaining education information and services. Hence, the industry penetration rate has huge room for improvement in the future. According to the prediction of the Chinese Academy of Sciences, the penetration rate of the K12 online education industry may exceed 55% by 2022.

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The fact that TAL owns 871 learning centers (offline tutoring centers), 648 Peiyou (好未来培优) centers and 128 one-on-one centers is the reason why we believe TAL is not pandemic-proof. Possible closure of these centers by the government in order to control the spread of COVID-19 will lead to huge declines in the firm's financials.

TAL does own online education apps – but they can't compete with the likes of VIPKID, Yuanfudao, and Zuoyebang, even though there has been an increase in revenue contribution of Xueersi TAL's online app from 17% in FY2Q2020 to 26% in FY2Q2021.

The re-emergence of COVID-19 in China is a headwind for TAL's offline classroom-based training business. Although the vaccine has emerged, children below the age of 18 are not allowed to administer it. TAL's stock price might soon fall when most investors realize that the company still focused on formal or classroom-based tutorials and training.

TAL has had stable growth since getting listed about nine years ago. Revenue has increased about 30 times, at a compound annual rate of 45.7% since then and gross margins averaged as high as 50.8%. 

Results from the last fiscal year ending February were materially affected by COVID-19 induced restrictions which had started early in China. Offline operations, primarily core Peiyou small classes, had to be quickly transferred to online platforms. As a result, some revenue was lost due to the lower selling prices for online classes, the total revenue in Q4 grew just 6.2% compared to 44.1% the previous year. Student enrollments were still up on aggregate with a rate of, 56.6% year-over-year.

Less venture investment presence 

Since 2017, the number of investments by TAL has been decreasing. New Oriental has been more aggressive compared to TAL since 2018. TAL's financing has dropped sharply from 24 in 2016 to only two in 2020. The two investments were made on an interactive learning SaaS platform UMU and an online children's math tutoring app.

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The entrance of tech giants 

Sales and marketing expenses surged as the competition got tough for online players in the summer. Sales and marketing expenses surged 64% year-on-year and made up 22% of the total revenue, up 4.9% year-on-year. 

With upstarts raising mega-rounds, things might get even tougher for TAL as more companies with huge capital to spend on marketing will try to grab market share. Other than that, Chinese giants such as Alibaba, NetEase, Tencent, ByteDance and Baidu engage their businesses into online education. TAL needs to upgrade its online education business to stay afloat.

The education field is likely to be divided up by companies outside of this industry. It is also worth mentioning that the firm's key competitiveness is its in-depth application of technologies such as big data and live broadcast intelligence in China's online education industry. The firm has not spent much on research and development in terms of proprietary tuition-based technology. There are few existing barriers to entry. Teaching staff and market share could be theoretically purchased by new entrants.

Allegation probe 

In April 2020, TAL became one of the scandalous US-listed Chinese firms after admitting to inflating sales figures, further hindering market confidence after Luckin Coffee's USD 310 million fraud.

Two years before this event, Muddy Waters released a report naming the company 'A Real Business With Fake Financials.' The report claimed that "TAL commits fraud in the financials for its core Peiyou business. The Peiyou fraud is more difficult to quantify, but our research suggests fraudulent overstatement of approximately 25% to 30% of the company's revenue."

Bottom line

This might not be a suitable time to invest in TAL Education. We give a neutral rating to the stock because we do not see the company handling the upcoming tough competition within the industry but are rather optimistic about its business capabilities and steady growth. Therefore, TAL does have a chance to enhance its online business and compete with newcomers and experienced enterprises, including the likes of Zuoyebang, Yuanfudao, Baidu, and NetEase.