Pivot or else: How China’s largest edtech company can survive the government’s latest crackdown

July 27, 2021, 8:25 AM UTC

China’s sweeping reforms on private education companies has precipitated a stock freefall for the country’s largest after-school tutoring firm. Shares of New Oriental Education, dual-listed in New York and Hong Kong, have plunged approximately 70% since Thursday.

Beijing’s moves also sparked a wider sell-off in private education companies and added to the carnage of Chinese stocks listed in New York. The Nasdaq Golden Dragon China Index, a gauge of the largest U.S.-listed Chinese firms, dove 15% in two days, its steepest drop in 13 years.  

On Saturday, China’s State Council announced a broad-based overhaul of the private education sector, citing the need to “protect students’ right to rest, improve the quality of school education and reduce the burden on parents.” The directive stipulated that education firms teaching core curriculum subjects such as math, science and history for kindergarten through 9th grade will be barred from making profit and must be turned into non-profit entities. Such companies are also banned from going public, raising capital, and offering tutoring services during weekends and holidays.

The tough new rules shocked the market. “Such a high level of tightening policy in the industry had not been anticipated,” Jenny Tsai, senior equity analyst for Morningstar, wrote in a Monday note.  

And it will likely put China’s $100 billion-plus private education industry at serious risk. “If the proposed law is enforced, the compulsory academic for-profit businesses will no longer be viable,” says Tommy Wong, analyst at China Merchant Securities. The industry is “essentially decimated, unless the Chinese government makes a huge U-turn on policy,” said Dave Wang, portfolio manager at NuVest Capital.

Despite the grim prognosis, a couple of avenues for survival remain open for edtech companies, particularly the sector’s most valuable titan, New Oriental Education.

Go bust or find another way

Beijing-based New Oriental Education & Technology Group, China’s largest education provider by market capitalization, has a network of 118 schools, 1,625 learning centers and both online and offline bookstores. Before the selloff, it was valued at nearly $11 billion. Michael Yu Minhong, a former English teacher at Peking University, founded the first New Oriental school in 1993; it offered English language test prep courses for college students. In the next decade, as demand for English lessons in China boomed so did New Oriental’s popularity. Its stock soared after its 2006 debut on the New York Stock Exchange. In 2005, 800,000 students were enrolled in New Oriental classes; that figure hit 10.6 million in 2020.

The group now offers an extensive menu of learning services, including K-12 tutoring in core subjects like math, geography and Chinese; test preparation for domestic and overseas exams; foreign language courses; and study abroad programs and consulting.  

The 28-year-old company has been among the hardest hit by the new crackdown. On Friday alone, when the market anticipated that the new rules were coming, short-selling of the company surged over 8,000%, according to Bloomberg data.

In an official statement on Sunday, New Oriental said that it expects the new regulations “to have material adverse impact on [our] after-school tutoring services related to academic subjects in China’s compulsory education system. [We are] considering appropriate compliance measures to be taken.” The company declined to comment further.  

Yet analysts say that New Oriental Education is best-placed to survive China’s edtech reforms because it can transform its business model to focus on the education segments untouched by the new regulations, such as exam preparation and non-academic learning in arts, crafts, sports, and computers.

While 75% of the company’s revenue comes from after-school tutoring in K-12 subjects—the main segment targeted in Beijing’s Saturday announcement—25% of its revenue is from exam prep, testing services, and language courses. That means the company has the option to pivot to the alternative businesses, says Osbert Tang, China analyst and managing director at Carresberry Capital, who publishes on the SmartKarma platform. Plus, the company’s strong financial position—$2.7 billion in cash reserves and $3.4 billion in short-term investments—gives it more leverage to shift its business model. “They have a strong balance sheet with sizeable cash to deploy,” said Wang.

For firms to remain listed, they’ll need to spin-off the regulated services into a non-profit entity while reallocating their resources to focus on non-academic tutoring, says CMS’ Wong. New Oriental may be able to pull that off, but it seems other rivals are less equipped for the challenge.

China’s second-largest edtech firm TAL Education only recently started offering services beyond K-9 tutoring. In January, it invested in a dance training institute called Happy Ballet. This month, the firm launched its ‘Qingzhou’ brand that covers postgraduate exam prep, language training, and overseas studies. It also expanded into arts and speech training for kids, and has plans to develop vocational educational content in skills and career training, Goldman Sachs said in a note on Monday.

Still, a firm like TAL will “probably see greater impact [than New Oriental]. Around 62% of New Oriental’s business may be impacted, while for TAL [this number] is around 80%” says Morningstar’s Tsai. The reforms have sunk New Oriental’s stock by 70% since Thursday, but TAL Education’s shares have endured a worse beating; they’re down 80%.

Education companies have two additional options going forward: delist or go private. But those options are unattractive since both would require investor buy-in, and investors wouldn’t want to “pay up to take the companies private at this junction,” says Wang. “[Any] buy-out would likely be well scrutinized by the authorities. With such an uncertain and negative outlook, I’m doubtful of any buyers.”

Analysts say that edtech companies can remain listed if they can successfully spin-off the regulated entities into a non-profit, while pivoting to new educational ventures. But as companies adjust their business models, they’ll need to pour investments into non-core businesses where they have less expertise, Wong notes. “All their tutoring peers will also be making similar business changes, moving into a narrower segment thereby increasing competition.” The strategy also introduces a new hurdle: convincing parents to fork out large sums of cash for non-academic courses, added Wang.

Reducing the burden

China’s new effort to rein in the edtech sector follows a series of government crackdowns on homegrown Internet companies. Beijing’s antitrust and cybersecurity regulators in recent months have reeled in tech behemoths from Internet platform Alibaba to ride-sharing app Didi.

But Beijing’s regulatory campaign against its private education companies has taken a different tone. As China’s population ages, the state wants to boost the country’s declining fertility rate, which many Chinese attribute to the high cost of child-rearing, particularly education and childcare expenses.

The country’s high-pressure education system that centers on the annual gaokao, or college entrance exam, fueled the private education sector’s boom in recent decades. The explosion of online learning in the pandemic exacerbated academic competition as well as education inequality, leading to charges of malpractice against the industry. In June, China’s market regulator fined private tutoring 15 firms for false advertising and pricing fraud.

In this campaign, instead of citing national security or antitrust concerns, the government is recognizing that the education system and edtech sector got too overheated, says Dev Lewis, research fellow at internet think-tank Digital Asia Hub.

“Reducing [students’] workload, reducing pressure on families and improving the quality of education are legitimate problems to tackle in Beijing’s pursuit of a more sustainable environment for Chinese families to have more children,” Lewis says. “But it remains to be seen whether its new rules are real solutions to these issues.”

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