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TAL Education: Muddy Waters slings mud…

This report contains my initial reaction to the Muddy Waters’ accusations on TAL Education (TAL). It represents my views as of posting time & date [Note: this was originally published June 14th], but please recognize that these are fast moving situations and so my views could change. Note that I own TAL Education stock.

I believe that the Muddy Waters’ accusations are not a reason to sell TAL Education stock. I continue to believe that TAL is a high-quality business and an excellent investment. I’ll explain why I think the Muddy Waters accusations are false in this report.

Background

The common model of the short-seller activists is to compile an extremely long & detailed report on the stock with many accusations in it. They hope that some of these accusations stick, investors lose confidence in the firm, more evidence comes to light supporting the shorts’ view, and the firm’s business model – and in some instances, fraud – unwinds.

Muddy Waters’ business, which is to write reports on stocks that they and their clients are already short, is half analysis, and half theatre. Muddy Waters has had some wins with this playbook, including Sino-Forest, NQ Mobile, and China Huishan Dairy, but their track record is far from perfect. American Tower Corp, Nidec and, notably for the TAL parallel, New Oriental Education, have all continued to prosper since Muddy Waters reported on them.

I believe the key differentiator between Muddy Waters’ successful calls and their unsuccessful ones is the ratio of high-quality, consistent & comprehensive investment analysis (which, to be clear, is good) to the level of theater they include with their investment analysis (which is unnecessary).

This report contains far too much theater.

Muddy Waters’ TAL Education report

Muddy Waters’ report is available here. On page 1 they summarize their arguments:

Although TAL is a “real business”, it has been fraudulently overstating its profits since at least FY2016.

We estimate that during FY2016 through FY2018, TAL has overstated net income by at least 43.6%. Our estimates of profit inflation are based only on what we are able to quantify – fraudulent profit inflation likely exceeds this estimate.

We estimate that TAL’s cumulative net income margin during this period was only 8.8% (versus 12.4% reported); we estimate its FY2018 net income margin was only 10.4% (versus 11.6% reported).

We believe the fraud pervades the core Peiyou business and is migrating into TAL’s online businesses.

This is Part I in a series of reports. In this report, we cover two sets of fraudulent transactions that we estimate inflated TAL’s FY2016-FY2018 pre-tax profits by pre-tax profits by up to $153.2 million, or 28.4%.

Muddy Waters then dives into the background of many Chinese frauds, and state that, because very few people did prison time after their frauds then many Chinese entrepreneurs have concluded that “[d]efrauding U.S. investors from China has proven to be a “heads I win, tails you lose” proposition.”

This may be true in general. But it isn’t necessarily true in this instance: we should not assume that TAL is a fraud just because other Chinese businesses have proven to be. This is one instance of too much theater, and not enough focus on pure analysis. There are many others as well.

Another example comes from the same paragraph. Block quotes Charlie Munger “Show me the incentive, and I’ll show you the outcome”. I agree it may apply to TAL in this instance. But for sure it also would apply to Muddy Waters: Muddy Waters slings mud at companies and profits if their share prices fall. They have an enormous incentive to sling as much mud at a company as possible, in the hope that some of it sticks, and they can profit from their short position. As investors we must take these incentives into account, and approach Muddy Waters’ analysis with a skeptical eye.

Who’s got the biggest…research?

On page 3 of the report Muddy Waters states that “[n]obody has performed the highly detailed research on TAL that we have”. That claim is false.

Consider the top institutional investors in TAL:

The top investors are very high-quality investment institutions that do extremely detailed research on companies before investing in them. I know this from first-hand experience, as many of them were my clients when I led Goldman Sachs’ GS SUSTAIN investment research team in Asia. Our focus was on high quality companies with strong governance & sustainable businesses, and we often discussed TAL.

We can see that Carson Block’s claim they’ve done the most research on TAL “over several months” is a joke when we consider that many of these high-quality institutions have been invested in TAL for years. If Carson Block was such an expert on TAL then why did he not spot these “frauds” two years ago, when they supposedly occurred?

I expect the reason why is that he didn’t even follow the company in 2016. Muddy Waters hasn’t done “the most detailed research on TAL”. They probably didn’t even follow the company two years ago. This claim is a convenient line to try to establish credibility, but one that falls apart under modest scrutiny.

More theatre

I found the video on Muddy Waters’ website to be particularly amusing.

The disguised voices, Carson taking a call in his Mercedes while driving through the countryside (but conveniently with a camera crew in the back), and casual interview/discussions while sitting outside (presumably at his home) are all storytelling techniques that try to establish Muddy Waters’ credibility and show how much work they’ve done.

But, theatre aside, there is little solid content in the video to support their claims. Yes, Muddy Waters has a video of a Chinese person sitting at a desk, stating “we’re all Xueersi (TAL)” in response to the investigator’s questions about transactions involving 1-on-1, and she then responds to further questioning about the transaction that “this is a senior level matter, so I’m not clear about it”. My response is: how would you expect her to respond? She appears to be a tutor in one of their learning centers, so why would she know more about corporate finance matters involving her parent company?

There’s also no verifiable date on the video, so we don’t know when it was shot. Remember, Muddy Waters appears to have only become aware of this “fraud” through their research in the past several months, but the events that they’re questioning occurred primarily in 2015/16…so why would they have this incriminating video? Did they stumble upon it online? Or did they shoot it recently, after 1-on-1 was bought back by TAL, in which case there’s nothing wrong with the tutor’s comments? I don’t know the answer, but either way their timeline doesn’t stack up.

Muddy Waters’ claims

There are more inconsistencies in Muddy Waters’ narrative when we dig into the specific claims.

Continuing with their second claim, regarding Guangzhou 1-on-1: on pages 31 & 32 of their report they first state that “our diligence found that Changing Edu established a new entity in May 2015 to supposedly own the GZ 1-1 business. That entity was called Guangzhou Shujia Education Technology Co., Ltd. (Shujia).” (page 31).

And then on the next page they continue with: “In the course of our diligence we also obtained SAIC financials and credit reports for Changing Edu’s VIE, Shanghai company, and Guangzhou companies. Shujia was established on April 3, 2016.” (page 32)

Their diligence, which they claim to be “the most detailed research on TAL”, claims that Shujia, which is a key component in their smoking gun, was established both in May 2015 and in April 2016. Which is it? It cannot be both.

Their story is internally inconsistent, which I have found is a classic sign that they’re trying to portray these events in the worst light possible and are short on evidence that’s truly damning.

Again, it’s a case of more theater, and less diligent analysis.

I found similar inconsistencies in Muddy Waters’ claims with the first transaction that they scrutinize: Shunshun.

Muddy Waters’ claims originate with the timing of three transactions to buy a material stake in Shunshun. The first stage was when TAL invested Rmb 237,000 (~US$35,000) in Shunshun in July 2015 for a small stake in the business; the second is when TAL transferred subsidiary Dongfangrenli (DFRL) to Shunshun in August 2015; the third was when TAL purchased a larger stake (for cash) in December 2015.

Muddy Waters argue that since TAL was invested in Shunshun from July onward then they should not have claimed the purchase accounting gains when they transferred DFRL to Shunshun in August of that year. But this is false, as TAL only had an extremely small share of Shunshun in July 2015 – they had only invested US$35,000 – so Shunshun was an independent entity and therefore the transaction appears legitimate.

In their report Muddy Waters’ conflate several transactions and the amount paid for them to give the impression of fraud, when the evidence I’ve seen is far from clear. Here’s another example: they quote media reports from June & July 2015 that state Shunshun is expecting an investment of up to US$18mn and then say they have evidence that TAL invested in Shunshun in July 2015, while conveniently forgetting to mention that their evidence shows that TAL invested <US$40,000 in the firm (see Appendix B of the Muddy Waters report), not the $18mn that their story implies.

Again, it’s a case of Muddy Waters slinging mud, and hoping some will stick.

My final point regarding these allegations relates to another claim that was repeated in their video. It stems from a restatement of the State Administration for Industry & Commerce (SAIC) financials for the Shunshun & DFRL companies. Muddy Waters shows this table on page 26 of their report:

My narrow point here is that accounting re-statements happen often, and that this is a relatively small amount of capital. But my broad point agrees with their claim that

“Cash balances require little skill to check, therefore the odds that someone made such a mistake in preparing year-end financials are low.”

I agree that cash balances require little skill to check, so let’s check TAL’s cash balances: at February 2018 (their fiscal year end for 2018) TAL’s cash balance was US$1.5bn, up from US$700mn in February 2017. If Muddy Waters’ claims were true, and TAL has inflated profits by more than 40% in the past three years, then cash in the bank would not be growing so quickly. The profits would be sitting in non-cash balances and the like, which are much easier to fake.

I believe that Deloitte would have checked TAL’s cash balance thoroughly as part of their audit, as it is one of the most basic elements of completing an audit correctly. This gives me much comfort that Muddy Water’s claims of profit being inflated by 43% simply aren’t true.

Conclusion

I believe that Muddy Waters has fallen well-short of the burden of proof required here. They’ve made vast claims about their expertise on TAL, written a long report, and produced a nice video, but I’ve found their claims to be internally inconsistent and incredibly hard to follow.

In the introduction to their report Muddy Waters quotes Occam’s Razor: Occam’s Razor holds that when faced with competing explanations, one should select the one that requires the fewest assumptions.”

Let’s apply that maxim to this situation.

Do we believe Muddy Waters, who is actively short the stock and trying to talk it down with a weighty but inconsistent report and a flashy video?

Or do we believe in TAL’s cash balance, their auditors, and the strength of the due diligence performed by high quality investment firms such as Baillie Gifford & Morgan Stanley who have excellent track records investing in Asia?

I believe that Muddy Waters is wrong here. I believe that there’s nothing materially wrong with TAL’s financial statements, and that it’s an excellent business and a very good investment. I do not intend to sell my stock, and I may buy more.

However, I could be wrong. These situations move quickly, and more compelling evidence may come to light in the coming days or weeks. If so, I could change my view.

TAL has already responded to these claims by Muddy Waters with a somewhat generic denial.

TAL’s best response from here would be to fully refute Muddy Waters’ claims and follow this up by buying back stock. Buying back stock would prove both their confidence in the firm, and that their $1.5bn of cash on hand is real.

It would also hit Muddy Waters where it hurts them most: in their wallets

 

Note: This article was originally published on Seeking Alpha on June 14th, 2018. I have not changed the content except for slight edits to improve clarity.


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