New Oriental Education's rise or fall depends on SEC review

As people who follow me on Tradingfloor.com will know New Oriental Education & Technology Group (NYSE: EDU) is heading for a make-it-or-break-it type event in the next couple of weeks with its SEC 20-F filing. This event will pretty much seal the fate of the company for the foreseeable future, but will also have potentially wider implications for US-listed Chinese companies.

Company management just released a press release regarding its independent commission's investigation into the accusations leveraged on the company by Muddy Waters (MW). In this document, management says that no evidence has been found to support the MW accusations, but that the SEC investigation into whether or not the company can consolidate its Variable Investment Enterprise (VIE) is ongoing and therefore it must file for an extension to the current 20-F filing deadline.

This means that these two potentially devastating events in the company's near future, its annual filings and the SEC investigation, have just merged into one event, with huge price fluctuation set to follow no matter happens.

If I read the company's press release correctly then it appears that the audit is already done and dusted, and all that we are waiting for now is whether or not the SEC thinks the company can consolidate the VIE. This fact is also central to a number of class-action lawsuits currently being filed against the company by US law firms, although their emergence has not dampened recent investor sentiment about the stock.

Source: Saxo Bank

If the VIE can be consolidated the outcome is quite easy to predict: the 20-F will be filed, another red flag will be gone and New Oriental Education's stock price will soar towards the mid 20-s where it was before the MW allegations. What will happen if the VIE cannot be consolidated requies a little more investigation and a look at some related numbers.

The company is in the education business in China, meaning it runs a large number of different types of schools as well as some Internet services and media distribution activities, which cannot be legally run by foreigners in China, so it makes sense for the VIE structure to be applied. However, because it has to hold entire schools under the arrangement EDU is what is classed as an asset-heavy VIE, in fact 62 percent of the company's assets are held in the VIE according to its latest 20-F filing.

Solid lines represent equity ownership and broken-lines contractual relationships (VIEs)
Source: SEC filings

Should the company have to deconsolidate its VIE it will have to take these assets off the balance sheet in its annual filings. Furthermore, 97 percent of the company's revenue is in the VIE as well as a reported 129 percent of the profits. This essentially means that if the VIE has to be deconsolidated then investors will actually be left with a loss-making shell with 38 percent of the total assets, and only 3 percent of total revenue.

What's in a consolidation anyway?
It is actually quite difficult to tell how real this risk is as we do not exactly know what the SEC is investigating, but having looked through the company's financials with regards to its VIE for the last few years I think there are two factors that are most likely.

In order to consolidate a VIE you have to meet two basic requirements, you have to bear the economic benefits and risks of the enterprise (sometimes referred to as residual profits and loss), and you have to be able to control it. You break one of these and you break consolidation. So let us consider one option for each of them.

Economic risk and benefit: There's one line of thought regarding getting the economic benefit from a company that says you should follow your agreements for them to really be applicable for consolidation. So in order for the agreement to transfer all economic benefit from the VIE to the Wholly Foreign Owned Enterprise (WFOE) to be valid it should also be practised. You would have to show you could actually get the residual profits of the VIE in practice, rather than just getting an IOU that you will never try to enforce.

This is clearly not the case in EDU. If it were the case what we would see a VIE that might well have all the revenue the company generates, but no income as this money should be transferred out to the WFOE per the VIE agreements. The reason this is not done is that it would add another layer of tax, and create the need to transfer back money needed for operations in the VIE, which would likely also incur some costs along the way.

So one possibility is that the SEC is taking this stricter interpretation and demanding that the money actually goes to the WFOE as it is supposed to, in order to allow for consolidation. But the language in the press release hints that what is being attacked is in fact EDU's ability to control the VIE.

Control: While there are a number of issues that could be under investigation here one seems more likely than the other due to the timing of the investigation. EDU announced a restructuring of its ownership structure on July 11 2012, and the SEC investigation was initiated soon after.

This may at first seem counter-intuitive to people who follow VIE happenings, as what essentially happened in the restructuring was that a number of former employees, who still held VIE equity, were pushed out in favour of having the founder/CEO take over the ownership. In my mind, and also probably according to almost every other long-time VIE watcher, this in fact strengthened control of the company.

However, when you change anything in the ownership of the equity your old equity pledges automatically become useless, so new ones have to be drawn up and registered anew, and as they are not enforceable until they are registered you could argue that there is a lack of control as a result. I think this might be what the SEC snapped on, tipped off by MW by most accounts. Although there are other options,management does not answer the question as to why specifically EDU is being investigated and why specifically now.

Conclusion
This interpretation is conditioned on the SEC not investigating VIEs as whole and their overall legimitacy, which I think is highly unlikely. If they are in fact investigating one of these issues, then quite probably the company will have some ability to rectify the issue rather than having to deconsolidate. Trying to force the equity pledge registration through, or starting to transfer the residual profits out of the VIE into the WFOE are both attainable outcomes.

This would then also mean that the wider impact of the SEC decision on US-listed Chinese companies using VIEs might not be so catastrophic. I think it is important to remember that there are no real winners if VIEs are forced off balance sheets. Just under half of all Chinese companies on the NASDAQ and NYSE currently use this structure so an outright ban seems unlikely. Enforcing stricter requirements on consolidating a VIE does not seem unreasonable however, as it would force some of these companies to follow up on what they say they are actually doing.

If they start demanding registered equity pledges, go get them registered. If they say you have to follow your agreements, start actually transferring the money. These are not insurmountable mountains though. They will cost some money to get atop of, but this is nothing when compared to what would happen to your stock price and overall reputation if you are forced to leave your investors holding 38 percent of the assets they bought with no revenue and no income.