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17 Education & Technology Group (YQ) intends to raise $288 million from the sale of ADSs representing its Class A stock in an IPO, according to an amended registration statement.

Beijing, China-based 17 Education was founded to develop an innovative hybrid offline-online model for tutoring K-12 students in China.

Management is headed by founder, Chairman and CEO Mr. Andy Chang Liu, who was previously principal of Shenyang New Oriental School, along with many years of education experience in offline schools.

The firm provides offline learning materials for free to more than 70,000 schools in China and those offline material service to onboard students into its online tutoring products, which now account for more than 90% of its revenues.

17 Education has received at least $1.37 billion from investors including Shunwei Capital, Fluency Holding, H Capital, CL Lion Investment, Esta Investments, Walden Investments Group and Long Great Holdings.

The firm provides a variety of education materials free to offline schools throughout China.

The company then leverages these offline relationships to generate interest in its after-school online tutoring services.

Sales and Marketing expenses as a percentage of total revenue have been uneven but trending upward as revenues have increased.

The Sales and Marketing efficiency rate, defined as how many dollars of additional new revenue are generated by each dollar of Sales and Marketing spend, rose to 0.7x in the most recent reporting period.

According to a 2019 market research report by ResearchAndMarkets, the market for Chinese education at all levels is forecast to reach $573 billion by 2023.

This represents an impressive forecast CAGR of 11.3% from 2018 to 2023.

The main drivers for this expected growth are an increasing urban population, growing discretionary income, increased government spending on education and growing broadband adoption.

Also, increased demand for online education along with the emergence of a two teacher model in lower-tier cities will also provide for increased educational success.

The market for ancillary K-12 education services in China remains fragmented and the company faces competition from numerous public and private education providers.

17 Education’s recent financial results can be summarized as follows:

  • Sharply growing topline revenue
  • Increased gross profit but uneven gross margin
  • Growing operating losses but decreased negative operating margin
  • Increased cash used in operations

Below are relevant financial results derived from the firm’s registration statement:

17pl

Source: Company registration statement

As of September 30, 2020, 17 Education had $119.9 million in cash and $156.4 million in total liabilities.

Free cash flow during the twelve months ended September 30, 2020, was negative ($84 million).

YQ intends to sell 27.4 million ADSs representing underlying Class A shares at a midpoint price of $10.50 per ADS for gross proceeds of approximately $288 million, not including the sale of customary underwriter options.

New investor CPE Fund has indicated an interest to purchase ADSs of up to $80 million at the IPO price.

Two ADSs will represent five Class A ordinary shares. Class A stockholders will be entitled to one vote per share.

The Class B shareholder, founder Mr. Andy Chang Liu, will be entitled to 30 votes per share.

The S&P 500 Index no longer admits firms with multiple classes of stock into its index.

Assuming a successful IPO at the midpoint of the proposed price range, the company’s enterprise value at IPO would approximate $1.8 billion.

Excluding effects of underwriter options and private placement shares or restricted stock, if any, the float to outstanding shares ratio will be approximately 14.61%.

Per the firm’s most recent regulatory filing, the firm plans to use the net proceeds as follows:

approximately 30% for improving the operation of our after-school tutoring services and student learning experience;

approximately 20% for enhancing the product offerings and educational content of our smart in-school classroom solution;

approximately 20% for investing in our technology infrastructure;

approximately 20% for sales and marketing and brand promotional activities; and

the balance to fund working capital and for other general corporate purposes.

Management’s presentation of the company roadshow is not available.

Listed underwriters of the IPO are Goldman Sachs [Asia], Morgan Stanley, BofA Securities, China Renaissance and Tiger Brokers.

Commentary

YQ is seeking U.S. capital to fund its expansion plans as a nationwide provider of educational materials and online tutoring services in China.

The firm’s financials show the positive effects of the Covid-19 pandemic on its topline revenue as more students have begun to use its online platform so far in 2020.

Sales and Marketing expenses as a percentage of total revenue have been uneven as revenues have increased; its Sales and Marketing efficiency multiple has increased sharply since revenue has increased so abruptly.

The market opportunity for providing supplemental K-12 education services in China is quite large but also fragmented and requires enormous capital to achieve significant scale.

Like many Chinese firms seeking to tap U.S. markets, the firm operates within a VIE structure or Variable Interest Entity. U.S. investors would only have an interest in an offshore firm with contractual rights to the firm’s operational results but would not own the underlying assets.

This is a legal gray area that brings the risk of management changing the terms of the contractual agreement or the Chinese government altering the legality of such arrangements. Prospective investors in the IPO would need to factor in this important structural uncertainty.

Goldman Sachs [Asia] is the lead left underwriter and the sole IPO led by the firm over the last 12-month period has generated a return of 12.5% since its IPO. This is a middle-tier performance for all major underwriters during the period.

As a comparable-based valuation, YQ is asking IPO investors to pay a 33% valuation premium to Youdao (DAO), which has been public for about a year now.

YQ has produced a higher topline revenue growth rate but at a lower revenue run rate and the firm is also generating higher operating losses and cash burn.

I confess I like YQ’s business model of providing free offline educational materials as a loss leader to generate leads for its online business.

I also believe the effect of the Covid-19 pandemic will continue throughout 2021 and beyond, which will favor online service providers like YQ.

However, the firm is producing high and ever-increasing operating losses, which is a serious concern that the cost of gaining market penetration, even during a period of strong natural demand, is excessive.

Therefore, my opinion on the IPO is NEUTRAL.

NEUTRAL

Expected IPO Pricing Date: Week ending Dec. 3, 2020.

Glossary Of Terms

(I have no position in any stocks mentioned as of the article date, no plans to initiate any positions within the next 48 hours, and no business relationship with any company whose stock is mentioned in this article. IPO stocks can be very volatile in the days immediately after an IPO. Information provided is for educational purposes only, may be in error, incomplete or out of date, and does not constitute financial, legal, or investment advice. Past performance is no guarantee of future results.)

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