New Oriental Education Called Into The Principal's Office

NEW YORK (TheStreet) -- Alarming news from New Oriental Education (EDU) is driving American for-profit stocks Bridgepoint Education (BPI), Apollo Group (APOL), Corinthian Colleges (COCO) and Devry (DV) lower.

If you're a current New Oriental Education investor, Tuesday's earnings must have you scratching your head.

New Oriental Education reported impressive beats on the top and bottom lines. Unfortunately, shares gapped lower and not higher. New Oriental Education is a Chinese company, but investors are liquidating the entire space. (See my recent article Will Bridgepoint Be Held Back a Year?)

BPI Chart BPI data by YCharts

New Oriental Education has lost about 30% of its market cap from Monday's close. New Oriental Education disclosed on its website they are the target of an active SEC investigation.

According to the website:

"On July 13, 2012, the Company was informed that the U.S. Securities and Exchange Commission (the "SEC") had issued a formal order of investigation captioned 'In the Matter of New Oriental Education & Technology Group Inc.' The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education & Technology (Group) Co., Ltd., a variable interest entity of the Company, and its wholly-owned subsidiaries, into the Company's consolidated financial statements. The Company intends to fully cooperate with the SEC in its investigation."

Only two sentences in an earnings report that is otherwise glowing with positive results. No one wants to read "SEC investigation" about their stock, especially one based in China.

New Oriental Education may not know the full details of the investigation, but there is one thing we do know. The SEC is suing auditors for not providing audit documents. TheStreet's Timothy Collins recently called EDU a short candidate. If you read Collins' article you would have known about EDU before the fall. (You need a Real Money Pro account to read, but Collins' analysis makes it worthwhile.)

New Oriental Education used Shanghai Deloitte as the auditor for the 2011 annual report. Shanghai Deloitte was sued by the SEC about two months ago for failing to submit requested documents to the SEC. Deloitte argues it is caught between two separate and conflicting sets of laws. Deloitte, in its defense, has claimed it is not legally allowed to hand over certain documents because of state secrets laws in China.

The bottom line is, investing in Chinese stocks adds another layer of risk for investors. The risk is further compounded by the current inability of the SEC to impose sanctions against Chinese nationals for securities fraud. U.S.-listed and -traded Chinese stocks are a perfect storm for securities fraud. There is nearly zero risk for a potential perpetrator and a life time of riches for a successful fraud.

I have written about the risks facing investors for about a year now. With so many opportunities available in the North America and Europe, there is no reason to play Russian roulette with your portfolio. In Russian roulette, players use a six-shooter, effectively giving odds of failure at 1 in 6. Based on my experience, the odds of failure with a Chinese company listed in the U.S. the odds of failure are about 1 in 8.

No one in their right mind would take the risk playing 1 in 6 odds with their lives. Do you seriously want your money to take a risk of 1 in 8? (Read my thoughts about investing in Chinese companies traded on U.S. exchanges in Chinese Stocks Are Still in Danger of Blowing Up.)

With that said, here is what the company did report for the quarter just ended.

The top and bottom lines improved with an increase in some margins. Wall Street was expecting earnings per share of 12 cents and the company beat that by 3 cents. Per-share 15 cents is a significant improvement over the same period results last year of 9 cents a share.

Reported revenue continues to grow aggressively. The mean estimate for revenue was $188 million and actual revenue reported was $193.3 million, for a $5 million beat. Gross margins improved from 58.7% in the prior year to 59.5% in the reported quarter.

New Oriental Education's CEO Michael Yu stated:

"We are pleased to see strong revenue growth of 40.7% in the fourth fiscal quarter. We sustained a healthy top line growth trend in the full fiscal year 2012 with revenues of about US$771.7 million, up more than 38%, and student enrollments of over 2.4 million, up about 15%. Our student enrollment growth in the fourth fiscal quarter was 7.7%, below the average for the full fiscal year. The slower growth in student enrollment in the fourth fiscal quarter was primarily due to the early timing of Chinese New Year in 2012. Many students enrolled in New Oriental's Spring tutoring classes in February of the third fiscal quarter rather than in early March of the fourth fiscal quarter. As a result, we experienced strong enrollment growth of 21.6% in the third fiscal quarter and slower enrollment growth of 7.7% in the fourth fiscal quarter."

Based on my experience with any reasonable type of investigations of Chinese companies, the stocks have an extraordinarily difficult time recovering. If the company can get on top of this and satisfy the SEC quickly, the damage may be repairable.

Considering the company doesn't even know what the investigation is about, a quick and favorable resolution appears to be challenge at best.

Bargain hunters and short-sellers covering positions could push the price up in relation to the gap down price this week. Looking at the chart, I expect short-term resistance near $8 and again at $20. Round numbers often attract like a price magnet and repel, causing a bounce. Expect a lot of volume to trade near $15 a share.

BPI Chart BPI data by YCharts

If you are anticipating Tuesday's drop in price to signal a buying opportunity, you may find the end of the day Wednesday or opening on Thursday better than Tuesday. There is no hurry jumping on board with New Oriental Education. Stocks dumping as a result of news like this can continue to fall for a long time. Take your time and do your homework before allocating capital here. Look for a second break above $20 as the one that "sticks." You may have a long wait before New Oriental trades above $20, however.

What's the best play with New Oriental Education? There may be an attractive short-term trade coming up Thursday. Near the end of the day, if still trading lower, sell out of the money puts.

Fear of continued losses tends to push portfolio insurance prices up dramatically, while at the same time the stock should bottom. Short interest is relatively small (about 5%), removing the largest catalyst for a move higher.

It's not one to get greedy with; hold on for a few days and as the implied volatility falls (hopefully with a dead-cat bounce), exit out with a quick hit and run for profits. Otherwise, for longer-term investors, the best play is to wait until the SEC investigation is finalized for an entry. (Read my Bridgepoint Gets Detention and Green Mountain's Down the Cliff article.)

BPI Chart BPI data by YCharts

The other education stocks will likely bounce back quickly as investors formulate the issue is isolated to New Oriental Education. I entered into a long position with Bridgepoint Education by selling put options.

At the time of publication the author was long BPI.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

More from Education

Pros and Cons of Buying a Home With a Pool

Pros and Cons of Buying a Home With a Pool

TheStreet Rewind: How to Make 'New Fashioned Wall Streeter'; Twist on a Classic

TheStreet Rewind: How to Make 'New Fashioned Wall Streeter'; Twist on a Classic

How to Wire Money Safely, Affordably and Quickly

How to Wire Money Safely, Affordably and Quickly

Best Ways to Save for Retirement - Even When You're Living Paycheck to Paycheck

Best Ways to Save for Retirement - Even When You're Living Paycheck to Paycheck

The 'Hidden Tax' That's Hiking Your Student Loan Costs

The 'Hidden Tax' That's Hiking Your Student Loan Costs