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TAL Education: A Real Business With Fake Financials
Part I
Report Date: June 13, 2018
Company:
TAL Education Group
Ticker:
(NYSE: TAL US)
Industry:
China For Profit Education
Stock Price:
$45.65
Market Cap:
$26.0 billion
Average Daily Volume (90-day):
$171.6 million
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 is short TAL Education.
Investors might recall the dark days of 2010 and 2011, during which numerous U.S.-listed China
companies went down as frauds.It seemed like every new trading day brought revelations,
resignations, or re-ratingspanies were revealed to be frauds, regardless of their lead
bankers, auditors, or top shareholders.According to the recent documentary, the China Hustle,
there were approximately 400 frauds from China listed on U.S. exchanges.
When the dust settled, there were in hindsight certain indicia that were often present in the most
troublesome companies:
Too good to be true – often growing revenues and profits at breakneck paces in highly
competitive industries,
Balance sheets blowing out – significant CapEx, acquisitions, or investments, which
often turned out to be fake uses of non-existent cash to get through audits,
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Significant non-cash transactions – this was one of the major flags of the granddaddy of
all China frauds – Sino-Forest.Non-cash transactions are far too easily manufactured in
China to be trustworthy.
There followed a retrenching period where many of the problematic companies were de-listed or
became penny stocks.The perception was that the companies left standing were the “real”
companies.However, what did not happen is as important as what did happen.
Out of literally hundreds of blatant frauds, almost no company chairman did any prison time.A
Securities and Exchange Commission judge ordered that the practice licenses of the China
affiliates of the Big Four, who had issued unqualified audit opinions to blowup after blowup, be
suspended for six months.However, the suspensions never came into effect.Instead, the U.S.
government settled with the affiliates for $500,000 each, which is roughly equivalent to a yearly
audit fee for one small client.In fact, it became difficult for the SEC to act against auditors
because auditor working papers supposedly became “state secrets” that would subject an
individual to prison time for providing them to a U.S. regulator.In other words, after about 400
frauds, virtually nobody has been meaningfully punished.
Charlie Munger is fond of saying “Show me the incentive, and I’ll show you the outcome”.
Defrauding U.S. investors from China has proven to be a “heads I win, tails you lose”
proposition.So, it does not shock us when we see that TAL began fraudulently creating profits
as early as FY2016.Since the beginning of FY2016, the value of Chairman Zhang’s shares have
skyrocketed from $900 million to close to $7.5 billion.The prospect of becoming Bobby
Axelrod rich is a powerful incentive, especially when you have no downside if caught.
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Summary
We estimate that TAL has fraudulently overstated its FY2016 – FY2018 results:
Operating Profit, overstated by at least 21.6%
Pre-tax Profit, overstated by at least 39.8%
Net Income, overstated by at least 43.6%
The foregoing is only what we can quantify enough to estimate.We believe the fraud is more
pervasive, and includes the core Peiyou business and is migrating into its online businesses.
What we can quantify results from various fraudulent M&A transactions and investments.The
below shows our estimates to historical numbers based only on what we can quantify:
We estimate that TAL’s profit margins have been significantly overstated for the past three fiscal
years:
The reality is that TAL’s margins have deteriorated more than have been reported.To cover this
up, the company has resorted to fraud.TAL combines the old school China fraud playbook of
simply penciling in more favorable numbers with the more sophisticated asset parking fraud of
Enron.(The well-known instance of Enron’s asset parking is when it entered into sales of two
electricity generating barges in Nigeria with secret agreements to repurchase them.)In this Part
I, we detail two asset parking transactions that we estimate from FY2016 through FY2018
inflated TAL’s pre-tax profits by up to $153.2 million, or 28.4%.
Nobody has performed the highly detailed research on TAL that we have.Over several months,
we retrieved over one thousand of pages of PRC government files on various entities belonging
to, or associated with, TAL.We obtained and validated third-party credit reports on many of
these entities.Our investigators made numerous site visits, and interviewed scores of people
who worked in TAL, its partners, or had knowledge of its operations.In this report, we provide
a detailed roadmap so that investors can recreate significant portions of our work.。