Consumer Discretionary Author: Qasim Khan Editor: Luke Sheehan Nov 06, 2020 12:30 PM (GMT+8)

Almost seven years ago in 2013, with increased easy access to smartphones, live-streaming classes and educational Apps the era of online access +education truly took off in China.

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Online education boom

According to a research report released by iiMedia (艾媒) on the development of China's online education industry, the online education market in China reached CNY 404.1 billion in 2019 and is expected to reach CNY 453.8 billion in 2020. The report further stated that the total number of online education users in China is expected to reach 309 million by the end of 2020, around 40 million more than the estimates of renowned research firm, iResearch.

Due to favorable policies from the government, such as the ‘Two-Child’ policy, the population of 0-14-year-olds in China has increased each year, and the potential demand for English for children has come to exceed 230 million, providing a broad market space for online English education firms.

If compared with other services, such as online videos, e-commerce and online payments, the penetration rate of online education is quite low.  

Since 2013 there has been an increase in the adoption of smartphones and other mobile devices in China, which has pushed the growth of the market. The increased per-capita spending capacity of the Chinese population and the flexibility in online education offerings have been key to driving the market. Training programs conducted by native English-speaking teachers can be availed of easily through the online medium.

The advantages of online learning have gained more recognition from parents in recent years. Data shows that the online learning market for children in 2018 was as high as 26.59%, way higher than the average online penetration rate of the education industry overall. The Internet not only brings high-quality foreign teacher resources to Chinese families but also saves a lot of time for both parents and children. Therefore, parents are more inclined to choose online learning for their children. It is expected that the penetration rate of online children’s English education will exceed 33% in 2019.

The survey found that ‘word-of-mouth’ is the most important channel for users to understand the brand. The results show that 71.40% of the firms are introduced to customers by their friends. The education firms spend a lot of money on advertising,  which only amounts up to 42.86%. In order to ensure ‘word-of-mouth’ referrals, it is necessary to solve the real needs of the user, such as the quality of teaching. 

Online Education is the main sector where most of the new investments have taken place in China. Companies like, VIPKID, Zouyebang, Yuanfudao, etc., have raised millions of dollars.

Educational companies in general yield good profitable business models with stable cash flow based on prepayment and a strong gross margin generated by high added-value. New products brought about by technology make the industry attractive for the capital market. 

With the continuous development of network technology, mentioned above, the penetration rate of online education has been rising, from less than 2% in 2013 to 15.2% in 2019. With the advent of the 5G era, the growth of online education will shape the coming years; it is expected to exceed 50% in 2022.

COVID-19: A blessing in disguise?

On January 29, after the Ministry of Education officially released a statement to suspend offline classes, large, medium and small public schools set up online classrooms. In addition to a large number of free online courses, online education institutions also saw this as an opportunity to expand their market. High-traffic platforms such as Kwai, Youku, Douyin, Xiguashipin (西瓜视频), and Jinri Toutiao made quick moves as well by using their traffic for educational institutions.

There were three major plus points caused by the epidemic: 
1.    The penetration rate increased. When offline schools were suspended, parents, students and teachers were left with no choice other than online education.
2.    Customer acquisition efficiency improved. First of all, in the short to medium term, from the perspective of the industry as a whole, the customer acquisition cost decreased.
3.    All types of regions went online. Regardless of whether students remained in first-tier cities such as, Beijing, Guangzhou, Shenzhen, or lower-tier cities, the delay of schooling in various places allowed the students in regions that previously had little access to online education to go online and learn.

It can be seen that situations such as the epidemic will bring benefits to the industry at a macro level, but it is too early to conclude whether the education industry has been completely transformed.

New Oriental-backed online education firm Koolearn’s (新东方在线) COO, Pan Xin (潘欣) analyzed the situation, commenting that “This epidemic is good for online education, but it is not good for online education institutions; it is bad for offline education, but it is not bad for offline education institutions. The winner is online education.” Indeed, from a micro-level perspective, for an individual educational institution, there will be an inflection point.

Other than TAL and New Oriental, the upcoming industry leaders such as GSX Techedu  , Yuanfudao (猿辅导) and the Zuoyebang, also saw their users grow. GSX Techedu claimed to have attracted 15 million students to sign up, Yuanfudao said that it had attracted more than 20 million students to register, and Zuoyebang attracted more than 28 million students to register.

Other than the epidemic, the advantages of online learning have gained more recognition from parents in recent years. Data shows that the online learning market for children in 2018 was  as high as 26.59%, way higher than the average online penetration rate of the education industry overall. The Internet not only brings high-quality foreign teacher resources to Chinese families but also saves a lot of time for both parents and children. Therefore, parents are more inclined to choose online learning for their children.

China's online education market has maintained steady growth over the past five years. As mentioned above the COVID-19 epidemic in 2020 has brought new vitality as it boosted demand.   

Some of the leading K12 online education firms took the opportunity to announce the provision of free courses during the outbreak, allowing them to gain a maximum number of users. 

Talking about financings of K12 online education firms in the first half of 2020, Yuanfudao set a new record with a staggering USD 1 billion in financings in March. Following that, Zuoyebang nabbed USD 750 million for its series E round, becoming the second-highest valued edtech unicorn in China. 

From celebrity endorsements, naming various popular online variety shows to placing small video ads on Douyin, Zuoyebang, Yuanfudao, NetEase Youdao and other head K12 online institutions have been working hard to prepare ample ‘ammunition’ to meet the upcoming summer enrollment season.

In the first half of 2020, 112 investment events occurred in the Chinese education industry; the number of transactions fell by 32% month-on-month and 45% year-on-year. The total amount involved was CNY 19.6 billion, an increase of 15% year-on-year.; the decline in the number of financings in the field is obvious, but the total amount of financing has risen, and the average amount of single financing has also increased by 77% year-on-year to CNY 175 million.

 On a global scale venture capital has been fueling global growth in edtech. The first three quarters have already seen a record USD 8.3 billion of VC investment. China retains the lead, and perhaps momentarily thanks to ByJu's, India takes second place ahead of the US. These three markets alone make up 90% of total global edtech investment.

USD 5.1 billion of the USD 8.3 billion was invested in 23 Mega Rounds (> USD 100 million). This is approximately half of all edtech mega-rounds in the prior five years.

GSX Techedu

Founded in 2014, GSX Techedu raised millions of dollars in the angel round from QF Capital (启赋资本), and a series A financing of USD 50 million in 2015 from Gaorong Capital (高榕资本), QF Capital (启赋资本), GP Capital (金浦投资), etc. before going public in June 2019. 

According to the prospectus, the firm submitted to the US Stock Exchange Commission, the firm had a fast-growing market size, a scaling net revenue, and a positive operating income, which is uncommon for Chinese online education companies. The company had experienced a 345% CAGR over the past seven quarters (pre-IPO), with 1Q 2019 net revenue of CNY 269 million (USD 40 million). 

Competitive advantage 

GSX believes that it has an advantage over its competitors because of its teaching quality although that is what every online education company says. 

GSX does have very strict standards when it comes to recruiting teachers. Basic requirements are that the instructor should be a graduate from a top-tier university and should have teaching experiences in huge education companies. 

According to the firm's financial reports which have been criticized for fraud for multiple things, the interview process makes sure that less than 5% of all the candidates can be employed as instructors. Such a selection process ensures that only the best instructors could join the company.

According to the prospectus, GSX has established a three-sided teacher system: lecturer, tutor, and AI teacher. Currently, GSX has around 200 lecturers, with an average of more than 11 years of teaching experience, and basically, all have work experience in well-known educational institutions. As for tutors, they are mainly fresh graduates from well-known Chinese universities with relevant academic backgrounds. 

The dual-normal large-class model is another so-called competitive advantage that GSX mainly promotes. GSX’s chairman Larry Chen even believes that “'the dual-normal large-class live class model is not even understood by the famous muddy water.”'

But in fact, most online education institutions currently adopt the double-teacher and big-class model. The double-teacher and big-class model is not high-tech, nor is it difficult to understand.

GSX has basically imitated the double-teacher model as we say TAL and New Oriental using it way before. 

In a perfectly competitive market with no barriers to competition, a profitable business model will be imitated immediately, and in the end, can only maintain market profits and losses.

Competitors can quickly copy any new business model. Unless the company has unique technology, invention patents, or market monopoly, and has established sufficient barriers, it is difficult for latecomers to enter, otherwise, the business model cannot be used as a competitive advantage.

Therefore, even if the double-teacher model has a comparative advantage, since almost all players on the same track currently use this model, and GSX is a latecomer to the market, without any scale and brand advantages, the model cannot give GSX a competitive advantage over its peers. The dual-teaching and big-class model cannot explain why GSX is currently the only large-scale profitable online education institution.

Now let's estimate the inflated revenue of GSX by the proportion of main operating costs.

At present, the listed companies that also adopt the dual-teacher and big-class model are TAL (Xueersi), New Oriental Online and NetEase Youdao. Out of the three New Oriental Online and NetEase Youdao have separately provided data of their main operation cost in the financial reports.

From the data, we can see that the main operating cost of GSX is much smaller than that of New Oriental Online and NetEase Youdao. Its main operating cost of 25.3% in 2019 is only 1/3 of that of New Oriental Online and Netease Youdao. According to past experiences, one of the characteristics of most financial fraud companies is that their main operating costs are low (abnormal gross profit margin), and GSX fits this feature very well. 


On February 26, Grizzly Research, a research firm that produces differentiated research insights on publicly traded companies, released a 50-page report, 'Why We Believe GSX Techedu is the Worst Publicly Traded Education Company.' The firm really took a hit on April 14, after short-seller Citron said it's 'the most blatant Chinese stock fraud since 2011.'

Following Citron's first report, as many as 16 US law firms initiated class actions to investigate the Chinese education company that was recently valued at USD 10 billion, for exaggerating profitability. The survey focused on whether the company overstated indicators such as profitability, income, student enrollment, and teacher qualifications, or did not disclose information related to investors.

What’s worse, on May 7, Citron Research issued the third part of the report in a series of GSX Investigations. Citron presented to US regulators definitive evidence of GSX Techedu committing securities fraud using multiple undisclosed related party transactions to hide expenses/liabilities. The report also pointed out that it is highly unlikely that GSX claimed to acquire a customer at half the cost vs. peers. And over 80 highly suspicious WeChat official accounts engaging in customer acquisition solely for GSX that were not registered to any disclosed GSX entity.

Muddy Waters, the same firm which unveiled the Luckin Coffee fraud, joined the party in late May, claiming at least 70% of the firm’s users are robots and calling it a massive loss-making business. The ADRs tumbled 34% from their Feb. 24 peak the following day. 

Some short-selling reports analyzed and pointed out that GSX transferred costs through affiliated companies, but the transfer costs accounted for a small proportion of the total cost. Therefore, GSX’s ultra-low-cost ratio is mainly due to inflated revenue. 

Through the monitoring of robot trainees, Muddy Waters has calculated that the proportion of inflated revenue from GSX is 70% to 90%. 

According to the annual APP downloads provided by Qimai Data Network, GSX (including GSX APP and Gaotu Classroom APP) has similar downloads with NetEase Youdao's Youdao Premium Class App. It shows that the number of real students in the online courses of the two companies is close. Assuming that the course fees of large-scale online education institutions are not much different, the revenue of these two companies should be close.

According to the short-selling reports, GSX inflated its revenue mainly through the following two channels:

1. Offline institutions. GSX has cooperated with a large number of offline educational institutions during the O2O platform period in 2015 and 2016, and has inflated its revenue by reporting classes through these offline institutions;

2. Illegally purchased bank accounts. The Grizzly research report pointed out that GSX purchased a large number of personal bank accounts and faked students to pay tuition fees, thereby inflating the number of students and revenue.

If an online education institution has 70% inflated revenue, then the number of inflated students should be close to or slightly less than 70% (considering that there are more inflated students enrolling in classes than real students). When 70% of students are basically robots in a class, we will find that: 

- Large class mode becomes the best choice.

- A company can convert normal teachers into famous teachers in a short period of time with the help of robot students. 

- The renewal rate is higher than the industry's normal level.

GSX is often compared with Luckin coffee case because firstly the timings of the fraud allegations of both the companies were quite near; secondly, the numbers of GSX were too good to be true just like Luckin Coffee's and thirdly because both the companies were shorted by the same research firm and fourthly because both the firms are Chinese.

We believe that it is not quite right to compare the two firms. Luckin Coffee provides physical services. Short sellers can obtain sales close to the actual sales volume by monitoring and sampling on-site stores, thereby estimating its inflated sales volume. GSX provides online courses, and short-selling institutions can only estimate the inflated revenue through certain technical means. Compared with Luckin Coffee, the recognition of such short-selling reports is relatively low.

The major shareholder of GSX paid real money for the inflated revenue, and its revenue is backed by real cash flow, so it was difficult to detect the fraud. This is the reason GSX was more confident.

However, due to the fact that GSX’s revenue growth rate and cost percentage fraud are too far from the norm of online education, and 11 short-selling reports have exposed its fraud, the market currently generally doubts the authenticity of GSX’s financial reports. In this case, it is more difficult for major shareholders to successfully reduce their holdings. At the same time, in order to maintain the illusion of high growth performance, the cost of fraudulent investment by major shareholders has also increased correspondingly, which may lead to a shortage of funds. Under financial pressure, GSX’s major shareholders are likely to have to reduce their shareholding by a large proportion, causing the stock price to collapse.

In addition, GSX also faces the following risks:

If GSX’s illegal purchase and use of other people’s bank accounts are exposed, according to the, its management will face serious legal risks.

The SEC in the United States launched the 'Whistleblower Award' program in 2010, awarding 10%-30% of the amount involved in the case to those who successfully provide effective clues. With the incentive of huge bonuses, GSX insiders may report their fraudulent behavior.

Upcoming competition

On the other hand, GSX must have in mind the competition which was just fueled by the virus outbreak. In addition to privately-owned online education companies, some of the technological giants also wanted to enter the online education market.

Nearly 300 million students & teachers used Alibaba's Dingding, during the lockdown. Although the software was rated one-star by many K-12 students, this marked Alibaba getting deeper into online education market. With a nationwide reputation and one of the best cloud platforms in China, it is totally reasonable for Alibaba to create its own online education platform.

Talking about the private bunch, with quite a few competitors like Yuanfudao, Zuoyebang and 17Zuoye plans of going public GSX will not have the advantage anymore, these firms have raised a lot of capital before the IPO and have accumulated a huge number of students. The firms have gone ballistic with marketing, spending with almost the same or even lower course prices than GSX. Once they IPO GSX will lose its position and its stock price and valuation will drop. With multiple accusations and law firms at tracking every step of the company, investors will opt for the safer stock which will be either of the above-mentioned companies. 

One of the biggest challenges for GSX will be to maintain its image or clarifying its image after being shorted 11 times over the past 10 months or so. With new companies going public learning from the mistakes, GSX has made it will be difficult for GSX to maintain its growth in the market. 

Other than that GSX's stocks have plummeted from USD 116/share to USD 66.42 over the past 25 days. There are two things that happened with the firm.

First, the leak of the next quarter’s financial report. GSX Techedu's management is going to significantly lower guidance for upcoming third-quarter earnings; this after the company confirmed last month that the Securities and Exchange Commission was investigating the company.

Second, Credit Suisse Group analyst said in a research report that the educational software developer is losing momentum due to increased competition and the 'mistakes' GSX made during its summer promotions. The analyst predicts that GSX’s conversion rate for this promotion will hit a record low due to similar offers from other companies. The report states that 'many parents choose to take turns in promotional courses' without actually paying for the entire summer.

Although we believe that the plunge in stock is more because of the leaked rumor rather than downgrading by the Credit Suisse analyst.