Short Seller Report Highlights Red Flags for Tal Education Group (ADR) Stock

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TAL stock - Short Seller Report Highlights Red Flags for Tal Education Group (ADR) Stock

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On Wednesday, shares of TAL Education Group (ADR) (NYSE:TAL) fell 10% after short seller Muddy Waters Research announced a short position in TAL stock. The detailed report accompanying the announcement alleges that a series of questionable transactions allowed TAL to inflate revenue and profits over the past three years.

At least some investors have taken the report seriously — and they should. Muddy Waters has a track record of discovering fraudulent activity in China, most famously leading Sino-Forest to collapse earlier this decade. And the heavily researched report does highlight transactions that appear to be dubious.

Some investors might see the decline as a buying opportunity in TAL stock. After all, even the short seller admits that there’s a “real business” here. Muddy Waters’ own numbers, if true, suggest only an ~11% adjustment to FY17 operating and net profit.

But there’s a clear risk that, as the old saying goes, “There’s never just one cockroach.” Meanwhile, TAL stock isn’t particularly cheap even after the decline. It trades at nearly 50x forward earnings even backing out the company’s net cash. Risk-tolerant investors could see a growing business available at a better price. From here, however, TAL looks like an avoid at best.

The Muddy Waters Report

The report itself doesn’t suggest TAL is a complete fraud. Indeed, the report admits that TAL operates a “real business.” But the research does highlight potentially questionable transactions that created a gain on sale in FY16 (ending February) as well as potentially inflated revenue over the past three years.

For its part, the company has responded with a brief statement:

“The allegations made by this short seller contain numerous errors, unsupported speculation, and malicious interpretation of events.”

But Muddy Waters makes a solid case, and its track record, particularly in China, gives the firm some credibility. At least four targets in that country have been delisted after the firm called out questionable accounting practices.

Link Motion Inc (ADR) (NYSE:LKM), formerly known as NQ Mobile, and Orient Paper Inc (NYSEAMERICAN:ONP) both trade near $1. China Internet Nationwide Fncl Srvcs Inc (NASDAQ:CIFS) has lost half of its value since Muddy Waters called it out in late December.

That history doesn’t mean Muddy Waters is right this time. Indeed, the firm missed on another Chinese education firm, New Oriental Education & Tech Grp (ADR) (NYSE:EDU), which has risen 10-fold since Muddy Waters challenged it in 2012.

But the 70-page report makes a compelling case that two “asset parking” transactions created a $50-million gain on sale in FY16, while also boosting revenue and allowing the company to move losses off its income statement.

One of the companies was founded by a 19-year-old student and seemed set for failure, only to be valued by a TAL investment at nearly $91 million a year later. Another transaction seems to violate related-party transaction disclosure. There are real questions here in terms of the accounting that need to be answered.

Does It Matter for TAL Stock?

It’s worth pointing out that Muddy Waters isn’t alleging that TAL is a fraud. And that might lead some investors to shrug off the accusations.

Chinese accounting can be notoriously opaque to Western eyes, as seen at Alibaba Group Holding Ltd (NYSE:BABA), another Muddy Waters target. Even if true, the allegations only suggest about 13% inflation in profit. TAL still is growing quickly, with guidance for 58-60% revenue growth in fiscal 2019.

Meanwhile, the biggest part of the profit impact comes from the $50-million gain posted in FY16. That gain was separated out in the company’s 20-F that year (although interestingly, and oddly, not in the company’s non-GAAP results, which usually exclude one-time factors).

Presumably, investors would have noticed the one-time nature of the contribution and adjusted future valuation models accordingly.

But the problem is not just what Muddy Waters found, but what it didn’t find. If TAL’s accounting isn’t completely above board, it becomes difficult, if not impossible, to trust the rest of the company’s numbers. And for a stock with a big valuation — some $21 billion at a 50x P/E multiple — that’s a big problem.

From here, there are enough questions to avoid TAL stock for now, even if there’s no proof that the company should be valued at zero. If TAL can answer those questions, perhaps the growth story can resume. Until then, it’s safer to stay on the sidelines.

As of this writing, Vince Martin has no positions in any securities mentioned.

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.


Article printed from InvestorPlace Media, https://investorplace.com/2018/06/short-seller-report-highlights-red-flags-for-tal-education-stock/.

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