Wednesday, July 18, 2012

EDU - Is China Collapsing into a Fraud Epidemic... Just Like the US?

EDU is trading $13.52, down 7.5% with IV30™ up 41.7%. The LIVEVOL® Pro Summary is below.

New Oriental Education & Technology Group Inc. is a provider of private educational services in China based on the number of program offerings, total student enrollments and geographic presence.

This is a vol and stock price note on yet another Chinese company embroiled in a potential accounting fraud with an abrupt single day stock decline. But, there's more to this story line now -- China is slowing down, and that's not fraud, that's just scary.

Further, I postulated in late September of last year:
Is China A State Backed Accounting Fraud Epidemic? (click the title to read the article).

Chinese stocks are getting crushed today, partly because of a report that the US government’s investigation of their accounting is gaining some muscle power.


Many of these names have already been hammered on such concerns for several weeks now. Some of them have political risk at home to contend with, too, along with growing worries about the strength of China’s economy.
Source: Chinese Stocks Crushed on Report of DOJ Probe

To get a better handle on the macro picture for China as of right now, I highly recommend reading my post on Thursday of last week:
Has the Chinese Apocalypse Started? Is China on the Cusp of a Deflationary Vortex?.

Bottom line, there is a non-trivial chance that both things are equally true: China could be in a fraud epidemic and China could be in a deflationary vortex.

Just to be clear, I'm not singling China out here -- quite the contrary, in fact. Human nature is human nature and if the history in the United States is any lesson, when a big bubble boom goes bust, fraud hits hard (remember Enron, WorldCom, Global Crossing, Arthur Anderson, Health South, etc?). Would I be unfairly picking on China for wondering if something similar is happening there (now), or would I be unfairly not picking on China if I didn't say it?

So is the single greatest catalyst to world wide economic growth in fact headed into a downward economic spiral and a fraud epidemic? That's not crazy talk, that's market talk... of course, it might not be true -- neither of them. In fact, there's a better chance that neither are true than the worst case scenario, right?

I'll get some other macro data points into this article, but ultimately I'll also focus on EDU, in particular. Let's start with the Charts Tab (one year), below. The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).

On the stock side, I've highlighted the massive decline in late Sep as well as the drop two days ago. Here is the relevant news for the recent drop:

New Oriental Education & Technology Group Inc. (EDU) tumbled the most on record, leading declines in New York-traded Chinese stocks, after the company said the U.S. regulator started a probe into the consolidation of its units’ financial statements.

New Oriental said yesterday the Securities and Exchange Commission is investigating its accounting practices, the second Chinese company in a month incurring a regulator probe. The SEC ordered on June 29 a two-week trading suspension of China Medical Technologies Inc. (CMEDY), citing questions on the accuracy of reported information. Sino-Forest Corp. filed for bankruptcy in March after it was accused by a short-seller of misstating business and assets.

Source: Bloomberg via Yahoo! News; New Oriental Leads Tumble on SEC Probe: China Overnight, written by Belinda Cao.

Ugly stuff... Two days ago the stock closed at $22.26 and one month ago the stock closed at $27.33. As of this writing the stock is down 39.3% in two days, and 50.5% in a month.

Turning to the vol side, we can see the explosion over the last two days. What's interesting is that while vol popped from 68.27% to 93.53% (37%) yesterday, its up another ~42% today to 132.54% -- so, the vol rise is larger today both in absolute and relative terms. And there isn't any "new" news... Gulp...

In fact, as I'm writing this, the IV30™ is now up 64% to 153.28. And now I see why:

11:55 EDT New Oriental Education initiated with a Strong Sell at Muddy Waters

Source: via Yahoo! Finance; New Oriental Education initiated with a Strong Sell at Muddy Waters

Sorry, that was real-time blogging (sort of...). In any case, the Muddy Waters point of view isn't exactly new either.

As I mentioned earlier, aside from the accounting irregularity accusations, there is a macro picture for China that is quite disturbing, and in many ways equally disturbing as a potential fraud epidemic. While I directed you to the prior blog about China's deflationary trend, here's a snippet from yet another article that points to the same macro gloominess:

BEIJING (AP) -- Some of China's biggest companies, from tech giants to airlines and retailers, are warning of unexpectedly sharp drops in profit of up to 80 percent, adding to pressure on Beijing to reverse a painful economic slump.


Forecasters say the slowdown might have bottomed out after growth fell to a three-year low of 7.6 percent in the second quarter but the timing and strength of a rebound are uncertain. Premier Wen Jiabao warned last weekend a recovery was not yet stable. On Tuesday, he said the employment outlook "will become more complex and severe."

"Economic growth will be unstable for the next six or even 12 months at quite a low level," said Zhang Jiuhui, an analyst for Great Wall Securities in Beijing.

Beijing has cut interest rates twice since the start of June and is pumping money into the economy through spending on building low-cost housing and other public works. It is trying to use targeted measures instead of flooding the economy with money after a binge of spending and bank lending that helped China rebound quickly from the 2008 crisis fueled inflation and a wasteful building boom.

Source: AP via Yahoo! Finance; Chinese companies see profits plunge amid slowdown

Let's turn to the Skew Tab for EDU, to get a feel for the month-to-month and line-by-line vols. I included two snapshots -- one with the front month included and the other with it excluded (to see the back two months on a better scale).

We can see the front is extraordinarily elevated to the back, priced at ~245% as of this writing. Looking to just the second and third expiries, we can see how the skew has retained its "normal" shape, and it makes sense that the second month is above the third given the short-term risk as these accusations and an SEC inquiry move forward.

To read about option skew, you can go here:
Understanding Option Skew -- What it is and Why it Exists.

Finally, let's turn to the Options Tab, for completeness.

We can see the monthly vols are priced to 245.10%, 132.54% and 113.16%, respectively. The lowest strike in Jul is $12 -- it would have been in interesting to see how the disaster puts would have been priced with just 2.5 days left to expo. My guess is that a $5 strike may have been bid, and it certainly would be in Aug.

Ultimately, as a single stock story, this is compelling but hardly macro. I still believe there is a gigantic macro risk (gigantic wrt to downside potential) -- albeit a small probability -- that has not been priced into the market yet.  If the risk is digested, VIX could hit above 40 by the end of the year.  Of course, some good economic numbers (or even stable numbers) from China could totally alleviate that risk.  Just to be clear, I'm not predicting a 40 VIX, I just think 16 feels kinda... absent minded?...
This is trade analysis, not a recommendation.

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