To OTC Journal Members: 
 

New China Idea #2: Investing in the Rosetta Stone of China

This year's hottest IPO has been Rosetta Stone (NYSE: RST). The company debuted on the NYSE on April 16th- only the third IPO in April. The IPO price was $18, and the stock opened for trading at $25.12. It's since seen a high of $33, but has recently fallen on harder times.

The success of the Rosetta Stone IPO brings out an important issue- the evolution of education with the advent of the internet and the soaring costs of attending terrestrial classes. Online and virtual education companies world wide are soaring as the cost of on campus education climb out of the range of affordability for many who want advanced education.

No where is the demand more rapidly outstripping supply than China. After three decades of the "one family, one child" policy, extended families have the resources of two generations of wealth to commit to one child's education, but a highly sought after on campus University education is not available to all.

As you can see from this bar chart, per capita spending on education per child his risen three fold since 2002.

I've uncovered a company you can look at as the Rosetta Stone times ten of education in China. Like others I've found, the company is growing in the range of 50% to 100% annually, has great margins, strong net profits, and is undervalued by any traditional metric.

I love this theme and this company. For your consideration:
 

China Education Alliance (NYSE AMEX: CEU): Growth, Profits, and Monster Margins

Imagine generating $8.1 million in revs in a quarter, and gross profits of $6.5 million. That's a margin of 80%!!!- wow- that's like drug company type margins. Huge.

So, if you have $6.5 million in the quarter to run the company, and your expenses are only $2.8 million, you make a net profit of $3.7 million on $8.1 million in revenues. That's mind bogglingly great margins. Of course, if you're making that kind of money, you have to pay taxes. So- you net $3.235 million for your shareholders. If you were in the US, you might end up in Nancy Pelosi's "windfall tax" cross hairs.

Such was the financial performance of China Education Alliance (NYSE AMEX: CEU) last quarter. That's right- it was the June quarter- not the year end. BTW- the $3.235 million net equated to $.15 in EPS for the quarter, which would imply $.60 in annual EPS.

Oh, and also BTW- the company achieved $4.45 million in revenues the same quarter in '08- a growth rate of 82%. And- how about the balance sheet- do they have a huge debt burden? How about $32 million cash, and no long term debt. All of about $1 million in accounts payable. $21.7 million in retained earnings over their history. In short, a money printing machine.

All of this, combined with the noble mission of providing online and virtual education opportunities throughout China. This one is just getting started.
 

The Business

The easiest way for me to describe CEU's business is to liken it to US based services. They have several different areas of focus. 

The company offers exam oriented training. Anyone with adolescent aged kids has looked at standardized test training. The SATs are the big ones for college. At my son's school in Southern California, they have STAR testing even at the elementary school level.

In China, there is standardized testing at the Middle School and High School levels, and there is fierce competition to "climb the scoring ladder". The company has actually developed 300,000 sets of original testing material for the middle and high school levels.

CEU also offers Vocational Training which is akin to the constant barrage of ads you see on TV to become a computer network specialist, physicians assistant, or law enforcement training.

They also offer extensive training in five different languages, which is where the become akin to Rosetta Stone. 

About 50% of their revenues are generated from online services, and the remaining 50% is generated in a class room environment in one of 90 facilities with the capacity to handle 4,000 students at a time.

CEU boasts a highly dominant position in the Northern most Heilongjiang Province of 35 million residents, and has learning centers in Beijing, Qingdao, Yantai, Xiamen and Shenyang.
 

On To the Fun Stuff

That's the company description. Boring, but necessary. Now, let's get on to the fun stuff. The numbers. The growth, revenues, and profits this company is generating. And, did I mention the balance sheet? This company has almost too much cash. They need to start investing it in even more rapid growth.

Here's the financial results for 2009:

• Q2 Revenues were $8.2 million, up from $4.5 million in Q2 of '08 (82% growth)
• 6 months revenues first half of '09 were $16.3 million, up from $8.5 million first half of '08 (92% growth)
• Profits in first half of '09 were $6.4 million, up from $3.5 million in first half '08 (83% growth)
• EPS for first half '09 were $.29 ($.26 fully diluted)

Here's the picture from the last filing: $32.5 million in cash and receivables, no long term debt, and a mere $1 million in payables. But wait- the balance sheet gets even better- read on.
 

Conclusion: Your Upside

There's a few more factors to consider in this idea, so let's start with the chart.

This is a weekly chart I thought would give us the best longer term picture. As you can see, this stock has traded extremely well this year. It started 2009 at about $1 on the bulletin board, and I wish I had found it then obviously. 

Here's what I like technically about this idea. Note the stock has been grinding in a range between $5 and $6 since mid July. This "grinding" period is allowing the market to absorb all the cheap stock, and replacing it with new shareholders at a high cost. Like water rising behind a weak dam, when the forces build up enough, the dam will burst with a break out to the upside in my view. You just can't be sure when it will happen. With these numbers, it's likely to happen much sooner than later.

Back to the balance sheet. Brokerage firm Rodman Renshaw, the premier underwriter in smaller stocks, just completed a secondary financing for the company. Rodman placed about 3.1 million shares priced at $5.50. After exercising part of what is called the "over allotment", the company received cash proceeds of about $20 million.

Net result- CEU has more like $52 million in cash at this time. With about 25.5 million I&O, this means CEU has over $2 per share in cash today!!!!!

Another words, you're buying a business for $3.50 ($87 million) that generates about $15 million in net profits annually at the current rate- and then there's growth.

Now, let's boil it down to simple upside. I don't see CEU generating any less than $.60 in EPS this year. The S&P 500, with it's minimal growth rate, is now trading over 20 times trailing earnings. If CEU trades at 20 times it's trailing EPS, you're looking at $12 per share- or about 118% ROI from its current level (double the ROI if you buy on margin). That's without factoring in growth.

My price target within one year: $15. Armed with all this cash, this company is going to invest in growth, and it has proven it can grow. It has a highly scalable model, great margins, huge profits, and over $50 million in cash. There's no reason this stock couldn't trade to $15.

Strong buy recommendation up to $6 immediately. You want to own your position before Q3 numbers come out. Rodman didn't raise $20 million for this one to see their customers break even at $5.50. SSL- $4.75.

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