EDU: China's Fraud Epidemic?

New Oriental Education & Technology Group Inc. (EDU) 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 potential accounting fraud with an abrupt single-day stock decline. But there's more to this story line -- China is slowing down and that's not fraud, that's just scary.

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 history in the United States is any lesson, when a big bubble 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 it be unfair not to pick on China?

I'll get to more macro data points in a bit, but ultimately I want to focus on EDU. Let's start with the one-year charts below. The top portion is the stock price, the bottom the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).

On the stock side, I've highlighted the massive decline in late Sept. 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 a U.S. regulator began a probe into the consolidation of its 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

Ugly stuff... Two days ago the stock closed at $22.26 and one month ago it 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...

As I mentioned earlier, aside from irregular-accounting accusations, there is a macro picture for China that is quite disturbing, and in many ways equally disturbing as a potential fraud epidemic.

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.

Finally, let's turn to the Options Tab.

We can see the monthly vols are priced to 245.10%, 132.54% and 113.16%, respectively. The lowest strike in July is $12 -- it would have been 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?

--- DISCLAIMER --
This is trade analysis, not a recommendation.