Is GSX Techedu a Fraud?

Last week, short seller Muddy Waters released a research report calling Chinese online education provider GSX Techedu Inc (NYSE: GSX) a fraud.

The report alleged that GSX Techedu had cooked the books by inflating the number of enrolled students on its K-12 e-learning platform.

It’s also alleged that over 70% of the company’s users are fake and as a result, even revenues look inflated by at least 70%.

Moreover, the firm alleged that GSX Techedu has also understated expenses. Muddy Waters said that a former manager from the company confirmed the findings.

Lastly, Muddy Waters warned investors in GSX Techedu that the company’s chairman has pledged US$318 million worth of stock of the company. If lenders sell that stock, it could lead to severe pressure on its share price.

The methodology 

The analysis from Muddy Waters primarily involved going through the user data which is available to all enrolled students.

The company analysed over 400,000 attendance records from 50,000+ students enrolled in GSX’s 200 programmes. The researchers found out three patterns that support their argument of fake users.

Precise joiners, or the users who join the class at exactly the same time on two different weeks, accounted for 50% of the sample size. The logic is, if the users are logging in at the same time, they might actually be bots.

The second issue is IP addresses. In Muddy Waters’ study, over 30% of the students or teachers were found sharing IP addresses on at least one occasion.

The third instance, burst users, are a large group of people who join at the same time. Muddy Waters claimed that this happened in the middle of no activity, making it suspicious.

GSX Techedu refutes allegations

In its press release, GSX Techedu refuted the allegations. Talking about precise joiners and burst joiners, the company said that live classes are initially subdivided among smaller groups.

After an interaction with separate instructors, these groups join the main live class with the tutor. This causes burst users and precise joiners.

GSX said that its own audit found out that only 0.78% of users share IP addresses against the 30% quoted by Muddy Waters.

On the issue of pledging of shares by the chairman, GSX said that the 9 million ADRs (worth US$318 million as per the Muddy Waters report) were deposited as the share certificates couldn’t be split due to lockdowns.

GSX may be in deep losses

On 6 May, GSX Techedu released its Q1 2020 earnings.

The company reported revenues of US$183.3 million, a 382% jump over the same quarter in 2019. If Muddy Waters’ allegations are true, the actual revenues could be less than US$55 million.

Assuming that the company’s expenses stay the same, the pre-tax losses would mount to over US$100 million from currently reported pre-tax profit of US$23 million. That’s not a pretty sight.

The drama will likely unfold over the next few weeks, if investors go by what happened to Luckin Coffee Inc (NASDAQ: LK).

Foolish conclusion 

Muddy Waters’ allegations against GSX Techedu are serious. The research firm has uncovered other frauds in the past, most recently calling out Luckin Coffee for creative accounting. Will GSX Techedu be the new Luckin Coffee? Only time will tell.