Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

New Oriental Education & Technology Group Inc. (NYSE:EDU)

F2Q 2013 Earnings Conference Call

January 29, 2013 08:00 ET

Executives

Sisi Zhao - Senior Investor Relations Manager

Louis Hsieh - President and Chief Financial Officer

Analysts

Philip Wan - Morgan Stanley

Jeff Meuler - Baird

Mark Marostica - Piper Jaffray

Ella Ji - Oppenheimer

Jin Yoon - Nomura

Steve Zhang - Macquarie

Fei Fang - Goldman Sachs

Vivian Hao - Deutsche Bank

Operator

Good evening and thank you for standing by for New Oriental’s Second Quarter of Fiscal Year 2013 Earnings Conference Call. At this time, all participants are in a listen-only mode. After management’s prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

I would now like to turn the meeting over to your host for today’s conference, Ms. Sisi Zhao. Thank you. Please go ahead.

Sisi Zhao

Hello everyone, and welcome to New Oriental’s second quarter of fiscal year 2013 earnings conference call. Our financial results for the period were released earlier today and are available on the company’s website as well as on Newswire services. Today, you will hear from Louis Hsieh, New Oriental’s President and CFO. After his prepared remarks, Louis will be available to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the view expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. New Oriental does not undertake any obligation to update any forward-looking statements, except as required under applicable laws. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on New Oriental’s Investor Relations website at investor.neworiental.org.

I will now turn the call over to New Oriental’s President and CFO, Louis Hsieh. Louis, please.

Louis Hsieh

Thank you, Sisi and thanks everyone for joining today’s call. We once again posted healthy revenue growth this quarter. Our bottom line performance was lower however, largely as a result of a slower performance in Beijing and Shanghai as well as cost and expense overhang following the aggressive network expansion we undertook in the last few quarters of fiscal year 2012.

As we flagged last quarter, we are now focused on pursuing a Harvest the Market strategy meaning our priority is to maximize utilization in our existing network. It’s important to note that in the four quarters prior to Q2 of this year during our Occupy the Market phase of our expansion, we added a net of 238 learning centers compared to just 86 in the four quarters before that. Headcount during that period increased by almost 10,000 from approximately 24,500 to 34,300. So, this gives you a sense of the cost pressure we are dealing with, but it will take some time to fully realign our cost structure and bring ourselves back to more acceptable levels of profitability.

We are confident as ever in the strength of the New Oriental offering and we are confident about our long-term future. In fact, our Occupy the Market strategy seems to have achieved its intended purpose benefiting New Oriental’s market position making us number one or number two in most key geographic markets where we have been established for over five years. And deterring most of our public and private company competitors from entering our key geographic markets are slowing their expansion plans.

Before we go through the business lines, I want to first give you a bit more color on our bottom line for the quarter. In line with our Harvest the Market strategy, we added a net of just 18 new schools and learning centers this quarter. Beginning in late October 2012, all new learning centers openings required the approval of my finance department and we will strictly control the number of new center openings. Almost all the 18 learning centers opened in the quarter occurred before the new approval process. During the quarter, we have started a strict headcount review school-by-school and department-by-department in an effort to reduce staff cost.

During the quarter, we were able to reduce headcount by around 1500 staffs. While this will aid long-term efficiency, we incurred additional severance cost in the short-term related to these reductions. In the next two quarters, we’ll look to reduce headcount by another 1,000 to 1,500 mainly in the administrative side, which will mean additional severance expenses. It will take a couple of more quarters for these measures to bear fruit on the bottom line.

Another reason for the slower bottom line this quarter was the continued slowdown in Beijing and Shanghai. There are a few reasons for this. As I have said, as our network outside these cities have grown many students who previously have attended our classes in Beijing or Shanghai are now opting to go to the New Oriental learning centers in their local areas, where they can get a comparable level of education. So, that is one factor. And second is that we are still working on integrating the new management teams that we have put in place in Beijing and Shanghai. We are confident that we are making progress here, but it’s going to take a couple of more quarters before we get to where we want to be. And on top of that, we are also seeing increased competition in these largest two cities. So, it’s a tough market in Beijing and Shanghai right now, but we are balancing this out by investing in Tier 2 and Tier 3 cities.

And finally, we also incurred further costs related to the SEC investigation of around $3 million in the quarter. We do not anticipate material further costs incurred related to this SEC in coming quarters. Obviously, the bottom line isn’t where we wanted to be, but we are encouraged that the revenue growth continued to be solid. Total revenues increased 30.4% year-over-year to $165.9 million in Q2, which is seasonally the slowest quarter for New Oriental. Total student enrollments increased 7.2% from year ago largely as a result of continued slowdown in Beijing and Shanghai.

Now, let’s go to the latest developments of our various business lines. The K-12 all subjects after school tutoring business remains a highlight. Enrollments grew 14% year-over-year and gross revenues were up over 50%. The New Oriental per ADS is especially strong in this segment and parents are willing to pay premium prices for the premium education only New Oriental can provide. Overseas test prep was slightly down this quarter. Enrollments decreased 7% year-over-year and gross revenues were up 22%. This was largely attributable to the slowdown in Beijing and Shanghai I just mentioned.

Furthermore, we are facing new competition from many private international schools and classes promoted by some public schools, especially in Beijing and Shanghai. On the positive side, after the end of last week in this current quarter Q3, overseas test prep enrollments have increased approximately 15% and cash revenue of approximately 37% for the quarter-to-date. So, this is encouraging bounce back. Our VIP personalized services classes showed encouraging growth with enrollment growth of about 25% year-over-year and cash revenue growth of over 38%. There is still some work to be done here in terms of utilization and our focus going forward will be to bolstering the one to five offerings, one teacher to five students, where margins are better. Our strong brand will give us some room to increase ASPs, particularly in our kids offering.

Our Vision Overseas Study Consulting business was a real highlight again this quarter with revenue growth of 97% to position ourselves to benefit from the huge long-term growth potential we are seeing here. We are trying to invest aggressively in Q3 to rollout Vision Consulting across more large cities throughout China. We expect this to put some cost pressure on our bottom line, but we feel it is the right time to invest, to capture this huge market opportunity and we are seeing strong demand across the market.

So, moving forward as I said, we think it’s going to be a tough couple more quarters to bring our costs and expenses structured back to line and return to better levels of profitability. This means continuing to implement our Harvest the Market strategy focusing on utilization of our existing network, reducing headcount, and looking to reduce cost in less profitable areas of our business. While we are seeing increasingly competition from much of the market, top-line growth should remain strong. And we expect continued business growth in areas like K-12 and overseas test prep and overseas study consulting.

In short, while the market is entirely more competitive, New Oriental is very much a premium player in this industry and the breadth of our offerings, depth of our expertise, and broad and deep geographic footprint. Thanks to our Occupy the Market strategy as we are well-positioned for the long-term.

Before we move on to the Q&A, I want to quickly go through some of the key financial metrics for this quarter. You can of course find most of these in the press release. Selling and marketing expenses for the quarter increased by 42.5% year-over-year to $34.3 million. This is primarily due to increase in the number of customers served service representatives and brand promotion expenses. General and administrative expenses for the quarter increased by 62.1% year-over-year to $77.7 million. This is primarily due to increased headcount as we expanded our network of schools and learning centers in the four quarters prior to Q2 and the investigation-related expenses accrued in the quarter.

As I have mentioned, we reduced headcount in the quarter by about 1500 and we look to improve efficiency and we’ll reduce that further in the next couple of quarters. Operating margin for the quarter was negative 16.2% compared to negative 2.5% in the same period of the prior fiscal year. Operating margins were significantly impacted by the substantial costs and expenses overhang due to the heavy investment in learning center expansion in the past few quarters. Net loss for the quarter was $15.8 million compared to net income attributed to New Oriental of $3.3 million in the same period of prior fiscal year. This is due to the factors outlined earlier in my prepared remarks.

Turning now to the guidance for the next fiscal quarter, we expect total net revenue in the third quarter of fiscal year 2013 to be in the range of $212.4 million to $220.9 million representing year-over-year growth in the range of 25% to 30%. This excludes the impact from the disposal of our ELITE English business. Compared to our reported net revenue for the third quarter fiscal year 2012, which includes the revenue from ELITE English business, growth is expected to be in the range of 22% to 27%. This forecast reflects New Oriental’s current and preliminary view, which is subject to change. At this point, I will take your questions. Operator?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. (Operator Instructions) Your first question now comes from the line of Philip Wan from Morgan Stanley. Please ask your question.

Philip Wan - Morgan Stanley

Hi, Louis and Sisi, thanks for taking my question. My question is about your overseas business, as you mentioned you are seeing intensifying competition, could you elaborate a little bit more on where do you see tougher competition in large class format or smaller class or one-on-one format? And if it’s more difficult to compete in one-on-one or due to other reasons and if that’s the reason, can New Oriental sustain the pricing power given a more competitive environment? Thank you.

Louis Hsieh

Thank you, Philip. Good questions. The competition overseas test prep is not in the large classes, it’s really in the small and one-on-one classes. And as you have known us for years and many of you know, some of our own teachers have left New Oriental to start competing schools. If the barriers entry are lower when you do small classes and one-on-one, some of our teachers as they takeaway just five students, it pays their whole salary. So, you can imagine that there is a lot of good teachers who are starting their own business in the one-on-one and small class, where brand is not as big a factor. In the large class, we still obviously dominate. So, that’s where the competition is coming from.

The second leg of competition, where middle and high schools throughout China have setup affiliate programs with international schools. So, they are actually getting paid to send their public school students to those other schools. They are getting paid by those schools of their profit share. And so that is also hurting New Oriental’s business, because as the public schools realized that more and more the students want to go to college internationally or graduate school, they are offering international classes on weekends and evenings in competition with New Oriental to affiliated programs. And they are obviously encouraging their students to go to their schools. So, those two areas of competition have put a damper on our overseas customer business. Having said that we have seen a very strong bounce back in this third quarter, so enrollments as I said, up to the end of last week were up 15% and cash revenue up 37% for the first, almost two months of this quarter. So, I think the margin remains healthy. Also Philip remember that the overseas test prep business as the number of students leaving China has slowed. I think last year 390,000 or so according to Ministry left China, that’s only 15% growth whereas in prior years, number of students leaving China, it was over 20%. So, I think the market overall has slowed a little bit the growth rate. And so I think those are the primary challenges we face in the overseas test prep business.

Philip Wan - Morgan Stanley

Also do you expect New Oriental to sustain the pricing power as we have seen has a couple of years? And do you have any specific strategy if you overcome the other two increasing competition that you just mentioned?

Louis Hsieh

Yeah, I think we will sustain the pricing power that we have enjoyed for the last year 10, 15 years. And I think what we will do is that we will continue to do what we have been doing, which is to distance ourselves and become a more premium product. So, in the one-on-one and one-to-five space, we’ll continue to raise prices and we actually hope that some of those students have actually picked the large class offering. Many students, their parents will not sacrifice in this area. So, they will always pick New Oriental as the best brand provider. So, if we continue to raise prices we expect some students to actually switch to the large classes. In addition for some of our best teachers, we are raising salaries Philip to keep them from trying to spin off on their own and compete against us. So, I think is that we are working on that, also we are working to increase utilization in the overseas test prep centers either one-on-one in the small class to improve profitability. So, doing all that at the same time, I am not so worried about the overseas test prep business like I said it’s our bread and butter and it will continue to grow. The market remains quite healthy. And the overseas study consulting business is booming with revenue growth between 60% to 80% year-over-year. So, I think we are well positioned here.

Philip Wan - Morgan Stanley

Thanks Louis.

Louis Hsieh

Yeah.

Operator

Thank you. Your next question comes from the line of Jeff Meuler from Baird. Please ask your question.

Jeff Meuler - Baird

Yeah, thank you. I guess Louis, could you just talk a little bit more about what you are doing specifically in Beijing and Shanghai in terms of a turnaround plan. And I know that you have a new management in place and some of the recent trends have been more encouraging. But as you talk about the increased competition and the students staying in their local markets instead of traveling to Beijing and Shanghai to take courses, it sounds like those might be longer term headwinds. So, I guess any additional specifics that you could talk about in terms of a turnaround plan, especially beyond just expense adjustments if you are doing anything to, I guess, stimulate stronger enrollment growth?

Louis Hsieh

Yeah, thank you Jeff. That’s a very good question. In Beijing and Shanghai, Beijing is not really that problematic. Beijing still had 26% revenue growth in the quarter. Shanghai is the more problematic one and that’s been the case for three years now. And so with Shanghai as you know and Beijing both we have put in new school heads and management teams. So, they need sometime to integrate and to mature. I think what we have also done is we have moved Zhou Chenggang who used to run Shanghai School is serious hero and runs Visions Consulting he is spending a lot more time in Shanghai with the new Shanghai school head. Also Chen Xiangdong, our President of Domestic Business and Sha Yunlong are two of our most senior five people are spending, focusing their time on Beijing along with Michael, our CEO. So, there you’ve got three of our five most senior people spending almost all their time focusing on Beijing, and then another couple focusing on Shanghai. So, I think is that we are confident the Beijing will get turnaround relatively soon, but Shanghai may take a bit longer, but I think we have the right pieces.

We are looking at doing more marketing in Beijing and Shanghai. We are looking at increasing, like I said, some of the teacher paid to prevent some defections in the overseas test prep area. We are increasing the utilization. So, Beijing’s issue is really not revenue, Beijing’s issue is more utilization and profitability. So, if we increase the utilization that will help Beijing significantly. We are also spending some money in Beijing and Shanghai on marketing. Even though many of the students are staying in the localities, I mean we think we can still pull some back into Beijing and Shanghai during the winter and the summer holidays. So, they are spending some money on summer camp marketing and winter camp marketing for overseas test prep, so hopefully that will improve their top and bottom line performance. So, we are doing all these. At the same time, we are also reducing headcount, especially in Beijing headquarters side to increase cost, so Beijing is an issue of profitability. Shanghai is an issue of growth and profitability. So, Shanghai is the more wounded of the two. So, Beijing we are quite confident will be fixed relatively soon Shanghai is the one that will take some more time. Did that answer your question, Jeff?

Jeff Meuler - Baird

Okay. And then, it did, thank you very much for that. And then in terms of I guess expense base inflation versus ASP increases if you strip out mix, so what are underlying ASP increases if you normalize for mix? And then how does it compare to what the expense base inflation is if you strip out lot of the one-time things that are going on the severance expense and the legal expense, regulatory expense, etcetera.

Louis Hsieh

Yeah, I think our enrollments have accelerated in this current quarter. So, I think is that if you look at it for year-to-date, our enrollments are probably up 11%, over 11%. And price increases up about on an apples-to-apples basis about 14%. So, that’s why you get 25% revenue growth just organically, not counting the mix difference, so the mix takes it up to 30%. So, that’s what we are seeing. As far as expense cost like I said, we are seeing salary inflation typically inline with what has been the past years of probably 10% to 12%, but the issue relates to other cost right, social welfare cost and others which take us up to about 13%, 14%. So, rent is stable at around 10% to 12%. So, it’s really – our ability still remains to increase cost. What’s striking us down is that we just over expanded. I mean, it paid off right. We got our intended target of Occupy the Market. We are number one or number two in almost every market that we have been there for more than five years, which is what our target was. We are growing very nicely in all those cities outside of Beijing and Shanghai, the Tier 2, Tier 3 cities. So, we achieved our objective with the Occupy the Market strategy. We probably added 238 learning centers in a four-quarter period is just too much. As I told you in the past, we add 80 to 100 learning centers a year. We typically it will be margin accretive. When you had 238, it’s going to destroy your margins in a big way. And so that’s why what I tell people is it’s like our where we’ve been our learning center binge now in the overhang period. So, we will probably be here for another two quarters. So, I think by Q4 or Q1 with that excess capacity would have been absorbed and so it will be like if we almost had no learning centers for the next two quarters, it will take us back to a rationale path.

Jeff Meuler - Baird

Okay, thank you, Louis.

Louis Hsieh

Thanks, Jeff.

Operator

Thank you. Your next question comes from the line of Mark Marostica from Piper Jaffray. Please ask your question.

Mark Marostica - Piper Jaffray

Yes, thank you. Louis, could you give us some more color as to where exactly you are going to take cost out of the business? Will you be looking to close learning centers selectively, if so how many? And then just more details around exactly where the costs are coming down? And then if you have a goal in mind in terms of how much cost you try to take out of the business that would be helpful as well?

Louis Hsieh

That’s a work-in-progress Mark, but I can tell you what we are doing. We are taking cost out and so as we are closing unprofitable learning centers. So, we are going center-by-center, school-by-school and looking at the number of employees in each school. And we have a revenue target per employee. And so schools that don’t meet those, profitability side, we have to cut employees. And so that’s why I expect another 1000 or 1500 to be cut by the end of this fiscal year in May. Yes, remember that many of these employees have actually signed contracts through the end of the fiscal year. So, we really can’t let them go. That’s why it hasn’t been more accelerating. The other thing is that severance cost, we have to pay one to two months for every year they have been employed. So, those costs are significant US$6,000 to US$10,000 per employee. So, it’s a very expensive cost, if you do it too quickly. So, those are the things that we are faced with. We are closing unprofitable learning centers. I would expect to close 15 to 25 learning centers that are unprofitable. And so that’s an ongoing review process around the specific number in mind as far as our cost out, because I think if you take out too much, you end up reduced, but we are looking more utilization. So, the other side is that, because we are not opening up any more learning centers other than like in very fast growing cities that are almost fully utilized. We would expect that as revenues continue to grow at 30%, 35% year-over-year, there is no capacity increase. If no capacity increase, then obviously the utilization will go way up and that will take the profitability up. So, that sort of our strategy is to reduce headcount, improve utilization, and close down unprofitable learning centers.

Mark Marostica - Piper Jaffray

Okay, thanks for that. And then one follow-up, deferred revenue growth saw a big jump this quarter, can you talk about the composition of deferred revenue this last quarter compared to a year ago just to help us understand how that deferred revenue gets recognized into revenue?

Louis Hsieh

Yeah, about $278 million of deferred revenue, it’s up 37% or 38% year-over-year, half of it about 51% will likely get recognized this fiscal quarter, Mark, and then the rest will be deferred into Q4 and into Q1. So, demand as you know revenue is not our problem.

Mark Marostica - Piper Jaffray

A year ago?

Louis Hsieh

Yeah, versus year ago, year ago it’s probably a little bit slightly higher by 53% or 54% was recognized and that’s because there is more and more students signing up for multiple quarters. And as you know as the one-on-one business grows, it would also add to the deferred revenue number. Now, we are trying to rationalize the growth of one-on-one meaning that we prefer students that take one-to-five classes than we take one-on-one because they are more profitable. We are also are going to, because we are going to stop or very severely curtail learning center growth, the one-on-one centers will actually increase utilization, which will increase your profitability. So, the fact we are not opening up more learning centers will reduce the one-on-one growth and hopefully but will improve utilization and will push students for one-to-five. So, that’s sort of our goal.

Mark Marostica - Piper Jaffray

Great, thank you.

Louis Hsieh

Thanks.

Operator

Thank you. Your next question comes from the line of Ella Ji from Oppenheimer. Please ask your question.

Ella Ji - Oppenheimer

Thanks. So, Louis, how much of revenue in Beijing and Shanghai school comes from the overseas test prep?

Louis Hsieh

In Beijing it’s higher, Beijing I think it’s probably around 50% or more. I think that would change over time as you can that’s better. That’s why I said I am not worried about Beijing, because when Q2, the revenue was still even 26% growth despite the fact that overseas test prep was down, enrollment 7% even the enrollments were up, I mean, revenues up 23%. And as you know, the enrollments are quite strong so far this quarter in overseas test prep, which benefits Beijing the most. Shanghai, I think it’s probably less than 50%, but like the Shanghai it has to work through other issues.

Ella Ji - Oppenheimer

Alright. And then so I say that your Beijing and Shanghai schools’ revenue grow 20% in a quarter, but bottom line declined 50%. Can you give us some colors why the margins at Beijing and Shanghai schools suffered so much in this quarter? Is there anything in particular and do you expect this declining bottom line to continue?

Louis Hsieh

I don’t expect it to continue. Actually, Shanghai actually lost money during the quarter. So, I obviously don’t expect that to continue. So, I think the cost pressures in Beijing and Shanghai relate partly to headcount, where the headcount increased, but the revenue did not over the last year, revenue up 20%, but the headcount was up way much more than that. I also think the, like I said that the fact that the overseas test prep was weak during the quarter, had a big impact on the profitability in Beijing and Shanghai for the quarter, because of as you know the utilization rate during Q2 was the lowest of the year and because of prior expansion if it’s the hardest in Q2. So, now that we have controlled the cost in the speed of learning center openings, I don’t expect this to repeat itself. I think we both will see much better profitability pictures going forward.

Ella Ji - Oppenheimer

How many learning centers did you open in Beijing and Shanghai in the past year?

Louis Hsieh

I don’t have that. Sisi, do you know that exact number?

Sisi Zhao

I don’t know the exact number, but it should be somewhere around 10.

Louis Hsieh

10 to 12, yeah, but see we have that and then you have the overseas test prep business which where the enrollments were actually down in the quarter year-over-year. And so those with more centers, more people and Shanghai actually revenue is only up 4% or is it Shanghai in the quarter was only up in revenue approximately we didn’t get the right exact number. Revenue in the quarter was up. Revenue was only up 4% in Shanghai. So, when you have number of headcount go up and you have centers go up, but the revenue goes up 4%, it crushes your profitability. So, like I said, China is going through a transition, it has a new school head and new department heads. And they need time, they can’t walk in and fix things in one quarter or two even take longer.

Ella Ji - Oppenheimer

Right, okay got it. And then regarding your margins I think last quarter I kind of get a sense that we expect – we are expecting margins improvement since the 3Q of this year, but you just mentioned improved margins in a couple of quarters probably toward the end of this fiscal year. So, could you elaborate on that is the cost and expenses that the impact from the past expansion is that being bigger and longer than you originally expected?

Louis Hsieh

Yeah, it’s bigger and it’s longer than originally expected. It’s also the severance costs are actually higher, right, and because a lot of these employees have signed contracts through the fiscal year end, I mean in May. If you let them go now, you have to pay them through May anyway plus their severance cost. So, actually the severance costs are quite high. So, we are staggering the reductions between Q2, Q3, and Q4. So, it is taking longer Ella. And also like I said is the learning center binge of adding 238 learning centers in four quarters, the impact is much greater on our bottom line than it should have been. The truth is I think a lot of that problems happened in Q4 and Q1, especially in Q1 where we added 89 new learning centers. And I think that was the time that honestly Michael and I were distracted by the Muddy Waters and SEC stuff. And I think we took our eye off the ball a little bit, so now we are paying the price. So, we are working as hard as we can to fix the situation, but you still need one or two more quarters. So, you are right, we originally were hoping to see the worst of it in Q2 and turnaround in Q3. I think that’s been delayed one or two quarters. It’s harder to kind of take the cost out than I was hoping for originally.

Ella Ji - Oppenheimer

Got it. Thank you. That’s all my questions.

Louis Hsieh

Thank you, Ella.

Operator

Thank you. Your next question comes from the line of Jin Yoon from Nomura. Please ask your question.

Jin Yoon - Nomura

Yeah. Couple of questions. Just on the Shanghai side of the business, so can you expect that business I mean obviously the business has been in trouble over the last few years? Can you expect that business to actually bounce back without incurring, I guess, pricing I mean with the same level of pricing levers that you have in other areas, because you may have to do more discounting or whatsoever, because of the fact that competition in that market is a lot more severe or increase your headcount in sales and marketing our expenditures to kind of entice the students back into that market. Can you bounce that business back with the same margin profile as some of these other cities? And the second question is regarding your expansion I know that you guys expanded 200 some odd schools over the last year or so. Can you shutdown the same schools as quickly as you open them or their cost implication that don’t allow you to do that, because I assume that most of these new schools that you opened are the main reason for the cost structure. So given the fact that they are not going to be profitable in the near 12 to 18 months anyways, is it easier for them to shutdown as quickly as you open them? Thanks.

Louis Hsieh

Those are good questions. On Shanghai, the answer is I don’t know Jin, because Zhou Chenggang used to run Shanghai school. So, he has been dispatched back there to help (Tian Hou) fix Shanghai school, the whole brand new team there. I don’t expect us to go down in as far as pricing ever. So, I don’t know how fast will take it up. I think Shanghai is quite competitive, especially at the mid end. So, I think if we don’t - we have to be at the premium end. So, just a matter of the pricing I will leave up to them, the people on the ground there to figure out what’s the best strategy to increase market share again. As far as your question on the learning centers, it’s a good point. I think we expanded too fast over the last year and now we are going center by center looking at utilization. In some of the newer centers, we do have breakage clauses in the leases, which as we still have to incur a big cost of six months rent. So, it’s these kind of breakage costs and severance costs that are killing our bottom line this quarter and into the next two quarters. That’s why I did anticipate what the cost is to rationalize this business.

And so it is a big problem. We are trying to combine some of the centers, the ones that we have added and we are letting some leases expire, which are up for an expiration from four, five years ago. And then we are just using new learning centers to take that capacity. So, we are imagining the best we can which are right, the breakage costs are quite significant. And it’s not easy to close a learning center that was just opened a year or year and a half ago. So, the ones that are just no chance will eat the six-month breakage cost. The ones that are expiring will try to combine centers nearby to save cost. So, we are doing everything we can like I said to get over this learning center binge that we were on for a couple of years, right. It doesn’t solve itself in one or two quarters, it takes sometime. So, we are in the overhang in the hangover period.

Jin Yoon - Nomura

Great. Thanks Louis.

Operator

Thank you. (Operator Instructions) Your next question comes from the line of Steve Zhang from Macquarie. Please ask your question.

Steve Zhang - Macquarie

Hi, Louis. Just going on utilization, can you talk a little more about what your utilization is right now compared to a year ag, and perhaps where you hope to be by the end of the year?

Louis Hsieh

Yeah. I think our utilization for Q2 this last quarter was an all-time low. It’s embarrassing it was below 25%. And so I expect Q3 obviously to be much better than that and I would expect even our slow quarter Q2 to be somewhere north of 35%. And that’s why I think if you figure it out right, if we keep our revenues growing at 30% plus a year and we don’t add any more capacity that will take care of the utilization question next year. It’s the 238 learning centers we opened. That is the big problem in the 10,000 headcount we added. And so it takes a year or two to absorb that. In the Q3, we expect utilization to be probably in the north of 40%, 45%. And obviously, our summer is our best utilization period, which is usually north of 60%. So, this utilization is the focus. We want more students in the seats. We want the more classes being opened with full students. So, that’s why utilization is our number one focus.

Steve Zhang - Macquarie

Okay. And just follow-up, are you still planning to keep your net adds within 20 sschools or are you thinking about reducing that?

Louis Hsieh

We actually have fewer learning centers today than we did as of November 30th, that’s how strict to control on keeping on the learning center increase. We are not allowing any learning centers unless the school is really booming. It’s really doing well, like if Chenggang wants to open a learning center, I will let them. The profit margin is super high. Any of this center, we are not letting them open learning centers unless their utilization is really high. And so, that’s why we are tracking utilization very closely now. You understand that it took a crisis for finance to take control of that process. It used to be that any VP could approve a learning center opening. And so school heads would just go to the VP that had a good relationship with and get approval as they were just keep opening learning centers. That was the easiest way for them to meet the revenue numbers and to expand the footprint, which is what our target was for them is to be number one, number two. So, they thought that it’s the bigger profitability would take care of itself, it didn’t work out that way. So, now finance has control of new center openings and we are being very – we have taken that away from operations. And so we are being very strict, like I said, the 18 that were opened last quarter, I think all were opened before we took that approval process. So, we basically approved like maybe one or two new openings since then for the last couple of months and we closed we have let 8 or 10 in close. So, we actually have fewer learning centers today two months into Q3 than we did at the end of Q2 in November. So, you can see that finance is much tougher to deal with for the school heads than their neighborhood Vice President was.

Steve Zhang - Macquarie

Okay, thank you.

Operator

Thank you. Your next question comes from the line of Fei Fang from Goldman Sachs. Please ask your question.

Fei Fang - Goldman Sachs

Hi, Louis and Sisi. Thanks for taking my question. Regarding the ASP increase, of course other segments, the trend has been very strong. So, how long do you think the momentum will last, especially as you execute the Harvest the Market strategy meaning probably the upside for enrollment growth could be limited. Can you give medium-term ASP increase guidance?

Louis Hsieh

I think it will continue about the same. I think part of the way we get the profit margin up is I want to increase prices, especially at the kids’ level. I think we’ve got each of our product lines high-profit model. So, I think we will continue to take prices up on a blended basis in the 16%, 17% range, so 14% for apples-to-apples and higher than that because of mix. So, I don’t see any slowdown in that. I think the key is to just slowdown is to increase utilization. If we do that, we don’t have a demand problem right, our enrollments even with these price increases are still growing back up again. We had a slow quarter in Q2, but they are rebounding in Q3. So, I think it’s not a demand problem it’s a cost problem for us. And I think the way we get the cost issue under control as utilization and control the learning centers, so there is no expansion. We still have pricing power is my point.

Fei Fang - Goldman Sachs

I understood. So, can we just briefly talk about the cost side as well, noticed that the increase of your sales and marketing expense has been outgrowing the revenue in the past few quarters. So, do you think it was partially driven by a business mix shift towards the more sales driven one-and-one business?

Louis Hsieh

That’s exactly what it is.

Fei Fang - Goldman Sachs

So, if that’s the case, can we assume that sales and marketing will sort of structurally outgrow revenue going forward?

Louis Hsieh

No, because we were trying to push more people to one-on-five. We are trying to curtail the one-on-one growth too, so we don’t want to open any more learning centers. So, the problem more take care of itself in the fact that one-on-one students will have to go at the existing centers and because we are not opening up new centers that will mean that the growth will slowdown on its own and we will push increased utilization in the existing centers, which is we won’t be adding a lot of more sales people, sales and marketing people there, because we are not adding centers, right, so that will take care of itself.

Fei Fang - Goldman Sachs

Thank you, Louis.

Louis Hsieh

Yeah.

Operator

Thank you. Your next question comes from the line of Vivian Hao from Deutsche Bank. Please ask your question.

Vivian Hao - Deutsche Bank

Hi, Louis. Thank you for taking my question. First of all, it’s a question on your guidance, so like-for-like you are guiding about 22% to 27% growth, but if I remember correctly last year was a abnormal seasonality of a shorter winter break between Chinese New Year and also New Year, but you are indicating the enrollment growth has recovered to 15%?

Louis Hsieh

The oversea test preps.

Vivian Hao - Deutsche Bank

Yes, just try to understand if it’s on easier compensation, why the guidance is still within this moderate range? This is my first question.

Louis Hsieh

Well, I don’t think 30% growth is moderate. I mean, if you look at our competitors, they are growing about 15%, 20%, whatever the other ones have announced. So, I don’t think it’s moderate. Number two is that don’t forget, it’s a double-edged sword, Chinese New Year was early last year, because of that actually the enrollments for Q2 were impacted. So, if you think about it, last year the enrollments from overseas test prep were front loaded into Q2, that’s why we have 7% enrollment decrease this year, right. So, it’s a double-edged sword because January 23rd was Chinese New Year last year, this year it’s February 10. The later Chinese New Year actually hurt Q2 enrollments. Right, so it goes, it cuts both ways. That’s why I always asked you guys don’t look at it on a quarter-by-quarter, look at it year-over-year. Right, so don’t compare quarters, because of the timing of certain holidays affects the timing of certain enrollments. So, Q3 should benefit means there is nothing wrong with overseas test prep by enrollment popping back up, because Q2 was down. Q2 was down, because last year Chinese New Year was so early, so pushed enrollments into Q2 of last year. Does that make sense?

Vivian Hao - Deutsche Bank

Okay.

Louis Hsieh

Yeah. So, you understand it, that’s why if you take year-over-year it’s fine. If you take the whole year, don’t just look at one quarter, that’s why I tried to explain to you during the script part of this call that we saw bounce back already. So, it’s not the oversea, you can write the overseas business off as dead. It fell this Q2 because last year Chinese New Year was early. So, the enrollments came in early, which means and so Q3 was weak, because Q2 was stronger. This year is the exact opposite. So, overall if you look at it, it’s the same. We are still seeing strong growth in overseas.

Vivian Hao - Deutsche Bank

Okay.

Louis Hsieh

Okay.

Vivian Hao - Deutsche Bank

Right. My second question is in terms of your center rationalization, you are saying that the key focus is on utilization improvement, so do you think I mean do you think that the students will naturally go from one center to the other EDU because you combine it or there will be certain permanent loss of traffic because of closing down of some of the unprofitable centers?

Louis Hsieh

I think there will be a permanent loss. I expect – fully expect a permanent loss of some students because of inconvenience. But that’s better than running a whole bunch of unprofitable centers, because they are cannibalizing each other. So, like I said, I don’t think our Occupy the Market strategy was wrong, it was correct. Basically we occupy the whole national market in the big cities. We have the position we want. We have the long-term brand name, the long-term market position we want being number one or number two in each city. I think we overdid it. I think when we went into 238 centers in one year is too much, it was my decision last year we would open 120 as I told you guys it’s just unfortunately I didn’t have control of that process last year, I do now. So, you will see us – so we will go from one way where we opened too many centers 238, to go the other way where we opened probably less than 50. And over two years that will take care of itself, yes. So the long answer is yes, Vivian I expect some permanent loss, but honestly I don’t care I have got to get this the profit margin up.

Vivian Hao - Deutsche Bank

Okay great. Thank you.

Operator

Thank you. Ladies and gentlemen, we are now approaching the end of the conference call. And I would now turn the call back to New Oriental’s President and CFO, Louis Hsieh for his closing remarks. Thank you.

Louis Hsieh

Thank you again everyone for joining in today’s call. If you have any further questions please feel free to contact me or any of our investor relations representatives.

Operator

Thank you. Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: New Oriental Education & Technology Group's CEO Discusses F2Q 2013 Results - Earnings Call Transcript

Check out Seeking Alpha’s new Earnings Center »

This Transcript
All Transcripts