New Oriental Education & Technology Group F3Q09 (Qtr End 02/28/09) Earnings Call Transcript

| About: New Oriental (EDU)

New Oriental Education & Technology Group (NYSE:EDU)

F3Q09 Earnings Call

April 21, 2009 8:00 am ET

Executives

Louis Hsieh - Chief Financial Officer

Sisi Zhao - Investor Relations Manager

Analysts

James Mitchell - Goldman Sachs

Catherine Leung - Citigroup

Mark Marostica - Piper Jaffray

Paul Keung - Oppenheimer

Adele Mao - Susquehanna Financial Group

Amy Junker - Robert W. Baird & Company

Jeff Lee - Signal Hill

Marisa Ho - Credit Suisse

Brandon Dobell - William Blair

Operator

Good day ladies and gentlemen and welcome to the third quarter 2009 New Oriental Education & Technology Group earnings conference call. My name is Josh and I will be your coordinator for today. (Operator Instructions)

I’d now like to turn the presentation over to our host for today’s call, the New Oriental Senior Investor Relations Manager, Sisi Zhao. You may proceed.

Sisi Zhao

Hello, everyone. Welcome to New Oriental’s third fiscal quarter 2009 earnings conference call. Our third fiscal quarter earnings results 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 Chief Financial Officer. 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 US Private Securities Litigation Reform Act of 1994.

Forward-looking-statements involves inherit risks and uncertainties. As such, our results may be materially different from the views 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-statement, except as required under applicable law.

As a reminder, this conference is being record. 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 CFO, Louis Hsieh. Louis, please?

Louis Hsieh

Good morning or good evening to everyone on the call and thank you for taking the time to join us today. I will begin by discussing some of the highlights from the quarter before taking you through the financials in greater detail.

As most of you know, the third quarter is typically New Oriental’s second strongest quarter with school aged children taking advantage of their winter holidays to attend New Oriental courses in English, all subjects training and test preparation.

This year we saw a revenue increase of 36.1% year-over-year even as the business was negatively impacted by two main factors. First, as we discussed in our press release in mid-February, when we adjusted the revenue guidance downwards for the quarter due to the weak macro economy and led lower anticipated enrollments in our adult English courses. Even as we continue to grow slightly year-over-year, these enrollments grew slightly year-over-year reaching 50,300 for the quarter, up from approximately 50,100 in the year ago period.

Second, our third quarter results were impacted by the early timing of the Chinese New Year holidays, which began on January 26 this year, almost two weeks earlier than in 2008. As a result of the compressed timeframe between when students completed their regular school sessions and the beginning of the early Chinese New Year holiday, our schools in Shanghai, Nanjing, and several other cities experienced scheduling problems with students’ regular school sessions leading to a dramatic slowdown in enrollments in the second half of January.

This said, we did see a strong pickup in enrollments during February, as total enrollments for the third quarter increased by 31% reaching 351,700 students from 268,400 in the same period last year, totaling so far this year 1,189,000 enrollments in our first three quarters. We are confident that we will reach the high-end of our fiscal year 2009 enrollment target of 1.475 million to 1.5 million student enrollments.

This solid enrollment growth helped to achieve year-over-year net revenue growth of 36.1% exceeding the high-end of our revised guidance. This is keeping in mind the difficult year-over-year comparison given our exceptional performance in Q3, 2008 when we saw a revenue growth of 46.9%, student enrollment growth of 34.8%, and then income growth of 38.1% compared to Q3, 2007.

If you followed New Oriental since our IPO, you know that the cornerstone of our business is the strong cultural emphasis Chinese families place on early education for their children combined with New Oriental’s leading national brand and reputation as the best provider of supplemental education. This continues to be the case with demand for our kids and middles in high school English course offerings seeing strong growth helping us offset weaker demand for adult courses.

Turning now to look at these business lines in more detail; New Oriental’s POP Kids English program remains one of our most popular offerings with children from ages 5 to 12 taking courses that blend humor and learning, and encourage students to engage making learning fun.

In the third quarter, Kids English experienced enrollment growth of 48% year-over-year bringing total enrollments up to about 86,000 for the quarter. For the first nine months of 2009, enrollments in Kids English reached 240,400, an increase of over 50% over the first nine months of fiscal year 2008.

To capitalize upon the successful and growing Kids English offering, during the third quarter we continued to expand our nation-wide network of schools and learning centers, opening a net of nine new learning centers in various cities throughout China.

We also opened a new kindergarten in Nanjing. As of February 28th, 2009, our total number of schools and learning centers was 257, up from 247 at the end of the second quarter of 2009. Another strong driver of growth is our all subject middle and high school training programs, U-Can.

During the third fiscal quarter, we continued to roll out U-Can in new cities throughout China and as of February 28th, 2009, it was available in over 30 cities with total enrollments for the third quarter exceeding 18,600.

In addition to this, the two acquired gaokao training schools, Mingshitang and Tongwen, also offered short term training courses for students preparing to take the gaokao this June, helping them achieve short-term enrollments of over 5,100 for the third quarter.

For the first [nine] months of 2009, enrollments in middle and high school of non-English courses surpassed 45,000 enrollments bringing us into the range of 40 to 50,000 that we had previously targeted for the entire 2009 fiscal year.

Though we are pleased to have reached fiscal with one quarter fiscal year 2009 still to go, we expect to see continued synergies between all subjects training and our traditional language and test preparation offerings. In order to capitalize on this trend, we will continue expanding our U-Can offerings to existing cities while rolling out new programs in new cities.

Looking ahead, we see much to be optimistic about. Education of their child or children will continue to be the top priority for Chinese parents and as we expand our offerings to meet a wide range of educational needs, we are confident that families will continue to turn New Oriental as their children’s lifelong education partner.

Now I’ll take you through the financials for the quarter. Please note that certain figures I will refer to that exclude share based compensation expense are non-GAAP. U-Can find the reconciliation to these figures to GAAP in the financial table at the end of the earnings press release.

For the third fiscal quarter 2009, we reported net revenue of $65.4 million representing a 36.1% increase year-over-year. Net revenues from educational programs and services for the third fiscal quarter were 60 million, representing a 34.7% increase year-over-year. The growth was mainly driven by an increase in the number of student enrollments, in language and test preparation courses.

Excluding share based compensation expense non-GAAP operating costs and expenses for the quarter was $52.7 million, a 47.9% increase year-over-year. GAAP operating costs and expenses for the quarter were $56.8 million, a 49.7% increase year-over-year.

Cost of revenues increased by 40.9% year-over-year to $26 million, primarily due to the increased number of courses and the greater number of schools and learning centers in operation. Selling and marketing expenses increased by 51.9% year-over-year to $10.5 million, primarily due to brand promotion expenses.

Non-GAAP general and administrative expenses were $16 million, a 55% increase year-over-year. GAAP general and administrative expenses for the quarter increased by 61.4% year-over-year to 20.2 million primarily due to increased headcount as the company expanded its network of schools and learning centers.

The total share based compensation expenses allocated to related operating costs and expenses increased to $4.1 million in the first fiscal quarter of 2009 from $2.3 million in the same period of the prior fiscal year. Share based compensation expense should drop below $4 million in the fourth quarter of 2009, fiscal quarter, so the next quarter.

Non-GAAP income from operations for the quarter was $12.8 million, a 2.4% increase from $12.5 million in the same period of the prior fiscal year. Non-GAAP operating margin for the quarter was 19.5%, compared to 25.9% in the same period of prior fiscal year.

GAAP operating margin for the quarter was 13.3% compared to 21.3% in the same period of the prior fiscal year. The drop in operating margin was primarily due to decreased operating efficiency, as the growth in operating costs and expenses outpaced revenue growth.

We also accrued a large amount for staff bonus payments in 2003. I’m sorry, in Q3 2009, which negatively impacted operating margins. Going forward, we expect to see a positive margin trend as the average class size is now decreasing as fast as previous quarters. If you strip out VIP, the average class size in the third quarter of 2009 was about 35 students in a class as compared to around 38 students in a year ago period.

Additionally, ASP for the third fiscal quarter of 2009 grew approximately 11.8% in RMB terms, and approximately 18% in US dollar terms to $169, up from $143 in a year ago period. Both of these factors should lead to higher margins in future quarters.

Non-GAAP net income was $14.5 million representing a 4.3% increase in the same period of the prior fiscal year. Basic and diluted earnings per ADS excluding share based compensation expense, or non-GAAP was $0.39 and $0.38 respectively.

GAAP net income for the quarter was $10.4 million representing a 10.3% decrease from the same period in the prior fiscal year. This decrease was due in part to the increased bonus accrual in the quarter as compared to last year and approximately $1.8 million increase in stock-based compensation expense as compared to last year to $4.41 million in this quarter. Basic and diluted earnings per ADS was $0.28 and $0.27 respectively.

Capital expenditures for the quarter were $4.4 million, which is primarily used to add one new school and a net of nine new learning centers during the quarter. As of February 28, 2009 New Oriental had cash and cash equivalents of $224 million as compared to $182.8 million as of November 30, 2008. In addition, the company has $62.5 million in short-term deposits at the end of the quarter. Net operating cash-flow for the third quarter of fiscal year 2009 was $21.7 million.

The deferred revenue balance at the end of the third quarter of fiscal year 2009 was $55.4 million, an increase of 54.8% compared to $35.8 million at the end of the third quarter of fiscal year 2008. Deferred revenue where students enroll and pay for courses to be complete in the future quarters, as most of you know, is essentially a measure of backlog for New Oriental.

Before I give guidance I would like to take a few, a brief look at the comparison between the first nine months of fiscal year 2009 and the first nine months of fiscal year 2008. Student enrollment in language training and test preparation grew 23.1% year-over-year to 1,189,300 or approximately 966,500 in the nine months ended February 29, 2008.

Net revenues were up 45.0% year-over-year to $233.1 million. Excluding share-based compensation expense non-GAAP operating income was up 37.6% year-over-year to $70.7 million.

GAAP operating income was up 28.7% year-over-year to $58.4 million. Non-GAAP operating margin went from 32% for the first nine months ended February 29, 2008 to 30.3% for the nine months ended February 28, 2009. GAAP operating margin went from 28.2% for the first nine months ending February 2008 to 25.1% for the nine months ended February 28, 2009.

Non-GAAP net income was up 32.7% year-over-year to $70.6 million. Non-GAAP basic and diluted earnings per ADS for the nine months ended February 28, 2009 was $1.90 and $1.84 respectively. GAAP net income was up 23.5% year-over-year to $58.4 million. GAAP basic and diluted earnings per ADS for the nine months ended February 28, 2009 were $1.57 and $1.52 respectively.

Moving onto revenue guidance, we expect our total net revenues in the fourth fiscal quarter of March 1, 2009 to May 31, 2009 to be in the range of $50.5 million to $53.5 million, representing year-over-year growth in the range of 25.7% to 33.2% respectively. This forecast reflects New Oriental’s current and preliminary view, which is subject to change.

As our reporting currency is the US dollar and our operating currency is RMB. We have benefited from currency translation gains during the periods when the RMB appreciates against the US dollar, which has been the case in the last several quarters when the RMB consistently appreciated against the US dollar by 8% to 10% year-over-year.

Our revenue growth for financial reporting purposes benefited from such appreciation, but given the current trend in the third and fourth fiscal quarters 2009 as the RMB/USD exchange rate has stabilized, our currency translation gains will shrink accordingly.

Once again, thank you for participating in our quarterly conference call. At this time, I’d like to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from James Mitchell - Goldman Sachs.

James Mitchell - Goldman Sachs

A couple of small questions, one was about the amounts of the staff bonus accrual. Could you give us some sizing around that and just confirm. I think last year you took that in the first quarter of the fiscal year whereas this year you spread it more evenly between the first and third quarter. And then the second question was around the tax rate?

Louis Hsieh

On the bonus issue is that last year in fiscal year 2008, we had a phenomenal summer, Q1 summer quarter, so we took a larger percentage of our bonus accrual. We’ve also since then changed our bonus policy to pay bonuses basically twice a year. One in February to the staffing and teachers for Chinese New Year, which is traditional in China.

The second for executive bonuses are now paid in the summer during July, August timeframe. So we basically begin to accrue bonuses accordingly and as you pointed out correctly James. We did take more bonus accrual this quarter, than we did last year at this time. The difference is between $600,000 and $800,000 which was bonus payments this quarter that was not made in the same period of last year for the teachers and staff. So that’s one issue.

On the tax rate, the tax rate was quite low this quarter because we had over accrued for taxes in Q1 and Q2, don’t forget we were applying for the emerging market status for several of our entities and until we got that, we basically accrued at a higher rate of over 12%. Our tax rate for fiscal year or calendar year 2009 should be somewhere between 11% and 12%.

So we did get a slight income tax benefit from taking back the accrual that we had over accrued for the last two quarters.

James Mitchell - Goldman Sachs

Great and the bonus went into the G&A principally?

Louis Hsieh

Yes, principally G&A, a little bit of marketing but most of it in G&A.

Operator

Your next question comes from Catherine Leung – Citigroup.

Catherine Leung - Citigroup

The first one is in terms of the margins. [Inaudible] approximately $3 million of revenues, which is about the amount that the guidance had been lowered in February. Even within that all disclosed to the bottomline, we are still looking at non-GAAP net margin about 25%. Then if our part is $600,000 to $800,000 on one-off, well the difference in the staff costs accrual treatment still looks like the net margin is down slightly in year-on-year basis.

Would you be able to help us quantify any other one-time reasons for this? I know that you said it on the conference call earlier that we’re still going to expect margin expansion in the next fiscal year. Would you be able to quantify as well the magnitude of the expansion?

Secondly, in terms of your network expansion, in the press release you had stated that you added nine learning centers. Are all these Pop Kids English centers? Can you share with us a little more detail on these schools, for example, where these are located exactly and how fast these schools have been filling up in the past quarter? Thank you.

Louis Hsieh

The second question is easier for me. We added a net of seven new POP Kids learning center out of the nine learning centers that we added. We added it in various large and medium size cities. I don’t have the exact breakdown.

POP Kids English school centers aren’t that big. There are about 15 to 20 classrooms. So, typically, we fill up about 30% or 40% in the first year and about 60% or so in the second year. They probably top out around 70% to 80% in the third year, but they are profitable within the first year. So it’s one of our fastest growing businesses.

On the margin question, we are going through budgeting currently for 2010 fiscal year. We’re already into our last fiscal quarter. We do expect margin expansion, especially in the gross margin line as the class size begins to abate. We went from 38 to 35 students per class this quarter which means the class size is not falling as fast, whereas ASPs were up 11.8% in RMB terms year-over-year. So, we do expect some margin expansion in the gross margin area.

We are going to a debate now within the management team with regard to how much to spend on marketing. Its looks like we will probably begin to accelerate marketing spending. I think we’ve been in the 12% to 13% range. We may move that up to the 13% to 15% range, which would not be obviously favorable for net margins, for operating margins.

However, we’ve done calculations. When we spend money on marketing, it actually accelerates our topline growth many times fold that we spend in marketing. So, if we do increase the marketing spending, likely, we will increase our revenue growth beyond the 25% to 30% that we’ve been guiding.

So we do expect some operating margin improvement, probably in the 100 to 200 basis points for fiscal year 2010. I believe you’ll see some margin improvement in the fourth quarter of 2009 as well. Does that answer your questions, Catherine?

Catherine Leung - Citigroup

Can I also ask as a follow-up? What type of courses or are there subject studies that you will be concentrating your marketing spend on?

Louis Hsieh

We’re going to be concentrating on marketing spending on two areas. One is POP Kids English centers. So as we roll into more and more cities with more and more centers, we will continue to spend on marketing for that. Then second, of course, is our U-Can program.

We’re very delighted to see that our enrollments have exceeded our expectations and that we’re getting a lot of traction, especially in obviously the non-English subject areas. So those two programs are the fastest growing lines; Kids English and middle and high school English including gaokao and after-school tutoring. So those two areas are where we’re spending most of our marketing dollars. They have the highest payback.

Operator

Your next question comes from Mark Marostica - Piper Jaffray.

Mark Marostica - Piper Jaffray

My first question relates to your overseas test prep business. I am wondering if you could give us a sense of what type of enrollment growth and ASP growth you saw in that line of business in the quarter?

Louis Hsieh

For the quarter, we saw enrollment growth of a little bit over 13% to 51,100 students in overseas test prep. ASP’s was up approximately 20%.

Mark Marostica - Piper Jaffray

Then as you look into the fourth quarter, in the May quarter, can you give us a sense of what your plans are for new school and center openings, and prospectively are looking forward into fiscal 2010, how you’re thinking about new center and learning center and school openings?

Louis Hsieh

That’s a great question. I think as we are going to probably open more learning centers maybe one more school. We’ve already opened more than four to five that we typically would open, and we’ll probably open another 10 learning centers. So we will finish the year with approximately 60 to 65 new facilities versus last year.

I believe in 2010 fiscal year we are planning to open fewer schools probably two to three new schools or new cites or through acquisition. We will probably open about 45 to 50 new learning centers, primarily in the kids and middle school area. So, the ages 5 to 18 year olds in China the students there are our fastest growing businesses.

Mark Marostica - Piper Jaffray

Then a question on deferred revenue noticing past trends, I think this is the first quarter that I recall that your deferred revenue at the end of Q3 exceeds your guidance for revenue in the subsequent quarter Q4. I’m wondering why is that this time around and perhaps you could talk about how deferred revenue in Q3 flows into the upcoming quarters.

Louis Hsieh

That’s another very good question. We currently have deferred revenue of $55.4 million of which we believe approximately $35 million will come into this quarter Q3, Q4 sorry.

The other $20 million will flow into the summer quarter. As you recall that we have the scheduling issues in Shanghai and Nanjing and other cities. Where, because of the early timing of Chinese New Year, many students didn’t get out of class from the regular school until after New Oriental’s classes already started.

So we have basically miss timed the opening for those classes before Chinese New Year, because of that many of the students differed their enrollments until the summer. So they are repaid for classes instead of canceling their classes they just differ their enrollments into the summer quarter, we also saw that in February.

So even though we had very strong enrollment growth and a lot of enrollments in February most of that revenue will flow into Q4 which is why we have such a high differed revenue balance. So this year was a little bit unusual.

Mark Marostica - Piper Jaffray

Got it, and then last question Louis, regarding the adult business understanding you had some challenges there. Can you give us a sense for how the adult enrollment growth behaved on a year-over-year basis throughout the quarter just as you look at the various months December, January and February and as you look at the month of March now that’s behind you and presumably April as well. You got some sense how is that behaving on a sequential basis?

Louis Hsieh

Those enrollments are relatively flat. They were down in January primarily because I think of the timing of Chinese New Year this year. So they were way down in January. They were up in December because they were minus 3% in the prior fiscal quarter. So adult enrollments for the whole quarter was 50,300 was up 200 from last year. In March and April I don’t have the April numbers, in March they were relatively flat year-over-year.

So this is we believe primarily due to their financial crisis. And we can see it because the slowdown is primarily in the cities that are most export related, meaning Shanghai, Guangzhou, Shenzhen, most of the eastern coastal cities, large cities are the most impacted by the slowdown in adult.

So even though adult is not growing at least its not declining year-over-year now, and we’ve been benefiting from adults who are signing up for New Oriental classes, or signing up for smaller classes, which means they are paying us more.

So, ASP increases and adult English is up about over 15% year-over-year because of this trend. So there’s fewer students coming. I mean, there’s a slower growth rate, but they are paying more.

Operator

Your next question comes from Paul Keung - Oppenheimer.

Paul Keung - Oppenheimer

Two questions; first was a follow-up to what Mark has assessed about the preferred revenue. You mentioned about $20 million of that as of the end of the February quarter, duly for the December quarter, not to worry towards the end of April.

I am just curious while actually giving a sense of guidance at all; just how strong is that really suggest to you, because as I was preparing kind of numbers a year ago suggests that even the first quarter of 2010, [Inaudible] business part of it maybe because they are very deep comps; I don’t think for last year. So, maybe tell us a little bit more about that.

Second question has to do with the competitive landscape. You recently saw the acquisition of Wall Street English by Pearson and there was some other small business as well. What kind of multiples are these private companies going for and then what does it suggest to you. Do you think multiples come down to a point that you actually might see some opportunities again? Do you think it’s still a frenzy overpriced side multiples stay in marketplace?

Louis Hsieh

Good questions. On Q1, we’re very hopefully for a good Q1 obviously because Q1 is our most important quarter during the summer when Chinese students get two months off. I think the early indicators are that the summer will be good, given especially since we don’t have the Beijing Olympics to contend with as we did last year, but it’s still early.

We had a rapid February. Every time we have a rapid increase, we usually have a slower next month. So, March was, which we saw growth but not at toward base of February, where enrollments were up over 40%. So, I always ask investors and analysts alike to evaluate New Oriental on a rolling 12-month basis, because we have monthly fluctuations in enrollments and revenues.

So, we have a very strong quarter. We typically have a weaker one, the next one and it all evens out over 12-month that showed nice growth patterns. So for the summer, it’s early. The reason Michael is not on this call, because he is on the dream tour. So he is traveling around to 25 to 30 cities giving a lot of speeches and marketing to basically draw my business for the summer.

Now, as far as the competitive landscape, we did see that Pearson acquired Wall Street Institute. We don’t see much change in the competitive landscape. It depends on what Pearson does with Wall Street. We have always been competing with Wall Street at the very high end. So with our Elite English offering and our VIP offerings, don’t forget we came after them in the market. They’ve been established in the high-end white-collar markets in Shanghai and Beijing before we win this business at the high-end. So we will still continue to compete against them. We don’t see any change there.

As far as our own M&A strategy, we continued to be very disciplined on the multiples we paid. Because we signed a copy of that agreement, I’m not allowed to disclose the multiples that Pearson paid for Wall Street based on their projections for 2009, but New Oriental has been making acquisitions at single digit multiples based on forward 12-month GAAP net income. So we continue to be disciplined.

Now, we do see a number of opportunities in the areas that we discussed which is primarily, number one, competitors in large cities, number two is domain knowledge we don’t have, and number three is gaokao re-taker schools. So we are basically in the process of integrating Tongwen and Mingshitang. They are going in quite smoothly. So we’ll begin to look at acquiring additional gaokao re-taker schools. Does that answer your question Paul?

Operator

Your next question comes from Adele Mao - SIG.

Adele Mao - Susquehanna Financial Group

Given that you are planning on accelerated marketing budget for fiscal year 2010, what level of enrollment growth you will be targeting for the year, and if you could also discuss your plan on tuition increases, that would be very helpful?

Louis Hsieh

I think they go hand-in-hand. So what happens is, if we increased prices more, we’ll get lower enrollments. If we market more, we’ll get higher enrollment. So it’s interplay between marketing dollars and also price increases.

So I think as we’ll begin, we’ll kind of monitor this over the quarter. We are basically targeting 15% enrollment growth and probably 10% ASP increases on a blended basis. That includes, because students are picking smaller class sizes. So we expect revenue growth in the range of 25% to 30% next year.

Now, obviously, if we don’t increase prices as much, we will probably get higher enrollment growth. So, it’s one of those things that we were constantly fiddling with to see what the maximum amount of the total marketing spend versus return and price increases versus enrollment growth.

Adele Mao - Susquehanna Financial Group

My other question is related to future salary. Could you just give out the numbers of part-time versus full-time teachers in the quarter? How many new teachers did you add in the quarter?

Louis Hsieh

Adele, give me one second. I have to pull that information out. I don’t have them handy. We ended up with 4,900 and so teachers by the end of the quarter. That’s what I recall. I’m looking to putting it now. For the quarter, we added a net of 530 new teachers. We have a total now of 10,450 employees within New Oriental.

Adele Mao - Susquehanna Financial Group

I remember you mentioned last quarter that 3% to 5% salary increase was approved for current employees. When are we going to see that salary increase hitting--?

Louis Hsieh

Prior to this quarter. It was approved just before Chinese New Year.

Adele Mao - Susquehanna Financial Group

So it’s already being reflected.

Louis Hsieh

Yes, it took effect on February 1. So you saw it partly in this and partly, you’ll see it in Q4.

Adele Mao - Susquehanna Financial Group

For the new teachers that you have hired, are you able to recruit for less because of the availability of college graduates out there in China or do you feel that the labor cost is actually increasing perhaps with the shortage of the qualified teachers?

Louis Hsieh

Well, we increased staff salaries and teacher salaries approximately 4% for 2009 for this year. We haven’t decreased our salaries. They have gone up 4%. We probably could find teachers for less, but we want to make sure we hired the best quality teachers. We train them. So we have not reduced teacher salaries even though the market is softer, employment market.

Operator

Your next question comes from Amy Junker - Robert Baird.

Amy Junker - Robert W. Baird & Company

I had a follow-up on the competitive landscape. In addition to Wall Street English, we came across the story that said that Disney is going to start to open some schools to teach children English. Are you familiar with that, how would you expect them to compete with you in given kind of the recognizable brand name. Do you have any idea if they are going to compete with you on price or any comments you would have on that?

Louis Hsieh

I think Disney has opened some centers in Shanghai and it’s ironic, because we had the discussion with them before IPO though three or four years ago to open up high end English schools throughout China with New Oriental running them with Disney’s brand name. So they took the idea obviously and ran with it.

There we don’t compete directly with them because they are priced well above us. They are priced more than double or triple what we charge for kids. So we after the vast market middle and up and they target the very high end.

I believe they’re still using the content that was developed by Pearson, which is what New Oriental uses. So the content is very similar but Disney customized it with their characters and with their brand on it.

So I believe that the English, the kids English market is huge in China and still growing and so I think there is as we compete with 30,000 other language training schools and test prep schools Disney obviously given its great brand name and it’s a well run company is going to be a competitor, but I think they are typically priced well above what most of our POP Kids offerings are.

Amy Junker - Robert W. Baird & Company

Just given the macro environment that you have seen, have you noticed any material difference in the enrollment ramp of any of your new schools as you have been opening those up this year are they behaving kind of similar to what you have seen in years past?

Louis Hsieh

The new schools are behaving similar to two years past, but we believe that we get much more bang for a buck by opening learning centers in existing cities, because as many of you have heard, we haven’t really penetrated any city to maturity yet and so we are going to aggressively rollout U-Can and Kids over the next year. That’s our primary strategy in existing cities, because the Kids programs are only six or seven years old. It’s growing 50% a year and U-Can is brand new.

So, if you think about it, we will probably have enrollments of close or over 1.5 million enrollments this year. 600,000 of them will come from ages 5 to 18 and so the 5 to 18 year old group will have doubled in less than three years. So that’s where we are going to focus our attention, as you also know Amy, it’s a life long value of that student. The younger we get them into New Oriental system, the longer they typically stay with us and the more they’ll pay us over their life times.

Operator

Your next question comes from [Hung] - Brean Murray.

Hung - Brean Murray

Louis, just quickly, what is the currency assumption built into your forward guidance?

Louis Hsieh

Our currency assumptions are basically the same as they are now which is 6.8395 is what we use for the income statement for fiscal year, for this last quarter.

Hung - Brean Murray

So if I take out your currency from your guidance and also the currency appreciation from this quarter’s growth, for some reason, I am actually seeing a decelerating top line growth share even though your marketing spending is increasing. Could you give us some color on that?

Louis Hsieh

I think our RMB growth rate in the quarter was 28.2% and it is slightly lower and that’s primarily because of the slowdown in the Adult English as we mentioned and number two is because of the scheduling problems we had in Shanghai, Nanjing and several other cities.

As Catherine mentioned earlier, those two issues account for about $2 million to $3 million. So if you add that back then you’ll see that our growth rate hasn’t really decelerated and you’ll see that, but I think as overall our long-term growth of course would decelerate because of the large numbers.

If you think about it, for last year we added 200,000 net new enrollments for fiscal year 2008. For fiscal year 2009 we should be very close to 250,000. So actually our business is actually growing very healthily. It’s just that we are going to get hit with the law of large numbers where the denominator of what we are comparing is getting bigger and bigger.

Hung - Brean Murray

Right, and also just looking at your top line growth conceptually, if I take out enrolment growth and currency growth for some reason I’m seeing a negative year-on-year AFP growth number this year.

Louis Hsieh

No. AFP growth is about 12% to 14% year-over-year in RMB terms. Cuts in dollars, so cuts in RMB terms, our AFP is way up.

Operator

Our next question comes from the line of Jeff Lee - Signal Hill.

Jeff Lee - Signal Hill

Louis, can you talk more about the impact of the economic fastness, I mean obviously it’s seen on the Adult English market. Is there anywhere else where you are sort of seeing that?

Louis Hsieh

We’re primarily seeing it right now Jeff in the adult segment. I am sure that it is probably impacting us in the margin at the middle and high school as well as kid’s level. So, by example, a family may send their child to two or three New Oriental classes a year, because of financial constraints, they may reduce the number to one or two, but it’s unlikely to go to zero. So, we may see that at the margin, but right now is we’re seeing it primarily in the adult sector.

Jeff Lee - Signal Hill

Can you talk about rents and personnel expense? How much did they grow in the quarter? How do you expect them to trend going forward?

Louis Hsieh

Well, personnel expense is easier for us, because we kind of set salaries once a year. We increased salaries by 4% in February. As far as the rent expense, for new learning centers and others, we aren’t seeing a double-digit increase as we had in past years. So 2007 calendar year, we saw double-digit increases. Now, they are low single-digits.

So that’s why we believe that we should get some margin expansion is because our teachers’ costs and rent, which are the two biggest components of cost, are going up low single digits. We are still able to raise prices on apple-to-apple classes between 8% and 10%, which give us 400, 500 basis points improvement in margin.

Jeff Lee - Signal Hill

Last question; the ASP increases, how variable are they across different programs? How sustainable do you think these increase are given the economic softness?

Louis Hsieh

Obviously, we get this question hundreds a time in the quarter. So far, we have been able to increase in ASPs for overseas test prep in the range of 15% to 20% a year. For Kids English, it’s much lower. It’s around 8% or 9%.

For middle and high school, it’s about 10% to 12%. So those are our three fastest growing lines. Adult sector, we’ve been increasing price over 15%, but that’s only because adults are picking more expensive options. They are picking smaller classes options in large numbers.

Finally, we are seeing a trend where almost 4,000 students signed up this quarter for VIP, meaning one-on-one instructions. The average ticket there is over $1,100. So that kind of, obviously, affects the ASP as well. So, we are seeing the wide range. On an apples-to-apples comparison, we’re still increasing prices around 8% to 9%, and that’s been the case for the last four-five years since I have been in New Oriental.

Jeff Lee - Signal Hill

You are not seeing really any pushback from an economics profits?

Louis Hsieh

No, I think as our competitors are doing about the same thing. Remember, price usually typically factors third in a family’s decision, where brand name is the first consideration, location is the second consideration. How far are we from their home or their school? Price is usually the third consideration.

Operator

Your next question comes from James Mitchell - Goldman Sachs.

James Mitchell - Goldman Sachs

One question was with regards to the pursue increase in marketing spending to 13% to 15% of revenue. Is that a response for the competitive environment or is that just more desired ship to grab land while it’s available?

Louis Hsieh

It’s really the second, James. It’s really that we’ve seen that, when we spend $1 marketing in kids and middle school, we get $3 to $5 in revenue. Whereas we spend $1 in marketing adults, we don’t get much for it.

Also, because we are trying to rollout U-Can as a brand new program for us and because we’ve been extremely successful in the first year, we’re beginning to feel very confident that this program has a lot of legs and have a long way. When you think about it, if you combine the ages 5 to 18 markets, this market dwarfs English language training and overseas test prep. The market is three or four times larger.

So, you could imagine that in such a large market and when we’re in such as the first inning of this trend that we are going to go after this as hard as we can to your market share because if we get a child when they are 6 to 12, they typically stay with us for many, many years.

James Mitchell - Goldman Sachs

Second question; I’m probably over analyzing this, but I think you said that you are confident you should be around the high-end of your enrollment target of 1.5 million high-end in fiscal ‘09. That would imply about 310,000 enrollments in the fourth quarter, which will be kind of flat year-on-year against 301,000 in the fourth quarter last year. Is there any reason why enrollment growth might be slow year-on-year in the fourth quarter of this year or…?

Louis Hsieh

It would only be because enrollment growth is so strong in Q3. So it’s like you said, that’s why I made the comment that we wish that investors and analysts would track us over six-month or 12-month basis. Because if you look at the call in Q1, we had a very strong enrollment growth is well over 20% for the summer. Then we had a slow Q2, where enrollment growth was only 13%.

All that meant was there was pent-up demand that we had enrollment growth of 31% in Q3. Well, 31% is double what our normal growth rate is. So we would expect that to fall in Q4. Then at the end of the day, if you look at 12 months going basis, we typically grow about 18% to 20% enrollments and about 35% in revenues.

James Mitchell - Goldman Sachs & Company

Right. In this quarter last year that we are now in, the earthquake was to--?

Louis Hsieh

Was in the May quarter or in the May month. So it’s a last three weeks of the quarter. So, yes, I mean yes, that we have easy comparisons this quarter. So that’s why I think we are confident that we will be above the 1.5 million rate. We’ll exceed that number.

Operator

Your next question comes from Marisa Ho - Credit Suisse.

Marisa Ho - Credit Suisse

Could you remind us of the actual ASP achieved for the full product areas, please?

Louis Hsieh

Let me have that to get all that out. You mean the actual U.S. dollar numbers?

Marisa Ho - Credit Suisse

US or…?

Louis Hsieh

I’m sorry, I don’t have it right in front of me. I just have the growth numbers to be honest, Marisa, is that okay?

Marisa Ho - Credit Suisse

Going back to one of the earlier questions, I mean on the 28% local currency revenue growth vis-à-vis the 31% and Roman growth and over the years still looking at positive ASP accretion on a year-on-year basis. Are we are looking at a relationship because you are looking at the mix shift towards the POP Kids English and tends kind of buy us in the actual ASP number dollar?

Louis Hsieh

POP Kids does have a lower ASP on average, but don’t forget because of raising prices across the board, the ASP will still go up year-over-year. Also, even in among POP Kids, right, they have two choices. One is a smaller class, 15% class and one is the 25% student class, which is about 35% cheaper. So even in POP Kids, it’s tiered.

I have the numbers now, Marisa. On overseas test prep, our average ASP was about $350. On high school including U-Can, the average price point was about $120. For Kids, it’s about $125 per course.

Marisa Ho - Credit Suisse

Also, on the tax rate in the third quarter, can you quantify the amount of over provision that was written back during the third quarter?

Louis Hsieh

I don’t have that rate. We paid 200,000 something in taxes, but you can figure out that our tax rate going forward is about 11.5% to 11.8%. So we had accrued a 12.2% rate in the first two quarters. So we got a little bit back. It’s in the range of little bit of over $0.5 million. Okay, I don’t know the exact number. You can contact Sisi for the exact number.

Operator

Your next question is from Chris Shuttler - William Blair.

Brandon Dobell - William Blair

Hey Louis its Brant for Chris. Just two quick ones here; the margin expansion number you talked about 100 to 200 basis points. Is that a GAAP number or is that excluding stock-based comp? How should we think about that, how are you talking about that?

Louis Hsieh

Stock-based comp is going to decrease in the quarters ahead as you know. So it’s going to go below $4 million this quarter. It will go up a little bit in Q1 as the August, and I won’t go, I mean, just stay relatively flat and they will drop significantly in Q3 of next year when the ‘07 options go away. The ‘07 options have been about $9 million a year and so we will have new grants, but they won’t be into that level.

So I would expect margin expansion. GAAP basis we are actually exceeding non-GAAP. So we’re at that tipping point now. The reason is our stock-based compensation was the highest this year was about $17 million. It would drop to between $12 million and $14 million next year and then hopefully would drop again excluding any acquisitions or very expensive hires.

So I think it’s that we would expect 100 to 200 basis points improvement from the ‘09 numbers in gross margin and we would expect probably something even better than that on the bottom line, on the operating margin and on the net margin. But don’t forget 2009 we were basically hurt by two main events.

We started off in the whole 250 basis after Q1, because of the Beijing Olympics. And then we didn’t execute well in Q3 in Shanghai school and Nanjing school in scheduling. And so we’re never again to dig ourselves out of that hole.

Brandon Dobell - William Blair

Okay. Then, if you look at the Kids business, if you could talk about the gross margin profile and the operating margin profile. I guess in the context of one of your competitors saying they hadn’t made any money in Kids and I don’t know. Its 5, 10, 15 years, something like that, just trying to get a feel for your level of confidence around your ability to make money in the operating line. How do you get to a decent operating margin number in Kids? Is it just, there is lower expense associated with a lower gross margin or is it a…?

Louis Hsieh

I think you are talking about English First, and they have a different model than we do right. They are trying to feed in the high end. Them and us are the biggest competitors of Wall Street, at very high end in White Collar English, and they use Kids as the last leader.

So they have a different motive. We use kids as bread and butter, because we don’t plan to just offer kids English. We plan to offer kids math and Chinese and other classes as well, and also I think EF is priced at a price point above New Oriental as well.

As far as your question on margins, if you take a standalone kids center, we should get over 60% gross margin from that center within the first year, year and half operation. When the center is mature after three years, it should generate gross margin in excess of 65% and operating margin in excess of 30%, with still very, very good business, when its well run, but it takes about three years to mature to that level. As you know we have been expanding so fast that we don’t have that many kids centers that are three years old.

Operator

Your next question comes from Adele Mao - SFG.

Adele Mao - Susquehanna Financial Group

I have a follow-up question regarding Kids English growth. The enrollment growth this quarter is 48% year-over-year. I believe this is partially driven by an increase in your school count given that 77 new centers were added in fiscal year 2008 and I think so far 50 new centers were added in fiscal year 2009. Many of these centers are for POP Kids English.

How much of that growth is from new centers that opened during the past year. Is there more of an organic growth number that we can look at just, not on aggregate basis but rather growth on per school basis for the schools that have been…

Louis Hsieh

I think that the schools tend to track very closely to a 30% or 40% number in year one and then a 60% to 70% number in year two and then it tops at 80% in year three. But you’re absolutely right, is that as we open up Kids learning centers near schools and near large residential areas, we’re seeing a very rapid ramp up in kids enrollments.

So, I don’t know the exact breakup, but the kid’s pattern is very simple. I think you know, typically if you build them in the right location the kids will come and you market correctly.

So, I don’t have the exact breakdown, but I think is that a lot of the growth in the kids area. If a learning center is three years old, it’s probably not growing much, its not contributing to growth, but a new center is probably, obviously in the first year is going to add a 1000 plus students and then in the second year it would double.

Adele Mao - Susquehanna Financial Group

Okay so for the POP English centers that has been there for the past let say three or four years. Would you be opening new kids learning centers around that center –

Louis Hsieh

We’ll probably open in other locations near other schools.

Adele Mao - Susquehanna Financial Group

Okay but in the same city.

Louis Hsieh

Yes in the same city, so that’s exactly right. So we’re opening up most of the kids centers in existing cities. We’re not opening in new cities. Number of convenience is more important to the families tipping in the price, right. So we need to be close in your elementary schools and elsewhere.

So if you think about it, we have a 127 schools and learning centers open in the last two years, probably 50% of them or more are kids centers, and so you can just do the math that they are going to contribute significantly. It will be 60,000 or so or 120,000 enrollments just from those new centers in the last two years.

Operator

(Operator Instructions) Your next question comes from [Inaudible].

Unidentified Participant

I think most of my questions have been answered.

Louis Hsieh

Thank you.

Operator

And at this time we are showing no further questions. Mr. Hsieh you may proceed.

Louis Hsieh

Well, thank you everyone for attending the New Orientals Q3 2009 conference call. We look forward to seeing you soon.

Operator

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

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