Noah Education Holdings Ltd. F3Q09 (Qtr End 03/31/09) Earnings Call Transcript

Noah Education Holdings Ltd. (NED)

F3Q09 Earnings Call

May 27, 2009 8:00 am ET

Executives

Dong Xu – Chairman, CEO

Dora Li – Chief Financial Officer

Rich Chen – Executive Vice President

Analysts

[Eco Hi – Oppenheimer]

Adele Mao – Susquehanna Financial Group

Presentation

Operator

Welcome to the Noah Education third quarter fiscal 2009 financial results conference call. (Operator Instructions) Joining the conference today are Mr. Dong Zu, Chairman and CEO, Mr. Rick Chen, Executive Vice President and Miss Dora Li, Chief Financial Officer.

After the close of the U.S. markets on Tuesday, Noah issued a press release announcing its third quarter fiscal 2009 financial results which are available on the company's IR web page at ir.noahedu.com.cn. This call is also being broadcast live over the internet and a copy of the presentation that will be used for today's call is also available on our web site.

Before management's presentation, I would like to refer to the Safe Harbor statement in connection with today's conference call. This call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 including certain expectations and goals which are subject to numerous assumptions and risks.

Forward-looking statements involve known and unknown risks and uncertainties many of which are beyond our control which may cause actual results to differ materially from any future results or achievements implied by such forward looking statements. The company's actual results could differ materially from those contained in the risk factor section of the company's final perspective or recent filings filed with the Securities and Exchange Commission. Unless required by law, the company undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

I will now turn the call over to Noah's Chairman and CEO, Mr. Dong Xu.

Dong Xu (Interpreted)

Good morning and to some good evening. Thank you for joining us today for our third quarter fiscal 2009 results conference call. I am pleased to report that we delivered another solid quarter, exceeding our revenue guidance and making some important operational and strategic progress. Our total net revenue increased by 16.5% year over year to 214.5 million RMB driven by strong momentum in KLD sales.

I am particularly pleased to announce that we have recently signed a definitive agreement to acquire 100% of Little New Star, a leading provider in Kids English language training in China. The transaction will propel our transformation from a leading provider of interactive education content into a more comprehensive supplementary education services provider.

The acquisition of Little New Star complements our ELP business by adding an already strong and well recognized Kids English training services segment to our business. This acquisition fits perfectly into our business expansion plans from a strategic growth standpoint and we expect to realize a number of growth and efficiency related synergies.

This transaction is also a testament to executing our well defined acquisition strategy. Specifically, we are advancing our goals to seek out strong businesses that further our vision of becoming a leading, comprehensive education services provider in China which is exactly what this acquisition does.

I will not turn the call over to Dora Li, our CFO to walk you through the fiscal third quarter financial results in more detail. Dora will be followed by Rick Chen, our Executive Vice President who will provide some additional insight into the Kids English training market potential as well as the growth opportunities that Little New Star will bring to us.

Dora Li

I'd like to begin with some of the key line items. We are pleased to report another quarter of solid results demonstrated by a year over year increase of 16.5% in net revenue to RMB 214.5 million. This strong performance was driven by growth in KLD sales which represented 27.5% of total revenue.

Net income was RMB 34.4 million or RMB 0.96 and RMB .95 for basic and diluted shares respectively for the third quarter of fiscal 2009. We also purchased a property in Chendu that will become our new headquarters for RMB 98.3 million.

The chart on Slide 5 illustrates our track record of steady ELP revenue growth over the past several years. In the fiscal third quarter, ELP remained our primary revenue contributor, accounting for 99.7% of total sales at RMB 213.8 million.

KLD sales represented 27.5% of total revenue. DLD accounted for 65.8% and E-dictionaries made up the additional 16.4%.

KLD remains the key growth drivers of our ELP business in the fiscal third quarter with sequential revenue increase of 59.9%. KLD sales improvement continued to offset declines in DLD revenue.

On Slide 6, gross profit increased 11.6% year over year to RMB 113.5 million representing a gross margin of 62.9%. This compares with gross profit of RMB 101.7 million and a gross margin of 55.3% in third quarter of fiscal 2008. The decrease in gross margin is mainly due to the change in product mix with increased KLD contribution to total revenue, and the decrease in the DLD average price.

Turning to Slide 7, our operating income continues to grow as a result of improving operating efficiencies. During the past quarter, we continued to be prudent in controlling our costs and as a result, our operating expenses as a percentage of total revenue decreased to 44.7% from 47% in the third quarter of fiscal 2008.

Research and Development expenses as a percentage of total revenues decreased year over year from 8% to 5.3%. Sales and marketing expenses as a percentage of total revenue, were in line with Q3 '08 at 30.4% and G&A expenses as a percentage of total revenue increased slightly to 9% from 8.3%.

Operating income for the third quarter of fiscal 2009 increased 11% to RMB 29.2 million representing an operating margin of 13.6% compared with operating income of RMB 26.3 million an operating margin of 14.3% in the third quarter of fiscal 2008.

On Slide 8 we have included a summary of our P&L. As I mentioned before, net income was RMB 34.4 million or RMB 0.96 and 0.95 per basic and diluted shares respectively for the third quarter of fiscal 2009. This compares with net income of RMB 55.4 million or RMB 1.45 and 1.40 per basic and diluted shares for the third quarter of fiscal 2008.

The decrease in net income in the fiscal third quarter was primarily due to the decrease in interest income and the other non operating income. Interest income decreased RMB 5.2 million to RMB 1 million in the fiscal third quarter versus RMB 6.2 million in the year ago quarter primarily due to the decrease in interest rates.

Other non operating income was RMB 0.4 million in the third quarter of fiscal 2009 compared to RMB 22.6 million in the third quarter of fiscal 2008 which includes an RMB 21.8 million foreign exchange gain. Although this impact on our bottom line, please be reminded that this is not reflective of any significant change in our operating performance.

As you can see on Slide 9, our balance sheet remains solid. Our cash, cash equivalents and short term investments remain strong at RMB 841.7 million at the end of March 31, 2009. This compares with cash, cash equivalents and short term investments of RMB 1.03 billion as of December 31, 2008.

We made the one time dividend payment of RMB 137.5 million in the third quarter of fiscal 2009 and purchased property for our new headquarters in Chengdu for RMB 98.3 million.

Moving to Slide 10, looking ahead to the fourth quarter of fiscal 2009, based on our current estimates, we expect net revenue for the fourth quarter of fiscal 2009 to be in the range of RMB 140 million to RMB 160 million which represents an increase of 16% to 18% year over year.

With that said, I'd now like to turn the call over to Rick to go over the Kids English Training market potential as well as the growth opportunity that Little New Star will bring to us.

Rick Chen

We are very excited about our acquisition of Little New Star, one of the top Kids English training service providers in China. The acquisition will bring additional growth to the Noah business and is the first important step of our multi-year strategy of becoming a more comprehensive provider of education products, services and content to the youth population in China.

As you can see on Slide 12, on May 22 we have entered into a definitive agreement to acquire 100% of Little New Star, a Kids English training service provider with nationwide coverage. The total consideration for the deal is subject to earn out adjustments and comprises part cash and part stock. The stock portion accounts for approximately 6% of the Noah outstanding shares.

We expect to complete the transaction in early July subject to customary closing conditions including regulatory approvals. Upon the completion of the deal, we can then share additional business and financial information with you in more detail.

As the transaction is scheduled for completion in July, which starts our fiscal year of 2010, we do not expect any financial impact or adjustments to our fiscal year 2009 numbers.

For those of you who have been following Noah, we have been pursuing a service line business to complement our product business ever since we went public in October 2007. It is a big part of our long term strategy to diversify and expand our education offerings to the three to 19 year old children in China.

We have put in considerable amount of time and resources in our pursuit but we have also been patient and selective. We really wanted to get a service business with high growth potential, a business model that can be replicated with scalability and a great synergy with our existing business.

After careful consideration of numerous potential opportunities, we have set our sight on the Kids English training market. Not only does the segment possess some of the key characteristics I just mentioned, it is also big and dynamic. The total population of children aged from three to 12 is about 130 million in 2007 and more than 70% of the primary school students seek supplemental education services in one form or another.

A recent report from [Deloit] puts the English training market in China at a 20 billion RMB a year and states that a Kids English training market is more resilient than any other English training segment based on recent enrollment trends.

Yet, the English training market is highly fragmented as there are over 30,000 service providers, most of them very small where no single player counts for more than 10% of the market share. It offers great consolidation opportunities to those companies with a recognized brand, standardized teaching methodology and an established system of quality content development in teacher training.

Little New Star fits the bill perfectly as it is recognized as one of the top ten foreign language training organizations in 2008 and is one of the top brands in Kids' English training in China. The company was established in 1992 as a private English trainings service provider based in Shenzhen, Hunan Province. It has achieved substantial growth over the last few years as it established itself as a top English training brand for kids in the second and third tier cities in the vast inland of China.

Currently, the company directly owns and operates 10 learning centers in Shenzhen, and Shanghai and has over 600 learning centers in its franchise network across China. The main revenue streams come from tuition income, selling of Little New Star training materials and the franchise fees. Every year, there are more than 700,000 kids receiving Little New Star English training.

In addition to its obvious strength in English training content development, teaching methodology and teacher training systems, the founder of Little New Star has over 20 years of experience in Kids English training and is highly regarded as a renowned expert in the field. With him taking the lead, Noah now has a team of highly qualified kid English teachers and teacher trainers that is second to none in the industry.

Slide 18 shows the potential synergies we expect to drive out of the combined company. Aside from the obvious cross marketing and cross selling opportunities we have between the two businesses, we will be able to package and promote our service offerings to a much larger audience through our nationwide distribution network with much greater fanfare.

We will also be able to leverage our technology expertise to help make Little New Star's in cost training even more attractive and fun. We expect to grow the number of directly home schools as well as the number of franchisees in the network at a faster pace in 2009 and beyond and establish ourselves as the leader in the Kids English training market in China.

In summary, as I just mentioned, this acquisition sets up a new direction and offers greater growth opportunity for Noah. In addition to our core ELP business, we now have a service business in the midst of one of the most dynamic and highest growth sectors in education.

That concludes today's presentation and we'll now open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Eco Hi – Oppenheimer]

[Eco Hi – Oppenheimer]

Could you talk about the revenue potential of Little New Star you acquired?

Rick Chen

Since we have not closed the deal yet, like we said, we expect to close the transaction by early July. At this point we're not at liberty to disclose the actual numbers with regards to this transaction. We can share additional information on that with you at the time of the closing.

But what we can tell you at this point is that the transaction is material to our business and be able to bring sizeable revenues and especially profits to our existing business going forward.

[Eco Hi – Oppenheimer]

You mean revenues and profit could be larger than what you currently have?

Rick Chen

It's sizeable and in terms of profit, I would say in fiscal 2010 it's definitely more than 10% of the total profit that we expect to generate.

[Eco Hi – Oppenheimer]

Could you talk about the growth potential of your KLD product or maybe e-dictionary?

Rick Chen

The KLD product remains to be the primary driver for our ELP business and as you can see from the numbers this quarter, we have a sequential growth of more than 20% and since we don't have the year over year comparison, it's hard to give the year to year indication of how fast we been growing the KLD business. But moving forward, we expect that the market will continue to grow as a whole more than 15% a year going forward and we expect to gain a much larger market share in the years to come.

And for the e-dictionary business, we've seen a natural rebound in the segment of the business and that's due to our additional new offerings in a couple of products and also it's basically a natural rebound from the low that have hit last year. So going forward, we'll expect the e-dictionary business to remain stable. We do not expect the e-dictionary to grow at a substantial rate. It's probably going to stable at a current or historical levels. So it's something that's going to remain at close to the current level.

[Eco Hi – Oppenheimer]

Does DLD, you expect it to continue to decline or to stabilize?

Rick Chen

For the DLD business, there are two major reasons that contributed to the decline of this segment of business in this quarter and the first reason is that actually what we view as short term and for competitive reasons.

As you probably know, one of our competitors, [Odin] has set off a low price strategy in the last quarter and it's probably going to continue that strategy in the June quarter as well and historically, [Odin] has been using the low price strategy on and off and without much success in the past. So we view this as a short term blink basically on our DLD business that was temporarily impacted by the low price strategy used by [Odin] in the March quarter.

In a broader picture perspective, the slow down of the China economy over the last six months has certainly impacted a lot of business and also has sort of impacted on our high end, very high end DLD products as consumers started to tighten up their purse string and want to be able to pick up low priced products in the same consumer category.

So it definitely had some impact on our very high end DLD products, but as the economy continues to improve over the next couple of months and going forward, we expect our high end DLD sales to come back.

[Eco Hi – Oppenheimer]

For the gross margin, do you expect at a certain point, you would see the recovery of the gross margin?

Rick Chen

The gross margin at this point, in this quarter actually has been pretty healthy. We had an above the average gross margin in the third quarter of 2008, over 55%, but that's way above the historical average. So the current gross margin that we see in the third quarter, 52% is actually in line with the historical average.

[Eco Hi – Oppenheimer]

In the future, if your KLD product is still growing faster than your DLD product, do you expect the gross margin to be lower?

Rick Chen

There is actually two parts in answer to that question. The first part is that the gross margin on KLD has actually improved over time. We have seen the gross margin on the KLD growing from the time that we introduced the product at high 30% to the low 40% and gradually all the way over to 45% or 46% range, so it has historically improved over the last few quarters.

The other part of the answer is that with the faster growth from the KLD business than the DLD business, our margin could decline a bit just from the overall ELP perspective, but we have stated repeatedly over the last two years, that we're confident that we'll maintain the gross margins for our core ELP business above 50%.

[Eco Hi – Oppenheimer]

Do you expect this newly acquired school can have a cross selling effect to your current KLD product? In other words, what kind of synergies can you see in particular, and also do you see any other opportunities in the future acquisitions in this field?

Rick Chen

First of all, we definitely see great cross marketing and cross selling opportunities between the two businesses and in terms of selling KLD into the population that covered by Little New Star, we definitely see that. But in terms of to what extent and to what degree we expect incremental revenues from that it is yet to be determined.

The first priority for us for this acquisition is actually to grow the business organically, to be able to greatly expand its reach across China through either expansion of the directly home school or expansion on number of franchisees in the network. We view this acquisition as a platform for us to step into the high growth Kids English training market and it will help us to accelerate the growth in this market and help Little New Star to accelerate its growth by leveraging our existing sales marketing network, the over 85,000 point of sales, our hundreds of distributors and the direct sales people to help to promote the brand, to help market its services across the country.

So we see that, and from a geographic coverage perspective, Little Star primarily operated in the second tier and third tier cities, and we have a very strong network in those areas. So we see affinities just being great between the two businesses and we believe by coupling our existing assets, in our brand, in our resources, our content capability, technology and sales marketing, that we'll be able to grow the Little New Star business substantially and to overtake other brands as the lead brand in the Kids English training market.

[Eco Hi – Oppenheimer]

Any new opportunities in this area for further acquisition?

Rick Chen

At this point, we want to be able to integrate the Little New Star acquisition into our existing business so that's our first priority and we want to be able to drive opportunities, particular synergies between the two businesses for the time being.

In terms of additional acquisitions, like I said, for the past two years since we went public in 2007, we have been very active in the acquisition front and we have always been active in discussing and communicating with potential target companies. But we are also very careful in selecting the right ones for our business.

So the short of it is that the door is not shut, but with this acquisition, we will probably become even more selective.

Operator

Your next question comes from Adele Mao – Susquehanna Financial Group.

Adele Mao – Susquehanna Financial Group

Going back to the DLD sales a little bit, I think in the past you've talked about your recent initiative in channel realignment. Could you give us an update on that? Have we seen some positive results from that as a result from recent channel alignment and do you foresee DLD sales although in the near term could be slowing down, but whether to recover in the longer term?

Rick Chen

We actually have seen some positive feedback from the channel realignment and in addition to that, when you look at the DLD product line and the KLD product line, the new introductions, or the introductions of a new KLD products have actually some features of the DLD products. It has added functionalities and added features into those new products.

So it's sort of blurred the line a bit if you may when we offer both product lines to the consumer audience. That indirectly contributes to part of the decline of the DLD sales, is that when consumers go to the point of sales and they see a KLD product with added functionalities and features, and a lower price point, they tend to go for the better deal, especially in this tighter economic environment.

That is one of the reasons for the decline of the DLD sales, but going forward, I think based on the recent realignment of the channels and the repositioning of some of our products as well as reshuffling some of the approaches to the marketplace, we will definitely see the combined ELP business to grow at a healthy rate in the foreseeable future.

Adele Mao – Susquehanna Financial Group

Looking at your G&A expense this quarter, it appears a little bit high at 2.8 million. Could you provide some details around that? Is there anything in the quarter that is non recurring?

Rick Chen

Yes. Like we mentioned in the last call or as you may know, we have implemented in the ELP system as well as the project in the last couple of quarters and so those expenses will be one time and non recurring, and those are two big spending items for the quarter.

And also, in the same quarter of 2008, we had not annualized or allocated part of the legal and auditing fees that was associated to the being a public company and over the last couple of quarters, or starting with the fiscal 2009, we have started to standardize those expenses and started to annualize or allocate part of those annual expenses into the quarterly basis. So that's why you see the G&A being high in this quarter.

Adele Mao – Susquehanna Financial Group

Do you quantify the non recurring items in the quarter so that we have a better idea in terms of your quarterly budget?

Dora Li

In terms of the numbers regarding the system implementation consulting services, we have an interest charge of about 1.2 million RMB in this quarter and the appropriation for the auditing related and the professional, legal service fee is around RMB 1.8 million and the allocated Sarbanes-Oxley related fee is around 620,000 RMB. So that's pretty much why the increase in the G&A expenses for this quarter.

Adele Mao – Susquehanna Financial Group

I'd like to ask more questions on the acquisition front. First of all, I understand not much detail can be discussed regarding your deal valuation, but I was wondering if you could discuss a little bit about first of all the percentage of revenue mix of Little New Star, how much of that is coming from the books and the teaching materials that they sell to students and the margin profile related to that to the extent that you're comfortable with providing information.

Rick Chen

Like I said previously, there are two major revenue streams for the Little New Star business at this point. With the acquisition, we could add additional revenue streams to the mix. Currently, with regards to the three main revenue streams, income from directly owned schools, the selling of the teaching materials and franchise fees, the breakdown is around 40, 40 and 20 so 40% coming from tuition income, 40% from selling teaching and 20% from the franchise fees.

From a margin perspective, as you probably know, the margin on franchise fee is very high. It is over 90%. The sale of teaching materials is also profitable with a gross margin probably over 50% and the direct owned schools, the margin is similar to other direct owned schools operated by other brands so its very similar to those margin ranges.

Adele Mao – Susquehanna Financial Group

Have you completed all the due diligence of Little New Star? Besides the regulatory approvals that you mentioned earlier, what are the hurdles that you would need to go over in order to close the deal by July 2?

Rick Chen

We have completed 100% due diligence effort on this transaction and right now what's standing in our way is just the customary closing conditions including the regulatory approval. The regulatory approval is basically that we just have to go through the motions to get all the paperwork in place, to get the proper sign off from different levels of government agencies and officials and then the deal will be closed.

So at this point, we do not expect any major hurdles blocking us from completing the deal. We just have to go through the motion and get these paperwork out of the way and get the proper signatures and the sign offs.

Adele Mao – Susquehanna Financial Group

Over the past year we have seen a number of education services companies pretty active in terms of acquisitions, and I think Little New Star may have their own plans as to whether to go public or do some things independent. I was wondering if you can talk about how you approach Little New Star and whether they have other alternatives to look at before striking a deal with Noah.

Rick Chen

It's actually twofold. First of all, it's true that over the last couple of years we have seen a number of education service providers in China want to explore the capital markets, whether it's through overseas markets or domestic markets. But over the last 18 months, or over the nine months, the capital markets both domestically and internationally have deteriorated to a level that it's very hard for relatively small players to go out and raise capital.

As a result, the number of companies who switch sides and went from wanting to go solo to interest in partnerships have increased probably ten fold. As a result, we have entered into various active discussions with a number of players over the last six months/.

Little New Star as a company has really stood out of the group and not just because of the market segment it is in, but also the core strength it has demonstrated over the years in terms of teaching, teaching training systems, in terms of its content development capability that is very well regarded in the Kids English market as well as its management team, especially its founder who has been regarded as one of the most respectable and a renowned expert in the Kids English training field.

We looked at all these elements, especially the segment that complements our existing business. We are also, through our KLD and DLD products, we also target the three to 19 year old crowd and our KLD product especially covers the three to 12 year old population which overlaps what Little New Star covers through its service offerings.

So there are a lot of potential synergies that we see between the two companies and these synergies and potential opportunities have also been seen by the management and the founder of Little New Star.

So they view this as the right step to take, sort of like instead of going solo, be able to partner with a strong provider in the education product arena, being able to partner with a company with much greater resources and a platform to operate from, they just think that this is something that's much better than if they would go public or raise capital by themselves.

So this is a great opportunity for us as well. We are very glad that the other side sees the same thing that we have seen, so that actually brings a lot of excitement and joy to our part and we believe that this acquisition will be a great springboard for the company both for Noah and Little New Star that with the combined resources and the combined brand and assets, we can make a big difference in the Kid English training market.

Adele Mao – Susquehanna Financial Group

You mentioned the founder of Little New Star. I was wondering what are the employment contracts are in place and how many years of commitment that the Little New Star management team have?

Rick Chen

At this point, we cannot reveal too much on that. Like I said, at the closing of the deal, we'd be able to share more on those details. But what I can tell you is that the founder is very committed to the combined business and he is in this for the long haul. We have commitment from him both contractually as well as personally that he's going to grow with the business and he's going to be with us for the long terms.

Operator

There are no further questions. I would like to turn the call back over to Rick Chen for closing remarks.

Rich Chen

On behalf of the management team, I would like to thank everyone for joining us today and for your support. We are committed to building shareholder value by executing our strategy and we look forward to keeping you apprised of our progress in business development and strategic acquisition.

If you have further questions, please feel free to call either Dora or me. Thank you and have a good day or good night.

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