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

F4Q09 Earnings Call

July 21, 2009 8:00 am ET

Executives

Sisi Zhao - Senior Investment Relations Manager

Louis T. Hsieh - President, Chief Financial Officer, Director

Analysts

Catherine Leung - Citigroup

Jeff Lee - Signal Hill

Mark M. Marostica - Piper Jaffray

Amy Junker - Robert W. Baird

James Mitchell - Goldman Sachs

Paul Keung - Oppenheimer

Hao Hong - Brean Murray, Carret & Co.

Brandon Dobell - William Blair

Mariso Ho - Credit Suisse

Adele L. Mao - Susquehanna Financial Group

Candy Hong - Nomura

Operator

Good evening and thank you for standing by for New Oriental's fourth fiscal quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the meeting over to your host for today’s conference, Ms. Sisi Zhao, New Oriental's Senior Investment Relations Manager. Please proceed.

Sisi Zhao

Hello, everyone and welcome to New Oriental's fourth fiscal quarter 2009 earnings conference call. Our fourth 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 President and 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 U.S. Private Securities Litigation Reform Act of 1994. Forward-looking statements involve inherent 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 statements except as required under applicable law.

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 T. Hsieh

Hello, everyone and thank you for taking the time to join today’s call. Overall it was a solid year for us and it’s my pleasure to take you through our fourth fiscal quarter and fiscal year 2009 financial results.

Before getting into the numbers, I would like to take a few minutes to discuss some of the quarter and yearly highlights.

As many of you know, the fourth quarter is typically a seasonally slow quarter for us in revenue terms as students focus on year-end examinations and we wrap up our marketing efforts for the seasonally strong summer quarter. Despite seasonality, however, this year we were able to beat the high-end of our guidance by nearly $6 million to deliver fourth quarter net revenue growth of 48% year over year. This strong top line result was primarily due to the approximately $55.4 million in deferred revenue balance, which is cash collected from registered students from courses and recognized proportionally as revenue instructions are delivered.

At the end of the third quarter fiscal year 2009, healthy Q3 deferred revenue was driven by stellar student enrolment, which increased 31% year over year to approximately 351,700. It is common for New Oriental to record slower enrolment growth in a quarter following exceptional student enrolment growth, like we experienced in Q309.

In the fourth fiscal quarter, total enrolments in language training and test prep increased by more than 8% year over year to approximately 330,200 enrolments, which brought enrolments for the full fiscal year to over $1.5 million, a 19.5 increase over fiscal year 2008 and exceeding the high-end of our fiscal year enrolment target.

Such healthy enrolments led us to deliver year-over-year net revenue of $292.6 million, a 45.6% increase over fiscal year 2008. Now with our disciplined approach to cost and operational efficiency, we were able to achieve solid bottom line results as well with non-GAAP EPS of $2.09 per ADS, up over 35% year over year.

As many of you know, New Oriental's long-term vision is to be the trusted educational partner for Chinese students throughout their lifetimes and as we are seeing, our leading brand recognition and consumer trust gives us the ideal platform to accomplish this, by developing lines of new businesses beyond our core language training and test prep classes.

Our reputation for quality also brings with it a strong pricing power. In the fourth fiscal quarter, blended ASP was up over 13% from the year ago period, due in significant part to the market-driven shift to smaller class sizes and the U.S. dollar depreciation versus the RMB in the year-ago comparable period.

Beyond the power of the New Oriental brand, it is important to keep in mind the scale of the potential market for our services. Take kid’s English -- Mainland China has over 130 million children between the ages of five and 12 and therefore eligible for our POP Kid’s English Program.

Past age 12 there are approximately 120 million middle and high school aged students in Mainland China who are eligible to take English classes as well as our You Can all subjects training and overseas test prep. It is important to mention that students will typically enroll in more than one course per year, and the vast majority of school-aged students who enroll in New Oriental's POPs kids and middle and high-school courses will continue in New Oriental for multiple years, thus creating steady recurring revenue streams with minimal associated student acquisition costs.

Considering we have enrolments of nearly $308,000 in POPs kids English for the fiscal year 2009 and over 283,000 for fiscal year 2009 in our middle and high school English and You Can all subjects training, it’s clear that there is a massive potential untapped in this market.

What’s more, the healthy growth of kids English despite a weak macro environment, enrolments for the year grew 50% year over year and revenue grew more than 50%, shows that the demand for our POP kids English program is relatively inelastic to economic conditions.

As we continue to expand using our scalable hub and spoke model, we expect the demand for our services to keep growing rapidly within these age groups.

Many of you already know that one of the reasons we have been able to grow so successfully over the past several years is our strong management team and disciplined approach to costs. Michael Yu is not only an excellent Chairman and CEO; at his core, he is a teacher and a role model for Chinese students throughout the country. He recently came back from his 2009 dream tour, in fact which visited over 30 cities this year, including several that were inaccessible last year as a result of the devastating earthquake in Sichuan Province in May 2008.

And supporting Michael, we have an impressive team of extremely experienced managers, including our COO, Chenggang Zhou, and our Senior Vice President, Xiangdong Chen, both of whom are teachers and who have been with New Oriental more than 10 years a piece.

Together New Oriental's management team, collective vision, and dedication to our New Oriental brand has allowed for smooth transitions into new areas while retaining our expertise in our traditional strengths. We believe that by creating a dynamic performance and challenging workplace for our teachers and staff, we can facilitate a high quality educational experience for our students of all ages.

Looking at the first quarter and fiscal year 2010, we are optimistic. It is still early in the quarter but already we have seen strong momentum in our overseas test prep, POPs kids English, and middle school and You Can program enrolment. This is particularly significant given that June and early July of last year were exceptionally strong for student enrolments, making year-over-year comparisons very difficult. Because of the Beijing Olympics last August, we expanded our programs in the first half of the summer while contracting them in the second half of the summer 2008 to permit students to enjoy the historic Olympic Games.

In other words, we front-loaded the summer last year. For New Oriental to see strong early demand in June and early July against these challenging backdrop is particularly encouraging.

While we believe our model is relatively isolated from weak economic conditions, given the value Chinese parents place on education for their children, child or children, we are also encouraged by the gradual churning up of the global economy. As consumption picks up, we expect New Oriental will be a beneficiary, especially in our adults English business, which many of you know has been hardest hit by the global economic crisis.

With our solid brand, scalable business model, strong management team, and focus on execution, we are very excited for what FY2010 has in store.

With that, I will turn to our financial results for the fourth fiscal quarter of 2009. Please note that certain figures I will refer to that exclude share-based compensation expense are non-GAAP. You can find a reconciliation of these figures to GAAP in the financial tables at the end of the earnings press release.

For the fourth fiscal quarter of 2009, we reported net revenue of $59.4 million, representing a 47.9% increase year over year. Net revenues from educational programs and services for the fourth fiscal quarter was $51.3 million, representing a 45.7% increase year over year. The growth was mainly drive by the increase in the number of student enrolments in language training and test preparation courses.

Excluding share-based compensation expense, non-GAAP operating costs and expenses for the quarter were $52.4 million, a 39.4% increase year over year. GAAP operating costs and expenses for the quarter was $56.9 million, a 41% increase year over year.

Costs of revenue increased by 45.9% year over year to $25.8 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 36.8% year over year to $10.3 million, primarily due to expanded head count in the selling and marketing department and increased brand promotion expense.

Non-GAAP general and administrative expenses were $16.8 million, a 30.7% increase year over year. GAAP general and administrative expenses for the quarter increased by 37.4% year over year to $20.9 million, primarily due to increased headcount as the company expanded the network of schools and learning centers.

Total share-based compensation expenses were allocated to related operating costs and expenses increased to $4.5 million in the fourth quarter of fiscal 2009 from $2.7 million in the same period of the prior fiscal year. Approximately $746,000 of the increase was due to a year-end adjustment to account for the lower-than-expected forfeiture rate in fiscal year 2009, meaning fewer New Oriental employees who receive stock-based compensation awards left the company and forfeited their unvested awards than anticipated.

Non-GAAP income from operations for the quarter was $7 million, a 175% increase year over year from $2.5 million in the same period of last year, and GAAP income from operations was $2.5 million for the quarter, compared to a loss of $200,000 in the same period of fiscal 2008.

Non-GAAP operating margin for the quarter was 11.7% compared to 6.3% in the same period of the prior fiscal year. GAAP operating margin for the quarter was 4.2% compared to a negative 0.5% in the same period of the prior fiscal year. This rise is primarily due to increased operating efficiency as revenue growth outpaced the growth I operating profit and expenses.

Non-GAAP net income was $7.1 million, representing a 58.0% increase from the same period of the prior fiscal year. Basic and diluted earnings per ADS excluding share-based compensation or Non-GAAP was $0.19 and $0.19, respectively.

GAAP net income for the quarter was $2.6 million, representing a 49.8% increase from the same period of the prior fiscal year [and basic] and diluted earnings per ADS was $0.07 and $0.07, respectively.

Capital expenditures for the quarter was $2.9 million, which was primarily due as we added one new school and a net of 12 new learning centers during the quarter.

As of May 31, 2009, New Oriental had cash and cash equivalents of $254.8 million, as compared to $224.0 million as of February 28, 2009. In addition, the company had $59.8 million in term deposits at the end of the quarter. Net operating cash flow for the fourth quarter of fiscal year 2009 was approximately $28 million.

The deferred revenue at the end of the fourth quarter of fiscal year 2009 was $74.8 million, an increase of 26.3% as compared to the $59.2 million at the end of the fourth quarter of fiscal year 2008. Deferred revenue, where students enroll and pay for courses to be completed in the future quarters, as many of you know, is essentially a measure of backlog for New Oriental.

Before I give guidance, I would like to take a brief look at the comparisons between fiscal year 2009 and fiscal year 2008.

Student enrollments in language training and test preparation grew 19.5% year-over-year to 1,519,500 from approximately 1,271,700 in the prior fiscal year ending May 31, 2008.

Net revenues were up 45.6% year over year to $292.6 million.

Excluding share-based compensation expense, non-GAAP operating income was up 43.6% year over year to $77.7 million. GAAP operating income was up 34.4% year over year to $60.9 million.

Non-GAAP operating margin went from 26.9% for the fiscal year ending May 31, 2008 to 26.5% for the fiscal year ending May 31, 2009. GAAP operating margin went from 22.6% for the fiscal year ending 2008 to 20.8% for the fiscal year ending May 31, 2009.

Non-GAAP net income was up 34.6% year over year to $77.8 million. Non-GAAP basic and diluted earnings per ADS for the fiscal year ended May 31, 2009 was $2.09 and $2.03, respectively.

GAAP net income was up 24.5% year over year to $61 million. GAAP basic and diluted earnings per ADS for the fiscal year ended May 31, 2009 was $1.64 and $1.59, respectively.

Moving on to the revenue guidance, we expect our total net revenues in the first fiscal quarter of 2010 from June 1, 2009 to August 31, 2009 to be in the range of $146.6 million to $152.6 million, representing year-over-year growth in the range of 24% to 29%, respectively. This forecast reflects New Oriental's current and preliminary view, which is subject to change.

Since we reported currency in U.S. dollars, our operating currency however is RMB. We have benefited from currency translation gains during the period when RMB appreciates against the U.S. dollar. In the last several quarters when the RMB consistently appreciated against the U.S. dollar by 5% or 10% year over year, our revenue growth for financial reporting purposes benefited from such appreciation. But given the current trend, since the fourth fiscal quarter 2009, RMB U.S. dollar exchange rate has stabilized and currency translation gains have been shrinking accordingly.

Once again, thank you for participating in our quarterly earnings conference call. At this point, I would like to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from the line of Catherine Leung with Citigroup. Please proceed.

Catherine Leung - Citigroup

My one question is that regarding the summer quarter, I am sure we are all wondering whether you would be able to share with us more color on how June and July have trended so far in terms of cash revenue collection. And given that this summer quarter will be more back-end loaded compared to last year, how do you think this has impacted or affected your [revenue facilities]? Thank you.

Louis T. Hsieh

Thank you, Catherine, that’s an excellent question. Our June month and first two weeks in July were quite strong, with revenue growth together well over 25% so the -- well over the bottom of our range. And don’t forget last year what happened was June and the first two weeks of July, we front-loaded all the courses due to the fact that the Summer Olympics were coming in August.

Because of that, we had extremely difficult comparisons. The last three weeks, enrolments have been exceptionally strong so we are very encouraged because the back half of the summer, we’re going to also operate a full suite of courses and they are going to have easy comparisons versus last year when we didn’t offer as many classes, given the Beijing Olympics was coming.

So because of that, you are absolutely right. We don’t have as much visibility going into the second half of the summer because last year it was just so front-end loaded. But because of that, we were probably a little bit conservative in our guidance.

But the short answer is the first half has been above our expectations as far as enrolments and revenue. But don’t forget -- we came into this quarter with only a 26.3% increase in deferred revenue, which is lower than last year’s growth. So because of that, we expected a strong June and a strong early July. The next two or three weeks will determine the summer and what the growth rate will be because last year, our demand began to fall significantly in the second half of July and all through the month of August. This year, we don’t expect that fall-off.

Catherine Leung - Citigroup

All right. Thank you. That was very helpful.

Operator

And our next question will come from the line of Jeff Lee with Signal Hill.

Jeff Lee - Signal Hill

Could you please talk about your pricing strategy and comment on your decision to hold prices for large lecture classes? I guess what kind of prices do you think you will be able to implement going forward and how much is economic situation, how much is competition weighing into pricing?

Louis T. Hsieh

Thank you. That’s an important topic. I think for New Oriental, we made the decision to hold prices in many large cities, particularly for large class sections in overseas test prep and others, probably primarily due to the economic crisis, meaning that we wanted -- you know, we wanted to make sure the students could afford our programs and services. So we did that. What we did though is we increased prices in the small class format, so we still expect pricing increases for the year to be in the range of 8% to 10%. Also don’t forget, Jeff, there is still the continuing move to smaller class sections and so the students who come in are taking our class format but because we have raised prices in the smaller class format, margins are actually quite a bit better so it’s going to help our margin structure.

So I think the net wash is holding the prices relatively flat year over year -- large classes will end up being a negative on the margins but I think because of our growth rates and because we’ve been keeping costs under control, we still expect margins to be quite healthy.

Jeff Lee - Signal Hill

Thank you.

Operator

And our next question will come from the line of Mark Marostica with Piper Jaffray.

Mark M. Marostica - Piper Jaffray

Thank you. Louis, on that very point, margins, clearly this quarter I think was one of the first in the last four that you actually saw leverage on each of the cost lines, G&A, selling promotion, and the cost of education services and I am curious whether or not there’s anything in those line items this quarter that was more one-time-ish in nature at all or is this the beginning of a new trend that we should see play out in the coming quarters?

Louis T. Hsieh

I think it’s a trend you will see playing out in the next coming quarters because last year, right, if you look at the numbers -- if you look at non-GAAP operating costs and expenses, they were actually in line with last year so this year and 2008 were very comparable. It was the stock-based compensation that -- as you know, Mark, stock-based compensation should begin to trail off, especially beginning in Q3 of this year or the February quarter as the ’07 stock options they basically are fully vested.

So I think a lot of it was due to stock-based comp because we had a large grant in 2007 that expires in February of 2010. Other than that, I think the margins were comparable to last year and we started in the whole a couple of percent because of the Beijing Olympics, so that means that for Q2, Q3, and Q4, if you combine those three, we actually saw an improvement in the margins.

And we don’t see anything coming down the pipeline now. Our cost structure is -- we believe is in line so we would expect some margin expansion.

The only thing that may affect margins on the negative side is the fact that we are not increasing prices as fast as we did last year, so we will wait to see how that plays out.

But you know, it’s one of those things -- if we don’t raise prices as much, we should see stronger enrolment growth, which means that at the end of the line, we should see hopefully the same or more in the bottom line, which is what we are shooting for.

Mark M. Marostica - Piper Jaffray

Okay, thank you.

Operator

And our next question will come from the line of Amy Junker with Robert W. Baird.

Amy Junker - Robert W. Baird

Thanks. Good morning, Lewis. Just a follow-up on the pricing -- can you -- do you expect that those prices freezes will be short-term or do you think extended throughout the year? How long do you think that that’s going to last? And you commented that you thought that that would lead to better enrolments -- are you seeing evidence of that so far?

Louis T. Hsieh

We’re definitely seeing enrolments as -- better evidence of that on the enrolment side, so I think that’s clear. On the how long we are going to do this pricing structure, I don’t know for sure because don’t forget, we review pricing every quarter. My -- if I had to -- if you forced me to answer, I would say this is temporary so that we will continue to increase prices in future quarters. Maybe not as fast as historically where we’ve been increasing 12% to 15% but certainly in the guided 8% to 10% range.

Amy Junker - Robert W. Baird

Great, and just as a follow-up of that, with respect to margins with all of these moving parts, at least for the fiscal first quarter so far, would you expect to see pretty healthy margin improvement? I think in the past you talked about 100 to 200 basis points of gross margin improvement in all of 2010. Is that something that’s achievable, given these pricing moves?

Louis T. Hsieh

We still expect 100 to 200 basis points in fiscal year 2010, the whole year. I think in Q1, as you know, Q1 margins are typically much higher than the rest of the year so given that we implemented this pricing structure this quarter, we may not get the full 100 to 200 basis points in Q1. So I think it depends on what we do in the Q2, Q3, Q4 period as far as pricing but I would still expect margins to be still gross margins to be improved by at least 100 basis points over the course of the year, and I think we’ll get even more operating efficiency on the bottom line, given that stock-based comp has come down and given that our -- you know, we expanded very rapidly last year to build You Can, our all subjects middle school and high school program. And this year, we’re going to begin to leverage the benefit as student enrolments increase in those courses, we don’t have to spend much more on adding teachers because we are just filling up classrooms.

Amy Junker - Robert W. Baird

Great. Thank you.

Operator

And our next question will come from the line of James Mitchell with Goldman Sachs.

James Mitchell - Goldman Sachs

Thanks for taking the question. Louis, it looks like the POP kid’s English business continues to grow at a very rapid pace, despite becoming a double-digit proportion of your overall business. Could you talk about the [inaudible] the growth in POP kid’s English? And also, when we look at the current enrolment growth of 50% year-on-year, could you kind of disaggregate that into what’s happening within existing cities versus opening POP kid’s English in new cities?

Louis T. Hsieh

Okay, that’s a great question, James. POP kid’s English is a relatively new program, despite the fact it has 308,000 enrolments already in fiscal year 2009. The program is only five, six years old, so we expect continued growth across the country. The only city that we don’t expect as fast a growth would be [Wuhan], because that’s where POP Kid’s English started. So we are seeing rapid growth in the major cities such as Beijing and Shanghai and others. So we expect POP kid’s to continue to grow. We have 308,000 -- we would expect well over 400,000 enrolments for fiscal year 2010 and we are probably modeling 35% to 40% enrolment growth plus another 10% pricing increases, so we expect revenue from this category to be well over 45%.

And we are also seeing not quite as fast an enrolment growth but we are raising prices in the You Can in the middle school sections, so we still expect revenue growth from that section to be 30% to 40% off a 283,000 student base. That also will be nationwide. So we are not -- it’s not -- we haven’t saturated any city in middle school and high school English in You Can and we are only probably close to maturity in one city, which is in Wuhan in China on the kid’s side. Overseas test prep is the other growth driver and that continues to be quite healthy. Our indications are June and July demand have been above our expectations. I think last year we grew about 11% enrolment; in the first half of this summer, we’re already well over 17% in enrolment growth in overseas, which as you know is our most profitable segment.

James Mitchell - Goldman Sachs

Sure. Thank you.

Operator

And our next question will come from the line of Paul Keung with Oppenheimer.

Paul Keung - Oppenheimer

Switching gears to revenue and margins, looking at your [inaudible] business and what’s interesting is one of your big competitors has actually done about seven or eight acquisitions so far and you are seeing a lot more consolidation happen. I’m curious if you feel like you may need to pick up the pace of that in order to make sure you don’t lose some key assets out there in the [inaudible] [space].

Louis T. Hsieh

That’s a good question. M&A is always a bit of a difficult thing, issue for us, just given that we tend to be quite conservative in what we are willing to pay, as you know, Paul. I think we have a lot of competitors in [Galcau]. We’re a relatively new entrant as well but because we had 283,000 enrolments in our middle and high school English in You Can last year and we had 58,000 enrolments in You Can in our first year, you know, non-English subject enrolment. We still expect that to grow to between 90,000 and 100,000 for this year. And if we do 100,000 at about an average of $150 a student, that’s a $15 million business. That makes us the largest [Galcau] business, we believe, school in China.

So we will obviously look at acquisitions but any acquisitions we make are relatively small so the growth will still come from organic growth. We acquired [Misha Tong] and [Tonwin] schools. I mean, [Misha Tong] has about 1,200 full-time students last year, boarding students for the [Galcau] retakers business and it had another several, you know, 4,000 or 5,000 short-term students.

New Oriental across the country in our 30 cities, 358,000 just in our first year and we expect, like I said, that to grow 70% to 90% this year. And so we are expecting to grow the vast majority of our [Galcau] business organically.

Paul Keung - Oppenheimer

Thank you.

Operator

And our next question will come from the line of Hao Hong with Brean Murray.

Hao Hong - Brean Murray, Carret & Co.

I just want to ask a quick question on your forward guidance -- I remember that in the first quarter financial year 2009, there was about $4 million revenue that was deferred into the second quarter, so if we normalize your first quarter 2009 sales and then use your current guidance divided by the normal revenue in the first quarter 2009, for some reason I only get about 20% to 24% year-on-year growth and that actually represents on of the slowest growths in the last two years. I’m just wondering whether my understanding is correct and --

Louis T. Hsieh

Yeah, I think what I would do is we are going to come into the quarter with $75 million of deferred revenue, of which probably $55 million will be recognized this quarter. So right away we’re at $55 million. Let’s say for calculation purposes, assume that our target is $150 million. That means that between June and July, we need to generate $95 million to hit our target. If we had $150 million, we’re about 27% growth year over year, 28% growth year over year. So that’s the way I would look at it and I think the early indications are that we should be in that range. June and July have tracked -- together have tracked well above 25%.

Hao Hong - Brean Murray, Carret & Co.

Okay.

Louis T. Hsieh

[From the] bottom of the range. Does that make sense? So I think cash revenue, especially -- to give you an idea, last year we had one week, our first week ever in the third week of June where we had revenue of RMB111 million in one week. Before that one week, the largest week we ever had was 65 million. This year, the last three weeks in New Oriental's enrolment, actually the last four weeks, three weeks have been over RMB100 million in revenue. So that’s very strong given how tough the comparisons are year over year. Last year the first half, we saw very strong enrolments in June and July and we saw a dramatic tail-off in August. We don’t expect that tail-off this year.

Hao Hong - Brean Murray, Carret & Co.

Okay. Thank you.

Operator

And our next question will come from the line of Brandon Dobell with William Blair.

Brandon Dobell - William Blair

I wonder if you could give us some color on your forward expectations for the number of schools and learning centers as well as CapEx in fiscal 2010.

Louis T. Hsieh

That’s a good question. CapEx for 2009, we spent $14.6 million. That’s to add a new of 70 facilities, including maintenance CapEx on the other 200 facilities that we had coming into the year.

Going forward in fiscal year 2010 ending May 31, we would expect to add maybe two new cities. We’re going to slow down the number of city growth and we’ll add about 50 to 55 learning centers, so the total new facilities will be about 55 to 57, bringing our total to 325 to 327.

CapEx for that we would expect to be somewhere in the range of $15 million to $17 million, but primarily half of it is for new school openings and learning centers. The other half is for maintenance CapEx on the existing facility base, which is growing quite large, as you know, to 270.

Brandon Dobell - William Blair

Right. Of the 50-plus centers, how should we think about the split between kids and -- standalone kids and mixed use centers?

Louis T. Hsieh

Probably it will be one-third kids centers, around 15 to 20 kid centers and the rest will be mixed use.

Brandon Dobell - William Blair

Okay. And then if you look at the four or five big cities for you guys, how should we think about capacity expansion and as well as just kind of organic same-store or same-network growth within let’s say Beijing and Shanghai?

Louis T. Hsieh

Well, Beijing is doing exceptionally well. Shanghai, as you know, had its challenges with Q3 of ’09, which we hope are largely behind us, you know, with the scheduling problems, so we would expect of the centers, Beijing should continue to grow. Shanghai, to be honest, over-built last year so Shanghai should not grow too many more centers. Maybe a couple of kids centers.

The other cities, [Wuhan] will not grow that many centers. So the primary increase in centers will be in the other large cities outside the big four, so it will be probably in Chengdu, in Tianjin, all the other sort of big cities within China and also the newer cities as we -- you know, the 04, 05, and 06 and 07 schools. So I think it will be weighted toward the newer schools, the newer cities not the older cities.

But I think we would still see significant enrolment growth in the large cities, especially in the kids and middle school area.

Brandon Dobell - William Blair

Okay, and then final question for you -- I’m seeing a number of headlines about increased or improved consumer spending in China in recent months, has that trickled into the adult business for you guys or is that still primarily financial services related and you haven’t seen too much impact yet?

Louis T. Hsieh

Adult English remains slow, to be perfectly honest but slow still means 10% revenue growth. So we are still seeing probably flat to slightly down enrolments year over year in adult but we expect revenue growth to be well over 10% in the adult category still, and so we are encouraged though -- I think as the economy begins to rev up again, we would expect more hiring in the financial services, which is because the stock market is doing well, as well as by multi-nationals. And I think that will drive our adult business hopefully to increase again year over year.

We are not counting on adults to drive our growth, as you know. As long as adults in domestic test prep can grow 10%, 15% a year in revenue, we’re quite happy. The growth above that is going to come from overseas test prep, kids, and middle and high school.

Brandon Dobell - William Blair

Okay, great. Thanks a lot.

Operator

(Operator Instructions) And our next question will come from the line of Mariso Ho with Credit Suisse.

Mariso Ho - Credit Suisse

Could you talk us through the ASP movement for your key product areas during the fourth fiscal quarter, please?

Louis T. Hsieh

During the fourth fiscal quarter, yeah, I can take a look. I had to pull out my chart. The ASP growth in overseas test prep for the fourth fiscal quarter was -- I’ll give you round numbers, was about 20% year over year growth in ASP. Domestic test prep was about 2% pricing growth. Adult English was about a 20% increase in average blended ASP.

In the middle school and You Can, the ASP was up about 18%, 17%, 18%. And for kids, the ASP was up, was relatively light around 3%.

Mariso Ho - Credit Suisse

And these are in RMB terms?

Louis T. Hsieh

These are in U.S. dollar terms -- so yeah, just subtract 2%.

Mariso Ho - Credit Suisse

Thank you.

Louis T. Hsieh

So overall last quarter, we were up 13.6%. If you take it in RMB terms, it was 10.8% increase in ASP growth.

Mariso Ho - Credit Suisse

Right. Can we also confirm the forex assumption you have used for your first quarter guidance?

Louis T. Hsieh

I just use the U.S. dollar number from last year, so the assumption is the current 6.83 that the RMB is against the U.S. dollar.

Mariso Ho - Credit Suisse

Right. Thank you.

Operator

And our next question will come from the line of Adele Mao with Susquehanna International.

Adele L. Mao - Susquehanna Financial Group

Just related to the earlier question on capacity expansion, could you give us an update in terms of the ramp-up in capacity utilization, especially for the new centers opened in fiscal year 2008? I remember you guys had 77 centers open in 2008 and 63 in total for 2009.

Louis T. Hsieh

That’s right.

Adele L. Mao - Susquehanna Financial Group

And my second question is I think you mentioned 50 to 55 learning centers plus two schools to be open in next fiscal year, so what’s your target total capacity at the end of fiscal year 2010?

Louis T. Hsieh

Thank you, Adele. On the first question, I think is that we have plenty of capacity. Given that we’ve added 140 new schools and learning centers in two years, basically doubling, more than doubling the number of facilities -- so we went from 130 two years ago to 270. As you know, it takes between three and five years to sort of fill up a learning center to about 70%, 80% capacity. So that means that half our network is less than two years old, facilities wise. Now the capacity of those facilities is smaller than the existing schools but that means that we have plenty of capacity.

The only quarter that we are challenged for capacity typically is in the summer quarter, this quarter, and only in Beijing. And but luckily for us, Beijing has a lot of colleges and universities and so what happens is those dorms are empty and we can lease them at affordable rates during the summer.

So capacity is really never an issue for New Oriental currently. The reason we opened up learning centers across the country is to make it easier for our students to get to our classes. Because remember, behind the brand of a school, convenience is the second criteria that parents look at when they pick a school for their kids. They don’t want to drive more than half an hour and I don’t blame them, given the traffic jams in China. So this is more a convenience reason why we open learning centers than a capacity issue.

So we believe with the second question you asked, with the 57, 55, 57 facilities for the year, we’ll still have plenty of capacity and it will help us to reach, to basically fill in our geographic footprint in certain cities where there have been [inaudible] so we get better geographic coverage within certain cities. So it’s not so much that we need the capacity -- it’s because we want to make it more convenient for our students to get to.

Adele L. Mao - Susquehanna Financial Group

Okay, that’s very helpful. Thank you.

Operator

And our next question will come from the line of Hao Hong with Brean Murray.

Hao Hong - Brean Murray, Carret & Co.

Lewis, I just want to ask whether there’s any [inaudible] of revenue items in your first quarter revenue numbers?

Louis T. Hsieh

No, there’s absolutely no one-off things. The only one-off thing was on the expenses, which was the -- you know, we had to book an additional $746,000 in GAAP compensation, stock-based comp awards which I didn’t expect. And that’s because our forfeiture rate went down, so that’s a good thing. That means that there’s fewer people leaving New Oriental than we expected.

Usually in a typical year, 10% to 17% of the people who receive stock-based awards, the stock would be forfeited, so we assume they, given historical numbers, a historical forfeiture rate. That rate happened to be too high, which means that fewer people actually left New Oriental than we expected this year, which is actually a good thing. That means that it shows you that the job market isn’t as robust as it was in past years, that fewer people left New Oriental or we’re a better employer, I don’t know. I would doubt it’s the second one.

And so I would expect that -- and that’s why we had the extra $0.75 million of in stock-based comp, just for the fact that fewer people left New Oriental, so that’s an actual number.

So I think it’s the other side -- if we had that $750,000, our net income would have been $3.3 million. It would have almost doubled year over year from the $1.8 million last year. So it was actually the other side. The expenses had a one-off.

Hao Hong - Brean Murray, Carret & Co.

Right, and also a quick question on your margin, now that your You Can business and the POP kids business is growing very fast, but I remember this business are operations with lower margins. And also if you changed your classes to smaller classes format to maintain your ASP, top of my head because of your fixed cost structure, I believe that the smaller class is actually less profitable than the large classes. I’m just wondering this kind of growth pattern and strategic change in class format, how is that going to affect your view that you can deliver 1% to 2% margin improvement in the next couple of years?

Louis T. Hsieh

That’s a good question. I think I would take issue with your assumption that You Can is not as profitable. You Can has a pricing that’s increasing rapidly and it’s enrolment is going to almost double hopefully this year in 2010, so You Can has a price point in U.S. dollars that is going up significantly.

And also all of the small classes, we are raising prices in order to more equalize the margin with large classes. And so yes, you are correct though that large classes will have better margins but the shift, the market driven shift is to smaller classes. But because we spent a lot of money the last year, year-and-a-half expanding to 140 facilities, plus we hired a lot of teachers in the last two years, we are well-positioned -- I mean, we went from 3,200 teacher a year ago to 5,200 teachers now. We are well-positioned to not have to add as many teachers going forward and yet we still expect the enrolment growth, meaning that we are going to get higher utilization in our classes, meaning more students per class.

And even our small classes are going to have 62% to 65% gross margins, or higher. So that’s still well above our average of 61.6% last year. So even if we did all small classes, and it’s the books and the other revenue that drives our margins down, so if we did all small classes, we would still have 65% gross margins, which is 400 basis points, 300 basis points above where we are at today.

Hao Hong - Brean Murray, Carret & Co.

Thanks, Louis.

Operator

And our next question will come from the line of Candy Hong with Nomura.

Candy Hong - Nomura

Two questions -- the first is about your [next year financial] ‘010, the enrolment growth guidance. And second is can you elaborate a little bit more on the volume growth in Shanghai and Beijing? Because I recall that Shanghai, the enrolment growth slowed down and only because of the timing of the opening schedule of the schools but also the slow economy. So can you elaborate more on the third quarter -- actually, in the beginning of the third quarter the enrolment growth in Shanghai particularly. Thanks.

Louis T. Hsieh

Thank you, Candy. Beijing is doing exceptionally well. So Beijing is more than making -- Shanghai is slow, so you are absolutely correct. But Shanghai is slow mostly in the adult side. And so kids continues to grow rapidly in Shanghai. Overseas test prep is doing okay in Shanghai and You Can is doing very well in Shanghai, and high school. So it is the adult sector that has been consistently slowing in Shanghai.

And that is probably due to competition and also to the economy of last year. We are beginning to see stabilization in Shanghai and continued increase but don’t forget, last year Shanghai had very tough comparisons. Shanghai grew over 60% in 2008 and it still ended up growing over 25% for all of 2009, which is still very good growth but given it’s our second-largest school. But it was out -- Beijing has out-done Shanghai in fiscal year 2009 and we are hopeful that Shanghai will resume its growth rate. But 25% growth in our second-largest city is still very healthy -- it’s just not what Shanghai is used to of 50%-plus growth. So we would expect Shanghai to continue to grow between 20% and 30% for this year. We’re hoping for the upper end of that range.

Candy Hong - Nomura

And you talk about 20 to 30 is the enrolment or the revenue growth?

Louis T. Hsieh

The revenue growth -- the enrolment growth for the year, that was your first question, we would -- we’ve guided probably 10% to 15% enrolment growth, plus another 10%-plus in pricing power, so we expect -- we would guide revenue for 2010 fiscal year to be between 25% and 30% growth.

Now, as you know, Candy, this is the same guidance we typically give every year and the last two years, as you know, we grew 41% two years ago and 46% this last year.

If you put it in RMB terms, which is what I sort of go by, we grew 41% 2008 and 35% in 2009, so we beat the top of our guidance this year by 5%. And so we would expect over the next three to four years is for us to be able to grow 20%, 25%, to 30%, starting at the upper end of that and moving down to the lower end of that over time, as the law of large numbers gets us.

Candy Hong - Nomura

Okay. Thank you.

Operator

And our next question will come from the line of Mariso Ho with Credit Suisse.

Mariso Ho - Credit Suisse

Could you talk about your expectations for selling and marketing expenses in the new year? And also, do you have a guidance for us for FDC in FY10?

Louis T. Hsieh

Very good questions, both. On sales and marketing, last year it was 13.2% of revenue, so it was up 0.6% from 12.6 the year before. This year we would expect it to be somewhere between 13.2% and 14%. So we don’t expect it to go above 14% and it will probably be not much of an increase over that. But we’ve gotten more out of G&A, so G&A made up the difference on sales and marketing.

Now, stock-based comp is where we expect a benefit. Last year we recorded $16.8 million in stock-based comp. Because the ’07 options expire in third quarter this year, we expect stock-based comp to drop to between $14 million and $14.5 million. So that’s going to be a $2.5 million to $3 million reduction year over year despite revenue increases and the like, so that will be another about $0.07 per share.

Mariso Ho - Credit Suisse

Thank you.

Operator

We are now approaching the end of the conference call. I will now turn the call over to New Oriental's President and Chief Financial Officer, Louis Hsieh, for his closing remarks.

Louis T. Hsieh

Thank you, everyone. We very much appreciate you taking the time to attend our call. By the way, I was surprised that no one asked about the share repurchase program but we can get into that with the analysts later on. Thank you, everyone, for joining us this morning and this evening and this afternoon if you’re in Europe.

Operator

Thank you for your participation on today’s conference. This concludes your presentation. You may now disconnect. Good day, everyone.

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Source: New Oriental Education F4Q09 (Qtr End 5/31/09) Earnings Call Transcript
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