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

F2Q10 Earnings Call

January 19, 2010 8:00 am ET

Executives

Sisi Zhao - Senior Investor Relations Manager

Louis Hsieh - President, Chief Financial Officer, Director

Analysts

Mark Marostica - Piper Jaffray

James Mitchell - Goldman Sachs

Catherine Leung - Citigroup

Adele Mao - OLP Global

Ella Ji - Oppenheimer

Jeff Lee - Signal Hill

Philip Wong - Morgan Stanley

Amy Junker - Robert W. Baird

Ingrid Yin - Brean Murray

Brandon Dobell - William Blair

Marisa Ho - Credit Suisse

Ming Zhao - SIG

Operator

Good evening and thank you for standing by for the New Oriental’s second fiscal quarter 2010 earnings conference call. At this time, all participants are in a listen-only mode. After management's prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. (Operator Instructions)

I would now turn the meeting over to your host for today’s conference, Ms. Sisi Zhao, New Oriental’s Senior Investor Relations Manager. Please proceed.

Sisi Zhao

Hello, everyone, and welcome to New Oriental’s second fiscal quarter 2010 earnings conference call. Our second 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 view expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. New Oriental does not undertake any obligation to update any forward-looking statement, 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 Hsieh

Thanks you, Sisi. Hello everyone and thank you for joining us today. Let me spend a few minutes on highlights and updates from the quarter before going through the financial and then taking your questions. Those of you, who have been following New Oriental, since our IPO would know, one of the top risk to our business is not the most significant risk, it’s fear of disease outbreaks and pandemics, as we experienced with SARS in 2003 and avian flu several years ago.

And this year with the outbreak of H1N1, our first and second fiscal quarter operations were negatively affected. The impact of the H1N1 flu pandemic has been especially strong in China, given the population concentration and density in large cities, and as parents worry about the well being of their often only one child. The number of reported cases of H1N1 in China increased throughout the quarter and peaked in the last week of November 2009. That said, we do believe, the worst is over for now.

As we anticipated with the H1N1 vaccine being widely rolled out in schools throughout China, the fear of H1N1 flu has begun to subside. As of January 12, approximately 58 million people have been vaccinated in the Mainland. And in Beijing and Shanghai, over 60% of school-aged children have received the vaccine. As the fear of H1N1 subsides, we expect to see a pickup in enrollments for Q3, which ends in February, 2010.

In fact for the first six weeks of quarter three, we have already seen a noticeable bounce back in cash receipts, which is cash collected in advance for enrollments. During the last six weeks, cash receipts have increased by at least 30% each week compared to the year ago period, a good sign for our Q3 and Q4 of 2010.

As you all know, the second quarter of New Oriental's fiscal year is typically our slowest. Chinese school-aged children returned to class for the first semester of their formal school year. I’m pleased to say, we still saw sustained revenue growth for the top line increasing 23.8%, year-over-year to $61.2 million.

Driving these results was continued strong growth in our leading segments POP Kids English, middle and high school English, and U-Can all-subjects training and overseas test prep, which saw revenue growth of over 40%, 50% and 20% respectively.

POP Kids English continued its successful track record this quarter with enrollments up over 35% in Q2, despite H1N1 fears. By now, you’re all familiar with the paramount importance Chinese parents placed on the education of their often single son or daughter and the drive to begin the education process at a younger and younger age.

With our fun interactive courses, talented teachers and exciting content, not to mention a longstanding and trustworthy brand, New Oriental continues to be a major beneficiary of the demand for early childhood education in China. We plan to further capitalize on our brand strength and existing student base by introducing children’s math and Chinese writing courses through a pivot program in several large cities with expansion of these programs set for this summer, our fiscal Q1 2011.

I’d like to talk a bit more about our U-Can all-subjects training program. Q2 enrollments in U-Can were up more than 100% year-over-year with over 13,400 students enrolling in this program during the quarter. Revenue growth was also striking, increasing over 200% year-over-year.

And if you look at the first half of fiscal 2010, U-Can enrollments have more than doubled to over 46,900 and revenues have increased four fold from the year ago period. As a result, we are well on our way to meeting our target of US$25 million revenue for U-Can in fiscal year 2010.

We’re pleased to see the extremely positive reception U-Can has enjoyed and we believe it will continue to be a major growth driver as middle and high school students look to enroll in after-school, weekend and holiday classes to prepare for the all important Chinese national examinations for entrance into middle school, high school and university.

The diversity of required subjects included in the national exams creates a tremendous opportunity for New Oriental to leverage our expertise, geographic reach and top brand to include new content offerings. For example, as part of U-Can this quarter, we offered a science pack, whereby students who signed up for the package had access to small sized classes in biology, chemistry and physics.

As part of U-Can, during the summer quarter, we also launched a customized learning program of small and one-to-one courses, which has proven to be a very attractive option. These courses are centered on non-English all-subjects U-Can program content, but instead of the large class typically in U-Can, this program allows students to choose small class sizes of one-to-six students.

Students are increasingly choosing these smaller more expensive courses, they’re given greater access to teachers and more individualized attention in class. As the trend continues, we expect a shifting of our enrolment mix to smaller courses and higher blended ASPs. In the first half of fiscal year 2010, over 10,000 students have enrolled in VIP classes ranging from one-to-one, one-to-six students in both English and non-English courses.

Many of these enrolments stretched over two-to-four quarters, but are accounted as only one enrolment. This trend toward higher price, multiple quarter enrolments will increase our blended ASP, but will also slow enrolment growth as those multiple quarter enrolments will only be counted in the quarter, the initial registration occurred.

We are confident that with our two-pronged strategy of offering both affordable larger classes and higher priced individual smaller classes, we will continue to enjoy 25% to 30% top line growth. With such high demand for U-Can in our customized learning platform, we have increased our fiscal year targets for the rollout of these programs.

We have already made U-Can available in 32 cities and have raised our target for fiscal year 2010 to 110 learning centers in a total of 37 cities. And for the customized learning platform, we have raised our target from eight to 10 cities to a total of 30 cities operating this program by the end of our fiscal year in May. To accomplish these aggressive targets, we plan to hire over 1,000 full and part time U-Can teachers in fiscal year 2010, bringing the total count to over 1,400 for U-Can.

In addition, we plan to significantly augment our U-Can department by adding over 250 staff, primarily in marketing and customer service and R&D content development. The incremental cost of this accelerated expansion will be approximately $4 million to $5 million for Q3 and Q4 2010, but this will position us well for the seasonally most important summer quarter and beyond.

We are optimistic about the rest of fiscal year 2010, it has been a challenging year so far with unforeseeable external factors. But as economic situation continues to improve and the worst of the H1N1 pandemic appears to recede, we’re focused on extending our reach in existing cities. We’re on track to open 65 to 70 new leaning centers for fiscal year end 2010 and rolling out new programs for our existing students.

As always, there's a large opportunity in our market. Last week, Credit Suisse released their results of Asian Consumer Survey of Chinese households, which found that respondents across eight Tier 1 and Tier 2 cities indicated that they saved 30% to 35% of their household income for their children’s education and 44% of respondents indicated that their children were enrolled in education programs outside of their formal schooling, a figure that was even higher for higher income households.

As a leading private education services provider, we are well positioned to capture an ever greater percentage of the private education market and will continue to spend on marketing and promotion and hire the best talent in the industry to reach that goal . In all, we’re looking forward to what lies ahead.

Now let me take you through the financials. For the second fiscal quarter of 2010, New Oriental reported net revenues of $61.2 million, a 23.8% increase year-over-year. Net revenues from educational programs and services for the second fiscal quarter were $53.6 million; a 22.2% increase year-over-year. The growth was mainly driven by the increase in the number of student enrollments in language training and test preparation courses.

Total student enrollments in language training and test preparation courses in the second quarter of fiscal 2010 increased by 5.1%, year-over-year to approximately 307,000 from approximately 292,200 in the same period of the prior fiscal year.

GAAP operating costs and expenses for the quarter was $62.1 million or 27.9% increase year-over-year. Non-GAAP operating costs and expenses for the quarter were $57.7 million, a 30.5% increase year-over-year. Cost of revenues increased by 28.1% year-over-year to $27.8 million, primarily due to increased number of courses and the greater number of schools and learning centers in operation.

Selling and marketing expenses increased by 40.8% year-over-year to $11.7 million, primarily due to brand promotion expenses, especially for new programs such as U-Can and the new customized learning programs.

GAAP general and administrative expenses were $22.6 million, a 21.9% increase year-over-year. Non-GAAP general and administrative expenses for the quarter increased by 28.5% year-over-year to $18.5 million, primarily due to increased headcount as the company expanded its network of schools and learning centers.

Total share-based compensation expenses, which were allocated to related operating costs and expenses, increased slightly to $4.4 million in the second quarter of fiscal year 2010 from $4.3 million in the same period of the prior fiscal year. Stock based compensation should decline in Q3 and Q4, as the 2007 stock option grants complete their vesting schedule this month.

GAAP loss from operations for the quarter was $0.9 million, compared to an income of $0.9 million in the same period of the prior fiscal year. Non-GAAP income from operations for the quarter was $3.5 million, compared to $5.2 million in the same period of the prior fiscal year. GAAP operating margin for the quarter was negative 1.5%, compared to 1.8% in the same period of the prior fiscal year.

Non-GAAP operating margin for the quarter was 5.6%, compared to 10.5% in the same period of the prior fiscal year. This decline in operating margin was primarily due to the negative impact from the H1N1 flu pandemic and the increased marketing expenses for brand promotion, especially for new programs such as U-Can and our customized learning platform. GAAP net income for the quarter was $1.1 million, representing a 63.9% decrease from the same period of the prior fiscal year. Basic and diluted net income per ADS was $0.03 and $0.03, respectively.

Non-GAAP income was $5.5 million, representing a 25.8% increase from the same period of the prior fiscal year. Non-GAAP basic and diluted net income per ADS was $0.15 and $0.14, respectively. Capital expenditures for the quarter was $3.4 million, which was primarily used to add a net of 11 new learning centers and remodel older learning centers during the quarter.

As of November 30, 2009, New Oriental had cash and cash equivalents of US$210.6 million, as compared to US$238.7 million as of August 31, 2009. In addition, the company had US$141.7 million in term deposits at the end of the quarter. Net operating cash flow for the second quarter of fiscal year 2010 was US$9.6 million.

The deferred revenue balance; cash collected from registered students for courses and recognized progressively as revenue and instructions are delivered, at the end of the second quarter of fiscal year 2010 was US$71.1 million, an increase of 34.9% from US$52.7 million at the period of second quarter of fiscal year 2009.

New Oriental expects its total net revenues in the third quarter of fiscal year 2010, which runs from December 1, 2009 to February 28, 2010 to be in the range of $82.5 million to $85.1 million, representing year-over-year growth in the range of 26% to 30%, respectively. Note that the Chinese New Year holiday will begin on February 14, 2010, 19 days later than last year, when the holiday fell on January 26, 2009.

We believe the late timing of Chinese New Year in 2010 will have the effect of pushing out some of our enrollments into the fourth fiscal quarter at the expense of the third fiscal quarter, as students return to their studies in early March, which is our fourth fiscal quarter.

The opposite occurred in 2009, due to the early timing of Chinese New Year, when students returned to their studies in mid-February 2009, our Q3, and enrolled for Spring courses in Q3 instead of the Q4 2009. Thus, in fiscal year 2009, New Oriental recorded Q3 enrollment growth of 31%, and Q4 enrollment growth of only 8% as enrollments shifted from the earlier quarter.

Thanks. At this point, I will take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Marostica with Piper Jaffray. Please proceed.

Mark Marostica - Piper Jaffray

Hey, Louis, I wanted to just dig into your 25% to 30% top line growth expectations going forward and with the focus on VIP and resulting slower enrolment growth and higher blended ASPs, I’m wondering how we should look at that 25% to 30% in terms of with growth you’re expecting going forward on enrolments, and what growth should we look at on the ASPs?

Louis Hsieh

I think ASPs are going to continue to increase and probably be higher than this quarter, Mark, of 13.8%. Enrollments should still be inline, we’ve done 14% enrollment growth for the first half of the year and I would expect a similar number for the second half of the year, but because the ASPs are going up, we would expect revenues to be higher in the second half and we are also currently experiencing a relatively strong bounce back from the H1N1 quarter.

So, as we've said in the prepared remarks, the cash revenues in the first seven weeks of the quarter, every week has been well over 30% and all of December was well over 40%. So I think, as we expect faster revenue growth in Q3 and Q4, but we’re also going to begin to spend for the --prepare for the summer given that U-Can demand is much stronger.

The growth in Q3 and Q4 will continue to be driven by the same three groups. Kids English for six to 12 year olds and middle schools 12 to 18 year olds, including U-Can and overseas test prep, so the same three drivers that have been driving the shift for the last year will continue to drive the shift.

Mark Marostica - Piper Jaffray

And on the point on ASPs, what would you say your pricing increase was and is expected to be versus the effective mix shift?

Louis Hsieh

I think the like for like price increases still remain in the 6% to 8% range, but there’s a very strong shift occurring toward one-to-six person classes and we’re also getting a large of number of VIP people, Mark, who are purchasing these. I call my Disneyland, all one year annual passes. They basically pay RMB 30,000 or about US$4,300, that their parents buy for them and they can go almost any class within the New Oriental network for one year.

So these are proving to be quite popular and the same with like science path that we talked about. So students can enroll in six person physics one quarter, biology another quarter, chemistry another quarter, and enroll upfront. So this is what’s going to drive the ASP up, because these students are paying on average anywhere from $1,200 to $4,300 per enrollment, and it’s a growing number of students.

Mark Marostica - Piper Jaffray

Ok, great. Two final questions, I’ll turn it over. Regarding the $4 million to $5 million of incremental investment, was that $4 million to $5 million in each Q3 and Q4 or $4 million to $5 million total for the back half?

Louis Hsieh

It's $4 million to $5 million total, Mark. And like I said, as we -- originally we had expected enrollment this year about 80,000 to 90,000 in U-Can, and now that we are already at 46,900 in the first half, the second half is seasonally stronger. So we would expect that we’re going to get a large, we’re going to probably beat that 80,000 or the 90,000 [ph] number by a significant margin. Given that, we would expect the summer to be quite strong.

The other thing is that, given the acceptance of customized learning and U-Can we want to rollout into more cities than we originally anticipated. We thought we'd go into anywhere from -- originally it was going to be three cities , no actually two cities, Beijing and Shanghai, then we thought we'd rollout to eight cities. And now we’re talking about rolling out into 30 cities all this year.

So that kind of rapid expansion is going to mean that we’re going to need hire another 1,000 teachers for fiscal year 2010. We’ve hired 300 of them so far in U-Can. So another 700 teachers to go in the next two quarters and that’s what’s going to drive up the G&A cost as we train these teachers, but it’s going to help us meet what we expect to be a very strong summer for U-Can and Kids enrollments.

Mark Marostica - Piper Jaffray

Got it. And then last housekeeping question here, you mentioned stock based comp should show some modest declines, Q3, Q4. Could you quantify that?

Louis Hsieh

Yes, we have $8.8 million a year that is tied to the 2007 stock option grant. They expire January 29 of this year, so in a week or so, a week and half. So in Q3, we’ll get one-third of that benefit, so you’ll get a 700,000 lowering and Q4 should get the full of $2.2 million.

Operator

And your next question comes from James Mitchell with Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

Sure, thank you for taking the question. It's pretty amazing you've layered the U-Can business onto to your existing models without crushing margins despite H1N1. Can you help us size the potential U-Can contribution to enrollments in fiscal ‘11? And also previously you expected gross margins to be up about one point for fiscal ‘10. Do you now expect margins to be down in fiscal ‘10 due to U-Can spending?

Louis Hsieh

Yes, I think gross margins should stay about the same, James. That's the second part. The first question on U-Can enrollments, we don’t have our projection for’11 yet, but we do expect now that ‘10 enrollments will exceed the 88,000-90,000 that we originally had forecast. The talk is that, ‘11 should grow at least 50%. So if you assume we do a 100,000 enrollment this year, we should do 150,000 next year, the key here is the ASPs are going up.

So the ASPs in U-Can last year will run a US$120, this last quarter, they were over US$300. So that’s why revenue jumps from $7 million last year to over $25 million this year and it should again very close to double next year.

James Mitchell - Goldman Sachs

And do you expect structural differences between U-Can and the initial batch of cities versus U-Can in second tier cities, where I’m guessing the market is smaller, but less competition?

Louis Hsieh

Absolutely correct. And right now, most of our competition is located in Beijing and Shanghai only or at least 90% of revenue is derived from Shanghai and Beijing only. So we’re doing very well in Shanghai and Beijing, but we want to get early mover advantage in the other 28 cities or 40 cities that we’re in. So the key is that the ASP will be lower, let's say it's RMB 300 per hour in Beijing for one-on-one tutoring, it only may be a 150 in a tier 2 or tier 3 city.

Also the teacher cost go proportionally down as well, but we think it’s important to get in there early, because our early success, even in tier 2 and tier 3 cities tells us that we want to get a foothold as early as possible and the market would develop much faster than we originally thought.

On operating margins, James, we do expect operating margins to be down year-over-year because of the H1N1 virus. If you think about it, our budget calls for 28% revenue growth for the year and I was conservative originally and 27% expense increases. So whenever we don’t grow at least 27%, we are going to take margin contraction on the operating line.

And then on top of that, when you layer in extra marketing spending as we went into the one-on-one program and also this rapid , more aggressive expansion plan in the U-Can, it’s going to wipeout the margin expansion hopes for this year. But like I said, I think it's, all we are doing is front loadings some expenses because this summer, we expect to be quite a good one, assuming there’s no more surprises ahead .

Operator

Your next question comes from Catherine Leung with Citigroup. Please proceed.

Catherine Leung - Citigroup

Hi. I’ve two questions. My first question is, firstly, would you be able to comment, whether you’re seeing similar demand for smaller classes in other segments, such as Adult English and the test prep segment? And secondly, regarding the accelerated expansion of the U-Can and the customized learning programs, would you be able to comment on content demand trend for these small classes in Beijing and Shanghai versus tier 2 cities?

So as your decision to accelerate expansion due to as you said, trying to preempt the competition, or have you already start to see the demand for the smaller classes increasing in the tier 2 cities as well? Thanks.

Louis Hsieh

I think the second question is, we have seen demand in the tier 2 cities begin to increase, and that's why we are -- so it’s both, Catherine. We are going to try and preempt competition and it's because we see the market, otherwise it would be a money losing operation to expand there too quickly.

On your first question regarding one-on-one, one-on-one started with English, so English still remains our number one one-on-one category. And so of the 10,000 enrolments that we’ve received in VIP in one-on-one in the first half of this year, more than half are for English and then there’s another probably 10% to 20% that are targeted at overseas test prep.

So one-to-one preparation for GRE, TOEFL, SAT etc., so it’s only about 3,000 of the enrollments that are targeted at U-Can, it's a non-English subject, but they are obviously the fastest growing portion. For all of last year, we got 12,000 one-on-one , or we are anywhere from one-to-six enrollment size, this year we expect over 20,000.

So that this small class in this one-on-one format is extremely popular and as you know the ASPs here average over US$1,300 versus a $120 for the big classes or each one enrollment is already equal to 10 other enrollments, so it’s very significant in our revenue mix.

Operator

Your next question comes from Adele Mao with OLP Global.

Adele Mao - OLP Global

You mentioned that cash receipts since early December has increased at least 30% each week compared to last year. Remember last year you had the enrollment figures for the first weeks actually reported and the number was I think 160,000. Could you give us the enrollment figure for the first six weeks of this year?

Louis Hsieh

I don’t have it handy, Adele. The enrollment increases are not as high, they’re probably in the 10% to 15% area. What’s happening is, as I said is, the deferred revenue number is going to continue to get bigger and bigger, because students are signing up for multiple quarter classes, so I can tell you the cash receipts for all of December were well up over 40% for the month and so far in January they are tracking over 35%.

So, but they don’t translate one for one into revenue, so what happens is that, because they are multiple quarter, a less or lesser percent of the cash receipts will be recognized in the same quarter. So that’s why we were conservative in saying we expect 30% revenue growth for the quarter.

Adele Mao - OLP Global

I also want to dig a little bit more into the impacts of the timing of Chinese New Year that this year Chinese New Year is 19 days later as you mentioned but when we look at that the winter break duration for most of students in China it seems that the winter break is actually one to two weeks longer.

Is it fair to assume that, during this winter break, more students are going to be able to take classes in more dates and allow EDU to actually book more revenue during the winter break versus the same period last year where you had sort of a scheduling issue in cities in Shanghai?

Louis Hsieh

That's a very good question, and thanks for raising that one. Chinese New Year is February 14 this year. So what we expect is, it’s actually a long front cycle now. So the first half of Chinese New Year is actually a week longer, so that’s going to happen is the first half of Chinese New Year we’ll see hopefully much stronger revenues than the same period of last year, where we were shortened because of the early timing of Chinese New Year.

The second half is the same way, so it’s still one or two weeks after the February 14 date, but the point we made about enrollments is that, because Chinese New Year is February 14 this year, similar to what happened a few years ago is that students go back to school is early March, which is already Q4. So by the time they enroll for Q4 classes or spring courses, they will be enrolling in Q4, so those enrollments are kind of Q4.

Last year, because Chinese New Year was so early, it was January 26, students went back to class around February 10, February 14. So when they signed up for their spring courses, they are counted in Q3 of 2009 and so Q3 2009 saw 31% enrollment increase, but then of course it just borrowed from Q4 and Q4 only saw 8% enrollment increase.

This year is a more normal year, because they have tough comparisons versus last year, enrollments were 31%, we’ll see hopefully better revenue, but lower enrollment growth and Q4 should have better enrollment growth, because it will get the bulk of the spring enrollment in Q4, when the students go back in March. It's a little bit complex, I hope I explained it so you understand that.

Adele Mao - OLP Global

The enrollment growth you’re referring to, it’s just the quarter end enrollment growth, because students may not have to…?

Louis Hsieh

Because our quarter ends February 28, and so whenever Chinese New Year is late, enrollments get shifted from Q3 into Q4, whenever Chinese New Year is early, Q4 enrollments get pushed into Q3 and this year happens be a late Chinese New Year. So enrollments will get pushed from Q3 into Q4. If you take a six months view, it'll all washout, be the same, which is growth anywhere from 12% to 14%.

Operator

Your next question comes from Ella Ji with Oppenheimer.

Ella Ji - Oppenheimer

I’m wondering if you can provide a mix of your revenue and the enrollment of your larger class, middle class and one-on-one small class within your U-Can segment.

Louis Hsieh

Okay, that's a great question. Luckily, I had that prepared. The one-to-one enrollment in the quarter was 1,200 out of the 13,000. The one-to-six was 605 and the seven-to-40 or seven students and more was 10,100 and change and then we also had some Mingshitang about 1,400 enrollments in short term.

Ella Ji - Oppenheimer

Do you have any target enrollments mix by year end or even longer term?

Louis Hsieh

Yes, for fiscal year 2010, we expect between U-Can and Mingshitang over 5,000 one-on-one enrollments, and over 2,500 one-to-six enrollments and over 85,000 larger than six people per class enrollments. So, we’re getting to be right around 90,000 to 100,000, that’s the target. Obviously, we were tracking better than that in the first two quarters. We are already at 47,000 and then usually, we have higher enrollments in Q3 and Q4 than we do in the first half.

Ella Ji - Oppenheimer

Shifting gears a bit, I want to ask about, I remember that last year in third quarter, your adult English had a relatively weak performance. I’m wondering if you can talk about the year-over-year comp in this year for that segment.

Louis Hsieh

Unfortunately, that’s not a positive point for us. We had 50,000 enrollments last year in Q2. We only had 41,900 this year. So basically it was a 11% drop in enrollments. Sorry, enrollment growth was down 17% and revenue was down 11% year-over-year, but this has been sort of a long term trend anyway.

As we teach kids in the middle school English, it’s obviously going to cannibalize Adult English, because these adults are 40 year old, these adults are 18 to 25 most of them. So as we do a better and better job in middle and high school English and Kids English, there will be no need for Adult English among many of our students in China, but this I think is longer term trend anyway.

Ella Ji - Oppenheimer

So do you believe it's -- you are believing that if the market size for Adult English is likely shrinking towards this, it could be likely that there's higher competition in the market, which one is the primary driver?

Louis Hsieh

I think our competitors are probably doing worse than us, from what I’ve heard in the market in the adult side. So I think we’re probably doing relatively better. For the first half of the year, our enrollments in Adult English are down from 173 last year, and 173,000 to 166,000 this year. So the enrollments are down 3%, but the revenue was up 6% for the year. So it’s still growing in revenue, it is just that it is much slower rate than five years ago.

Ella Ji - Oppenheimer

My last question is regarding your marketing and the related promotional spending for U-Can. Can you just talk about how much you spend versus you originally budgeted?

Louis Hsieh

We originally had not budgeted for one-on-one spending at all. So we originally budget for U-Can, I mean the $39 million budget for fiscal year 2009 -- 2010 when we budgeted last April and then that's before we started the one-on-one programming. Of that $39 million, more than $10 million was allocated for U-Can in middle and high school English for 12 to 18 years olds.

When we decided to go into one-on-one customized learning during the summer, we increased the budget by $6million just for one-on-one learning and you know of course it benefits U-Can as well. So we've increased it from above a little over $10 million to $16 million in marketing spend for 12 to 18 year olds.

The total budget is $49 million, so it went from $49 million to US$55 million for the year. For the first two quarters, we’re at $26 million, so we’re a little bit less than half of the revised budget of $55 million for sales and marketing promotional expenses.

Operator

Your next question comes from Jeff Lee with Signal Hill. Please proceed.

Jeff Lee - Signal Hill

What kind of impact would you say H1N1 had on enrollments during this quarter? I mean obviously it was quite a bit negative. Were there any other factors leading to the 5% enrollment growth?

Louis Hsieh

Well, I think the enrollment growth was also impacted by students signing up for multiple quarter of classes, which is a good thing, because obviously we lock them in longer, we get the cash upfront, so that also. But I think H1N1, we only grew 5% in enrollments in the quarter. Even last year, we grew at 13% and that was in a very good Q2.

So we grew 13% this year like we had done last year it means difference about what about 30,000 enrollments for the quarter. If you do the same thing, add several percent for Q1, it impacted us just by about 80,000 to 100,000 enrollments, by 80,000 enrollments in the first half of year.

Operator

Your next question comes from Philip Wong with Morgan Stanley. Please proceed.

Philip Wong - Morgan Stanley

I have two questions, and number one, about the increase in enrollment for December, are they mainly from U-Can or the new customized learning program or from the traditional English training classes? Number two, before introducing the U-Can and small classes tutoring, we expect margin expansion on utilization improvements and how should we look at the margin trend going forward as we are expecting higher revenue’s contribution from the smaller classes with lower margin?

Louis Hsieh

Yes, that's a good question. I think on the December enrollments, the growth is in the same areas. It’s U-Can, it’s in Kids English and it’s in overseas test prep. Those are the three fastest growing areas and that’s expected, because it’s during the school holidays. Now, the other thing you should be aware of though is that as U-Can grows, it also has a negative impact on middle and high school English, because remember the students are used to taking New Oriental only for English, now we’re switching and taking, some quarters are taking U-Class classes, other subjects than English.

So English enrollments are growing slower than in the past, because of being cannibalized by U-Can, which is fine. The net effect is that, the overall number of classes a student takes is increasing and the dollars they are paying is much higher, so it's the effect we expected , but it’s happening faster than we thought, because of the rapid increase of U-Can.

Our margin is that, before H1N1 came in and before we decided do one-on-one tutoring, we had a budget that like I said, that called for 28% top line growth conservatively and 27% expense growth. So what happens is that if we didn’t change the budget, anytime if revenue growth is below 27%, you can see margin contraction. If revenue growth is above 27%, you’re going to see margin expansion. We expected it to be above, we expected to get margin expansion, that obviously didn’t occur.

So revenue has only increased 25% in the first two quarters and also because we are expending a lot of money, over $6 million in sales and marketing that’s new and another $8 million to $10 million in building out U-Can in a much faster rate that we expected. So that of course is going to be negative to margins all around.

Now gross margin did stay relatively the same for the year, about 61% to 62%, but operating margin should be below by about a 100 to 150 basis points. Now I also want to make one point though, we have not changed our EPS for calendar 2010. All we’re doing is frontloading some of the expansion expenses from next year into this year because of the rapid growth of U-Can.

So we were going to have to spend that money in the next 12 to 18 month anyway. We’re just frontloading it. So I think we don’t expect to do it for nothing. So we expect some enrollments and the numbers beyond that to pickup, Q4 and Q1 of next year to pickup. So we still expect 260 to 270 in GAAP EPS for the whole year.

Operator

Your next question comes from Amy Junker with Robert W. Baird. Please proceed.

Amy Junker - Robert W. Baird

If I can just touch on the margins again and make sure I understand in your comment about the full year EPS, calendar EPS guidance not changing, which I guess I’m a little surprised by that comment. So the $4 million to $5 million incremental spend, first can you help us understand, how that’s going to spilt between third and fourth quarter, will it be pretty even or is one quarter going to be hit more than others?

Louis Hsieh

Q3 would probably be a little bit hit more. So let's say its $4.5 million, probably Q3 will incur $2.7 million to $2.8 million of it and Q4 will probably 1.7.

Amy Junker - Robert W. Baird

Does that account for, does the $4 million to $5 million account for, I guess, any additional drag on margins, because I would assume as you invest there, I guess there’s going to be more of an incremental hit on just $4 million to $5 million? Am I thinking about that the right way and kind of like with that’s…?

Louis Hsieh

The drag is on fiscal year 2010, and it will fiscal 2011. So it’s building ahead of the demand. So if we don’t add these 700 teachers in the next two quarters, we won’t be ready for the summer, because we’re expecting better demand than we had. If you think about it, I want to step back, if you think about what New Oriental did in rolling out one-on-one programs is that, we could have bought our way in. It would have been very expensive.

So if we bought our way in by buying one to two or three large competitors in the space, we probably would have to pay somewhere between US$200 million and US$300 million. That would have been huge dilution to our shareholders. What we would have gotten is a business that looks like U-Can in about six months. So in 18 months, we can build a similar size program as we would have bought last year. So we’re 18 months to two years behind, but we can do it for US$30 million to US$40 million.

So we’re asking our investors to understand that this is the right strategy for the long term benefit for the company, but it’s a make or buy decision and if we weren’t successful in buying it, but it would cost probably eight to nine times as much, and we would have to deal with over lapping learning centers, we would have to deal with cultural issues and redundancies among different departments and things. And so the analogy I use is that, you have the choice of buying a house that’s been remodeled or starting with a foundation and building the house the way you want it. And the way you did building a new house, it takes you an extra 18 months, two years, but it’s exactly the way you want it, and it’s only one-eight or one-ninth the cost, but you do take a hit in the market in the meantime. So we are building it ourselves. We are taking the hit now, but I think it will be a much better product when it comes out in the next six months to nine months, when we catch up, but in the meantime, it is short term paying.

Amy Junker - Robert W. Baird

I guess help me understand, what’s the execution risk of going into 30 cities and maybe to use your analogy? What’s the risk of that this house that you’re building, that you think is only going to take 18 months, the contractors are slower than what you signed on for and it really takes 24 to 36 months to build?

Louis Hsieh

It wont take that long because it's rolling as we speak and we are -- the 700 teachers we’re hiring in these next two quarters are right on schedule. I mean we’re actually ahead of schedule on demand and we’re right on schedule as far as teacher hiring for the first two quarters. We didn’t expect demand to be that strong. So that’s what we’re adding incrementally in Q3 and Q4, knowing that Q1 at the summer is our all important quarter.

And so if we’re ready by then, we will see even more demand in Q1 as a result of preparing in Q3 and Q4. Just the idea of, same thing as we use to do with learning centers, we just had a lot of learning centers in Q3 and Q4 to prepare for the summer. Now we are just doing with teachers as well as for staff.

The other thing we’re doing, which is new in New Oriental, relatively new, we are actually expanding a lot of money in building our content. So we want a competitive advantage in the market, New Oriental wins through best brand, through teacher quality, and now we are expanding our content development team drastically by about 60 to 80 people, so more than doubling it to focus on six to 18 year old student content.

Amy Junker - Robert W. Baird

That’s included in the four to five million…?

Louis Hsieh

Yes, it is included. So the 250 headcount that’s included in U-Can for this year, 60 to 80 [ph] is in content development, another 100 or so is in customer service and marketing. So those people, those customer service agents that help families decide on the course of study for their children, we’re increasing that significantly, because customer service becomes obviously more and more important as you build a expensive one-on-one offering platform. You’ve very demanding clients, so we want to compete not just based on our brand and best teachers, but also on best content and best service. We think that formula works all throughout China, at least in the 40 cities we’re in today.

Amy Junker - Robert W. Baird

Just last housekeeping question on tax rate, because it looks like you got a benefit this quarter. What are your expectations for the full year?

Louis Hsieh

Expectation is 9% tax rate for the year. We did get a benefit because we didn't make as much money as we thought. That’s one of the few benefits of the slow down.

Operator

Your next question comes from the line of Ingrid Yin with Brean Murray. Please proceed.

Ingrid Yin - Brean Murray

So we talked a lot about U-Can program, could you give more guidance on the U-Can program revenue growth rate going forward? The year-over-year growth rate is really impressive, it's 100%. Do you still see the market still underpenetrated, what kind of revenue rate or growth rate we could expect going forward for the rest of 2010 and if possible for 2011?

Louis Hsieh

Yes, I think for 2010, at this point, if we take fiscal year 2010, last year we had 57,000 enrollments or so, $7 million in revenue. This year we expect probably close to 100,000 enrollments and probably revenue of $25 million or more. So basically, enrollments will grow by 70%, 80%, but revenues will almost quadruple .

Next year we would expect probably enrollment growth at least 50% from what we do this fiscal year and we would expect revenue to grow faster than that because ASPs continue to climb. So we would expect revenue growth to be probably 10 to 15 points higher than our student enrollment growth.

Ingrid Yin - Brean Murray

The second question is on increased selling and marketing cost. So it really makes sense to me to invest early to get prepared for this summer, but how many quarters will we need to invest in this segment to get established in U-Can even in the second tier city?

Louis Hsieh

I think is that this year is the high point as far as percentage of revenue. I don’t think we’ll hit 15, but we’ll be very close, between 14% and 15% of revenue. I don’t believe we’ll be that high going forward. So I think this is the year that we have U-Can going, one-on-one going and we’re also beginning to ramp up in kids marketing as well as you rollout kids math and kids writing. So we have many programs going at the same time right now. I don’t see that many new rollouts in the next few years.

Ingrid Yin - Brean Murray

Can you comment on the potential share buyback and dividend payout plan?

Louis Hsieh

We haven’t discussed it for calendar year 2010 yet, but last year we spent $30 million and we bought back 400 and some odd thousand shares. The year before, we spent $64 million and bought back one million shares. So right now, we have about $350 million, $360 million in cash. So we usually discuss that in the second half of the year.

So we had the few last years, we started our buyback program in April or in July. So we’ll most likely look at that again at the next Board meeting in March or April. We just finished one in end of November, so we would look at another one depending on cash flow factors and how the business is doing in the next Board meeting.

Operator

Your next question comes from Brandon Dobell with William Blair. Please proceed.

Brandon Dobell - William Blair

Just two questions for you. First on teacher retention, how things have been going, you are satisfied with the trends there? Then second, the overseas test prep business, any updates on dynamics there, enrollment growth pricing and opportunities for different kinds of business models, those kinds of things would be great?

Louis Hsieh

Teacher retention has not really been much of a problem since the IPO as you know given that we gave stock options to our start teachers and that we continue to pay among the highest in the industry if not the highest in many cities. So teacher retention is not an issue, we still hire less than one in every 10 applicants or so. Now, I think the percentage might go up a little bit as we hire more part time teachers for U-Can, but we are not having tremendous difficulty finding teachers right now.

Overseas test prep, the trend is TOEFL is still going to grow, the number of test takers are still growing 20% or so, same way with IELTS, GRE well -- I mean they’re all growing, I mean they’re growing low single digits for us in enrollment, but the key is the pricing increase is still up about 20%.

The other thing that’s important about overseas test prep is that there’s a shift towards the SAT and younger students leaving China to go directly overseas for college. So that kind of test prep pull forward in IELTS and SAT test prep were all growing in the double digits and we don’t see any change at least in the next 12 months.

Brandon Dobell - William Blair

Any opportunity there to migrate that model to some kind of an online format, or do you think that the test taking population just isn't ready for that kind of switch yet?

Louis Hsieh

Well I think is that, don't forget the students, most of the students who take SAT test prep, they usually come from very wealthy families. If that’s the case, they are not going to want their test prep online, most of them, because that’s the least effective way to learn versus a live teacher versus one-on-one. So if any thing, it's going toward migrate toward one-on-one and one-to-six teaching.

I mean we have students who want one-on-one writing instruction for SAT, you can't do that online, and so that the shift is actually towards smaller classes and more expensive classes. Online is the much less expensive option You think about it, even in Korea, right, where you have Megastudy, , these superstar teachers and things that go on online in this great platform. Don’t forget that, probably 50% to 70% of Korean high school students take one-on-one tutoring for the KSAT. So they use online as the supplement, not as the key studying tool.

Operator

Your next question comes from the line of Marisa Ho with Credit Suisse. Please proceed.

Marisa Ho - Credit Suisse

You now seem to be positioning for margin expansion in FY 2011, which is pushed out for FY ‘10, what is the risk of that happening? I mean for example, if over the next six months, you continue to expand into U-Can and you find that the market is actually a lot larger than you're originally thinking, would you find yourself frontloading more investment into FY ‘11 and thereby the margin expansion not happening?

Louis Hsieh

I don’t think we’ll frontload anymore than we are now. I mean, part of our calculus right is that the summer is all important. So if we frontloaded in Q3 and Q4, we’re ready for the summer. Actually, the summer in Q2 is a slowdown. So the right time to frontload it if any will be in Q3 and Q4, which is what we’re doing.

It’s unlikely we’ll have to do that again in 2011. If we do, it will be at end of fiscal 2011, it will be Q3 and Q4 of next year. That will be a high class problem to have. If we didn't have H1N1, our revenue growth, that means, is well north of 30%. So we'll have plenty of margins to play with if that happens.

You are seeing my point, right, is that we’re using it to do frontloading of the capital building in Q3 and Q4. So if we do it this year, we’re fine until Q3 of next year. Q2 next year, if demand is so strong, that means that the markets have already gone up. This year, if we didn’t have the H1N1, our revenue growth was in excess of 20%, we would still have relatively margin neutral or margin expansion despite the build out. It's because our revenue growth is trailing, that’s the issue.

Operator

Your final question comes from Ming Zhao with SIG. Please proceed.

Ming Zhao - SIG

I just wanted to question on the -- in your expectation, do you have a breakdown of revenue for each major segment in fiscal year 2010? What’s the percentage of revenue U-Can can contribute in this fiscal year?

Louis Hsieh

I wouldn’t count U-Can as a separate group, but U-Can should contribute $25 million out of approximately $360 million, $370 million. The U-Can should be about 6%, but if you take U-Can plus it’s the same student, right, 12 to 18 year old. The English portion would be $40 million or $45 million, together with that $70 million add up to $360 to $370 million in revenue for fiscal year 2010. If that segment grows let’s say 40%, 50% next year, it will grow to about a US$100 million out of about $430 million or so for next year, it becomes over 20%.

You can see that within -- we expect the 12 to 18 year old segment within four or five years to be the number one revenue contributor in New Oriental and the number one profit contributor within New Oriental. This can overtake overseas test prep. It'll probably overtake overseas test prep in three years in revenue and overtake overseas test prep in four or five years in contribution to the bottom line. That’s how important this business is to us.

Operator

We’re now approaching the end of the conference call. I would now like to turn the call over to New Oriental’s President and Chief Financial Officer, Louis Hsieh, for closing remarks. Please proceed.

Louis Hsieh

Thank you. I just want to thank everyone for joining this call today and we look forward to seeing you in the course of the quarter. Thank you very much.

Operator

Ladies and gentlemen, thank you for your participation in today’s presentation. This concludes our call. You may now disconnect. Have a good day.

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Source: New Oriental Education & Technology Group Inc. F2Q10 (Qtr End 11/30/09) Earnings Call Transcript
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