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New Oriental Education & Technology Group (NYSE:EDU)

F2Q14 Earnings Call

January 21, 2013 8:00 AM ET

Executives

Sisi Zhao – Director, IR

Louis Hsieh – President and CFO

Analysts

Ella Ji – Oppenheimer

Zhuang Chao – Macquarie

Fei Fang – Goldman Sachs

Trace Urdan – Wells Fargo

Philip Wan – Morgan Stanley

Tian Hou – TH Capital

Clara Fan – Jefferies

Vivian Hao – Deutsche Bank

Charles Cartledge – Sloane Robinson

Kenny Lou - Flowering Tree

Operator

Ladies and gentlemen, good evening and thank you for standing by for New Oriental’s Second Fiscal Quarter 2014 Earnings Conference Call. At this time, all participants are in listen-only mode. After management’s prepared remarks, there will be a question-and-answer session. Today’s conference call is being recorded. If you have any objections, you may disconnect at this time.

I would now like to turn the call over to your host for today, Ms. Sisi Zhao, New Oriental’s Investor Relations Director. Ms. Zhao, please proceed.

Sisi Zhao

Hello everyone, and welcome to New Oriental’s second fiscal quarter 2014 earnings conference call. Our financial results for the period were released earlier today and are available on the Company’s website as well as on Newswire services. Today, you will hear from Louis Hsieh, New Oriental’s President and 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 1995. 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 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

Thank you, Sisi. Hello everyone and thanks for joining us today. I am very pleased to report a stellar set of quarterly financials in our seasonally slowest period and strong top-line and bottom-line growth driven by very encouraging growth in enrolment trends and efficiency improvements across the network.

We began to pivot towards our harvest the market strategy in November 2012 with an expectation that it would deliver a greater utilization improvements in operating margin and increased profitability.

Today’s results demonstrate yet again how this approach is reaping rewards in fact since the pivot in November 2012 we have recorded very strong margin expansion and GAAP operating margin reaching 17.4% in the last four quarters compared to 12% in the previous four quarters.

We raised our GAAP operating margin guidance last quarter to 16% to 17% and we are well on our way to exceeding that target for the full fiscal year 2014 any measure we want.

We will strive for balanced healthy top-line growth with improving margin albeit at a slower pace than the past year with respect to margin improvement in the quarters ahead.

On the top-line, we recorded solid revenue growth of 25.6% driven primarily by a very impressive 11.8% increase in student enrollments. This is obviously very encouraging particularly when considered that we actually ended the second quarter with 711 learning centers and schools, 33 fewer than the year ago period.

This really highlights how we are gaining traction across the learning center network and benefiting from the network expansion efforts we undertook from 2009 to 2012 to build out our K-12 after school all subjects tutoring and VIP businesses.

I am particularly pleased to note that we recorded a 16% increase in enrollments for our K-12 all subjects after school tutoring business. This is a very important business line for us. So the growth trajectory is very positive and underlines our success in capturing market share in this fast-growing segment.

The other major contributor to our improved enrollments is actually domestic test prep for the CET 4 and CET 6 college English exams. This is a segment where we have experienced a slowdown in the recent years.

What we’ve seen however is that the new change in the test format introduced in December 2013 have made the exam more challenging by adding a translation dictation and comprehension questions.

We are now seeing students coming back to New Oriental because they recognize that our premium brand offers the best preparations for the new and more difficult exams. It’s too early to tell this is a long-term trend but we will keep you posted.

We are also pleased to record strong revenue growth while actually experiencing slower growth in ASPs which grew only 9.5% year-over-year in the quarter as we shifted our product mix toward larger class sized courses.

As you know, our goal is to cap our VIP class offerings at around 20% of overall revenues to ensure that we can maximize the efficiency of our learning center networks.

Looking at the bottom-line, in the second quarter, we achieved dramatic improvements. Operating income grew to $0.7 million from a loss of $26.9 million and net income rose to $4.3 million from a net loss of $15.8 million last year. This is obviously very encouraging and again underlies how we are benefiting from organic growth as well as efficiency initiatives we have worked hard to implement over the past year.

As you know, we are focused on driving efficiency across the network improving our utilization rates, getting the right headcount mix and managing our expenditures appropriately. So these bottom-line numbers are a direct results of that approach.

Looking at our network, in the second quarter, we opened eleven new learning centers in nine fast-growing and high profitable markets and closed thirteen learning centers including six underperforming ones.

To meet the seasonally higher demand – market demand for K-12 after school tutoring in the coming winter and spring quarters, in the second half of the fiscal year, we will continue to open some new learning centers in fast-growing cities.

We will maintain our focus on operational efficiency and we will open learning centers in locations where it makes obvious financial sense for us to do so.

Moving to the breakdown of our performance across our individual business lines, we continued to see healthy growth across our core offerings for the second fiscal quarter, in particular in our overseas test prep and K-12 after – all subjects after school tutoring businesses.

Our K-12 all subject after school tutoring business has achieved gross revenue growth of 26% year-over-year for the second fiscal quarter. This is encouraging as we enter the seasonally busy winter and spring quarters when students prepare for end of term examinations at the end of spring semesters as well as the Zhongkao and Gaokao high school and college entrance exams in early June.

Our overseas test prep and overseas study consulting business continued to perform well. We recorded combined revenue growth of over 28% across the two lines for the second fiscal quarter. Our domestic test prep business performed well this quarter.

This business line achieved gross revenue growth of over 30% year-over-year for the second fiscal quarter. The national English exams have undergone quite a new format change making them much more difficult starting from December 2013 as mentioned earlier.

Thus more students registered for our domestic test prep in the second fiscal quarter to get better prepared for that new format.

Finally, our VIP personalized classes business recorded about 24% year-over-year cash revenue growth in the second fiscal quarter. We intend to cap the percentage of revenue generated from our VIP offerings to about 30%. This will help to improve our operating margin since larger classes typically have higher margins.

While I talk about our business lines, I do want to highlight some of the important progress we have made in developing our online offerings. We are very excited about the potential of the online segment for New Oriental.

This is an industry where high quality content and premium branding power would drive success. So obviously we believe New Oriental has a significant advantage vis-à-vis our peers.

There are two primary pillars to our online education offerings. The first pillar involves integration between our online and offline offerings to improve the learning experience for our students and drive cross-selling opportunities.

So for example, we have recently started to rollout our online interactive learning platform. This platform will cover all of our major product lines, enable students to go online after class to do exercise and quizzes interactive teachers at real-time.

We believe the new online interactive learning platform will tremendously enhance the learning experience for our customers and create new revenue streams with online value-added services and many – also – bring online to offline traffic to generate more enrollments and revenues.

We have also recently started some pilot programs to broadcast some of our most popular test preparation classes. Paying users can log on to the live broadcast on our official website or on Koolearn.com platform and they can also watch streaming videos of their classes at any time.

Our pilot program is already proving quite popular with thousands of registrations with a few days of launch and we are very optimistic of the potential here. We believe that the new type of offering will increase our productivity and utilization and education resources such as our content and teachers.

Our secondary strategic focus online involves our purely online learning product. As you know, we already have a very mature and successful online learning platform called Koolearn.com.

We now offer them over 2000 online courses for teenagers and adults on Koolearn including language training, test preparation and vocational training. And I am pleased to say that Koolearn is already the number one player in this market growing rapidly at over 30% annually and highly profitable.

We have also recently developed a suite of mobile and web game-based learning applications aimed at providing an enjoyable English math and Chinese reading learning opportunities for children ages two to eight branded Donut. This suite of product is now being rolled out very quickly.

Most of the applications are currently free to download but includes various in out purchases options that will allow us to improve monetization. The content is uploaded monthly which ensures users taking it.

Finally, we continue to explore opportunities to work together with large-scale internet companies to further develop our online offerings and we will keep you posted on this effort.

Looking at our acquisition strategy, as you will have seen from our release earlier, we signed a definitive agreement to acquire a kindergarten in Changsa that has over ten kindergartens and 3000 students in 2013.

The aim of this acquisition is to increase our presence in the pre-school market and ultimately support our POP Kids and U-Can middle and high schools tutoring businesses lines. We will be consolidating the kindergarten’s financial results into New Oriental’s results in the fiscal quarter when the transaction is completed.

Let us move to some of the other important financial metrics for the second fiscal quarter in addition to revenue which we’ve already discussed. Selling and marketing expenses for the second fiscal quarter increased by 7.1% year-over-year to $36.8 million.

The schools that have been opened from two or three years are now increasingly able to rely on word of mouth and repeat business to drive enrollments which is very healthy. In line with this, actual brand and market promotion expenses declined approximately 2% year-over-year to $13.5 million.

In addition, general and administration expenses for this quarter decreased by 5.6% year-over-year to $73.4 million. Headcount at the end of November stood at approximately 29,900, a reduction of 3,000 for the same period last year.

This strict control of sales and marketing G&A and headcount expenses contributed to our impressive operating margin improvement of 1660 basis points compared to the year ago period. As I highlighted previously, quarterly operating income increased 102% year-over-year to $700,000.

Operating margin for the quarter amounted to 0.3% compared to negative 16.2% in the same period in the prior fiscal year. On a non-GAAP basis, operating margin for the quarter was 2.9% compared to negative 12.1% in the same period last year.

Capital expenditures for the quarter was $7.2 million, compared to $16.2 million in the same period of the prior fiscal year and were primarily attributable to the opening of 11 new learning centers and renovation of older existing learning centers.

We generated approximately $21.6 million in operating cash flow for the quarter, compared to $4.3 million in the year ago period representing an increase of over 400%.

Now let me quickly talk about our expectations for the third quarter of fiscal 2014. For the third quarter, we expect total net income to be in the range of $260 million to $270.9 million representing year-over-year growth in the range of 19% to 24%.

This forecast reflects New Oriental’s current and preliminary view which is subject to change. As always, we want to thank you for all your support to New Oriental. At this point, I will take your questions. Operator, please?

Question-and-Answer Session

Operator

Thank you, Mr. Hsieh. (Operator Instructions) The first question comes from the line of from Ella Ji of Oppenheimer. Please ask your question.

Ella Ji – Oppenheimer

Yes, Louis, congratulations on very strong quarter. I wanted to ask you regarding your online education initiative. Do you expect to rollout a purely online live courses in larger scale in the near term? And can you also discuss your price strategy for such courses?

Louis Hsieh

Thank you, Ella. We do – we have live classes now. So some of the – like CET 4 classes and others in Q2 were done live. So we do have the ability to have hundreds of thousands log on at the same time.

So we already have that. We expect the pricing to be significantly below what our offline pricing is, but obviously volume will make up for it. So you would expect discounts of – in par around 50% or so or more for the online classes. That answers your question?

Ella Ji – Oppenheimer

Yes.

Louis Hsieh

But we will continue to rollout more and more popular classes online. Yes, the margins are quite high. Our online business for the trailing 12 months is approximately $30 million with 19% operating margin. So it’s actually already a very profitable business.

Ella Ji – Oppenheimer

That’s good to know. Do you also expect to rollout courses in the overseas test prep and K-12 sectors?

Louis Hsieh

Yes, we would expect more and more classes to have it online as well as online format. If you think about rolling in 50 cities in China today, the ability to rollout across the country will increase our reach many folds.

So we will be able to increase the distribution and obviously online has a higher profit margin and I think there is no other company is well positioned as we are with our brand name to take advantage of this fast-growing market.

Ella Ji – Oppenheimer

Look forward to that. My next question is regarding, you discussed, and you will spend $10 million in R&D this year, so I wonder if this is still on budget? And if this $10 million spending already kicked in, in your P&L?

Louis Hsieh

Yes, it’s already kicking in and it’s being used mostly for our online offline integration as we mentioned. We want students to be able to work off their mobile phones and tablet device as well as PCs in order to access our content to talk to teachers live and to able to do quizzes and homework online. So, all that initiatives in the content development and transition in the infrastructure is being spent now.

Ella Ji – Oppenheimer

And should we expect this to be sort of evenly distributed in the coming quarters?

Louis Hsieh

Yes, it should be evenly distributed, it should be a little bit front loaded as we build up this presence online and it will begin to tail-off and become hopefully more of a steady expense stream.

Ella Ji – Oppenheimer

Got it. Thank you, Louis. I will get back to the queue.

Louis Hsieh

Thanks, Ella.

Operator

Thank you. And the next question comes from the line of Zhuang Chao of Macquarie. Please ask your question.

Zhuang Chao – Macquarie

Thank you for taking my questions and congrats on the very good results.

Louis Hsieh

Thank you, Zhuang.

Zhuang Chao – Macquarie

Yes, Hsieh, you talked about last quarter, the sort of two halves of the year, first half of margin expansion and second half of a revenue growth acceleration. Could you sort of talk about where we are in that process?

Is it actually the case and related to that, you gave the full year guidance in terms of the enrollments and sort of revenue growth for the full year, given the enrollment in last quarter appeared to be pretty solid better than your full year guidance, any change for your full year sort of enrollment and revenue growth guidance?

Louis Hsieh

Okay, thank you, Zhuang. I think, for us, Q3, the reason is not 20% to 25% revenue growth, it’s because we didn’t opened as many learning centers as we wanted. We actually wanted to open 20 to 30 learning centers; we actually were at negative two for the quarter, because we closed six underperforming ones.

So I think is that, Q3 also is a overseas test prep in English, English quarter. Q4 should be quite good. But I think Q3 will be good, but not as good as Q4 this year. It’s our expectation, because Q4 has been overperforming each of the last three years because the Zhongkao and the Gaokao are in June.

So, the deferred revenue coming into Q3 is good. So we expect a solid Q3 but the revenue growth we expect will be – should be higher in Q4, which is sort of the historical trend the last several years. As far as enrollment goes, there is no change.

We’ve guided 5% to 7% enrollment growth for the year, especially organic and right now we are 5.7%. So we would expect to be hopefully try to be conservative and with it for 5% to 7% for now.

Zhuang Chao – Macquarie

Okay. Just a quick follow-up. Now the margin expansion, I know you clearly did an amazing job in Q2 for your margins. Do you – now, you feel like the low hanging fruits are the part of the improvement for the year is kind of done and going forward or for revenue growth do you still feel that there is further margin expansion still be in that?

Louis Hsieh

I think you will see some margin expansion, but it will be small. It won't be the big numbers. So I would expect, right now we are 22% plus operating margin for the first half. It’s a 700 basis point, some 290 basis point improvement over the last year.

I expect the second half of the year to be closer to be 100 basis points, because last year, in Q3 and Q4, we already had some substantial expenditure cuts – expense cut. So we already are rationalizing the business. So I expect less in the operating margin improvement.

But we will finish the year somewhere between 17%, 18%, well above our guidance at the beginning of the year 15% to 16%. So, but I would expect healthy revenue growth and continued margin expansion, although the margin expansion will be at a slower rate.

Zhuang Chao – Macquarie

Okay. Great, thanks for the comments.

Louis Hsieh

Thank you.

Operator

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

Fei Fang – Goldman Sachs

Hi, Louis, thanks for taking my questions. So in the past few quarters, operating margin has been very impressive and a lot of strength was actually from savings from the service and marketing expense.

First can you elaborate on the details of the savings and also I want to back on the expansion track which cost item we will see more meaningful pickup? Thank you.

Louis Hsieh

Yes, I think, thank you, Fei. I think the sales and marketing has the savings because we weren’t opening learning centers. When we now open learning centers, all the business come from word of mouth, almost all of it. So we don’t need the market because of our strong brand name.

So our brand promotion expenses were already 6.5% of revenues this quarter versus 8.3% last year. So you can see that. As we open new learning centers in locations we are not at, we’ll have to spend more on marketing, but brand promotion expenses traditionally have been very low in New Oriental, it’s been around 7% of total revenue.

So that shouldn’t change. So you won’t see a meaningful pick up, but you’ll see a small pick up on the expense side. The other thing I would highlight, which is sort of unrelated, I apologize, I should have mentioned this earlier, is the Beijing School is actually doing exceptionally well.

The Beijing revenue was up about 35% in Q2 and it still continues into Q3 and it’s doing particularly well in the K-12 after school tutoring segment. And so this is our largest market and it’s going – K-12 grew about – over 40% last quarter in Beijing.

So we expect continued strong growth in Beijing which should be much stronger than we expected going into this year. So that, that will – I think it will also help the margins, the Beijing is our highest margin school.

Fei Fang – Goldman Sachs

Thanks, Louis.

Louis Hsieh

Thank you.

Operator

Thank you. And the next question comes from the line of Trace Urdan of Wells Fargo. Please ask your question.

Trace Urdan – Wells Fargo

Thank you. Hey, Louis, you had a pretty significant presence in online for quite some time. I am wondering whether the - sort of why the added emphasis in particular now? Is there something happening in the market or is it sort of being driven by now having sort of more time and attention in your own business to develop the online? Can you elaborate there as to why we are hearing more that online opportunities today?

Louis Hsieh

Yes, to be honest with you Trace, it’s because we are getting more questions from the investment community on it. And that maybe because of our competitors are talking about it more and so we feel the need to address it as well. As you said, you are right.

We’ve been the leader in K-12 online for years. We have over 8 million registered users over 170,000 paid users, about $30 million of revenues, with about $5 million in trailing net profit in the last 12 months. So we are by far that we don’t really hype it. But now it has, you look around China, you see a very strong trend to young kids and teenagers and college students all running around with mobile phones.

And so we know that, they prefer to do with their exercises online and so we made a conscious effort over the last 12 months to really spend on R&D to make our online platform and mobile learning the best in China. So it is a new initiative in New Oriental to spend R&D dollars and make it much more – much better experience for our students.

But the talk about it has been sort of spurned by questions from the investment community as well as from our internet competitors who talk about their education businesses online.

Trace Urdan – Wells Fargo

I see. Okay, and then I wonder if you could maybe elaborate a little bit further about the strategic benefits of the kindergarten acquisition, because it seems to run counter to the trend that we’ve seen over the last couple of years to sort of shed non-core assets.

And so, can you just maybe be a little bit more specific about where you see the benefits? Is there a brand associated with this kindergarten benefit your core business?

Louis Hsieh

Yes, I don’t want to talk the sort of the names because the deal hasn’t closed yet. This is the leading kindergarten in Changsa. So if you do your homework you can find out who it is and it’s a highly profitable business.

It’s growing, it has a very strong brand name and we think it will be a good feeder into the kid business and pre-school education seems to be an area that Chinese parents are willing to spend a lot of money on, especially for private, good kindergarten pre-school services.

So it is not core like K-12 or overseas test prep, but I think it is still a good bolt-on for our – it has good synergies with our kids business. So that’s why we are looking at and it’s not very expensive. So I think it will be an accretive acquisition over time.

Trace Urdan – Wells Fargo

Okay, great. Thank you.

Louis Hsieh

Thank you.

Operator

Thank you. And the next question comes from the line of Philip Wan of Morgan Stanley. Please ask your question.

Philip Wan – Morgan Stanley

Thank you for taking the question. My first question is about your VIP business. You mentioned that your intention to cap VIP class contribution to be 30% and I just wonder how are you going to do so if demand shift from the large class into that? And I have a follow-up question.

Louis Hsieh

Thank you, Phil. That’s a good question. The way we cap the VIP class business, that we stop opening VIP learning centers, all the growth comes from organic within the existing VIP network. We are still opening learning centers for our small and large classes, emphasizing those formats.

Also we are giving special bonuses to our teachers for the larger – if they fill their classes. So we’ve actually seen a trend in Q2 which is also helping in the margin where our class size is beginning to go up again. So it shows that the utilization – improvements on utilization as well as improvements on margin.

And so we are encouraging and telling the students to take small classes and large classes at the expense of VIP although we still offer VIP. And so you’ll see a VIP – we sort of capped this last quarter of about 24% growth in revenues year-over-year.

Philip Wan – Morgan Stanley

What’s the enrollment for VIP for this quarter?

Louis Hsieh

Sisi, do you have that?

Sisi Zhao

Yes, it’s – the growth.

Louis Hsieh

The revenues – it’s student enrollment.

Sisi Zhao

Yes, 15% growth, year-over-year

Louis Hsieh

Which is the enrollment?

Sisi Zhao

Enrollment is 29,000.

Louis Hsieh

29,000.

Philip Wan – Morgan Stanley

Thank you. And then my second question is regarding your Shanghai operations. You mentioned Beijing has been doing very well this quarter and could you comment on the progress of your Shanghai operations?

Louis Hsieh

Yes, Shanghai had a good quarter in Q2. Revenue was up 6%. But, it still needs – it’s early days for its K-12, I mean, for middle school you can’t, as you know, Shanghai was late and was not effective enrolling it out three four years ago. So I think, it’s still not where we wanted to be, but I think it’s better than it was.

Q1 was sort of the bottom point for Shanghai, it’s beginning to improve. So Q2 was a nice quarter. Q3 is more flattish it hasn’t had the pickup that we want in Shanghai yet. But Beijing is more than making up for it. So it’s buying Shanghai some time.

Philip Wan – Morgan Stanley

Okay, thanks for the color, Louis.

Louis Hsieh

Excuse me.

Operator

Thank you. And the next question comes from the line of Tian Hou of TH Capital. Please ask your question.

Tian Hou – TH Capital

Hi, Louis, Sisi. Congratulations on good quarter. So the question regarding your new open plans for the second half of the year. You have been through a process of gradually shut down a lot of your non-performing centers and what is the – opening plan for the second half of the year?

I guess, you have already finished those non-performing centers and by the time to open some new centers. So how many do you expect to open for the second half of the year? That’s the first question. Second question is regarding the Chinese New Year.

So every year seems like Chinese New Year fall in different timeframes and seems like sometimes it’s a positive impact, sometimes a negative impact. So I wonder what’s the impact this year could be. And that’s it, just two questions.

Louis Hsieh

Thank you, Tian. Those are good questions. For the learning center openings, I would target 20 to 25 learning centers for the second half of the year. The problem we have is that, we gave the KPIs towards go-aheads based on profit and to do such a good job including their profit and so we are going to set up a new program where we are not going to punish them for opening up learning centers on the cost side.

So, we will try to spur more learning center openings in fast-growing cities the next couple of quarters and that will sort of balance out our revenue and margin improvements both. So, our goal is to grow revenues at 20% to 25% and have some margin improvement going forward.

As far as impact to Chinese New Year, Chinese New Year this year is sort of January 30, 31. So a week little so earlier than last year, the break is about the same period of time. It shouldn’t have a big impact, but if there is one, it will probably be negative. It won't be a positive impact on the third quarter. But it shouldn’t be – it’s not like it’s too early or too late. So I think it will be probably neutral to slightly negative.

Tian Hou – TH Capital

Okay, thank you, Louis.

Louis Hsieh

Thank you.

Operator

Thank you and the next question comes from the line of Clara Fan of Jefferies. Please ask your question.

Clara Fan – Jefferies

Hi, hello. Thank you for taking my question. I’ve got two questions. First of all for, as you just mentioned, we are looking at net center open of 20 to 25 centers for the second half of this year and we have an assumption that next fiscal year will be back to the probably the normal rate of 60 to 70 centers.

Should we expect a significant improvement in enrollment going forward, because this year we are only looking around 5% to 7%? And also secondly, can you give us some updates on what’s the competition like in – now from the local competitors – they like easing a little bit or still intensifying? Thank you.

Louis Hsieh

Thank you, Clara. On the enrollments and learning center growth, we would expect to go back to our normal rate of 60 to 80 learning centers next year which of course will increase our enrollment growth. So the reason the enrollment growth is slower this year is because we’ve been reducing learning centers.

So you are obviously correct, 60 to 80 will have probably 4% to 5% to the enrollment side in the K-12 or particularly if we go back to normal growth cycle. As far as the competition goes in cities, the competition is always been quite intense but we continue to gain market share across the board.

So like at Beijing, we are particularly encouraged, because you are – we are a latecomer to Beijing we are the largest in K-12, college by far in Beijing. We are the largest in Shanghai as well and we are either – our goal is we are number or number two at every city we go into and we are well on our goal to – on the road to reaching that goal in cities we’ve been in longer than five or six years.

So I think, as the competition remains strong on a local basis with some strong local competitors in every city. I don’t think the intensity has really increased or decreased, but it’s still quite formidable.

Clara Fan – Jefferies

Can I have a follow-up question?

Louis Hsieh

Sure.

Clara Fan – Jefferies

Just quickly on – you mentioned that the overseas test prep and consulting business reported at 25 – 28% year-over-year growth. I want to drill on a little bit more detail on what’s the growth rate of the two separate business and on the overseas test prep, what’s the enrollment growth and ASP growth like – I am just trying to get a grasp on how fast is the overseas test prep enrollment growing? Is ASPs still driving majority of the growth? Thank you.

Louis Hsieh

Yes, Q2 is a slow period for overseas test prep. So enrollments were actually negative 1%. So they were – for the quarter, what’s enrollments – enrollments was 60,000 for the quarter. So it’s slightly down from last year. But revenue was up 29% for overseas test prep.

It’s also a slower quarter for overseas study consulting, so revenue was up around 26%, 28% as well. So that’s why they are about the same growth rate. The busy period for overseas study consulting is actually Q4, right. So the May quarter is when you’ll see a large revenue jump and because we recognize revenues once the students get in to a school and they accept us and we recognize our revenue.

So you will see a huge jump in overseas study consulting revenue in Q4. Q3 will be an overseas test prep quarter as well as Q1 and then the Q2, Q3 and Q4 are the K-12 our fiscal tutoring quarters. That help you with the understanding of our business.

Clara Fan – Jefferies

Yes, I am just trying to see, whether overseas test prep the enrollment growth, would that be on a year-over-year basis will it be like picking up or we still heavily rely on – relying on ASP growth?

Louis Hsieh

Overseas test prep enrollment is up for the year-to-date. But it was negative 1% for the last quarter. It’s dependent on ASP growth but not as much as you think. It’s actually more dependent on the shift towards smaller classes.

So a lot of students in the overseas test prep are taking one-on-one or small classes. So that does – the ASP growth is about 15% and the other portion is – and the enrollment growth is between 2% to 4% and the rest of it is due to small class shift.

Clara Fan – Jefferies

Okay, thank you.

Louis Hsieh

Thank you, Clara.

Operator

Thank you. And the next question comes from the line of (Inaudible) of Deutsche Bank. Please ask your question.

Unidentified Analyst

Thank you for taking my question. My first question is regarding the online education. What is the number of online enrollment for the last quarter and which segment do we consider will have the greatest impact from online competitors and we hope to - have consider partnership with other online platforms?

Louis Hsieh

Okay, yes, the number of paid users in the quarter was 61,000, which was up – let me see what’s the growth rate was. It was up 21% year-over-year. So it was a good quarter for growth on online. Most of the classes will be in the K-12 sector and overseas test prep sections.

So just our K-College regular business. We don’t really see any real competitors in this K-College segment yet. I know you’ve heard lot of hype from – then they disappointed on their platform.

We don’t really see anyone else. I think we are all kind of starting in this business and I think, as we have the best brand name we believe that we have an advantage going into this business and so we intend to pursue it aggressively.

Unidentified Analyst

Okay, thank you and I have another question. Given the strong cash flow and operations for this fiscal year, would you consider dividend to shareholders? Thank you.

Louis Hsieh

Yes, I mean we paid dividend the last two years and we’ll consider it again after Q4, the fiscal year is finished. So we – the Board will talk about it at most board meetings and then we’ll consider it again in the July board meeting after Q4 earnings.

So we know how much cash we generated this year. Our cash flow has been quite strong, as you know $189 million, versus the $111 million last year. So it’s up almost 70% year-over-year. And that’s because we haven’t opened so many learning centers.

And so the CapEx is quite low and this year we’ll generate probably $220 million to $230 million in free cash flow much higher than our net income. That shows you how efficient our business model on a capital use basis.

Unidentified Analyst

Okay, thank you.

Operator

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

Vivian Hao – Deutsche Bank

Hi, sorry, actually I think my team has jumped up.

Louis Hsieh

You are trying to ask two questions, that you’ve been clever.

Vivian Hao – Deutsche Bank

Sorry about it. I am dwelling in some overseas, so that’s – I’m sorry about that.

Louis Hsieh

I am just joking. Thank you Vivian. You can ask a question if you like.

Vivian Hao – Deutsche Bank

Yes, I think my question is just been asked and got answered. Thank you.

Louis Hsieh

Thank you, Vivian.

Operator

Thank you. And the next question comes from the line of Charles Cartledge of Sloane Robinson. Please ask your question.

Charles Cartledge – Sloane Robinson

Hi Louis, congratulations on your results. My question relates, you started to monitor capacity utilization in a way that you didn’t do previously perhaps if you could share with us how that’s changed because these results would seem to indicate lower learning centers and high revenue as you highlighted, that these numbers are going up.

And then, could you share with us your thoughts on the longer term maybe using – maybe Beijing too much of an aspiration, because it’s very mature, but the – what’s the medium term outlook for capacity utilization and what might that mean for your operating margin sort of two or three years out?

Louis Hsieh

Thank you, Charles. Yes, our utilization for the quarter was up about 300 basis points, so it’s actually quite good. You are talking between – last year it was about 13% to 14%, this year it was closer to 17% 18% for the quarter.

So it’s actually quite good. I think long-term, we would be happy over the next two or three years with utilization numbers in the 20% to 22% range. If that happens, our operating margin will go over 20% on a GAAP basis, so it would be very healthy for our business and we will – now, it sounds low but as many as you know, we count every seat in every operating hour that the school is open.

So the number will, ideally the best we can do in a learning center will be close to 30%, 30% to 35%. So, it is 20% is quite good and we are typically around 15% but that number is climbing.

So over the last 12 months, it’s been up 2 to 3 percentage points across the board almost every month. So, and that’s why you are seeing the improvement in operating margin and that’s part of the effort we have undertaken to encourage more enrollment in large classes and small classes and to still more the seats for each of the class and then that's really helping with our utilization on operating margin as well.

Charles Cartledge – Sloane Robinson

Thank you.

Louis Hsieh

Thank you.

Operator

Thank you. And the next question comes from the line of Kenny Lou of Flowering Tree. Please ask your question.

Kenny Lou - Flowering Tree

Hi, Louis, congratulations on the strong results.

Louis Hsieh

Thank you.

Kenny Lou - Flowering Tree

My first question is about, in the past two three quarters, you have very tight grip on the learning center openings and then just now you mentioned that you are going to keep more opportunity to the – if they can grow profit they can maybe they have more freedom in opening new learning centers. Is that a shift on the management side or what’s – why there is such a change?

Louis Hsieh

Because the business is so good, the demand is quite strong especially in the K-12 sector. And we went from one extreme to the other, right, we went from opening learning centers because we incentivized the school heads based on revenue mostly and then we shifted this year to incentivizing them only based on – mostly based on profits.

I think, now we are happy with the progress expense control and the operating margin. We want to get growth because we want to capture more market share. So I think as – but this year meaning we are half way through the fiscal year, our school has incentivized on profits, many of them already well in excess of their profit numbers. So we want – but we don’t want to punish them for opening up learning centers that will benefit us in the long term.

And so we are going to set up a system where they don’t get penalized for opening learning centers, especially the profitable ones and I think that won’t hurt our operating margin long-term it will actually improve that as well as improving our top-line. And so – and improving our market position each city.

So we think it’s the right approach. So we went from too faster growth on revenue and low – declining margin to incredibly increasing margins and slower revenue growth. The balance for us is 20% to 25% revenue growth and then operating margin improvement every year of up to 100 basis points or so.

That’s a nice steady state for us. And that requires opening 60 to 80 learning centers. I encouraged to open learning centers they actually – were actually over the net minus two, even though we opened 11 new learning centers, because we closed seven replacements and six underperforming learning centers were closed.

So we want to encourage them to opening more learning centers by not penalizing them on the profit side. So it won’t hurt the margin. The margin will still be accretive.

Kenny Lou - Flowering Tree

Okay, so what will be the mechanism in place to ensure the quality of the new school openings?

Louis Hsieh

Well, it’s the same process, we look at every cities which ones are profitable and the utilization rates in each learning center of every city. And so that some of the cities are performing really well and we are going into busy season for K-12, especially middle and high school.

So I want to encourage those cities to open up learning centers as soon as possible to capture the end of Q3 and Q4 which is the busy season for middle and high schools at Zhongkao and Gaokao. So we want to – I would like to ideally to open 20 to 25 learning centers between now and in May.

And so the way to do that is not to penalize those school heads because they are already very profitable and exempt them on the basis of these expenses for these new learning centers. And I think that will benefit New Oriental in the next fiscal year and accelerate our enrollment as well as our revenue growth.

Kenny Lou - Flowering Tree

Okay, so we find out then correctly, the new school opening process still need to the center leads controlled by the finance department?

Louis Hsieh

It will controlled by my department by finance. Stephen Young and our team will control it.

Kenny Lou - Flowering Tree

Understood, okay. If I can ask another question, on the management side, so – for some reasons, I mean how does the board or the management think about the future structure of the senior management? Is that still going to be a ETO going forward or Michael is going to be Chairman and ETO.

Louis Hsieh

Yes, I think - we’ve anticipated this happening for a couple quarters now. So this is not a surprise to ask internally. The good thing is for – in my view is that Michael will have to work harder, so it’s good. So I think these are positive events making the meaning Michael will be even more engaged in the business than he already is.

Also we have a deep bench, (Inaudible) Stephen Yang; we have a lot of people who will also pick up the flag. So we very much appreciate – 15 years of devoted service to New Oriental. He has been a great asset to us. But this really wasn’t unexpected. So we’ve been preparing for it a little while now.

Kenny Lou - Flowering Tree

Okay, got it. Thank you very much.

Louis Hsieh

Thank you.

Operator

Thank you. And the next question is a follow-up question from the line of Charles Cartledge of Sloane Robinson. Please ask your question.

Charles Cartledge – Sloane Robinson

Yes, could you help us better understand with regard to your online offering whether it’s a sort of nice to have profitable in its own way it’s operational, do you think that it could be a whole new business line and scale for revenue and profit as large as those that you introduced in the last five years like K-12 for example?

Louis Hsieh

Yes, I don’t think that will be as large as K-12 or overseas test prep, but I think it will be significant. I mean, the $30 million growing, 30% to 50% a year, so I would expect it to be a significant business in several years. And it’s highly profitable, so you know it is scalable.

And the key thing is, there is really strong synergies between the online and offline world. The winners of the future in education will need the technology platform of online as well as the offline learning centers. So we’ve seen in many countries and many businesses, that online offline integration is the best experience for the students. So we need it.

So it’s integral to our business. But it’s not going to outpace K-12 offline revenue. It’s not going to outpace overseas test prep revenue in the next five years but it will be significant and it’s highly profitable, it’s high margin business.

Charles Cartledge – Sloane Robinson

Thank you.

Louis Hsieh

Thank you, Charles.

Operator

We are now approaching the end of this conference call. I will now turn the call over to New Oriental’s President and CFO, Louis Hsieh for his closing remarks. Over to you

Mr. Hsieh.

Louis Hsieh

Thank you operator and we want to thank everyone for joining us today. And we look forward to seeing you in future conferences and calls. If you have any other questions, please feel free to contact Sisi or any of our representatives at New Oriental. Thank you and have a very good day.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may all now disconnect.

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