New Oriental Education & Technology Group Inc. F3Q10 (Qtr End 28/02/2010) Earnings Call Transcript

| About: New Oriental (EDU)

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

F3Q10 Earnings Call

April 19, 2010; 8:00 am ET

Executives

Louis Hsieh - President & Chief Financial Officer

Sisi Zhao - Senior Investor Relations Manager

Analysts

James Mitchell - Goldman Sachs

Ella Ji - Oppenheimer

Jeff Lee - Signal Hill

Catherine Leung - Citigroup

Amy Junker - Robert W. Baird

Brandon Dobell - William Blair & Co.

Chenyi Lu - Cowen and Company

Mark Marostica - Piper Jaffray

Operator

Good evening and thank you for standing by for the New Oriental’s third 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 like to 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 third fiscal quarter 2010 earnings conference call. Our third fiscal quarter earnings results were released earlier today and are available on the company’s website, as well as on newswire services.

Today you will hear from Louis Hsieh, New Oriental’s 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 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 www.investor.neworiental.org.

I would now turn the call over to New Oriental’s President and CFO, Louis Hsieh. Louis, please.

Louis Hsieh

Thank you Sisi. Hello to everyone on the call and thanks for being with us today. Let me begin by taking you through some highlights from the quarter, after which I’ll go over some financial results and we’ll wrap up with some Q-and-A.

As many of you already know, the third quarter is typically New Oriental’s second strongest quarter, with students taking advantage of the month long Chinese New Year holiday to catch up on their individual studies. This year Chinese New Year falls on February 14, two and a half weeks later than it did in 2009, when the holiday fell on January 26.

As a results of the later Chinese New Year holiday this year, enrolments for spring classes were logged both in the third quarter which ends on February 28, and in the fourth quarter which begins on March 1. By contrast with the earlier Chinese New Year holiday in 2009, when Chinese students returned from vacation and signed up for our spring classes, the enrollments were mostly logged in the third fiscal quarter. In fact, student enrolments in Q3 last year increased by a whopping 31%, to approximately 351,700.

As such, the comparison of Q3, 2010 to Q3, 2009 is a difficult one. So I’m very happy to say that despite this tough comparison, our third quarter fiscal results are still very strong with student enrolments up 18%, to over 416,000, and net revenues up 36% to $89.2 million.

In most years, in order to give students more options for Chinese New Year time classes, we offer short-term sessions before and after the holiday. This gives students more flexibility to fit in some extra training. This year in light of the later timing of the Chinese New Year, in a majority of our schools we offered an additional special short-term session before the start of the holiday. So we were offering two pre Chinese New Year and one post Chinese New Year short-term sessions.

This proves to be a good move, because it gives students more options to fit a course in before leaving for the family vacation or taking part in the traditional New Year festivities. This boosted our enrolments for this quarter, but at the expense of our ASP growth. Shorter duration classes carry lower ASP’s. Average ASP’s for language training and test prep course came in at just over 10% for Q3; slightly below our norm.

Now I’ll go into a bit more detail on each of the major growth drivers for the quarter; POP Kids English, Middle and High School English, all-subjects U- Can training and Overseas Test Prep.

POP Kids English felt continued strong growth in Q3, with enrolments up more than 40% to over 121,000 for the quarter, reflecting the abatement of the H1N1 fears that had parents keeping their children inside in a precaution against illness. We have emphasized before, that crucial role early childhood education plays in China, with parents willing to pull out all the stops for their only one child.

The creative and fun POP Kids English curriculum combined with New Oriental’s leading brand name and stellar reputation, results in an offering that parents turn to when choosing education solutions for their children from age five to 12.

In observing the huge opportunity for our kids POP’s English program, we have been thinking about ways to reach children in an even younger age, and helping instill in these kids and help them learn as they grow up. So in the third quarter we launched our partnership with Kinderdance; the US based provider of dance, music and motor development, gymnastics and fitness programs for young children.

Due to this partnership, we’ll be offering Kinderdance programs in which children engage with both their parents and the instructor in the series of dance movements to the accompanied music.

At New Oriental’s KinderPlace early childhood learning centers, so far the program is about in three centers and we’ll be rolling it out into additional centers in new and existing cities throughout the fourth quarter in fiscal year 2011. We expect to be in over 10 major cities by 2014. We believe that this innovative new offering is a wonderful marketing opportunity for us, as it gives parents the opportunity to begin their child’s education even earlier.

Another major growth driver this quarter was our Middle and High School English and U- Can all-subjects trainings. Enrolments in this segment were up more than 25% to over 93,000 in the third quarter, with revenues up more than 70% to over $15 million. U- Can in particular saw strong continued growth.

As many of you know, we had originally targeted 80,000 to 90,000 U- Can enrolments and revenues of $25 million for fiscal year 2010. The 80% year-over-year enrolment growth we have seen in the first three quarters has brought us to more than 83,000 students enrolled in U- can courses year-to-date, and total revenues of around $20 million, which gives us confidence in our ability to meet or exceed the higher end of the original expectations for U- Can.

As we said before, demand for the type of the all-subjects training offered by U- Can is very strong in China. Our students are eager for every advantage as they prepare for the diverse and the many exams for entry into Chinese top high schools and universities.

As U- Can grows and continues gaining popularity, we have extended the program to fit the varying needs of the students. One example of this is the new customized learning program we launched earlier this year, which offers courses with teacher-student ratios of 1:1 and up to 1:6, for students who prefer more individualized training.

Another example is our new VIP pass, which allows students to buy a single all you can need [ph] pass, that allows them to attend any U- Can class throughout the semester and which proves even more popular this quarter as students increasingly recognize the benefit of shopping around courses and choosing the topics and the structures that fit their needs.

In fact we recorded over 9,900 VIP one-on-one and one-to-six enrolments in the third quarter, up from approximately 3,800 in the year ago period, representing an increase of about 160%. We will continue to design customized learning options for the students diverse needs, and expect that such initiatives will continue to help throughout Middle and High School English and U- Can growth.

With the enormous popularity U- Can has enjoyed, we have been rolling out the program out in additional learning centers and new and existing cities. By the end of this quarter U- Can was available in about 120 learning centers in 34 cities.

Now we are on tract to meet our target for fiscal 2010 of 110 learning centers in a total of 37 cities. For this customized learning program platform, you may recall, we raised our target from just eight to 10 cities to over 30 cities, offering this program by the end of our fiscal year; a goal which we are well on our way to achieving. We expect U- Can to continue to enjoy robust growth as we make the program available to more and more students.

Finally Overseas Test Preps, the third major driver growth this quarter. Our Overseas Test Prep program which helps prepare students for all sorts of exams they need to perform well, in order to travel abroad for overseas education, saw enrollment growth of over 7% to more than 54,800, and revenue growth of over 34% to approximately $28 million as students took advantage of the Chinese New Year holiday to fit in prep courses to start SAT, GRE, GMAT, IELTS or TOFEL for example.

So these were the main growth drivers this quarter. In terms of some of our other offerings, Adult English saw the same revenue growth of around 20% during the third quarter, and domestic test prep also saw growth with net revenues up over 30% as teams gear up to take their all-important GaoKao College examinations in June.

As China’s leading private education provider, we take very seriously our responsibility to help prepare Chinese students at all ages with the challenges and opportunities they face in life. There are many companies in China who try to do what we do, but none showed a nationwide brand recognition, excellent reputation, that New Oriental has built over 17 years.

As you grow and adapt our programs and as China increasingly engages with the global economy, there will be even more opportunities for us to develop offerings that address specific needs. In fact, Michael and several of our teaching star teachers are about to hit the road for the Annual Green tour. With this year, we will target 29 cities throughout the country, personally reaching out to students who are looking for ways to enhance their lives with the sort of quality education which New Oriental can offer.

Now let me go through the financials. For the third fiscal quarter 2010, New Oriental reported net revenues of $89.2 million, representing a 36.2% increase year-over-year. Net revenues and education programs and services for the third fiscal quarter was $82.6 million, representing a 37.6% increase year-over-year.

This 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 prep courses in the third quarter of 2010 increased by 18.3% year-over-year to approximately 416,000 from 351,000 in the same period of the prior fiscal year.

GAAP operating costs and expenses for the quarter were $75.5 million, a 33.1% increase year-over-year. Non-GAAP operating costs and expenses for the quarter was $70.7 million, a 34.1% increase year-over-year.

Cost of revenues increased by 36.1% year-over-year to $35.4 million, primarily due to the increased number of courses and the greater number of schools and learning centers in operation.

Selling and marketing expenses increased by 31.3% year-over-year to $13.8 million, primarily due to brand promotion expenses, especially for new programs such as U-Can and the customized learning program.

GAAP G&A expenses were $26.2 million, a 30.1% increase year-over-year. Non-GAAP G&A expenses for the quarter increased by 35.3% year-over-year to $21.7 million, primarily due to the 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 by $4.9 million in the third quarter of fiscal 2010, from $4.1 million in the same period of the prior fiscal year. Approximately $590,000 of the increase was due to the one-time one-off adjustment to account for a lower than expected forfeiture rate in the first nine months of fiscal year 2010, due to the fact that fewer New Oriental employees who received stock based compensation awards left the company and forfeited their awards than anticipated.

GAAP income from operations for the quarter was $13.6 million, a 57.0% increase from the $8.7 million in the same period of the prior fiscal year, and Non-GAAP income from operations for the quarter was $18.5 million, compared to $12.8 million in the same period of the prior fiscal year.

GAAP operating margin for the quarter was 15.3% compared to 13.3% in the same period of the prior fiscal year. Non-GAAP operating margin for the quarter was 20.7%, compared to 19.5% in the same period of the prior fiscal year. This rise in primarily due to improved operating efficiency, as revenue growth outpaced the growth of operating cost and expenses.

GAAP net income for the quarter was $13.8 million, representing a 33% increase from the same period of the prior fiscal year. Basic and diluted net income per ADS was $0.37 and $0.36 respectively. Non-GAAP next income was $18 .7 million, representing a 29.1% increase in the same period of the prior fiscal year. Non-GAAP basic and diluted next income per ADS was $0.50 and $0.48 respectively.

Capital expenditures for the quarter was $5.2 million, which was primarily used to add a net of 26 new learning centers, and remodel all the learning centers during the quarter. As of February 28, 2010 New Oriental had cash and cash equivalents of $250.8 million, as compared to $210.6 million as of November 30, 2009. In addition, the company had $120.4 million in term deposits at the end of the quarter. Net operating cash flow for the third quarter of fiscal year 2010 was $ 22.7 million.

The deferred revenue balance, cash collected from registered students for courses and recognized proportionally as revenue in the instructions that are delivered, at the end of the third quarter of fiscal year 2010 was $69.8 million, an increase of 29.5% from the year ago period.

Before giving guidance for the fourth quarter, let me briefly compare the first nine months of fiscal year 2010 to the first nine months of 2009. For the nine months ended February 28, 2010, New Oriental reported net revenue of $299.7 million, representing a 28.8% increase year-over-year.

Total student enrollments in language training and test preparation courses for the nine months ended February 28, 2010 increased by 15.2%, to approximately 1.370 million students from approximately 1.189 million in the same period of the prior fiscal year. With one fiscal quarter remaining we are well positioned to meet or exceed our target of 1.73 million to 1.77 million enrolment for the 2010 fiscal year.

GAAP income from operations for the first nine months of fiscal year 2010 was $73.7 million, a 26% increase year-over-year. Non-GAAP income from operations for the first nine months of fiscal year 2010 was $86.6 million, a 22.5 % increase year-over-year.

GAAP operating margin for the first nine months of fiscal year 2010 was 24.6%, compared to 25.1% for the same period of the prior fiscal year. Non-GAAP operating margins for the first nine months of fiscal year 2010 was 28.9%, compared to 30.3% in the same period of the prior fiscal year.

GAAP net income attributable to New Oriental for the first nine months of fiscal year 2010 was $72 million, representing a 23.4% increase year-over- year. GAAP basic and diluted earnings per ADS for the first nine months of fiscal year 2010 amounted to $1.91 and $1.86 respectively.

Non-GAAP net income attributable to New Oriental for the first nine months of fiscal year 2010 was $84.9 million, representing a 20.2% increase year-over-year. Non-GAAP basic and diluted earnings per ADS for the first nine months of fiscal year 2010 amounted to $2.25 and $2.20 respectively.

Now moving into revenue guidance; New Oriental expects its total net revenues in the fourth quarter of fiscal year 2010, running from March 1, 2010 to May 31, 2010 to be in the range of $75.5 million to $78.4 million, representing a year-over-year growth in the range of 27% to 32% respectively. This forecast reflects New Oriental’s current and preliminary view, which is subject to change.

At this point I want to thank you, and then take questions. Operator.

Question-and-Answer-Session

Operator

Thank you (Operator Instructions). Your first question comes from the line of James Mitchell with Goldman Sachs. Please proceed.

James Mitchell - Goldman Sachs

Thank you for taking my question. Looks like you saw a pretty meaningful revenue acceleration in Adult English and in domestic Test Prep, which I think has been historically somewhat more mature businesses. Can you talk a little bit about what drove the revenue acceleration in the quarter?

Louis Hsieh

For Adult English and domestic test prep, I think part of it -- there are several factors; Adult English, I think it has been down for several quarters. There was a meaningful bump up for two things; one was the aftermath of H1N1; and number two was the Shanghai expo coming up. So Shanghai saw a nice jump up in enrolments in Adult English as people wanted to get jobs in the expo and needed to improve there English skills. Actually the number of enrolments didn’t go up much, it was actually due to ASP increases of a little bit over 10%.

The second one was domestic test prep and remember, last year we had the scheduling kind of problems in Shanghai and a number of other cities, and so this is an easier comparison verses last year, and also because Chinese New Year this year we ran two sessions before the actual holiday of February 14. In past years we took about one session before Chinese New Year and one session after.

James Mitchell - Goldman Sachs

And when you are on the second session before the New Year, does that extra shorter lower ASP session generate comfortable margins to a normal extended session?

Louis Hsieh

It does James, because it’s sort of priced such as the same amount per hour. But because there was more actual hours, because the Chinese New Year break was a little bit longer this year than last year, that helped the revenue on both the domestic, on GaoKao and on overseas across the board, on any kind of test based subject for school age children.

James Mitchell - Goldman Sachs

Great. Thank you for taking my question.

Louis Hsieh

Thanks James.

Operator

Your next question comes from the line of Ella Ji from Oppenheimer. Please proceed.

Ella Ji - Oppenheimer

Hi Louis, good evening. Congratulations from the strong quarter. I want to follow-up on the earlier question on your strong revenue growth in the quarter which was 36%, and it’s above the normal range of 25% to 30%. So could you talk about how much of that is driven from the pent-up demand of H1N1, and do you think it’s above the range of growth that’s sustainable into the summer quarter.

Louis Hsieh

Thank you Ella for your question. New Oriental is about to embark on a sort of revenue acceleration again. After a few quarters of slow down, not due to the H1N1, but also due to the fact that we were building the customized learning platform in U- Can. U-Can and the customized learning platform are now taking the critical mass.

So as you guys have all know, we have been investing heavily in the middle and high school programs, but now the number of students is reaching up to 83,000 this year and we should go very close to, if not exceed 100,000 for the year, with revenues exceeding $25 million from U-Can.

So because of that, if you think about it, if we have a base of $370 million or $380 million in revenues this year, $25 million from U-Can is already about a 6% increase, and we expect U-Can to grow steady to $28 million this year, it should grow well over $40 million next year. So we do expect revenue acceleration to continue.

Now I want to make a point though, that Q4 we had very typical comparisons. Q4 last year we grew over 45% in revenues, so it has typical comparisons. For us to guide 27% to 32%, it means that that demand is strong.

As far as the summer goes, it’s too early, because The Dream Tour is just beginning next week, and the enrolments for the summer really begin to pick up at the second half of May and into June. So it’s too early to know how the summer will go, but if we have a net of an extra 70 or 80 learning centers opened this year, and if demand continues to grow as we expect it to, we expect a good summer obviously.

Ella Ji - Oppenheimer

Great to hear that. I want to switch gears a bit and talk about your growth spending. Could you give us an update on the $4 million to $5 million of growth spending; does it remain on track?

Louis Hsieh

Growth spending? What do you mean gross spending?

Ella Ji - Oppenheimer

The $4 million to $5 million additional spending that you mentioned last quarter.

Louis Hsieh

Yes, we are spending that and more essentially. So what’s going to happen this quarter is, Q3 was a little bit light on marketing. We grew marketing about 31% year-over-year.

Q4 is the big marketing season right, because it gears up for the summer, and we are going to make an aggressive push into where we feel we face the strongest competition in Beijing and Shanghai, and then we’re going to spend across the country where we don’t have so much competition, where we’re going to establish an early mover, and hopefully a dominant position in the other 38 cities that we are planning to go into. So we will spend heavily in marketing.

We are also planning, we are going to do budging now, but we are expecting to add another 70 to 80 learning centers next year, so that spending will be more than taken up. I think the demand for U-Can also is outstripping our expectations; which means ofcourse we’re going to have to aggressively hire teachers and customer service representatives and add learning centers. So it’s a good problem to have, but its still a problem, so we will continue to spend aggressively in this area.

But what I think many of the investors and analysts didn’t get, was that we spend all this money, it’s not just on the expense side. It creates additional incremental revenue that will drive our revenue hopefully above 30% going forward for the next couple of quarters.

So it matches the spending and its an expense line, because there is a revenue associated with it, and we believe that by summer this year we have turned the corner, and that the U-Can program will begin to really kick into gear and to generate even faster revenue growth than in past summers.

Ella Ji - Oppenheimer

Right, thanks. Just to clarify; so the $4 million to $5 million of spending, so could you help us break down how much you spent really in this fiscal third quarter.

Louis Hsieh

We added 26 learning centers, and we added -- let me check the number of employees -- it was more than half of the $4 million to $5 million, and the rest of it will be spent up this quarter. It’s not so much for marketing, because marketing was really on the budget. It’s more for adding staff and teachers.

Also we are going through the budgeting process now, but we are also spending heavily on IT upgrades, mostly you can. And the idea is that we will reach $1.75 plus or minus 20,000 students this fiscal year. We expect to come very close if not exceed 2 million students enrolments next fiscal year, which means that our IT infrastructure needs a large upgrade.

We also are up spending a lot of money on content development for the 12 to 18 year old group, as well as hiring customer service representatives. So all this is our budget. U-Can is actually going above our original forecast, and that’s only because of the strong demand we are seeing. I don’t know the exact break down, but we spent $4 million to $5 million and we will exceed that, but the margins are falling because of the increased revenue that it is generating.

Ella Ji - Oppenheimer

So net-net, do you anticipate the margins for next fiscal year? Would you see year-over-year growth, or will that be still temporarily pressured?

Louis Hsieh

We should see year-over-year growth, because the first half of this year was hindered by the flu virus, the H1N1 virus, so we should we some growth, but it’s not going to be very dramatic.

Partly it’s a tug-of-war between U-Can and Kids English. In the long run Kids English have lower gross margins than U-Can, which could have larger classes. A Kids English class are going to average 18, 19 students per class. U-Can for 12 to 18 year olds can have as many as 80 to 90 students, and typically there’s many student classes with over 40 to 50 students. So the gross margins are going to be higher for U-Can in the long run, but they are both growing very fast.

So we expect gross margins will still be 62% to 63% next year on a blended basis, and I think operating margins, we should improve hopefully about 100 basis points over this year, whatever we finish this year at. But like I said, we are going through budgeting now, so that’s just my preliminary estimate that we are trying to target.

Ella Ji - Oppenheimer

Right, I will turn it over. Thanks.

Louis Hsieh

Okay, thank you Ella.

Operator

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

Jeff Lee - Signal Hill

Hi, thank you. It looks like a very strong quarter. Congratulations.

Louis Hsieh

Thank you Jeff.

Jeff Lee - Signal Hill

I wanted to ask about enrolment expectation for the next quarter, and is there any way to quantify how much the Chinese New Year should help us with that, the time of your Chinese New Year.

Louis Hsieh

It should help a lot, because last year Q4 the enrolment, we are only up 8%, because Q3 was up 31%, so basically Q3 is followed on Q4. This year’s the opposite. So Q4 should see very strong enrollment growth, but Q4 had a very strong revenue growth last year at 45% top line growth, so there’s very very difficult comparisons.

The enrollments are easy, but the revenue is difficult. So I think as you probably see enrollment growth in the 20% plus range for Q4, but you’ll see revenue growth somewhere between 27% and 32%. Much of the second half of the enrollments in Q4 will actually be for the summer. The enrollments that come into May, that is actually for the summer quarter. The bottom line is just the strong top line growth of 27% to 32%. We see even stronger enrollment growth relatively up over 20%.

Jeff Lee - Signal Hill

Can you break out how many of your enrollments in this quarter were due to the short session, and is there any sort of effects where you think those short session enrollments this quarter is going to take away from the next quarter’s enrollments?

Louis Hsieh

The short session enrollments won’t take it away from next quarter’s enrollments, but what it did was it reduced the ASP, but increased enrollments. So if it was a normal spring quarter or winter quarter, I would have expected about probably ASP growth in the 13% to 14% range; which means enrollments should not 18%, it should be probably 14% to 15%. So we probably added 3% or 4% just because of the shorter sessions; there’s two of them there.

Jeff Lee - Signal Hill

I’ll turn it back over. Thank you Louis.

Louis Hsieh

Thank you Jeff.

Operator

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

Catherine Leung - Citigroup

Hi. Good evening and I do want to add my congratulations. My question is on your geographic strategies; will you be able to tell us how much leverage you’re going to generate from Beijing and Shanghai, which have been the fastest growing cities.

Also secondly, the company hasn’t really expanded in terms of city coverage over the past few years. Under what circumstances would the company consider expanding again?

Louis Hsieh

We’re going to expand this quarter. So we will be adding three to four new cities in the next 12 months, so we are going back to expansion on a geographic basis. We did hold it off because of a number of factors as you know Catherine. We wanted to focus on U- Can. We had enough on our plate with U- can, with H1N1 and a host of other programs and execution issues.

Your first question on Beijing and Shanghai, this quarter they accounted for 45% of revenues of the whole company. Most of the others have been growing very fast. So the top 12 cities as a blended group were 32%. These cities in 2005 I suppose was 44% and the schools from 2006 grew 58%, that gives you an idea. So obviously the newer schools grow faster at lower bases.

But even the 12 original schools that were started from 1983 to 2004 grew to a 32%; just as we had expected, so that we’re getting on all. We do have some schools that are still lagers, but we did overall see a very, very good improvement.

Catherine Leung - Citigroup

And may I ask, your faster growing cities, is this a function of, for example you are expanding the U-Can and your combined learning programs of these centers, or is there a sense of this general economic development that you see, that explains the faster growth.

Louis Hsieh

You remember Catherine, economic growth helps us, but even during the financial crises we still grew 35%, so it’s because of the quality of spending for Chinese families. So when you look at the different cities as they develop, the growth you’re seeing is driven mostly by Kids English and Middle and High School English and U-Can.

So the cities that have a lot of universities, we enter those cities earlier, so we will grow at overseas test preps and domestic test preps and Ault English there as well, but even city has obviously Grade Schools and Middle and High Schools, and so the fastest growth is actually driven by the six to 18 year old groups of POP Kids English and Middle High School English. And we expect further growth as you roll into five to 12 year olds. We’re going to roll into Chinese writing and mathematics, so that you will have more and more opportunities for these students to take classes.

Remember, it’s those three things that we talked about in one of those slides, right. We want to get life long value of the student from the age five or even before age two, all the way to adult hood. We want to get that recurring revenue stream, where they take us for many, many years, quarter-after-quarter.

We want to become one stop shop. We don’t want that revenue leaking, those enrolments going to other schools. So we want to offer them, like the Wal-Mart model where they can come in and pick up all the classes that they’d want for their children. So because of that, that creates a lot synergy in our centers, and that will help utilization and also wrap up revenues, I think is accelerating verses last year.

Last year I think we were targeting 25% to 30%. This year it should go down a little bit, but actually we won’t reduce the target. There’ll still be 25% to 30% for the next two to three years, and in fact I believe we would actually be at the high end for next year.

Catherine Leung - Citigroup

And if I could just have a last follow-up on your decision to add the three or four cities in the fourth quarter, should we read anything into this. I’ve been understanding that a lot of the focus in the past year or past 18 months has been on the U- Can and the customized learning program. Can that suggest that the initial or the bulk of the build-out for U- Can, the customized learning program seem to be behind the company already and is that why your….?

Louis Hsieh

Yes, it’s now behind us, because the demand is outstripping our forecast. So it’s a good problem to have, but it’s still a problem, right. So our demand is outstripping our forecast. We’re probably very close to 1000 U- Can teachers now; we still need to get to 1,400 by this summer. We’ll probably fall short by 50 or so teachers or so. So we are still building it out.

We have 120 learning centers that have U- Can now. By next year I would expect that to be very close to 180 or more learning centers, maybe even close to 200. So we’re going to add another 70 learning centers next year, 70 or 80, so the same as this year. So we’re always trying to plan ahead and grow learning centers.

The new cities; you should understand that Michael our CEO get so many requests from cities all throughout China for us to open New Oriental schools there. Many cities offer us land, and they want New Oriental schools in their cities; they see the benefits. So we have slowed it down in the last year as the issues we discussed earlier, and I think that now we’re going back to the normal pattern of two to three, maybe four cities a year.

Catherine Leung - Citigroup

Okay, thank you.

Louis Hsieh

Thank you.

Operator

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

Amy Junker - Robert W. Baird

Hi. Louis, thanks for taking my call. I just had a couple of follow-up questions from previous, but with respect to the teachers that you’re ramping up, are you finding it counting it all to attract higher quality teachers and to what extent are you needing to perhaps raise salaries in order to get the people to start with you?

Louis Hsieh

That’s an excellent question. Because we’re early in the teacher hiring, what we’re doing is we are spending a lot of resources in training teachers. In fact we have now over 7000 teachers in the network. We added 946 teachers just in the quarter. So it is a big challenge for us to find qualified teachers, and even more importantly when we find them, we actually have to train them.

So we have a staff of approximately 100 people that are teacher trainers as well, plus we are using the internet and online platforms to train teachers. It is an enormous task for us. It is our biggest challenge and why we don’t grow faster is hiring qualified teachers.

Our employee base at the end of the quarter was 13,984, so we’re going to grow to over 14000 people now, an increase of 3,500 this year. So we’re having to increase teacher hiring as well as staff hiring.

As far as salaries go, in order to attract the best teachers we have to pay up. So we did raise teachers’ salaries last quarter by 8% in Beijing and Shanghai, and probably 4% to 6% in most of the other cities across the country, and so we do have to pay up, but lucky for us, our ASP’s typically outpaced the increase in teachers’ salaries.

Amy Junker - Robert W. Baird

Then I know a challenge that you’ve had is turnover among some of the school heads. Can you talk about how that’s been trending?

Louis Hsieh

As far as I can remember, we didn’t loose any school heads last quarter and we didn’t fire any. So it’s still a problem though. I mean there are still some schools that aren’t over the hump yet, and that’s a problem we always have though.

So in any typical year, we would probably remove between two and five school heads, and that was another reason to Catherine’s earlier question, was that’s why we didn’t expend in too many cities. Because at that time, at the beginning of the year, we thought many of the schools were actually under performing. So we wanted to make sure that we righted our ship before we plan to go into new geographies and so that’s a third reason why we had held off on going into new cities.

But Michael and Zhou Chenggang and Xiangdong and the whole team have spent a lot of time in recruiting school heads and also Vice School heads. So we’re actually increasing the depth of management of each of the schools in preparation for even continued expanded growth across the country.

We recently took some school heads from sort of Vice Principals or Vice School Heads at existing cities. So we’re adding more and more Vice School Heads at each school, especially at larger ones, and that’s actually a training ground for us to pick new school heads.

Amy Junker - Robert W. Baird

And you feel that those under performing schools from earlier, have those turned around at this point?

Louis Hsieh

Well, the turn over process is a gradual process, right. It takes typically when a school is what I call broken or just under performing. If you put the right school head in, it still takes four quarters to eight quarters, so one to two years to right the ship. But you can definitely see by the performance last quarter that the numbers were much better than the previous quarter, and the schools that were having trouble, most of them showed market improvement.

Amy Junker - Robert W. Baird

Can you quantify how many schools you think still have room for improvement and I guess I’m thinking of it more on what’s the margin potential upside once these schools actually turn around, could it be really really meaningful.

Louis Hsieh

I think at any time we’re going to have between four and six cities that I think are candidates for replacing the school heads. Lets say we are 40, of the other 34 or 36 cities, there’s probably another 10 that are on an annual basis going to be below budget.

But then at the same time you’re going to have 10 that are just not going to cover off at all. They are exceeding the budget by substantial amounts. So I think at one time there are probably 15 schools in total that are probably under performing, but we would expect them in a budget.

Like I said, as long as it’s not Beijing or Shanghai, you won’t see a material difference yet. Although Beijing and Shanghai became smaller and smaller right, I’d say they are about 60% of revenue and now they are down to 45%.

Amy Junker - Robert W. Baird

Okay, and then last question, switching gears over to you U-Can. If you go into newer cities, what kind of brand loyalty are you up against in the non-English subjects and on the flip side of that question, are you seeing any first advantage in cities where larger competitors currently aren’t established.

Louis Hsieh

That’s exactly our strategy on why we’re going into the 37 cities by the end of this year. Outside of Beijing and Shanghai, in most of the cities there is not large established players, and so when we go in, maybe not first movers, we are usually never first into a city, but we have early mover advantage and we are much larger than the indigenous schools, and most of these cites, don’t forget Amy we already have existing schools. So this is just adding more program that we may have at both schools already. We have POP Kids English schools already and Middle and High Schools English.

So when we go into U-Can, its just another offering in our program that schools can pick from and so that gives them a huge advantage, because we already have the mind share of great number of students that could be used from the past, and so that helps us a lot in going into cites outside of Beijing and Shanghai, and the competition not being quite as strong or as large helps us as well. So we are very confident when we go into most of cities.

Beijing and Shanghai, we are also very confident, because we have been established in English in Beijing for 17 years, and in Shanghai for nine years. So even though we are not the number one player in all subjects, we are the number one player when you count Middle and High School English and all-subjects, which is a fair way to compare, because English is probably the GaoKao.

So each of these other competitors in those cities have there own specialties, whether it would be mathematics or sciences and if you add them all together, our enrolment outstrip any one of them. So we expect to become one of the top or three players in Beijing and Shanghai. We already are climbing all the way to the top in a couple of years. So we’re trying hard in the two most victorious cities of Beijing and Shanghai and we think we have a big head start in the other 38 cities.

Amy Junker - Robert W. Baird

Great. Thanks a lot.

Louis Hsieh

Thank you.

Operator

Your next question comes from the line of Brandon Dobell with William Blair & Co.

Brandon Dobell - William Blair & Co.

Thanks. Good evening Louis. Just a couple of quick ones for you. Could you guys kind of frame out how big The Dream Tour is going to be this year, verses last year, verses two years ago. Is it the number of cities or the length of days that might give us a sense of how big it is?

Louis Hsieh

Last two years ago it wasn’t that big; it was about 15 cities. Last year it became a bigger deal, we hit 30 cities. This year it’s very comparable to last year at about 29 cities, so it’s comfortable, but I don’t know the exact numbers of attendees.

We have many teams, many of the star teachers will go on different tours. So Michael’s tour this year goes down the costal cities, so from Beijing down to Guangzhou along the coast. Then we have other start teachers, and other senior management in the middle of China and into the western side of China. So there’s a number of tours.

I would say it’s comparable to last year, but I don’t know the exact number of features that are given. But you can imagine, any year several million students will attend these Dream Tour events.

The other thing that Michael was commenting about which was interesting was that, in the past when we did these Dream Tours or we went to schools, we used to pay for auditorium space. So we would have to rent facilities to house all those students. Now in many cases the schools are giving us the school unit space for free, because they want us to come and talk to their kids.

So it just shows you the popularity of the Dream Tour and how schools see the benefits of having their parents and the students learn from New Oriental, basically star teachers and management team members about the benefits of spending on training for their children.

Brandon Dobell - William Blair & Co.

Right, okay. Within the GaoKao business any comments that you can give us on how many programs or courses a single kid is going to take if it’s just one subject, two subjects, three subjects. I’m trying to get a sense of -- it’s always on a same customer growth opportunity we’re seeing.

Louis Hsieh

Yes, one of the investments we’re making as I said earlier is in the IT area. So we are developing our own customized customer relationship management system. So we’re adding an extra IT staff. Right now we have like one or two IT staffs in to the schools, we want to improve that and increase that.

One of the initiatives is to create this, so we can track the students more closely. Anecdotally what the idea is, that the average student takes five classes a year Brandon. So the repeat rate within New Oriental I’ve heard as high as 80% to 90% plus. So they become one and take more classes. In a year or so we’re going to track that very very closely.

The other benefit of the sign systems is that when students move the registrations, if their families move, that registration will follow them. It will enable the customer relationship manager to be able to give them much much better service as well.

But if you can tell, you know us very well from the brand awareness studies, we don’t lose that many students, and I think the average spending is about $500 per year in cities for first supplemental training with a white band. I mean, some will spend $100 or $200, some will spend tens of thousands per year.

Brandon Dobell - William Blair & Co.

Right. I might have missed this; did you give the number of cities of the Kids business that is in right now or you got some expectations on how that should look for the year?

Louis Hsieh

The 5 to 12 year kids business is in every city, all 40.

Brandon Dobell - William Blair & Co.

Any sense of how it’s skewed towards Beijing, Shanghai, Guangzhou, the majority of the business.

Louis Hsieh

Well the kids business is actually skewed towards Wuhan right, because Wuhan is where it started. But the percentage of kids in Wuhan is shrinking every year. It was at 22% a couple of years ago, it’s probably down to 14% to 15% now.

Beijing and Shanghai are taking off and so are all the others cities. I mean our enrolments in kids English two years ago was 200,000; last year it was 300,000. This year it’s going to be probably 420,000, a 40% increase in enrolments, and next year we would expect that number to continue to climb somewhere north of 550,000, very close to 600,000 enrolments, those enrolments are across the country, and it’s a product that is up everywhere.

It not like Overseas Test Prep, it only works in the college accounts. It doesn’t have a high concentration of sort of higher tier 1 type universities. The middle school U-Can and the kids program is universal across China.

Brandon Dobell - William Blair & Co.

And you are so comfortable with how the ASPs look in those tier 2 cities? Are you still getting enough price there?

Louis Hsieh

I think for the larger class it’s within 30% of Beijing and Shanghai. For the one-on-one classes it’s within 50% of Beijing and Shanghai, but as you know Brandon, the cost is also lower there. So the margins are still going to be very good. The ASP was still at least north of 55% on one-on-one tutoring and don’t forget, below the gross margin on this there’s really nothing, expect marketing.

Brandon Dobell - William Blair & Co.

Got it.

Louis Hsieh

As soon as we take off the marketing accelerator, the margins will be quiet high.

Brandon Dobell - William Blair & Co.

Yes, makes sense. Thanks.

Louis Hsieh

Thank you.

Operator

Next question comes from the line of Chenyi Lu with Cowen and Company. Please proceed.

Chenyi Lu - Cowen and Company

Great, thank you. I have two questions; the first question is, you have talked about the strong growth in the Kids English, and also mid-to-high school segments. Can you give us an indication for you’re overseas test preparation in the fiscal year 2011, given that this quarter you see the enrolment growth by 7%, and revenue growth by 34%. So I just want to get a sense of what you see in fiscal 2011 in terms of ASP and also enrolments for overseas test preparation.

Louis Hsieh

Yes, I think we expect enrolment growth would be somewhere between 8% and 10%, and revenue growth north of 30%. So it will be as we said it’ll grow between 30% to 35%. We see no change for next year. The drivers will be the number of students actually leaving China and studying broad, but also the shift towards more and more students taking the SAT and the TOEFL at a younger age, and the IELT. So, I think it’s beginning to move less, so the growth rate for GMAT and GRE will not be as fast as the growth rate for SAT and TOEFL.

Chenyi Lu - Cowen and Company

How about your ASP growth for 2011 for this oversea?

Louis Hsieh

We haven’t done it yet, but we are doing budgeting right now. Unless something changes, I would expect it to be north of 20%.

Chenyi Lu - Cowen and Company

North of 20%, great. My next question is regarding the ASP. I know the overall ASP growth is about 10%. Can you give us the indication for ASP growth for Kids English and the mid-to-high school segments?

Louis Hsieh

Last quarter the Kids English program -- don’t forget this is in track exactly, because enrolment came in this quarter, and some of the students will go in the next quarter, but the English program, the ASPs I don’t have it here.

The average ASP was $123 for the quarter, and I don’t have the actual growth rate; I apologize. It was relatively flat for this last quarter. Don’t forget, partly it’s because the sessions were shorter, because we had two sessions before Chinese New Year. So the normal ASP growth for Kids English is 8% to 9%, but this quarter was an anomaly, and that’s why ASP is only 10% versus a normal 13% or 14%.

For middle and high school, blended the ASP growth was over 50%, about 58%. For U-Can itself, the ASP increase was 141%, and that’s driven by the shift towards one-to-one classes, and one to six classes on VIP.

So you can see the power of the platform for middle and high school students in not just English, but the whole variety right. The analogy I have used in the past with investors and analysts as I used to say “Look, we offer all kinds of cars. You can buy a Hyundai, you can buy a Toyota at the middle end, you can buy a Mercedes or BMW at the high end.” So we offer the full product and its up to the students to pick.

Chenyi Lu - Cowen and Company

Alright, thank you Louis. One more question; regarding your sales and marketing, I know that you always spent heavily in 4Q to come out for the summer. I think in the past three years, 4Q basically, the sales and marketing spend as revenue continues to decline. I just want to get a sense of why you see the sales and marketing expense as a revenue for the 4Q fiscal year 2010, given that your probably going to spend heavily on U- Can.

Louis Hsieh

Q4 marketing will increase. We spent about $41 million in marketing this year. We still have another $15 million in the budget, and Michael may go slightly above that, because of the push in the U-Can, and also we want to make sure we have a strong summer. So, I can see marketing being quiet high in Q4 to be honest.

Chenyi Lu - Cowen and Company

I mean, this quarter your sales and marketing should come in slightly below everyone’s estimate.

Louis Hsieh

Last year we spent $10.3 million in sales and marketing in Q4. So this year I would that expect that number to be hardly 40% or 50% higher to $14 million or $15 million.

Chenyi Lu - Cowen and Company

Okay great, thank you.

Louis Hsieh

The budget was $56 million; we are at $41 million. So there is some room in there, and that is rough percentage of about 13.8% for the year, but that should come down hopefully in subsequent years.

Chenyi Lu - Cowen and Company

Alright. Thank you Louis.

Louis Hsieh

Thank you.

Operator

Your next question comes from the line Mark Marostica with Piper Jaffray. Please proceed.

Mark Marostica - Piper Jaffray

Thank you. I want to talk about your comments concerning the spending on IT systems, content development, and customer service rep. Should we expect that spend to be concentrated in any one particular quarter in the first half of fiscal 2011 or back half. How should we think about the timing of that spend?

Louis Hsieh

That timing will be gradual over the next 18 months, so a year and a half, but once you have these IT it’s permanent, so that will continue to be there. The development of the CRM system is targeted for this next 12 months, so we are going to roll it out in the next 12 months and get it rolled out to as many schools as possible.

As far as the customer relationship management people, it’s the same way, it’s like a marketing personnel, they will continue to grow. We want to have 250 of them for U-Can by the end of this fiscal year. It will probably come in a little bit short at 200 to 230, and then that will grow depending on the needs and the growth of U-Can, but that will continue grow as well. But at the end of the day we have to service our customers, so we have to give them a high level. So we have to be able to track them wherever they go, and deliver a higher level of service.

On the content management side we have more than doubled our staff, so I think it’s pretty close to 160. We have developed content for 6 to 18 year olds. Content differentiation in quality is part of what builds the brand along the teaching quality. So even though it’s a lot of money, its going to pay off dividends in the long run and its going to sustain our brand name and our leading position.

Mark Marostica - Piper Jaffray

Regarding the systems evolving, what are you planning to do to build a better customer interface. I am curious whether or not any of that stand or development work actually will be concentrated in your peak enrolment period or your peak delivery period, and whether or not you see any execution that’s tied to any of that systems development work.

Louis Hsieh

No, I think it’s a separate way of developing. I mean, like we’re hiring in the next few quarters a 100 additional IT people to develop the system and upgrade our IT systems across the whole country. So I don’t think it will interfere until the implementation stage, which will probably be in -- we’ll typically try it in Beijing first, and then work out the case and then began to roll out to Shanghai and other cities gradually. In the course of two years we usually get it out to all the cities.

Mark Marostica - Piper Jaffray

And the timing of the Beijing launch will be when?

Louis Hsieh

I don’t have that yet. We are just into development right now, so like I said we are going through budgeting now, so I’ll have a clear answer by the end of May. The idea is to have it rolled our in most of the schools in the next two years, and the spend will continue to grow.

But don’t forget Mark, when we do this it serves our customers better. There is a payout, a payback as far as the customer loyalty, as far as customers taking more classes, as far as helping us to market to them better, so we know we’ve seen the whole history, and we know what their needs are, so it’s going to payback. It includes a huge bettered entry for anybody who wants to enter this space, who wants to go nation wide.

Mark Marostica - Piper Jaffray

One last follow-up question; regarding stock base comps, it came in a little bit higher [Inaudible] I am curious as you look through Q4 in fiscal 2011what should we be looking at the stock based comp then.

Louis Hsieh

That’s a good question. Stock based comp shocked me too, because the law came in and told us that we had to take down the forfeiture rate again. Michael is not good at getting people to leave yet, so our forfeiture keeps going down which means our stock base comp keeps going up.

Q4, the stock base comp will defiantly come down, because the 07 options are done with. They expired October 28 during the quarter. So as I told you earlier, in Q4 you’ll begin to see noticeable decline in stock base comp, but Q1 we expect to issue the annual set of options. We haven’t issued any options at this year, our stock based comp. So that will jump back up probably in Q2. Q1 will still be better than Q4, it will go down, and then Q2 will begin to rise again.

When I map it out, it looks like about $3.2 million in stock base comp, so $1.7 million drop and then Q1 right now, it’s under $2 million, so a lot of options expire in Q1, but there will be a new group to replenish those, but as a percent of revenue, every year stock based comp should began to decline, unless we began to be very, very generous with stock based comp.

Operator

Ladies and gentlemen, this concludes our Q-and-A session. This is all the time we have for today. Thank you for your participation. I would like to turn the call over to Mr. Louis Hsieh; please proceed.

Louis Hsieh

I just want to say thank you to everyone who participated on the call. Michael and I and all at New Oriental, we really appreciate you guys continued support, and see you guys at future conferences. Thank you and have a good day.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!