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

F4Q10 (Qtr End 05/31/10) Earnings Call

June 19, 2010 8:00 am ET

Executives

Sisi Zhao – Senior IR Manager

Louis Hsieh – President and CFO

Analysts

Philip Wan – Morgan Stanley

Chenyi Lu – Cowen and Company

Marisa Ho – Credit Suisse

Ingrid Yin – Brean Murray

Mark Marostica – Piper Jaffray

James Mitchell – Goldman Sachs

Amy Junker – Robert W. Baird

Brandon Dobell – William Blair

Ella Ji – Oppenheimer

Operator

Good evening and thank you for standing by for New Oriental's fourth fiscal quarter 2010 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 is being recorded. (Operator Instructions).

I would now like to turn the meeting over to your host for today's conference, Ms. Sisi Zhao.

Sisi Zhao

Hello, everyone and welcome to New Oriental's fourth fiscal quarter 2010 earnings conference call. Our fourth fiscal quarter earnings results were released earlier today and are available on the company's website, as well as on newswire services.

Today, you will hear from Louis Hsieh, New Oriental's President and Chief Financial Officer. After his prepared remarks, Louis will be available to answer your questions.

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 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 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, everyone and thanks for being with us today. I will start by taking you through the quarterly and yearly highlights and then move into financial results. After that, we will finish with some Q&A.

As many of you are aware, Q4 is seasonally a slower quarter for us as students look to year-end examinations. Nonetheless, we reported continued strong revenue growth and even stronger bottom line growth for the quarter, beating the high-end of our guidance.

As we mentioned last quarter, since Chinese New Year was relatively late this year, the vast majority of student enrollment for spring courses, which is our Q4, were logged in the quarter, which boosted quarterly enrollments compared to past years where a significant portion of the spring quarter pre-enrollments occurred in the winter or Q3 period.

Overall enrollments across the businesses in the fourth quarter were very healthy, increasing more than 32% year-over-year to 437,000. The blended average selling price increased about 13% year-over-year to about $235.

Full-year results were also outstanding, especially given the disruption caused by the H1N1 flu outbreak last summer and fall and the ongoing impact of the global financial crisis. Total student enrollments for the year increased 19% to approximately 1.8 million, driving top line growth of 32% to $386 million, exceeding our 25% to 30% revenue growth target for fiscal year 2010.

Driving growth this quarter were our three key business segments. Let me take you through some highlights for each of these. POP Kids English continued to be a top performer with enrollments growing more than 50% in the fourth quarter and quarterly revenue growth of 43%. Full fiscal year enrollment for POP Kids was over 40% to a total of more than 434,000 enrollments with yearly revenues up over 44% to approximately $50 million.

As many of you know, one of the reasons POP Kids is so successful is parents' trust in New Oriental to begin their often single son or daughter on the right education path from early age, giving them the best possible educational experience and helping them attain the skills they need to succeed throughout their education careers.

On the back of our success with POP Kids English program and with the continued high demand for early childhood education options, the first of our two large-scale initiatives for fiscal year 2011 is to expand our offering for kids aged six to 12 with the addition of Kids' Math and Kids' Chinese writing classes under the POP Kids brand.

With the wide and growing base of POP Kids students, we expect these new offerings to be a natural next step for parents looking to start their kids off on the right track. We have actually been piloting the program in several cities and feedback and demand so far has been extremely positive. So we are looking forward to rolling this out across our entire nationwide network in fiscal year 2011.

Another significant growth driver, non-English U-Can courses for middle and high school students, also outperformed over the quarter. Enrollments in Q4 were up 150% to 36,800, making a total of approximately 120,000 enrollments for fiscal year 2010, well above our target of 80,000 to 90,000. And non-English U-Can revenue in the quarter grew more than 200%, bringing us to $34 million for the full fiscal year, significantly higher than our $25 million target.

The success we've seen with U-Can since its launch in 2008 underlines the strength of the New Oriental brand and the trust that our students and their families have in our course offerings. It also demonstrates our ability to serve as a more robust and versatile education partner for our large student base, meaning a student can come to us for English language training and decide to stay for other subjects, test preparation, and tutoring as well.

As of the end of fiscal year 2010, U-Can has been deployed across 39 of our 40 cities or schools, forming a central part of our nationwide offering. As U-Can continues to track new enrollments in cities throughout the country, we recognize the need to enhance our systems to add additional value to our hundreds of thousands of students taking advantage of this program.

So in fiscal year 2011, as our second large-scale initiative, we will be launching a new proprietary learning system for U-Can English and non-English high school and middle school students. The system focuses on skills assessment, development, test preparation, and improvement and will serve as a quantitative measure of students' progress over time, while also giving us a useful tool to assess our students' needs and provide targeted support where it's best applied. We believe this is the most comprehensive and scientific assessment system, covering all subjects through each level of middle school and high school in China.

With the addition of POP Kids' Math and Chinese writing and the U-Can middle and high school learning system, we believe that we will possess the most comprehensive highest quality learning and test preparation for Chinese students aged six to 18 to complement New Oriental's – to complement their formal public school programs. Thus, we fully become a true one-stop-shop for Chinese students as they look at afterschool, weekend, and summer/winter holiday academic subject training and test preparation programs for their child or children.

Finally, Overseas Test Prep, the other major driver this quarter, saw a 25% increase in enrollments and a 40% increase in revenues for the quarter. For the full fiscal year 2010, enrollments grew 12% to over 256,000 and revenues grew about 32% to approximately $107 million.

In addition to these main growth drivers, our other business segments have been progressing well, thanks to continued smooth execution. Koolearn, our online education offering, recorded over a 90% revenue increase this year and now has over 6 million registered users. And revenue from our overseas consulting business grew more than 50% over the same period. While overall contributions into these segments are small, they continue to grow healthily and, we believe, serve an important offering outside of our core growth segments to meet the diverse needs of our students.

During the full fiscal year 2010, programs for six to 18-year old students became the largest portion of our business, generating over $115 million of revenue. We are targeting over 1 million enrollments in programs for six to 18-year olds in fiscal year 2011, up from 790,000 in 2010, driven by our ongoing success of our POP Kids and U-Can all-subjects training for middle and high school students and the new Math and Chinese writing initiatives.

Combined with the over 1 million adult enrollments we are expecting in the same period, we are targeting a total of well over 2 million enrollments for fiscal 2011. In fact, we estimate that we will surpass the 10 million cumulative student enrollment milestone by the end of this calendar year 2010, demonstrating once again the strength of our brand and the trust that Chinese families place in our high-quality education programs and instructions.

I'd like to take you through some of the things we are going to do to drive the expansion of our network and achieve our ambitious growth targets. In Q4 2010, we added a net of 43 new learning centers, bringing us to a total of 367 at fiscal year-end, 97 more than we had at the end of fiscal year 2009 and exceeding our expected net adds of 70, showing us to – allowing us to better penetrate existing key cities throughout our network.

In fiscal 2011, we plan to ramp up the expansion by adding another 100 learning centers in existing cities and entering into two to four new cities. Expanding our network allows us to capitalize on increasing demand for high-quality education all over China, particularly in the fast-growing Tier 2 and Tier 3 cities. Moreover, our hub-and-spoke business model allows us to leverage our on-the-ground network of teachers and administrators to measure demand nationwide, identify the best areas to grow, and scale our business quickly and effectively where we can see new opportunities.

Those of you who have been following us for a while will know that central to our success is the quality of our teachers and administrative staff. And so as we grow, we continue to make recruitment a major focus. In fiscal year 2010, we employed a total of 5,400 new staff, over half of which are teachers, bringing total headcount to approximately 16,000.

Another important element of our expansion plan is the investment we are making in – to upgrade our IT infrastructure and implement a completely new customer relationship management system or CRM system, which will allow us to improve our customer service and business management. We expect to invest about $3 million to $4 million in IT upgrades and this new CRM system over the next two years. The new CRM system will give us an important set of tools, which will let us tailor new products and focus existing offerings based on student needs, ultimately serving our students better.

And we firmly believe that investing in better systems and infrastructure is essential if we want to continue delivering strong top line growth of 25% to 30%. Although at the same time, we will continue to pay close attention to cost control. We are targeting profit growth of 25% or higher in this new fiscal year, notwithstanding our aggressive expansion plans.

Looking into Q1 and fiscal year 2011, we have every reason to be confident. Our brand continues to be the most trusted in our market with more and more students of all ages coming to us to – for help in their personal development. We have overcome some large obstacles in the past year, not least among, which is H1N1 and the global economic challenges and emerged a stronger business.

And education has never been more important in China. As the economy grows, we fully expect it to remain a priority for families who want to see – who want to see their children – child or children get ahead in this very competitive market. New Oriental continues to provide these ambitious students with quality education to help them achieve their goals.

Now, let me take you through the financials. For the fourth fiscal quarter of 2010, New Oriental reported net revenue of $86.6 million, representing a 45.7% increase year-over-year. Net revenues in educational programs and services for the fourth fiscal quarter were $74.3 million, representing a 44.7% increase year-over-year. The growth was mainly driven by the increase in number of student enrollments in language training and test preparation courses. Total student enrollments in language training and test preparation courses in the fourth quarter of fiscal year 2010 increased by 32.4% year-over-year to 437,200 from approximately 330,200 in the same period of the prior fiscal year.

Operating costs and expenses for the quarter were $82.9 million, a 45.7% increase year-over-year. Non-GAAP operating costs and expenses which excludes share-based compensation expenses for the quarter were $79.7 million, a 51.9% increase year-over-year.

Cost of revenues for the quarter increased by 41.1% year-over-year to $36.4 million, primarily due to the increased number of courses and the greater number of schools and learning centers in operation.

Selling and marketing expenses in the quarter increased by 69.4% year-over-year to $17.4 million. As we mentioned previously, this is primarily due to brand promotion expenses, especially in relatively new programs such as the U-Can all-subjects training program, which has been successfully rolled out throughout the entire network of 39 cities. This program allows us to target higher revenue opportunities in the future and gives us better – better penetration in cities and we expect the relatively higher level of sales and marketing expenses as a percent of revenue to come down in the coming two years.

General and administrative expenses for the quarter increased by 39.7% year-over-year to $29.2 million. Non-GAAP general and administrative expenses, which exclude share-based compensation, were $26 million, a 56.2% increase year-over-year, primarily due to increased headcount as the company expanded its network of schools and learning centers.

Total share-based compensation expense, which were allocated to related operating costs and expenses, decreased by 27.2% to $3.3 million in the fourth quarter from $4.5 million in the same period of the prior fiscal year.

Income from operations for the quarter was $3.7 million, a 46.3% increase from $2.5 million in the same period of the prior fiscal year. Non- GAAP revenue from operations for the quarter was $6.9 million, a 0.9% decrease from $7 million in the same period of the prior fiscal year.

Operating margin for the quarter was 4.2%, the same as last year. Non-GAAP operating margin, which excludes share-based compensation expenses, in the quarter was 8% compared to 11.7% in the same period of the prior fiscal year.

Net income attributable to New Oriental for the quarter was $5.8 million, representing a 118.7% increase from the same period of the prior fiscal year. Basic and diluted net income per ADS attributable to New Oriental was $0.15 and $0.15, respectively.

Non-GAAP net income attributed to New Oriental for the quarter was $9 million, representing a 26.9% increase from the same period of the prior fiscal year. Non-GAAP basic and diluted net income per ADS attributable to New Oriental was $0.24 and $0.23, respectively.

Capital expenditures for the quarter were $6.4 million, primarily used to add a net of 43 new learning centers. As of May 31, 2010, New Oriental had total cash and cash equivalents of $281.1 million as compared to $250.8 million as of February 28, 2010. In addition, the company had $137.9 million in term deposits at the end of the quarter. Net operating cash flow for the fourth quarter of fiscal year 2010 was approximately $48.2 million.

The deferred revenue balance, which is cash collected from registered students for courses and recognized proportionally as revenue as the instructions are delivered, at the end of the fourth quarter of fiscal year 2010 was $107.1 million, an increase of 43.2% compared to $74.8 million at the end of the fourth fiscal quarter of 2009.

Before giving guidance in the fourth quarter, I would like to take a look at the comparisons between fiscal year 2010 and fiscal year 2009. For the fiscal year ending May 31, 2010, New Oriental reported net revenues of $386.3 million, a 32.0% increase year-over-year.

Net revenue from educational programs and services for the fiscal year ending May 31, 2010 was $352.9 million, representing a 32.5% increase year-over-year. The growth was mainly driven by the increase in the number of student enrollments in language training and test preparation courses. Total student enrollments in language training and test preparation courses for the fiscal year ending May 31, 2010 increased by 19.0% to 1,807,700 from approximately 1,519,500 in the fiscal year ending May 2009. Let me repeat that. This year, we had 1,807,700; last year, 1,519,500.

Income from operations for the fiscal year ending May 31, 2010 was $77.3 million, a 26.9% increase year-over-year. Non-GAAP income from operations for the fiscal year was $93.5 million, a 20.4% increase year-over-year.

Operating margin in the fiscal year ending May 31, 2010 was 20% compared to 20.8% for the fiscal year ending May 31, 2009. Non-GAAP operating margin for the fiscal year ending May 31, 2010 was 24.2% compared to 25.5% for the fiscal year ending May 31, 2009.

Net income attributed to New Oriental in the fiscal year ending May 31, 2010 was $77.8 million, representing a 27.5% increase year-over-year. Basic and diluted net income per ADS attributed to New Oriental for the fiscal year ending May 31, 2010 was $2.06 and $2.01, respectively.

Non-GAAP net income attributed to New Oriental for the fiscal year ending May 31, 2010 was $94 million, a 20.8% increase year-over-year. Non-GAAP basic and diluted net income per ADS attributed to New Oriental for the fiscal year ending May 31 was $2.49 and $2.43, respectively.

Moving on to revenue guidance. I would like to note that – here that because Chinese New Year was relatively late this year, taking place on February 14, the winter break was a little longer than usual and the summer break consequently shorter by a week or more in most provinces this year. In addition, the recent massive floodings in South and Central China has made it difficult for many of our students in the affected areas to register for attend New Oriental classes. These are likely to have some negative impact on our Q1 2011 revenues and profitability.

Now, notwithstanding these challenges, we expect total net revenues in the first quarter of fiscal year 2011 from June 1, 2010 to August 31, 2010, to be in the range of $188.2 million to $197.2 million, representing a year-over-year growth in the range of 26% to 32%, respectively. This forecast represents New Oriental's current and preliminary view, which is subject to change.

Once again, thank you for participating in our quarterly earnings call. And at this point, I will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Philip Wan of Morgan Stanley.

Philip Wan – Morgan Stanley

Hello, Louis and Sisi. Thank you for taking my question. And first of all, congrats on the very strong quarter.

Louis Hsieh

Thank you, Philip.

Philip Wan – Morgan Stanley

I have the question – I have a question on your U-Can program. Could you share with us what's your expectation in terms of enrollment and ASP growth for this year? And also, how does the growth rate compare against the – like older cities like Beijing and Shanghai versus new cities that you have just penetrated into in recent years? And what are the revenue contributions for Beijing and Shanghai?

Louis Hsieh

Okay. Those are good questions. The last one first. Beijing and Shanghai is approximately one-third, maybe a little more one-third of the revenues for U-Can currently. The whole country is growing very, very fast in U-Can. As you know, we grew from 57,000 enrollments to over 120,000 in one year. Revenue basically more than tripled. So our ASP went from about $135 to $280 – $110 to $282 in the last fiscal year. And that's driven by the move towards smaller classes.

As far as forecast for 2011, we would expect the enrollments to grow in the range of 40% to 50% to about 170,000 U-Can. And then you add that on to the English enrollments; we expect 12 to 18-year old enrollments to be pushing very close to 0.5 million students. And so the revenue should grow probably faster than the enrollments. So revenue should go up at least 50% for the U-Can segment. So we would expect somewhere north of $50 million in the U-Can non-English. If you add in English together, this number will be much higher.

It's really the same student, right, Philip? It's the same 12 to 18-year old student. So the enrollments – the – that's the whole beauty of the cross-sell, and that's why we are going to do the same thing for children – the POP Kids, six to 12 and add in Math and Chinese, the other two subjects the parents want.

Philip Wan – Morgan Stanley

Okay. Just to clarify, you said $50 million on non-English U-Can for next year?

Louis Hsieh

Yes.

Philip Wan – Morgan Stanley

And mainly driven by the enrollment growth, right?

Louis Hsieh

Yes, it could be both. It will be the continuation of ASP increases, as well as the increase in enrollment, as well as the shift towards smaller one-on-one and one-to-six classes. So all three will have a – will play a role.

Philip Wan – Morgan Stanley

Okay. I'll get back in the queue. Thank you.

Louis Hsieh

Thank you, Philip.

Operator

Your next question comes from the line of Chenyi Lu of Cowen and Company.

Chenyi Lu – Cowen and Company

Hi, good morning. I have a question regarding these new programs for POP Kids' Math and also for Chinese writing. Can we – can you give us the – what revenue view and enrollment view currently you have for next year?

Louis Hsieh

Yes, I think this year will be similar to what U-Can did two years ago, it's the pilot year. So we are going to begin to roll it out. But the truth is you actually begin to roll out more seriously in the winter quarter. So this is a second half of 2011 exercise, although we are piloting now in Beijing and Wuhan and Shanghai and some other cities, they will begin to roll out in the winter quarter. So I wouldn't expect a large contribution, maybe 15,000 to 20,000 enrollments in non-English for POP, but that number will go – will accelerate dramatically in the year – if it's successful in the year after, similar to what U-Can did.

Chenyi Lu – Cowen and Company

So basically, you are going to select a few major cities to roll out first and then you could poll and get pretty good acceptance, then you are going to roll out across the country?

Louis Hsieh

We expect to roll out across the country in the second half of this year. The reason is that we have our hands full with U-Can new learning system, right? And so it's hard for us to do two major rollouts exactly at the same time, even though it's different sort of age groups, it's just – our management resources are very stretched and we are trying to 100 learning centers, there is too much going on.

So we are – it is very – it is proving to be very successful in Beijing, Shanghai, Wuhan, and other cities. And so we fully expect to roll it out at 20 to 30 cities by the end of this fiscal year. But because it's more of a second-half event, it won't have as big a revenue contribution as if it was started this quarter, let's say.

Chenyi Lu – Cowen and Company

And then can you just give us what ASP you have in mind?

Louis Hsieh

ASP will be about the same as for POP Kids, which is about $110, $120 a class.

Chenyi Lu – Cowen and Company

Okay, great. Thank you.

Louis Hsieh

So you just do 20,000 times – you do 20,000 times $120, you get a – several million dollars, but it's not as big an impact as U-Can. But we expect that program to grow very quickly.

Chenyi Lu – Cowen and Company

Yes. Well, it will be similar momentum like U-Can, right? In the beginning, it was relatively small. And then the –

Louis Hsieh

Exactly. It's exactly the same track. It doesn't have as big a potential as U-Can, because the ASPs in U-Can are much higher.

Chenyi Lu – Cowen and Company

Right, right. I agree, I agree. Because U-Can generally – U-Can have also multiple subjects. But in this case you only have Math and the Chinese writing, so –

Louis Hsieh

Exactly. You are limited to three subjects, you are limited to 25 students per class. But – don't forget, this is all a strategy, right, for New Oriental. If we get the children between six and 12 and we offer them quality – top-quality program and services, we are their natural choice when they turn 13, when they go 12 to 13 and they move into the U-Can program. So it's a feeder program for us.

And so it is – it's our way of keeping those students from age 6 all the way to 25 in the New Oriental system. Remember – I reemphasize again to our investors really, it's the one-stop shop, it's the recurring revenue model and it goes right toward our goal of being the trusted education partner for Chinese families for their children between ages six and into their 20s.

Chenyi Lu – Cowen and Company

And they make sense, because you already offer 12 to 18, right? It's very easy to offer for six to 12.

Louis Hsieh

Exactly. And it also leverages the same teachers. We don't have – we don't need to add that many new teachers in POP Kids, because most POP Kids English teachers can actually teach first grade Math, let's say. So it really leverages the infrastructure we already have in the POP Kids English centers. So it is a natural extension that we've been planning for a couple of years now.

Chenyi Lu – Cowen and Company

Okay, great. Thank you.

Louis Hsieh

Thank you.

Operator

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

Marisa Ho – Credit Suisse

Hello, Louis.

Louis Hsieh

Hi, good evening, Marisa.

Marisa Ho – Credit Suisse

Hi, how are you? I want to better understand your revenue comparison dynamics, I mean, on a Q-on-Q basis going into FY '11. You just mentioned that, because of the floods and also to some of the other difficulties, you are expecting these to have somewhat of an impact on the first quarter. And that's probably one reason why you are guiding towards relatively conservative revenue numbers for the first quarter. But as you move into the second half of FY '11, you are probably running into a tougher comparison base as well, because you've been doing so well in the second half of FY '10.

So if I look at the full year, does it mean that you are probably looking at a revenue growth range more towards the high end of the – like a 25% to 27% range, I mean, rather than over 30% for the full year? Would that be –?

Louis Hsieh

Well, what I really think – yes, I think what's going to happen is we'll be – if we are successful in rolling out 100 learning centers throughout the year, which means that our business is good, we should be at the top of that range of 25% to 30%.

Marisa Ho – Credit Suisse

All right.

Louis Hsieh

Yes. And then the summer, don't forget, we have the benefit of an easier comparison because of H1N1 last year. That's what offset these floods and the – and the other – the floods and a shorter summer quarter.

There are two other things I didn't mention. There are also negative headwinds. I mean, they are smaller, right? There is the World Expo, right? Many of these Chinese students who are 12 to 18 years old are supposed to be studying this summer, but they are learning in a different way. They are going to the Expo to learn about the different cultures around the world, which is a very useful educational experience. So they are – they've been slow to register for classes this summer.

And the other thing which is – which cracks me up is the – a lot of students waited to register for summer classes, because they wanted to watch the World Cup. So we had a slow start to June and then the last three weeks, we have had the three best weeks in the history of New Oriental in registrations – in revenue.

So it was a slow start, but it's beginning to pick up. And the reasons we heard were World Cup, Expo, floods, and the – and – I think that we did calculate that the summer is actually shorter than last year. So that would negatively impact our revenue as well. But the underlying demand is still very, very, very strong. So we expect to be in that 26% to 32% range.

Marisa Ho – Credit Suisse

Yes. And when you are talking about the profit guidance, I mean, the 25% year-on-year growth in FY '11, you – you've been painting [ph] quite a bit of margin reduction, I mean, to get a 30% plus top line growth to 25% bottom line growth.

Louis Hsieh

Yes. And that really – we tried to highlight in this, Marisa, that we are trying to build – we don't care about one year. We care about five, 10, 20 years from now. So we are trying to build the systems and the – and put in new content in this new learning system that would give us competitive advantage for years to come. So we are not really worried about each year. We – I keep telling investors that every time I meet them. If you want to buy a New Oriental stock for one quarter or two quarters, don't bother. This management team is building this company to last for a long period of time.

And so we need this IT infrastructure in order to grow into 50 or 60 cities; we need that upgrade. We have – the CRM system will let us serve better our students. This new system we've been working on for a year now, the content that – it's – much of it's computerized, that will help assess these students' skill between 12 and 18 in a specific subject, identify weak points, set up a program to help that student improve on those subject areas, and really test their mastery of each of the subjects.

That kind of system doesn't exist in China right now. So we think we have the best proprietary system out there for 12 to 18-year old learning and we are going to roll it out starting this quarter. And I think there will be a – there have been some press releases; there will be more within China this week.

Marisa Ho – Credit Suisse

If I can just ask one more question before I go, for this new computerized and content of system, is the investment mainly in the form of OpEx or CapEx?

Louis Hsieh

It's mainly – it's mainly in the – it – with headcount and – so it's head – and CapEx. So if you think about it, our CapEx last year was $19 million – $19.9 million. This year, we expect it to be $26 million to $28 million. So it's a net of an increase of $6 million to $8 million. That's probably the 100 learning centers, but it's also for the – $3 million to $4 million is for the IT and CRM systems. And then – and those are necessary in order for us to deliver this computerized system for 12 to 18-years olds in a very effective and timely manner.

So this whole upgrade is all part of the same exercise in delivering an unparalleled experience and education experience for kids 12 to 18. There is nothing else like that, we believe, in China right now.

Marisa Ho – Credit Suisse

All right. Excellent. Thank you so much.

Louis Hsieh

Thank you, Marisa.

Operator

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

Ingrid Yin – Brean Murray

Hi, good evening, Sisi and Louis.

Louis Hsieh

Good evening, Ingrid.

Ingrid Yin – Brean Murray

Congratulations on a great quarter. Thank you for taking my question. So my first one will be on the fiscal year 2011 guidance. So you guided about 25% to 30%, similar with what you do every year. How much do you think it will come from enrollment and how much of it will be from blended ASP growth?

Louis Hsieh

I think it will be about half and half. So I think it will probably be 15% from enrollment increases and probably 15% or so from blended price increase. Most of that price increases will be due to smaller class sizes than – organic price increase is probably the same 6% to 8% or so.

Ingrid Yin – Brean Murray

Yes. So you just mentioned that we are going to grow like a Kids program this year and we are really growing the company at the long-term horizon. So what will be after U-Can and the Kids program?

Louis Hsieh

This is the focus for the next two or three years. This is what we said last year, right? We said, for the next two or three years we are going to focus on six to 18-year olds. So there's – there is nothing we expect to roll out new in 2012 for now. So this is it.

So if we get it rolled out successfully – you know, I know I say this every year, but if we get this rolled out successfully, then in 2012 there shouldn't be any new large-scale marketing initiatives that we need to do. Marketing will still – we believe will – in our budget, is scheduled to decrease as a percentage. This year, it was all-time high, 15%. It should be somewhere between 13% and 14% for fiscal year 2011.

Ingrid Yin – Brean Murray

So we should expect –?

Louis Hsieh

And it should go down there. Yes.

Ingrid Yin – Brean Murray

Yes. We should expect operating margin to go up from – starting 2011 or after –

Louis Hsieh

Yes. Well, probably not early because of the expenditures we are going to spend on the IT side. So it's going to be the – it's going to be more infrastructure additions.

In addition, because we are be rolling out 100 centers, right, we need to add another 4,000 or 5,000 people. And that's what happened this year, right? We added 5,000 people sort of ahead of the demand and that's the same thing we'll do again this year. We'll add another 4,000, 5,000 people, half of which are – more than half of which are teachers. But they are fully deployed, right? They are trained and they are in there, but they are not fully deployed. So they are not – we are not able to leverage them the way we'd like to.

Ingrid Yin – Brean Murray

Okay. If we look at U-Can together – non-English and English together, how much did they contribute to the total revenue?

Louis Hsieh

Together, they were about almost $60 million – no, I would say more than that. So more than $60 million – almost $70 million. There were about 386,000 enrollments for fiscal year 2010. So if they increase 25%, 30%, we will be very close to 0.5 million enrollments in U-Can. Kids is 434,000 this year. We expect that to increase about 35%, 40%. So it will be probably over 600,000, which means combined, it will be 1.1 million enrollments for six to 18-year olds. That with 1 million adult enrollments we expect this year, we should be right around 2.1 million enrollments – 2.05 million to 2.1 million enrollments.

Ingrid Yin – Brean Murray

Okay, great. Thank you for the answers.

Louis Hsieh

Right. And maybe the other flip of that is that we are at – by the end of this calendar year, we will hit a – we should hit 10 million cumulative enrollments since New Oriental was established in 1993. And then by fiscal year 2011, that should hit 11 million. So we are really ramping up here.

Ingrid Yin – Brean Murray

Okay. Wonderful. Thank you.

Louis Hsieh

Thank you.

Operator

Your next question comes from the line of Mark Marostica of Piper Jaffray.

Mark Marostica – Piper Jaffray

Hi, Louis. I just wanted to touch on your comments regarding operating margins in fiscal '11. What – to what degree – and perhaps if you could bracket it for us, to what degree should we see operating margin compression in fiscal '11 versus '10?

Louis Hsieh

Well, I think what we try to do is – it's hard for me to answer that, Mark, because what we try to do is we typically outgrow on revenues, right? So we've got 25% to 30%, but we've grown 41%, 35%, and 32% over three years. So our goal is to grow earnings 25% or more and that's what we said in the earnings release. But because – so we will see – I mean, if we do get margin compression, we should see gross margins stable, similar to what they are, 61%, 62% or so. Grow our operating margins – because of the investments we are making this year, I don't expect it to fall more than 1 percentage point, if that.

Mark Marostica – Piper Jaffray

And so –

Louis Hsieh

But a lot of it depends on revenue growth, right? If we outgrow in the revenue side, then the EPS side will be very healthy.

Mark Marostica – Piper Jaffray

All right. And then tied to that then, if you look at these incremental spending initiatives, the new learning system, and the IT upgrade, CRM system, it – I know you said $3 million in $4 million in IT upgrades. Is that entirely expense?

Louis Hsieh

That will grow – the computerized system will be expensed over three – will be capitalized over three years, right, three or four years over time. But we are adding over 100 IT personnel, Mark, and those are permanent.

Mark Marostica – Piper Jaffray

Yes.

Louis Hsieh

Right. So these are people that maintain the system, help develop that – develop and maintain it and this is across a soon-to-be 480 or 470 learning center network.

Mark Marostica – Piper Jaffray

Right, right –

Louis Hsieh

So these are permanent – these are permanent hires, right?

Mark Marostica – Piper Jaffray

If we strip out the incremental cost tied to the new learning system and the CRM system for fiscal '11, I'm trying to get at in my mind what the organic operating margin expansion might be. You see –

Louis Hsieh

Well, I don't know. If you take out $4 million, you are going to look at 4 – you are looking about – and if you strip out to a more realistic – I mean, we should grow 70, 80 learning centers a year, we are aggressively growing because of the strong demand, right?

And so I think is that – these – and the new rollout of the content. I think normally we should grow toward that – right now, we are 20%. We should grow that 23%, 24%, Mark, over several years. But we are just not going to – we are not going to stop rolling out new initiatives until there is nothing else that we think we can do that's worthwhile. And we may reach that point next year. So – but we don't know. I mean, those are really new things, we got to be dynamic, we want to change where the market changes. And so if we think we can have a very profitable business in a new area, we will go there.

Mark Marostica – Piper Jaffray

Right, right. I guess what I'm trying to get at, Louis, is that you are saying operating margins maybe down a percentage point in fiscal '11 year-over-year. But if we stripped out the incremental spending initiatives this year and looked at organic operating margin expansion –

Louis Hsieh

Well, they should go up, right? This they should go up because, market [ph] can go down next year.

Mark Marostica – Piper Jaffray

Yes. Well, I'm just trying to quantify what perhaps that might be. So if we got $4 million –

Louis Hsieh

Well, it's what I've always been saying. It should be 100 basis points to 150 basis points.

Mark Marostica – Piper Jaffray

Yes, yes.

Mark Marostica – Piper Jaffray

– improvement each year if we don't have new initiatives, which of course – I am the bean counter and Michael is the strategic big picture thinker, right? So he looks at new opportunities and they look great to us. And so far he has been right most of the times. So they – I mean, like U-Can was worth going after, we believe Kids' Math and Chinese is worth going after. And so we are going to do it.

Mark Marostica – Piper Jaffray

And in fairness, who knows in fiscal '12 what you will be looking at in terms of new –

Louis Hsieh

But the – and the other point I wanted to make sure you guys understood is that we are committed to trying to grow the bottom line at least 25%, and the top line should grow better than – if we grow the top line well over 30%, then the bottom line will also go up well over 25%.

Mark Marostica – Piper Jaffray

Right. And then lastly –

Louis Hsieh

So you know – yes.

Mark Marostica – Piper Jaffray

Okay, last question and I'll turn it over. You mentioned 100 new learning centers in this coming year with the Tier 2 and Tier 3 focus is what I thought you said. Maybe give us a sense of what proportion of the 100 will be in the Tier 2, Tier 3 and then look at what that same percentage was in fiscal '10. I'm trying to get a sense of –

Louis Hsieh

I think the number of centers going into Tier 2, Tier 3 cities is increasing. If you look at the Math, Beijing, Shanghai, and some of the other cities only added a net of 10, 12, 13 learning centers, right? The other 90 – the other 80, 85 are in what you may call Tier 2 cities.

Mark Marostica – Piper Jaffray

Similar year as last year?

Louis Hsieh

Similar this year, right? So we would expect probably another 10 or 15 learning centers in the top two or three cities, but then the majority of them will be in Tier 2 cities.

Mark Marostica – Piper Jaffray

Got it. I'll turn it over. Thank you.

Louis Hsieh

Thank you, Mark.

Operator

Your next question comes from the line of James Mitchell of Goldman Sachs.

James Mitchell – Goldman Sachs

Great. Thank you for taking my question. I had a couple actually. So one was with regards to the Overseas Test Prep business. It looked like the enrollment growth was the fastest in a couple of years. Is that just because you had a relatively easy comp from the fourth quarter fiscal '09 or is there anything else that's happening in Overseas Test Prep that's –?

Louis Hsieh

No, that is correct. That is – because Chinese Year was late this year and it was early last year, what happened was that this year, we didn't – we had easier comparisons. We only had 8% enrollment growth last year at this time. So it is just – it's just – it should be steady 12%, 30% – 12% enrollment growth, 30% revenue growth for us. So it was an easy comparison.

James Mitchell – Goldman Sachs

Right. And then for the Kids' Math and Kids' Chinese writing courses, am I right in thinking those are kind of general training courses rather than test prep? And when you look at your business as a whole, is there a notable margin difference between general training courses and test prep? I guess Overseas Test Prep is high margin, but Domestic Test Prep is lower margin.

Louis Hsieh

Domestic Test Prep is lower margin. For Kids six to 12, we are not trying to emphasize test preparation obviously. So this is general learning. And that's the way we are moving toward U-Can as well. We are not trying to – try to, say, just before of the Gaokao – I mean, you can't tell a 12-year old kid to prepare for the Gaokao, right, which is – that could take six years. So what we are trying to emphasize is just mastery of key academic subjects like Physics and Chemistry, Biology by year. So we are really trying to teach the – and then as they get closer to their senior year in high school, then we'll begin to emphasize the test prep aspect as well. So the classes are geared that way.

It's where the margins go – as you – it's where the margins go. Well, the kids have always had a lower margin because of the size, right? You can't have more than 25 people per class. The ASP is lower at about $110, $120, right, versus you can with – you can have as many as 60, 80 students per class and the ASP is over $200.

James Mitchell – Goldman Sachs

Okay. That's great. Thank you.

Louis Hsieh

Okay, great. Thank you, James.

Operator

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

Amy Junker – Robert W. Baird

Hi, thanks for taking my question. Louis, if you can just talk a little bit, within the U-Can business, obviously the strength that you've had there is attracting some competition and I think forcing you to market a bit more aggressively. At what point do you think your land-grab strategy and brand establishment will abate those pressures and do you have evidence that that strategy is working outside of Beijing and Shanghai against the two current dominant players?

Louis Hsieh

I think out – can you repeat that last part, Amy? You mean, outside of Beijing and Shanghai against the two dominant players –

Amy Junker – Robert W. Baird

Correct.

Louis Hsieh

– or within Beijing and Shanghai against the dominant players?

Amy Junker – Robert W. Baird

Outside.

Louis Hsieh

Well, outside of Beijing and Shanghai, we are probably the dominant player, right? So as – any city we go into, we are quickly – we will become the largest in six to 18-year old training. We already are today, across the country. We are already the largest – as far as enrollment goes and revenues, as far as we know, we are the largest by far in children six to 18-year old in all of China.

Amy Junker – Robert W. Baird

Okay.

Louis Hsieh

So I think strategies are clearly working, right? We – with 790,000 enrollments going to over 1 million this year. There is no one even close to 1 million enrollments in China. So we are already the largest.

As far as the marketing spending goes – don't forget, this marketing spending is – we are spending about 15% of our revenue, which is much, much less than most of our competitors. Most of them spend between 20% and 60% of the revenues on marketing. So we do have to spend to keep up, let's say, and to roll out new programs. But after a while, as you said, the marketing spending abates because you don't get the same bank for the buck. So I think as – over time that number goes down.

And the example of that is like Adult English and Overseas Test Prep, we don't – we only spend – we spend well less than 10% of our revenue on marketing in both Overseas Test Prep and in Adult English and Domestic Test Prep. So as the program gets older, your percentage of revenue on marketing goes way down. And as we've said, the same may happen with kids in middle school over time.

Amy Junker – Robert W. Baird

Great. And if I – can I just sneak one more in? It's a small one. But if we look at the impact of both inflation and having to pay up for your teachers, what confidence do you have that you will be able to – that your pricing increases will be able to outpace salary increases and as we head into fiscal 2011, especially given that you held pricing for some of the larger classes last year, given the environment?

Louis Hsieh

I think our prices went up 13.1% for the quarter. Inflation was not very high in China. I think our biggest issue was wage inflation and wage inflation in the bigger, say, Tier 1 cities like Beijing and Shanghai where it went up about 8% for the year. We only raise salaries once a year. So that's done for the year.

Amy Junker – Robert W. Baird

Okay, great. Thanks –

Louis Hsieh

We are pretty confident that we can – we can still raise prices above what we are – the price increases in Beijing and Shanghai were much higher than 8% on an organic basis. So we are able to raise prices still above what our costs are going up for – the direct cost.

Amy Junker – Robert W. Baird

Perfect. Thank you.

Louis Hsieh

Yes.

Operator

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

Brandon Dobell – William Blair

Hi, Louis.

Louis Hsieh

Hi, Brandon.

Brandon Dobell – William Blair

Following on Ingrid's question about pricing – you may have covered this earlier, if you did I apologize. But as you extend these into Tier 2 cities, especially in Kids, I mean, talk to us about the pricing differentials of those programs versus Beijing and Shanghai. And what do you expect, on a go-forward basis, your ability to raise price in the Tier 2 cities will look like compared to what you are going to do in Beijing and Shanghai?

Louis Hsieh

I think that we track Beijing and Shanghai over time. Currently, for one-on-one classes, the price is about half of what Beijing and Shanghai are. The larger classes of, let's say, 15 students or more, it's about 65% to 75% of what Beijing and Shanghai are. So there is a slight decrease, but don't forget, the costs are also much lower in these cities. The teacher's salaries are lower, the rent is lower. So the operating margins in most of these cities after schools have been around for six to eight years is still north of 25%.

So there – I think over time, the fees were developed where they are very similar to Beijing and Shanghai were five years ago. So basically, they – as they grow and develop, the parents see the same thing, they see a need for – to get their children ahead by spending money on education and as the walk here, they are willing to do so.

So – yes, we've seen this with Wuhan, with Guangzhou, we are seeing it now with Changsha, we are seeing with Tianjin. So many of these cities are developing quickly. Well, a lot of people call it Tier 2 cities. The profit margins for us in these cities is going up every single year. We expect the same to continue. In other – in some of the cities, Xi'an, some of the – Shenzhen, the profit margins are going up year-over-year.

Brandon Dobell – William Blair

Okay. And with this number of centers in the previous fiscal year and the current fiscal year going into, are you at all concerned with your ability to fund the right people to manage? That's a lot of new –

Louis Hsieh

That is a concern, and that's always been a concern for us. And that's why I personally believe 100 learning centers is too fast. So I've always been a proponent of about 70 learning centers. I mean, last year, we had a net add of 5,400 people, 2,900 teachers. Yes, I think it's hard to hire and train 2,900 top quality teachers in addition to the teachers you lose, so you have to hire about 4,000 teachers.

So, it's a very daunting task, and that is what I do worry about. And I think many of the senior management think the same thing, is our ability to continuously find top quality teacher. We don't – our brand name is tied to the quality of our teachers than the quality of our materials. And so that is an issue. That's always the biggest issue for us.

Brandon Dobell – William Blair

So as we think about the timing for the 70, 80, 90 or 100 centers and so whatever it ends up being, historically you guys have started to concentrate the opening in advance of the summer session just to maximize the opportunity. Should we expect that same kind of logistical trend this year as well that you know –?

Louis Hsieh

Yes. I think you'll see Q4 higher, Q1 lower as far as net adds; Q2 higher, Q3 lower. And again, Q2 and Q4 are a little bit slower, so they are good time to add centers in advance of the two busy seasons.

Brandon Dobell – William Blair

Okay. And then just a couple of housekeeping ones. If we think about stock-based comp and tax rate for our fiscal '11 models –?

Louis Hsieh

Stock-based comp will remain where it is now, which should be around about $16 million a year, $16 million and $16.5 million. So all the old grants are gone now, so we just have one grant that we – that recurs every year, it's about $16 million, so $4 million a quarter U.S. The tax rate will go up because of new regulations, so it should be between 9% and 10% for fiscal year '11.

Brandon Dobell – William Blair

Great. Thanks a lot.

Louis Hsieh

Thank you, Brandon.

Operator

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

Ella Ji – Oppenheimer

Hi, Louis. Congratulations.

Louis Hsieh

Thank you.

Ella Ji – Oppenheimer

My first question is, do you have a target number of learning centers in this course in the next three to five years?

Louis Hsieh

Well, I think as – we will – we should add two to three new cities per year. So in the next three years, we should be in 40 – 46, 47 cities or 48 cities in China, with 56 total schools or so.

Learning centers, we normally would target 70 or 80, but because of the enormous opportunity – our school heads are telling us that demand is very strong for six to 18 year olds and we need to be closer to the local elementary schools and junior highs. The number will probably be somewhere between 80 and 100. So my guess is that we should be at 470 learning centers and schools by next year. And probably in two years after that, we will be probably around 620 to 650. And even then, we will always still be two-thirds of the way penetrated in the first 40 cities; they should easily have over 1,000 learning centers.

Ella Ji – Oppenheimer

Right. So it appears that your expansion in learning center and the schools, well, you were just to maintain the speed in the next three to five years –?

Louis Hsieh

Yes. My guess is it's a little bit fast last year. It will be a little bit fast this year because of the stronger-than-expected demand for U-Can and for Kids English and – as well as in Kids' Math and Chinese. So I think it's 100 last year or 97 last year, 100 this year. It will probably go back to 80 or so the year after, which will – obviously will be margin accretive for us.

Ella Ji – Oppenheimer

Right. So you mentioned earlier that you are expecting margins to return higher in fiscal year '12. So most of that margin improvement will be coming from – you will spend less in sales and marketing expenses?

Louis Hsieh

We will spend less in sales and marketing. And the time we start to slow down in the number of learning centers we open, we will get – just like we did in 2006, 2007, we will get a huge margin accretion.

Ella Ji – Oppenheimer

All right, got it. Also a follow-up with an earlier discussion in terms of teachers' salary. As some of your major competitors are preparing for maybe become public, will that increase the cost of teachers going forward on the market?

Louis Hsieh

Well, I think the pressure is always in the big cities, in Beijing, Shanghai. So it does and that's why we raised salaries 8%. Yes, and I think it is necessary for us to keep the best teachers, but by paying more. And you are absolutely right. All our competitors are lining up to go IPO. I – the school year starts in September and I think there is a huge class of education companies trying to IPO out of China. So I would call, the also ran class that are trying to come in this next calendar year.

Ella Ji – Oppenheimer

Okay. And for your proprietary new learning system, I just want to clarify, it is a customer services tool, right?

Louis Hsieh

It is. It is a – well – no, the – Well, there is two things. We are rolling out a customer relationship management system that will help us identify and learn more about each student, what classes they have taken, and help us serve them as they move from cities. Let's say their family moves from one city to another, all their profile and everything will follow them. So that's a separate system. It gives us better data about our students and it lets us suggest and market to them better, and it lets us serve them better on the customer service side.

A second thing we are doing, which is a little bit more hard to explain unless you see it, is we are trying to – we have been spending a lot of time in the last year building a new testing – computerized testing system for children 12 to 18 years old by subject, and that's being rolled out now.

The culmination is that a student can come in and will take an assessment test in a subject, let's say math. That assessment test tells that student and tells the parents and the teacher exactly what areas that student needs to work on; they are weak in that subject. And then we will customize a class targeted at that student's weak points and we can measure as the student begins to master each of the subjects that they didn't understand at their original assessment stage, and that's how you – and that's a better way to learn.

We believe that instead of just going over all the subject matter by rote is why not test the student, find out what areas do they need help in, identify those areas, and work only on those areas and focus on those areas. And then by the time they are done, they should have mastered that subject. So the idea is that this system is a better way of learning. It's computerized, it's a better way of learning than the old – everyone learns the same way, the same book, the same materials.

Ella Ji – Oppenheimer

Got it. So, I guess how you are going to capitalize on that is just by – just via this system you hope to attract more enrollments?

Louis Hsieh

Well, I think we will attract enrollments. I think it's just a better way to learning. So I think we will attract more enrollments and they will realize this is better and they will stay. So it's just something that our competitors don't offer. So I think it's something that we think it will give us a big competitive advantage in this market. And it also has lot of stickiness. Once a student we expect gets on this system and we identify their weak points, they – only our system can teach them, identify exactly where they are weak and help them improve on those areas. So it creates a stickiness factor as well.

Ella Ji – Oppenheimer

Got it. And lastly on –

Louis Hsieh

We think – Ella, bottom line, we think it's a better way to learn; it's better content, better learning system.

Ella Ji – Oppenheimer

Right. And lastly, your deferred revenue balance increased to 43% as of the quarter-end versus your guidance of 26% to 32%. I know there is always a time difference, but is your guidance relatively conservative when comparing to –?

Louis Hsieh

Well, I think it's realistic given that this summer is actually 10 days shorter than last – seven days to 10 days shorter than last year. That's a lot of revenue for us, 10 days is a lot of revenue. We can't have (inaudible) the actual vacation shorter so that our classes are actually shorter, right? So it's a big difference. The other thing is the flooding is a real issue, right? I mean, if you can't get to your school in Wuhan or Changsha or Chongqing, right, what do you – how do you count kids out of the classes? So it is – those are real issues. So – but I think as the underlying demand remains very strong and so I think it's the 26% to 32%, probably the higher side of that is realistic.

Ella Ji – Oppenheimer

Okay. Thank you. That's very helpful.

Louis Hsieh

Thank you, Ella.

Operator

We are now approaching the end of our conference call. I would now turn the call over to New Oriental's President and CFO, Louis Hsieh, for his closing remarks.

Louis Hsieh

Okay. Again, thank you for joining us today. If you have any other further questions, please do not hesitate to contact me or any of our Investor Relations representatives. Bye-bye.

Operator

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

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Source: New Oriental Education & Technology Group Inc. F4Q10 (Qtr End 05/31/10) Earnings Call Transcript
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