New Oriental's Management Discusses F3Q2014 Results - Earnings Call Transcript

Apr.28.14 | About: New Oriental (EDU)

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

F3Q2014 Earnings Conference Call

April 28, 2014 8:00 AM ET

Executives

Sisi Zhao - Investor Relations Director

Louis Hsieh - President and CFO

Stephen Yang - VP, Finance

Analysts

Jiong Shao - Macquarie

Ella Ji - Oppenheimer

Vivian Hao - Deutsche Bank

Fei Fang - Goldman Sachs

Trace Urdan - Wells Fargo Securities

Tian Hou - T.H. Capital

Clara Fan - Jefferies

Charles Cartledge - Sloane Robinson

Kenny Lou - FTIM

Operator

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

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

Sisi Zhao

Thank you. Hello, everyone. And welcome to New Oriental’s third fiscal quarter 2014 earnings conference call. Our financial results for the period were released earlier today and are available on the company’s website, as well as on Newswire services.

Today, you will hear from Louis Hsieh, New Oriental’s President and Chief Financial Officer. After his prepared remarks, Louis; and our VP, Finance, Mr. Stephen Yang 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 maybe materially different from the views expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. New Oriental does not undertake any obligation to update any forward-looking statement except as required under applicable law.

As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on New Oriental’s Investor Relations website at investor.neworiental.org.

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

Louis Hsieh

Thank you, Sisi. Hello, everyone, and thanks for joining us today. I am pleased that we are today reporting our fifth consecutive quarter of margin expansion and profitability improvement.

While we recorded a somewhat softer performance in the topline during the third quarter, by continuing to successfully execute on our harvest the market strategy, we delivered sustained improvement across all our key metrics of efficiency and profitability.

In the third quarter, our GAAP operating margin increased 120 basis points to 12%, compared to 10.8% in the same quarter of fiscal 2013 and GAAP net margin increased by a very impressive 370 basis points to 16.5% compared to 12.8% a year ago.

These are significant improvements that highlight the success of the strategic approach and put us firmly on track to succeed our -- to exceed our full year GAAP operating margin target of 16% to 17% for fiscal year 2014. As a result of this sustained improvement in efficiency across the network, we recorded net income growth of 50.2% year-over-year to approximately $42.1 million.

I am particularly pleased that we have achieved a strong bottom line performance despite slightly lower than normal growth rates in both revenues and enrollments in the third quarter. We maintained a steady revenue growth rate of 16.4% year-over-year, although this was below our guidance range.

This slower growth rate was due to a dip in enrollment growth in the third quarter to 12.5% year-on-year. I want to spend a couple of minutes here to walk you through the 3 primary factors that impacted enrollment growth in the quarter.

First, we opened new learning centers at a slower pace than we had anticipated, and as a result, we had fewer schools and learning centers in operation than in the same quarter a year ago. We ended the third quarter with 700 schools and learning centers in operation, 33 fewer than we had in the same period last year.

During the quarter, we opened just five new learning centers but closed 16. As you know, we have given our school heads very strict bottom line targets consistent with our harvest the market strategy,so over the last quarter, many of them chose to focus on improving the profitability of their existing centers better than investing in new openings.

From this quarter forward, we’ll adjust the incentive scheme for our school heads to encourage both topline and bottom line growth, so we expect to see a ramp up in new school openings, learning center openings in the fourth quarter of fiscal year 2014 in preparation for the crucial summer period in the first quarter of 2015 with the focus on fast growing, high profit cities.

In the fourth fiscal quarter and throughout fiscal year 2015, we aim to open 60 to 70 new learning centers. Most of these centers will be designed to support our K-12 after-school tutoring business.

The second factor impacting enrollments was a continued slowdown in our legacy adult English and domestic college English test preparation classes, where revenue decreased 3.5% and 2.8% respectively year-over-year.

As we have noted in the past, this is a long-term trend, and we expect that the slowdown will continue. As we and other English training schools have been teaching children's English for over 10 years, many of these children have reached adulthood and already proficient or fluent in English thus dampening demand for adult English classes. In short, we have been cannibalizing our own adult English market by establishing Kids English for the last decade.

Third, we are in the midst of rolling out a major refresh of our POP Kids programs targeting kids ages 6 to 12, and as we transition from the old courses to new courses, we have seen a noticeable dip enrollments. During the quarter, enrollments declined 12.2% year-over-year to approximately 163,400.

This is the most significant new program introduction for our POP Kids offering since we launched this business in 2004. The new program basically will be a complete renewal of the existing business line, featuring updated teaching content, new teaching technologies, as well as live blackboards and fully integrated digital and online elements.

We are now trialing the new offering in a number of schools and learning centers across the country, and we will be rolling it out to all schools during the first quarter of fiscal year 2015, this summer.

As we wind down our existing POP Kids program, we have reduced our marketing effort behind these courses in preparation for a big push in support of the new offerings. As a result, we've seen enrollments decline across the market network.

This is in line with our experience during previous program introductions as we expect to see a sharp uptick in enrollments once again as we role out the new offerings across the network.

Before I move on, let me quickly look at ASP's which grew at a moderate 11% to 12% during the third fiscal quarter. As I have noted in previous quarters, we are looking to cap our VIP class offerings at about 30% of overall revenue, which we think is a good ratio to ensure healthy utilization and efficiency across the learning center network.

We have more or less achieved this target already, so we are now devoting more efforts to promoting our small and large class offerings, which as you may know have lower ASPs and VIP class offerings.

With that, let me address our performance across our individual business lines. We continue to see healthy growth across our core offerings in the third quarter and particular in our overseas study business in middle and high school, U-Can businesses for kids grade 7 to 12.

In overseas test prep and overseas study consulting business, we continue to record healthy growth. Revenues across the business lines grew approximately 22.2% and enrollments in test prep grew 12% during this quarter.

We continue to leverage our obvious competitive advantage versus peers in the sector to capture the most important opportunities in this market. We have not noticed any impact in the business from recently announced changes to the SAT test, and in fact we are confident that students will increasingly rely on New Oriental’s demonstrated expertise in this area to navigate these forthcoming changes.

Our K-12 all subjects after school tutoring business achieved gross revenue growth of 17.6% year-over-year for the third fiscal quarter, although the program transition in our POP Kids offerings dampened growth in this segment during the quarter.

We are pleased that our middle and high school U-Can business for kids grade 7 to 12 all subjects after-school tutoring business continue to perform well and recorded year-over-year revenue growth of about 21% and enrollment growth of 12%.

Finally, our VIP personalized classes businesses recorded about $12.9 year-over-year cash revenue growth in the third fiscal quarter. As mentioned earlier, we have already achieved what we believe is a very healthy revenue contribution for our VIP business, so we are focusing on maintaining this ratio in the quarters ahead while increasing our marketing efforts in the large class sizes.

While I talked about our business lines, I would like to talk you through some important progress with our online education strategy. As I’ve mentioned previously, we have a clear strategy in place to leverage market leadership in private education in China to grow and solidify our leadership position the K-College online education market.

I do want to highlight the New Oriental has a significant advantage compared to our peers given our unrivaled brand recognition, extensive database of high-quality learning resources and our pool of the best and most experienced teachers in China.

There are three main pillars in our online strategy, O2O integration, deployment of our online platform Koolearn.com and partnerships with leading online players. I am pleased to say that we've made very encouraging progress across all fronts during the last quarter.

First, we continue to make an important progress in the development of our O2O Two-way Learning Platform, which involves integration between our online and off-line offerings.

Our goal is to fully integrate our online and offline offerings and resources to provide a better learning experience for our students and drive cross-selling opportunities. To achieve this, since 2012 we've been working on standardizing, digitalizing our education content and user database to establish a learning modules for registered users.

We are now able to supplemental our additional off-line classroom teaching offerings, with online products and services that support student learning activity. For example, we can provide online self-study elements and quizzes that help students in progress more rapidly and learn more effectively. And our system is able to track users test records and performance that we can recommend personalized content or customized additional courses to them.

We’re particularly excited by new pilot programs we started at certain schools in Beijing which provides students across our U-Can middle and high school tutoring program. We have suite of online offerings to support self-learning, practice and assessment after class.

Reactions from the students so far has been excellent and over -- and over time, we hope to rollout this across all our courses covering our entire network by the end of this year. We believe the new O2O two-way learning platform will increase customer stickiness and create new revenue streams through the provision of value-added learning services.

Second we continue to invest in our exclusive online platform Koolearn.com. Koolearn.com provides students, teenagers and adults with pre-recorded and interactive online sessions ranging from language training, overseas and domestic test preparation to vocational education.

Now it hosts over 2,000 online courses and have accumulated 9 million registered users at the end of the third fiscal quarter. The real competitive strength of Koolearn.com from New Oriental that there is no limit on the class size, which means that we can service any student anywhere on this platform regardless of whether they have access to New Oriental school in the neighborhood or not.

We continue to integrate -- sorry, to migrate more and more popular offline courses to the online platform. So students can choose to take our courses either in a classroom or via internet-enabled devices. We believe the online platform is ideal for large non-mission critical, short duration courses such as Chinese, English test level 4 and 6 test preparation.

During the third quarter, we continue to invest in the development of new offerings for Koolearn.com that uses our existing resources to create new revenue streams. For example, a new training program featuring live broadcasts of a series of New Oriental’s most popular offline test preparation classes were launched through Koolearn.com in November 2013.

We have had over 167,000 registrations in the third fiscal quarter and the first seven weeks of the fourth fiscal quarter. At the same time, we have invested in migrating our Koolearn.Com offerings from PC-based platforms, excuse me -- to mobile and tablets. In particular, our DONUT game-based mobile learning applications for children aged 2 to 8 have achieved about 7.5 million downloads since being launched in September 2012.

The third part of our strategy is to partner with the leading online players in China. While we are making excellent progress to our own offerings, we believe that select partnerships with the online market leaders will offer a very exciting way for us to leverage our clear advantage in terms of brand recognition and teaching resources.

These partnerships will leverage New Oriental’s brand content and high quality education experience as well as our partner’s technology and market reach to deliver more innovative, attractive and unique online education products to a larger range of users. At this stage, I’m not in a position to disclose details about the potential partnerships but I can say that this is -- we're very pleased with the progress we’re making and excited about the growth prospects with this aspect of our strategy.

This is obviously a very exciting segment in China and one where New Oriental is ideally positioned to benefit. So we are investing to support our online initiative. In fiscal 2014, we have invested total robust spending $10 million in our online programs and associated R&D. As we move into fiscal year 2015, we’ll step up our investment further. And we expect to allocate between $25 million and $30 million in investments in our online programs.

Before I turn to the financials, I’d like to address some recent policy and testing changes that are relevant to our business as I’m sure some of you will have questions about this potential business impact.

Looking first at the SATs, the college board announced the exam will be revised in 2016 to focus more on the practical aspects of learning. For New Oriental, we don't see this as having a negative impact in our business. And in fact, we see an opportunity to us as far as the growth as a result of this. Our experience, when other exams like TOEFL and IELTS were changed, was that even most confident and prepared test takers get nervous about taking new format and want some extra help in preparing.

When these SAT changes, SAT changes are introduced, we expect that learners will look to the best known, most reliable brand in the test preparation market for help and that is of course, New Oriental.

Turning to changes in education policy within China, the government announced earlier this year that kids in grades 1 to three should not be assigned any homework. Furthermore, the starting year of English teaching in public schools will be postponed from grades 1 to grade 4.

This is significant for New Oriental because we expect that many parents will want to ensure that the kids are using their valuable after-school time productively and will look to find enough for after-school tutoring program especially for English subjects. Our POP Kids program is specifically designed to, kind of, cater to learners in the age groups. So we expect to see strong growth in demand here.

In terms of high school, the government has also announced plans to change the Gaokao or college entrance exam. That slightly reduces the weighing of English versus other subjects in their overall exam score. The English exam will be administered several times in a year.

Students will have an opportunity to retake exam. We don’t see this having a negative impact for New Oriental because we expect that there will be additional demand for test preparation courses throughout the school year due to the multiple exam administrations, which should lead to a growing retaker preparation market.

Furthermore, English is just so important to students in China right now when they apply for colleges or try to find jobs that we see continued large and growing demand for English tutoring programs regardless of the exam weighting. Simply put, most students will need to be fluent in English if they want to succeed professionally in a global market place.

As you probably know, the government -- Chinese government has also announced that one-child policy was eased and the families where one parent is an only child will be allowed to have a second child. This change is expected to be rolled out gradually over the next two years starting in the large urban areas. As a result from 2018 onwards, we expect to see an increase in the number of school age kids in tier 1 cities which is of course exciting growth opportunity for New Oriental.

Now let’s move to some of our key financial metrics for the third fiscal quarter in addition to revenue and profit which we already discussed. Selling and administrative expenses, sorry -- selling and marketing expenses for the third fiscal quarter increased by 19.9% year-over-year to $37.9 million, mainly attributable to brand promotion expenses.

General and administrative expenses for the quarter increased 8.2% year-over-year to $78.1 million. Head count at the end of February stood at about 30,300, the reduction of about 1,300 from the same time a year ago.

Thanks to our strict control of operating expenses, we’ve recorded continued operating margin improvement of 120 basis points compared to the year ago period. As I highlighted earlier, quarterly operating income increased 30.5% year-over-year to $30.7 million. Operating margin for the quarter amounted to 12% compared to 10.8% in the same quarter of the prior fiscal year.

On a non-GAAP basis, operating margin for the quarter was 14.2% compared to 13.8% for the same period last year. Capital expenditures for the quarter was $7.1 million compared to $16.1 million in the same quarter of the prior fiscal year and were primarily due to the opening of five new learning centers and renovations at older, existing learning centers. We generated approximately US$78.7 million of operating cash flow for the quarter, compared to 68.1% in the year ago period representing increase of 15.6%.

Now let me quickly go through our expectations for the fourth fiscal quarter 2014 before we move onto the Q&A session. We expect total net revenue in the fourth quarter to be in the range of $278 million to $287.6 million, representing year-over-year growth in the range of 16% to 20%. The both forecast reflects New Oriental’s current and preliminary view, which is subject to change.

As always, we would like to thank you for your support of New Oriental. At this point, I will take your questions. Operator, please begin.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jiong Shao from Macquarie. Please ask your question.

Jiong Shao - Macquarie

Hi. Thank you very much for taking my question. I guess, my question is on the revenue for the quarter and the guidance. I think the further reason Louis you talked about of the new curriculum for the POP kids program, when did you say you’re going to roll that out? I was just wondering about how much longer the impact may be, but also related to that, you probably would have saw this impact coming when you launched this new curriculum. Was that last quarter, sort of the negative impact was even greater than what it initially anticipated? And then just a very quick clarification with the lower sort of revenue this quarter and sort of the guidance that revenue re-acceleration still to 16% to 20% not sort of massive, do you have an update for us in terms of your full year enrollment growth targets? Thank you.

Louis Hsieh

Thank you, Jiong. Yes, the impact was actually greater than we expected. It’s really reasons, one and three, meaning that we have 33 fewer learning centers in operation. We expected to sort of opening more learning centers in Q3 and Q4. Just as we said, the rate of expansion has slowed. Also, our Pop Kids program is being rolled out currently across the country and there will be a massive launch in Q1, which is December quarter beginning in June.

And as a result, our marketing, we also changed Pop Kids directors last quarter. So the strategy is – it was a little bit influx and so we didn’t anticipate fully the impact of the new program launch in our forecast for Q3. So, I think, and your other question regarding how long this impact will last, it will last through this quarter, Q4. In Q1, we will step-up marketing effort. We purposely didn’t market in Q3. We are not marketing much in Q4 in the kids side, because we are waiting to relaunch this new program. This is the most significant refresh of our business in 10 years since Pop Kids was launched.

The new content makes much better use of interactive teaching techniques, online and offline integration. And I think it will be a much better, a much more valuable experience for children ages 6 to 12. So we are very excited about the new program launch and it will also increase ASPs as well. So, I think this is our attempt to increase the margin in Pop Kids, so it's consistent with something more related to U-Can in overseas test prep. So, I think this is a very important strategic initiative on the company's part, and we expect big things for Pop Kids beginning in the summer of -- this summer in a month or so, month and a half.

Jiong Shao - Macquarie

Okay. And my question early on the enrollment target for this year?

Stephen Yang

Enrollment target for this year is, we are at about 5.4%. We expect it to stay between 5% and 8% as we originally had said, so that’s still in place, although it’s at the lower end of that. We actually expect a revenue reacceleration next year, because as we roll out 60 to 70 learning centers over the next five quarters, that will significantly pop the revenue. So we are kind of at the -- we believe at the bottom in the revenue growth side. In addition with the launch of Pop Kids and the policy changes by the government that we have discussed, we expect there is a lot of growth drivers . And then in 2016, which will start next year 2015 fiscal year, there will be changes to the SAT. And that’s our fastest growing overseas test prep course. And we are very encouraged by the 17% increase in enrollments -- sorry, the 12% increase in enrollments for overseas test prep. So we are seeing very nice market share gains in this area.

Jiong Shao - Macquarie

Great. Thank you very much for the comments.

Louis Hsieh

Thank you, Jiong.

Operator

Thank you for your question. Your next question comes from the line of Ella Ji from Oppenheimer. Please ask the question.

Ella Ji - Oppenheimer

Good evening, Louis, Stephen, and Sisi. So my first question is relating to your long-term strategy. In the past couple of years, the company has been trying to find out balance between the growth and the margins, and obviously it’s not that easy. And then now you mentioned that that you will give school heads more incentives to grow topline, and since that’s a reverse back to your prior strategy before you emphasized margins performance. So can management talk about your long-term strategy between the growth and margins, what’s your long-term target and how do you plan to achieve that?

Louis Hsieh

Okay. Thank you, Ella, very good questions. Our long-term target is 20% to 25% top and bottom-line growth and our operating margin -- the fiscal year, our GAAP operating margins so far is 19.6%. And we expect to finish the fiscal year now around 18%, which is actually our target for next year, not this year. So we are already well ahead of our operation targets for margin.

But in the long-term, we expect 20% top and bottom-line growth, with operating margins between 18% and 20% GAAP operating margins and non-GAAP two or three percentage points higher than that. So, that’s where the long-term is . As far as our incentive system, in the past before we started to harvest the market strategy, revenue accounted for about 70% to 75% of a school head’s compensation, the bonus part of his compensation. And so they are obviously incentivized to grow quickly, which we did on purpose because there was a land grab after the policy change in 2009, and so we opened sort of 180 to 200 learning centers a year for several years, and that was too fast.

So in November of 2012, we flipped to harvest the market strategy and we change the incentive, so that 70%, 75% of compensation for bonuses which tied to margin growth for profitability. Now, we think the balance should be back to 50-50. So we went too far on the revenue side at 75 that we went too far on the profit side at 75, where we think the nice balance for 2015 fiscal year starting in June 1 is 50-50.

So, I think we are ready to strike that balance. It doesn’t move as fast as we would like. And you have to remember also that over the last year, we have changed 10 school heads, that’s one-fifth of our schools and that also causes volatility and disruption. And as I said, with respect to Jiong’s question, we changed the Pop school head last quarter. And that’s why I think there is a slight description in that business as well. And that’s why there was a slight crop in the enrollment.

Ella Ji - Oppenheimer

Okay. Thank you, Louis. That’s very helpful. And then my second question is relating to your online business. Could you give us more colors in terms of, what are the most popular courses on koolearn.com, who are your enrollments? Do they also take your offline courses as well, or are you seeing some level of cannibalization?

Louis Hsieh

I think that’s a very good question. I think most of our students are high school and college students and some adults. So really is for, of ages 14 or 15 and up to 23-25, those are the majority of the students. So taking mostly subject classes for high school and also overseas test prep and then some vocational classes is sort of the mix. I think most of our students are off-line students as well, and they are taking additional supplemental learning online, those who are in high school and in college. So it's unlikely that for such an important exam as the TOEFL, IELTS or SAT, that a student will rely purely on an online course.

Remember, the issue here is not money. For most of the students it's time. And everyone knows the best way to learn is in a classroom or one-on-one experience and not to learn just by viewing at a monitor or a tablet. So, I think as for us, most of our students, we cross-sell them. And that’s where the O2O strategy is very important to us. We want sell students online products from offline and also offline products from online. And I think is as these combination is very powerful, don’t underestimate it. I think what’s going to happen is that it differentiates us.

Our online competitors can’t offer the offline business and our offline providers, most of them can’t afford to scale up to online. We think the combination is very valuable for both students and their parents. The under kids can’t learn purely online. They don’t have the attention span. And these exams are too critical to their future for parents to rely just on an online administration. So we think the best strategy is offline to online and online to offline or O2O.

Ella Ji - Oppenheimer

Got it. Thank you for taking my questions. I will get back to the queue.

Louis Hsieh

Thank you, Ella.

Operator

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

Vivian Hao - Deutsche Bank

Hi, Louis. Thank you for taking my question.

Louis Hsieh

Hi, Vivian.

Vivian Hao - Deutsche Bank

Hi. My question is could you please get give us a split in terms of percentage of your current composition of large class, small class, one-on-one format and also probably a reference for a year ago? And also if possible given in ballpark members, can we have the earnings distribution in each of this format of those formats segments? Thank you.

Louis Hsieh

Okay. I don’t have the second answer unfortunately, Vivian. But as far as the breakdown of large, small and one-on-one or VIP, I think the current number is approximately little bit under 40% is large class. I think 53% or 54% or so is small class enrollments and 6% or 7% is one-on-one and VIP enrollments. But VIP accounts for about 30% of revenues because of the higher price point. And I think the small class accounts for about 50% of revenue and then the large class about 20% of revenue.

Vivian Hao - Deutsche Bank

Okay. Fair enough.

Louis Hsieh

And those were up significant. The shift is towards small class and one-on-one. Although our utilization rate increased by 2% in the quarter year-over-year to about 14%, 15%, because we were incentivizing large class teachers and small class teachers to fill their classes and so the utilization went up at the expense of one-on-one. So we are purposely dampening, as we said in the remarks, we are purposely dampening the demand for VIP in order to get higher margins. So we are actually turning away from revenue.

Vivian Hao - Deutsche Bank

Right. Can I ask one follow-up question regarding the large class? For large class, is it possible to stay up between the different segments, say, K-12 versus for [Technical Difficulty]?

Louis Hsieh

Yes. I think our -- well, large class for us is 40 or 40 or larger, and for overseas test prep, it’s closer to 100 or larger. I think there’s very few classes that are kids that are large class. So you are right, it’s split between adult English between domestic test prep, overseas test prep, they are most predicted in the summer, in the winter and then also in the middle and high school business. The middle and high school business usually is between 40 and 60 students. So I don’t know the exact breakdown between overseas test prep and U-Can enrollments. But, Sisi can give you that separately.

Vivian Hao - Deutsche Bank

Okay. Very helpful. Thank you.

Louis Hsieh

Thank you.

Operator

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

Fei Fang - Goldman Sachs

[Technical Difficulty]

Louis Hsieh

For some reason, I can’t here you. Can you repeat the question? Or Sisi if you heard it, can you answer it for Fei? I’m sorry, you’re breaking in and out or maybe my line is bad. Could you repeat the question please?

Fei Fang - Goldman Sachs

[Technical Difficulty]

Louis Hsieh

Sisi, you take that question, I can’t hear Fei’s question for some reason. I apologize.

Sisi Zhao

I cannot hear as well.

Louis Hsieh

I can’t hear you. You’re splitting. Can you I guess -- I don’t maybe…

Fei Fang - Goldman Sachs

I apologize again. One second.

Louis Hsieh

This is coming in and out. I can’t hear it.

-- it’s coming in out I can’t hear it.

Fei Fang - Goldman Sachs

Sorry, is the line better?

Louis Hsieh

Yes. This is better. Sorry. Yes, this is better. Go ahead, Fei.

Fei Fang - Goldman Sachs

Thanks. I apologize. So in terms of your expansion plan, you highlighted the focus here in high margin cities. So maybe could you elaborate on which cities are the focus and what will be the format?

Louis Hsieh

Yes. For the expansion, we expect to open middle and large learning centers. So probably 800 to 1,200 square meters, that’s roughly floors of a building. The high growth cities, I think we will start opening learning centers in cities like Beijing and Shanghai and Xi'an, Chongqing. It’s a very high margin, fast growth and cities like that.

Fei Fang - Goldman Sachs

Got it. Great. And for the online education initiative, Louis you highlighted few strategic focus here and also $25 million to $30 million to pursue those strategies. So, can you elaborate on the details of the spending on the G&A or sales and marketing, are you not going to bring in more people and also I would like…

Louis Hsieh

Hi. This is Louis.

Fei Fang - Goldman Sachs

… meaningful incremental revenue from this?

Louis Hsieh

We expect meaningful incremental revenues. Our target for koolearn and the online platform is 50% to 100% revenue growth for next fiscal year, starting June 1. So we do expect most of this spending will be on G&A with some marketing effort as well, but the G&A spending is mostly on R&D to I guess set for the online, offline integration rollout. So we want students to be able to do their homework online after class, take visit online to get instant feedback on their progress, and for parents to track the progress of their students online. So they know that their child is doing the work and they can interact directly with teachers as well. So we think that’s where most of the spending is.

Also, we are developing new programs, things like DONUT. And also, as I said, we have partnerships ongoing. They were in position to announce yet to develop new innovative programs. So I think that the winning strategy on the online site will be someone with an online, offline strategy. So it’s like the rest of the China, right. In the e-commerce sites, online, offline integration and everything, even in I think Korea with MegaStudy if online itself doesn’t work. So you need the learning centers as well as the online platform.

And we think the New Oriental with its depth of content, its brand, our brand, our teacher base, is the best position to take this market, to take a lion’s share of this market. We don’t think pure online play doesn’t work. Yes, sustainable, especially for mission critical exams like the TOEFL, the IELTS and SAT. And even since that there are certain announcements about YY this last quarter that they are re-launching their online platform for the third time by the way. So they have been trying to do this for three or four years without success. So we still saw 17% increase in IELTS enrollments and 10% increase in TOEFL enrollment. So obviously they didn’t have any impact on our business even with this massive launch.

Fei Fang - Goldman Sachs

All right. Great. And then lastly…

Louis Hsieh

Sorry, go ahead.

Fei Fang - Goldman Sachs

Last housekeeping question here. Can you talk a little bit about the tax rate?

Louis Hsieh

Yes. The tax rate was 12.1% for the quarter. It was higher by, I think, 1.5% in the last quarter. The tax rate was certainly moved up I think believe toward 15%, as we lose the benefit of some of our tax efficient structures. So many -- much of our technology is developed in New Oriental’s house, in high tech entities. And they have a certain period of tax preference or treatments. When they expire, our tax rate tends to go up.

Fei Fang - Goldman Sachs

Got it. Thank you.

Louis Hsieh

Thank you.

Operator

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

Trace Urdan - Wells Fargo Securities

Yes. Thank you. Louis, could you describe maybe the revenue streams that come from online more specifically, and then maybe how you expect those to change kind of sort of percentage-wise going forward?

Louis Hsieh

Yes. That’s a good question, Trace. Right now, the online revenue is pure online revenue. So that’s pure koolearn revenue where the class, everything is signed online and is given online. There is a competitive advantage that we have with the online, offline integration. With the online components in our classroom classes, we are going to begin to charge more, and that will be a hit in online revenue basically. Well, I think because it’s such a much more valuable learning experience, when students can be much more productive inside the classroom and outside the class, we believe we can charge more for this and that’s sort of going to be hit in online revenue and that’s significant and also creates stickiness.

So I think what the investment communities understand is that we believe that this is the right way to go. Just like, you have Alibaba and JD.com competing in e-commerce sites, it doesn’t work if you just have pure online orders. You have to fulfill them offline. In New Oriental, we believe the same thing.

Students, they have a certain fixed amount of time to take these classes. They can’t do it online, because many of them don’t have attention that and second because they can’t ask questions and not effective. The way, the best way to do is to learn in the classroom and if you miss the class take it online. If you need to do additional testing, take it online and you can interact with the teachers. I think this is the most effective to maximize your use of time. And I think that’s a critical factor. So we believe that this online, offline strategy is going to generate a lot of stickiness among students and would differentiate us in the market and will create a lot of sort of semi-online revenue that will be counted as offline revenue, but the online is part of - pure online should grow 50% or more.

Trace Urdan - Wells Fargo Securities

Got it. So I understand. So when you -- as you pursue this O-to-O strategy and the online components are added to the offline programs that you won’t specifically be asking the students to pay something incremental that would just be included in the price of the program?

Louis Hsieh

Correct, and the price will, just like our POP Kids program, that’s we enrolled this summer. There will be a significant price increase for that program because it’s going to have a live interactive blackboards. It’s going to have a lot of online components, right. And that does nothing even seen like that in the kids sector in China. So we are going to short form for it, and so we may not -- this is the way for us to drive the profitability of kids up. And then with the policy changes where the kids have nothing to do after school and raise 1 to 3 anyway, we think that many of them will choose to come to New Oriental. So we are basically targeting the very high end and that’s been consistent with New Oriental strategy for years as we are kind of the very highest end of the market.

Trace Urdan - Wells Fargo Securities

Got it. Thank you.

Louis Hsieh

Thank you, Trace.

Operator

Thank you for your question. Your next question comes from the line of Tian Hou from T.H. Capital. Please ask your question.

Tian Hou - T.H. Capital

Hi, Louis, Steve, and Sisi. I have a couple of questions. The first one is related to the rate of expansion. I think the past three quarters of the fiscal year, the rate of expansion somehow I believe is below expectation. I wonder what’s the reason and also you also give guidance for the next several quarters about 65 to 70 and how can you make sure you can accomplish that opening target. That is the number one. Number two, when you open such amount of centers with larger size and can you still maintain the margin at a stable level while growing the top line?

Louis Hsieh

Yes. Good question, Tian. Yes, I think for revenue growth, it’s slower than we expected for this last quarter and slower in Q1, but Q2 was actually better than expected. So in Q4, like say we tempered the expectations of 16% to 20%. I think the reason for that is because of our shift to the harvest to market strategy. When you incentivize school heads to focus only on profitability, not on revenue growth, you get the results. So we took our operating margins up significantly, it’s a 19.6% now from 12%, 13% a year ago. So you can see that it has this artifact. Now we are going to incentivize them half-half.

So going forward in the new budget starting June 1, the school heads will be incentivized to both generate top and bottom line in a balanced approach. And so I think it should have the desired effect. Also, we have changed 10 school heads. And those 10 school heads, when the new comes in, they closed more learning centres and we expected them to. We thought we had closed up most of the non-performing learning centres over the last several quarters, but new school heads come in and have their own way of doing things and they have closed another 11 -- another 16 in the quarter, 11 of which were closed for non-performance.

So I think as for us is that we are pretty confident that our revenue should be accelerate as we open learning centers. There will be 33 fewer learning centers this year than a year ago. 33 fewer centers is 50,000 to 100,000 enrollments a year. So that you can see what that would have 5% to 7% effect on revenues anyway. As far as making sure our margins don’t go down, our margins dropped from 22 to 12 because we are opening up 150 to 200 learning centers a year for several years. Opening 67 should not be margin dilutive, it should be neutral or margin accretive. So we believe that that 5% to 10% add is not going to be margin accretive. What we are doing is we are ding 30% to 50% add in the past and that was margin dilutive.

Tian Hou - T.H. Capital

That's very helpful, Louis.

Louis Hsieh

Okay.

Tian Hou - T.H. Capital

And also you are doing online education at Koolearn.com and you also mentioned that you are going to form a partnership with some leading Chinese Internet companies. I wonder what could be the difference, what are you going to offer on the new partnership platform different than you are currently offering in the Koolearn.com?

Louis Hsieh

Yes, I think Koolearn will be part of that partnership -- those partnerships. So I think it will give us two things as we said. One, the most important thing is marketing reach. We have 9 million registered users, but as you know, the Internet leaders in China have 500 million users or more and so that gives a significant distribution help. Also, they have technologies that we don’t have. And so, we believe it’s a win-win partnership where they will provide best technologies that we don’t have an R&D capability to have, we provide -- we like Walt Disney. We have the content that we have all the brand name content that we have invested in the last 20 years and so we married that and then with their distribution can increase Koolearn and our classes distribution power. And we got couple of innovated new programs because of the technology than no one else has in China currently. Ad those, I said I will be new offerings for Koolearn and for New Oriental and our distribution partners, our technology partners. And so, I think it will create a win-win situation, but I think as we are hoping to announce something, sometime this calendar year.

Tian Hou - T.H. Capital

Thank you. That's my question.

Louis Hsieh

Thank you. I can’t be more specific because of confidentiality.

Tian Hou - T.H. Capital

That’s okay.

Louis Hsieh

Thank you, Tian.

Operator

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

Clara Fan - Jefferies

Thank you for taking my question. Couple of questions. Firstly, since we’ll be picking up the rate of opening centers in the next few quarters, what kind of enrolling growth should we be looking at, guess it should be higher than the 5% to 7% we are looking at for the fiscal year ’14? And secondly, could you give us a little bit more color on the financial and operating statistics of your Koolearn platform? Thank you.

Louis Hsieh

Sure. Thank you, Clara. Yes, on the enrollment growth, we expect 5% to 7% for this year, about 5.4%. We expect that number to increase to 7% to 10% next year. So that 3% or 4% enrollment increase will mean at least 5 or 6 percentage points in revenue growth. So we expect to go well over 20% revenue growth for fiscal year 2015. So we will be one of few companies that reaccelerate revenue in the upcoming year with the new center openings.

As far Koolearn opportunity, we don’t break them up separately. We will begin to track Koolearn with more detail in the next fiscal year starting June 1. The Koolearn did about $25 million to $30 million in revenue over the last 12 months and it was profitable. So the operating margin was between 10% and 15%. However, for fiscal year 2015, I told them don’t make money, we want you to expand rapidly and we want you to spend on R&D and new products. So we are not asking Koolearn to make money in fiscal year 2015, but instead to grow at a much faster rate. It’s been currently growing at 25% to 30%. We want to accelerate that growth to 50% to 100%.

Clara Sand - Jefferies

Thank you.

Louis Hsieh

Thank you.

Operator

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

Charles Cartledge - Sloane Robinson

Hi. Louis. Congratulations on the result.

Louis Hsieh

Thank you.

Charles Cartledge - Sloane Robinson

And I think you have -- you would have a Board meeting in April and you can anticipate this question I am sure? Could you tell us what the Board’s thinking is as with regards dividends and/or share buybacks please?

Louis Hsieh

The Board did discussed but we have not come to a conclusion yet and so we will discuss it after Q4 earnings typically is when we will come -- and also on share buybacks, we will always look at it on an opportunistic basis when we feel our shares are falling. So we discussed that at each Board meeting, but we really make the decision after Q4. So we’ll probably do in July.

Charles Cartledge - Sloane Robinson

All right.

Louis Hsieh

Okay.

Charles Cartledge - Sloane Robinson

Thank you.

Louis Hsieh

Thank you. Thanks, Charles.

Operator

Thank you for your question. Your next question comes from the line of Kenny Lou from FTIM. Please ask your question.

Kenny Lou - FTIM

Hi, Louis. Thanks for taking my question.

Louis Hsieh

Hi, Kenny.

Kenny Lou - FTIM

Hi. Yeah. It’s about this new program for POP Kids, because we never like discuss it in the previous quarterly earning call, right. So it’s kind of a surprise to me? And so you mentioned that is growing out in this quarter and in Q4, but at the same time the school held for POP Kids has been changed at this special juncture? Can you tell us more about like the progress in, I mean, school had been changed when they are rolling on program its little bit interesting, right? So can you tell me more about that?

Louis Hsieh

Yeah. I think the prior school head of POP Kids was kind of a temporary role anyway a transition period and so he has since left the company. And yeah, it is little bit -- the reason we don’t announced it earlier is for competitive reasons, we don’t typically announce things year advance to give -- to let our competitors know. But we had to this time because of the results were little bit even below our expectations on the kids enrolments side, so we had to give you the, transparency to give you the reason why.

I think the new program like I said is the most significant change in our POP Kids program since it was founded more than 10 years ago. So this is a big rollout for us and so we wanted to find a more capable POP Kids head and I think, we have done that from internal hires, we brought in one of our best school heads to do that.

So we are excited about the new rollout. It was not communicated a year advance, which we typically don’t do, but because of the earnings results, we had to let you know the reasons why.

Kenny Lou - FTIM

Understand. So can you tell us more about the strategy thinking behind this new program, so how well this new program helped New Oriental’s POP Kids business in terms of growth and profitability in 2005 -- 2015?

Louis Hsieh

Yeah. I think it should help profitability a lot, because right now we are charged about RMB1,000 or US$150 U.S. per class and I think this one will allow us to charge typically more than that, although, I don’t want to discuss exact pricing at this time.

Kenny Lou - FTIM

Sure.

Louis Hsieh

Also is a much better experience, like I said, with interactive blackboards, with the content has rebounded, it has been completely modernized, it has interactive components online and offline components as well. So students can do their work while they are not in the classroom as well, and so this whole integrated approach with much more uptick content and it’s much more friendly -- user-friendly for children, it’s much better learning environment then just we need from the textbook or looking at pictures in a book. So the content is suppose to speak to you and come out live. So we think it’s a much, I think, it’s a differentiator in the market. So we believe it will also improve the profitability of POP Kids. Right POP Kids and VIP have the lower profit margin, right, upper margins of 10% to 15%. This will allow us to charge more and we believe that the program will differentiate us in the marketplace and will allow us to increase profitability and increase enrollment.

Kenny Lou - FTIM

So you turn 15 when pocket return to normal enrollment growth. What is your expectation on the enrollment growth?

Louis Hsieh

We expect POP Kids and U-Can to grow 10% to 15% enrollment range. That’s what’s driving most of the enrollment increases for several years now, right. Adult English is shrinking. Overseas test prep is growing 5% to 8% a year. So most of the enrollment growth has been coming from POP Kids and from middle and high school.

The problem has been the POP Kids is not very profitable. So this is our attempt to improve the profitability profile of POP Kids. U-Can is very profitable, right. Its operating margin is well over 20%. POP Kids is half of that. So this is our way to improve that picture so that their margins will improve for that whole kid at total sector.

Kenny Lou - FTIM

Understood. And regarding the 4Q guidance, can you tell us that what’s your assumption on the overseas test prep and U-Can growth because you’re making appropriate…

Louis Hsieh

It’s all been driven. It assumes that continued decline in POP Kids enrollments for Q4 as we were not marketing, right. We’ve basically begin to build buzz for the Q1 launch of POP Kids. I think overseas test prep remained healthy and the middle high school is very healthy. So U-Can is doing very well. Overseas is doing very well.

But I think is that the negative will be the same thing in this quarter, which is kids will be -- adult English will be the factor. It’s taking us longer to ramp up learning standards than when we had expected because of the incentive system we put in a year ago.

And also because we change -- usually we change five to seven school head. This year we change 10. So that -- the new school has had their own way of thinking and their own decision making process on closing learning standards. They close more than we thought they would. But I think in the new fiscal year starting June 1, they incentivize not just to make money but also to grow. So I think that 57 learning center should add probably 100,000 to 150,000 enrollments next year, right. That’s significant, that’s 6% -- 5% to 6%. So I think that will -- that itself will drive enrollments way up and revenue way up.

Kenny Lou - FTIM

I see. So basically in Q4, you expect the overseas test prep and U-Can grow -- continue to grow above 20% while the POP Kids…

Louis Hsieh

Yeah. We are over the state -- yeah, we were state subdued. I should think that in all sort of kid, Q3 and Q4 for the last three years have seen stellar growth, an average over 30%. So we had very -- we had three years of really fast growth in Q3 and Q4, which I think came to an end this year because of the learning center closings and the rollout of the new programs.

But I think is that typically the opening up of K-12 in U-Can especially has muted our seasonality. We use to make our money in Q1, now we have three out of four of very profitable quarters. Q1, the summer, Q3 the winter and Q4 the spring. And so we think that that will continue. Q3 and Q4 in future years should grow faster than Q1 in the summer.

Kenny Lou - FTIM

Understood. Thank you very much Louis.

Louis Hsieh

Thank you.

Operator

Thank you for your question. Your final question comes from the line of [Angus Koblin] (ph) from CCAM. Please proceed.

Unidentified Analyst

Hi Louis. I know it sort of been over this but I just wanted to get a bit more of an idea about what revenue guidance should look like for 2015. As you said, you’re adding 5% to 10% more learning centers in the future, you don't expect that to be margin dilutive and also your ISPs will continue to increase and in fact, if mix continues to improve, should we be looking at our existing 2015, ‘16 forecast and adding revenue to that’s and upping our numbers 5% to 10% as well?

Louis Hsieh

Yeah. I think for us we would guide Q fiscal year ‘15 next quarter. But tentatively we’re expecting probably 21% to 26% revenue growth for fiscal year 2015. So that’s a significant increase from the 17%, 18% were at this year. So it’s about 5% more. And that’s the direct result of the new center opening and we don't believe that the utilization will go down much, if any and so should be margin accretive because of the price increases.

Unidentified Analyst

Okay. Great. Thank you.

Louis Hsieh

Okay. So we expect enrollments to go from 5% to 7% growth to 7% to 10% growth. And revenue go from 17%, 18% to more normal 21% to 26%.

Unidentified Analyst

And for how many years, do you think you can sustain that build out of learning centers. Is this just one or two years or could this be, would this become a more general build out from now on?

Louis Hsieh

I would like to see a more general build out. I would like to see -- we went too far one way by super fast expansion because we had a chance to grab the market right. This was a land grab five years ago. And then I think this last year, we’ve gone too far the other way where we’ve actually trended a number of learning centers. We repeated 746. We have 46 fewer learning centers than we did a few quarters ago. So the 46 learning centers is over 100,000 enrollments typically. But the profitability picture has jumped to 19.6% from 13.8%. So, I think, we’re already at 2015-2016 targets for operating margin. So, I want to see that balance back down to 20% to 25% top-line growth and 20% to 25% bottom line growth. I think it’s a nice balance for us.

Unidentified Analyst

Given that and its very measured growth, you’re counting a lot of cash. You talked about making decisions about that cash after the fourth quarter. I mean, if you talk about a buyback, that should be something that you look to do through the year rather more in splits and spurts, and where does the dividend capitalize well?

Louis Hsieh

Yeah. I think for us, the part of the issues we face is something similar the U.S. companies are aware of, is that all our cash is on RMB, almost all of our cash is in RMB. And then like last year, when we paid you a dividend, we had to pay 10% tax to the Hong Kong government -- sorry to the Chinese government to take the money out of China. And that it was not that efficient. So that’s one of the reasons we haven't been more aggressive on the buyback in a given attempt. But if you think about it over the last several years, we paid a $105 million in dividend and we bought back $150 million in stock. So we turned almost a $0.25 billion in the last several years.

Unidentified Analyst

Yeah, I think that’s fine. What about the argument that you can probably borrow in the U.S. what you can yield on your cash in RMB and…

Louis Hsieh

That’s one of the things…

Unidentified Analyst

… virtually I’ll split that way?

Louis Hsieh

Yeah. I mean that’s one of the things we are considering. Last year, we didn’t do it because if you recall a year and a half ago, Muddy Waters attacked us and said that we had a phony structure, blah, blah, blah. We prove to you and to the SEC, which had asked us about this that we’re able to take money from the operating entities within China and upstream it to the [Wolfy’s] (ph) and then pay it to the Cayman’s company and pay it to you. So we show that the system works. And that’s part of the reason why we did it that way last year, we paid the full tax on it. But you’re right. More tax efficient way is to do a loan structure, which we are looking into as well.

Unidentified Analyst

Okay. Right.

Louis Hsieh

The other thing is don’t forget, of the $1.1 billion in cash on our book, about $350 million to $400 million doesn’t belong to us. We can’t touch it anyway, those are prepaid.

Unidentified Analyst

I can understand.

Louis Hsieh

So, I don’t think we can really touch it. And we needed about $300 million or $400 million. Don’t forget that the biggest risk to New Oriental is the pandemic. So the number 2003 is far as almost bankrupt to us. So we need a $300 million, $400 million in cash as a reserve fund in cases another pandemic or something that where we wouldn’t be able to collect revenue for a year.

Unidentified Analyst

Yeah. There is plenty of cash.

Louis Hsieh

Yeah. Okay.

Unidentified Analyst

Thank you.

Louis Hsieh

Thank you, [Angus] (ph).

Operator

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

Louis Hsieh

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

Operator

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

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