New Oriental CEO Discusses F1Q11 Results - Earnings Call Transcript

| About: New Oriental (EDU)

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

F1Q11 (Qtr End 08/31/2010) Earnings Call

October 18, 2010 8:00 am ET


Sisi Zhao - Senior IR Manager

Michael Yu - Founder, Chairman and CEO

Louis Hsieh - President and CFO


Ella Ji - Oppenheimer

Catherine Leung - Citi

Jeff Lee - Signal Hill

Brandon Dobell - William Blair

Adele Mao - OLP Global

Chenyi Lu - Cowen and Company

Ingrid Yin - Brean Murray

Eric Wen - Mirae Asset

Eugene Yeoh - Deutsche Bank


Good evening and thank you for standing by for New Oriental's first fiscal quarter 2011 earnings conference call. (Operator Instructions)

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

Sisi Zhao

Hello, everyone, and welcome to New Oriental's first fiscal quarter 2011 earnings conference call. Our first 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 Michael Yu, New Oriental's Founder, CEO and Chairman; and Louis Hsieh, New Oriental's President and Chief Financial Officer. After his prepared remarks, they 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

I would now turn the call over to New Oriental's Founder, CEO and Chairman, Michael Yu.

Michael Yu

Thank you and hello to everyone and thank you for joining us today. To start our call, I want to take this opportunity to clear up some misleading and erroneous market share information, which is being disseminated by some of our competitors, and it concerns our key business segments of K to 12 after-school children, overseas test preparation and the English language training.

Our aggressive growth strategy of our application as China's premier private education service provider and our high-quality instruction and custom service has made New Oriental the clear market leader in China across our three key business segments by both revenue and the enrollment. Specifically, our K to 12 all-subjects after-school children is the clear number one market share leader in China in terms of both revenues which totaled approximately USD$139 million and the enrollments which totaled approximately 860,000 over the last 12 months.

We continue to be dominant in overseas test preparations with revenues of about USD$124 million and the enrollment of approximately 272,000 in the same period.

In the English language training, we are the runaway market leader with approximately USD$183 million of revenue and the enrollments of approximately 1,330,000 over the last 12 months.

To sum up, New Oriental has been one of the pioneers and a clear leader in China's private education market for more than 17 years, and we are privileged to be the most trusted name in each of the markets we serve.

Knowledge is a competitive market. We clearly have been extending our market leading position by growing our network of schools and the learning centers in a rational manner, controlling costs and maintaining our high-quality instructions that have gotten us to where we are today.

In the past four quarters, as we told you in our preliminary earnings announcement, although revenue was strong, our enrollment grew less than in previous quarters. Enrollments were affected by this year's summer break which was one week shorter than usual because of the longer-than-usual winter break to accommodate the Chinese New Year. This means that a student has less time to attend our holiday classes compared to previous years.

Secondly, we found that the Shanghai World Expo has an effect on enrollments in Shanghai which were down 6% year-over-year. We believe that many students were discouraged from coming to study in Shanghai because of the crowd visiting the expo and as a consequent increase in costs of accommodation and the living expenses. In addition, we believe that the students that visited Shanghai mainly chose to spend their time and money visiting the expo rather than enrolling in classes.

As we expected, as the expo begins to wind down, the enrollments are rebounding and are growing steadily. In September, the first month of our second fiscal quarter, we are seeing enrollments up around 27% year-on-year to about 198,000, and the revenues were up 40% for the same period.

Despite these challenges, during the first fiscal quarter, we achieved net revenues of USD$192.3 million, representing 28.8% growth year-over-year, well within our guidance range. Enrollments grew 8.8% and the planned ASP grew approximately 20%.

Turning to the business and the financial highlights, once again our growth in the quarters was driven by our three core business segments. POP Kids remains a strong driver, with enrollments up 29% year-on-year to 168,800, and the revenues up by more than 48%.

As we know, POP Kids is a strong performer because of the trusted New Oriental brands, which parents know will give their kids the best of start from a early age and allow them to continue on the right path to achieve success throughout their educational careers.

You may remember that last quarter we announced we were expanding our POP Kids offering to include the Chinese Writing and the Maths classes. We have now rolled these out to more than 20 cities, and encouraged by the high demand. We have also expanded into kids' music and art.

These four new subjects attracted 9,800 new enrollments over the quarter, and we are confident in the future growth of this category. We continue to target a full nationwide rollout of these classes during the current fiscal year.

Middle and high school U-Can all-subjects training was also a strong performer in Q1. We achieved enrollments of $182,500 and revenue growth of over 39% during the quarter. U.K. and our English program in particular outperformed with year-over-year enrollment growth of about 135% and revenue growth of approximately 112%.

The strong growth in this business segment testifies to the Oriental's market dominance. We are the largest after school private education provider of K-12 in China, recording over 351,000 enrollments in the first quarter, and around 860,000 enrollments and $139 million U.S. in revenues over the last 12 months.

We are successful because students trust us to provide high quality instruction customized to their needs throughout their educational careers and across a wide range of subjects.

As U-Can has grown, we have developed customized learning programs to fix the varied needs of our students from more affordable, larger classes to one-on-one tutoring. We have also seen growth in demand of our smaller classes. In fact, in Q1 we recorded 14,400 VIP students, Level 1 students, and one to six enrollment, up more than 100% year-on-year.

This makes a total of approximately 44,700 enrollments and over $65 million revenues over the last 12 months. This alongside an average 8% to 10% of price increase has driven growth in our branded ASP.

As we mentioned last quarter, we have been working to develop and roll out our proprietary computerized all-subjects testing, assessment and learning system for U-Can over the quarter. This system focuses on skills assessment, development, testing and improvement and is already proving its worth as a valuable tool to help students' development.

(technical difficulty)


Ladies and gentlemen, there were technical difficulties, but the speakers are now back on line. You may proceed.

Michael Yu

Sorry for the disruption. So far, this system has been rolled our across our in-time network of cities and is being used across the board as a placement test for new students.

In addition, we are using it for all of our VIP students to provide continuous assessment of their progress. We plan to roll out this system to all of our U-Can classes by the third fiscal quarter this year. We believe that this system is the best of it's kind and will provide the students with a comprehensive assessment tool in each subject at every level of middle and high school in China.

With the widest range of subjects in China, New Oriental has built a powerful education ecosystem and has truly become you one-stop-shop for students educational needs. We deliver high-quality instruction for students from kindergarten through college in convenient facilities located throughout China. (That) provides individualized customer services and supplemental study materials.

As competition for high paying jobs remain tense in China, education has never been more important, and we are confident that our trusted brand will make us the first choice for parents as they prepare their child or children for the challenges ahead. Our oldest business segment oversees test prep, where New Oriental has established a dominant market. Market share position in terms of gross revenues in enrollments in China continued its undaunted strong growth. Enrollments grew at around 21% year-over-year to $90,400 and its revenue gross of about 38%.

This makes a total of 272,000 enrollments, and $124 million in revenue for the last 12 months. The largest programs in this sector are towards test preparation which recorded about 100,000 enrollments and $46 million in revenue during the year and IO test preparation which achieves 65,000 enrollments and $33 million of revenues in the same period. We also maintain a dominant position in terms of enrollments and revenues for the GRE, GMAT and SAT test preparation courses.

Some of our newer businesses continue to develop nicely. For instance, our online education platform, Koolearn, and our overseas study consulting businesses continue to perform well. Koolearn is the clear market leader in China with over six million cumulative registered users and over 260,000 paid users in the last 12 months. And our consulting business is also a stellar performer with revenue growth of 190% during the quarter. These businesses are growing steadily and also they make a small contribution to overall revenue compared to cost segment, they serve to extend our platform and provide our students with the further tools to help then achieve their goals.

As you know, we are in the period of investment into our business. And in the first fiscal quarter, we opened two new schools in the cities of Zhengzhou and Shanghai respectively as well as a net of 33 learning centers. This brings our total number of schools and learning centers to 402 compared to 287 at the end of the first quarter of fiscal year 2010.

Although the New Oriental is a primarily expanded organically, we do occasionally make acquisition when good opportunities arise. On August 24, 2010, we signed an agreement to acquire 100% equity interest in Newave Education, a Shanghai-based training school that is specialized in English language training for students aged from 3 to 17.

Combining Shanghai's number two K to 12 English language training schools with our number one K to 12 after-school children, New Oriental will further extend its largest network in Shanghai with 63 schools and learning centers and over 105,000 K to 12 after-school children enrollments in the last 12 months.

We have also been expanding our headcount. As many of you know, our reputation is viewed of having the highest experience of teaching and we refuse to compromise this as we grow our network. In the first quarter, we hired about 2,900 new staff including over 1,900 teachers; bringing up our total teaching headcount to approximately 10,100.

As we look ahead to the rest of the fiscal year 2011, we are very confident. Market fundamentals remain very strong. We are in a unique position in this market as a leading player in after-school private education and in test preparation. And we continue to grow at our target rate of around 30% or higher year-on-year.

We understand that the market is increasing comparative, perhaps the only private education provider with a nationwide network and a premier planning in the business. We are confident that we will remain at the forefront of the education industry here in China.

Now, I will turn the call over to Louis to go through the financials, and I look forward to speaking with you during the Q&A session.

Louis Hsieh

Thank you, Michael, and welcome to, everyone, on the call. For the first quarter of fiscal year 2011, New Oriental reported that revenues of a $192.3 million representing 28.8% increase year-over-year. Net revenues of educational programs and services of the first fiscal quarter was $180.9 million, representing 27% increase year-over-year.

The growth was mainly driven by the increase in the number of student enrollments in academic subjects tutoring and test preparation courses. And higher ASPs associated with students selecting more expensive, smaller class options. Total enrollment in academic subjects tutoring and test preparation courses in the first quarter of fiscal year 2011 increased by 8.8% year-over-year, from approximately 704,500 from approximately 647,500 in the same period of the prior fiscal year. ASPs were up approximately 20% year-over-year.

Operating cost and expenses for the quarter were $146.4 million, a 42.9% increase year-over-year. Non-GAAP operating costs and expenses, which excludes share based compensation for the quarter, were at $121.4 million, a 43.3% increase year-over-year.

Cost of revenues for the quarter increased by 39.4% year-over-year to $66.4 million. Primarily due to the increased number of forces and a greater number of schools and learning centers in operation. Selling and marketing expenses for the quarter increased by 50.5% year-over-year to $23.3 million, primarily due to promotional activities around our new offerings and also because of the addition of over 900 customer service representatives and marketing staff in the past year.

General administrative expenses for the quarter increased by 44.9% year-over-year to $36.6 million. NON-GAAP general administrative expenses, which excludes share-based compensation, were $31.9 million, a 46.2% 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 cost and expenses, increased by 33.7% to $4.9 million in the first quarter of fiscal year 2011; up $3.7 million in the same period of the prior fiscal year.

Income from operations for the quarter were $55.9 million, an 8.2% increase from $60.9 million in the same period of the prior fiscal year.

Non-GAAP income from operations for the quarter was $70.9 million, a 9.7% increase from $64.6 million in the same period of prior fiscal year. Operating margins for the quarter was 34.3% compared to 40.8% in the same period of the prior fiscal year. Non-GAAP operating margin which excludes stock-based compensation expenses of the quarter at 36.9% compared to43.3% in same period of the prior fiscal year.

Net income attributable to New Oriental for the quarter was $62.4 million, representing 9.3% increase from the same period of the prior fiscal year. Basic and diluted net income for ADS attributed New Oriental was a $1.64 and $1.61 respectively. Non-GAAP net income attributed to New Oriental for the quarter was $67.3 million, representing a 10.8% increase in the same period of the prior fiscal year.

Non-GAAP basic and diluted net income per ADS contributed New Oriental was $1.77 and $1.73 respectively. Capital expenditure for the quarter was $12.4 million, primarily used the net of 35 schools and learning centers. As of August 31, 2010, New Oriental had cash and cash equivalent of $293.3 million that compared to $281.1 million as of May 31, 2010.

In addition, the company sales $194.3 million in term deposits at the end of the quarter. Net operating cash flow for the first quarter of fiscal 2011 was approximately $79.8 million. The deferred revenue balance, which cash collected from registered students for courses and recognized proportionately as revenues and the instructions are delivered at the end of first quarter of fiscal year 2011, was $100.6 million, an increase of 73.6%, compared to $57.9 million at the end of the first quarter of fiscal year 2010.

Moving on to guidance, for the second quarter of fiscal year 2011 New Oriental expects its total net revenues in the second quarter of fiscal year 2011 which runs from September 1, 2010 to November 30, 2010 to be in the range of $82.6 million to $85.7 million, representing a year-over-year increase in the range of 35% to 40% respectively. This forecast reflects New Oriental's current and preliminary view, which is subject to change.

Thank you. And at this point, we'll take questions. Operator?

Question-and-Answer Session


(Operator Instructions) And the first question is coming from the line of Ella Ji from Oppenheimer.

Ella Ji - Oppenheimer

You mentioned that you shifted focus to increase utilization rates and more stringent cost of controls. Could you please elaborate a little bit on that? And is there any update on your long term learning center expansion plan?

Louis Hsieh

We added 180 learning centers in the last two years. And we added 76 learning centers in two quarters, that's too fast for us. If you guys remember, it takes the first year of a learning center kind of breaks even as marginally profitable. The second year of a learning center's life, it typically will generate single digit operating margins. It takes the third year for that learning center to become profitable into the double digit operating margin.

Well, that means that half of our network is less than two years old. So we added aggressively in the last two years because we started rolling out non-English U-Can programs. And in doing so across the 40 cities, we realize that our learning centers were not optimally located near middle and high schools, so we've been correcting that.

Also, we did have critical mass in some big markets like Beijing and others, so we've been aggressively adding in these markets to get better coverage. Now that we've done that, we will begin to slow down the learning center growth. And then as the natural affect of this large network of learning centers fills up, in the next quarter or so, you'll see the utilization increase which will drive leverage, which will drive operating margin up.

So, that is our intention. We opened 33 learning centers in the first quarter; we would expect somewhere to open between 60 and 70 for the whole year.


Your next question comes from the line of Catherine Leung from Citi

Catherine Leung - Citi

So the follow-up question is in terms of the near-term over the next few quarters, what should we be expecting in terms of operating margin per se? And also, can you remind us what the longer-term available margins the company is targeting on the operating levels?

Louis Hsieh

The operating margin will obviously depend on us on revenue growth. So right now, we are growing faster than expected. Q2 will still be challenged as you know, because Q2 is normally a very slow quarter for us. So we will be hopefully profitable, but it won't be a quarter to write home about. Revenue growth is tracking well above expectation on for quarter.

So we're going to expect it look better than our internal forecast. Long term, Catherine, we know that our margin expectation for operating margin still will remain in the mid 20s. And also our net income margin, we expect to still be north of 20%. So that remains our target. I think that if you run off these learning centers overtime, you will see that we should be able to achieve them, assuming our business continues on track.


You next question comes from the line of Jeff Lee from Signal Hill.

Jeff Lee - Signal Hill

Can you talk about the acquisition of Newave Education, why did you feel like you needed to do that now? And do you claim to do more acquisitions in the future? I mean does this signal sort of a new round of acquisitions for you?

Louis Hsieh

No, this is because of the reason they've been kicking around for two years. So we looked at Newave two to two and a half years ago, and we couldn't agree on price. And so we continued to grow our Shanghai presence and then they came back to us. So we got this approximately $3.6 million, seven times earnings over the next year or two payoff. So it's a very attractive price, it solidifies New Oriental's market leading position in Shanghai.

Looking backwards at 105,000 enrollments together. And we will dwarf the competition moving forward as far as enrollments and revenues go in the K-12 sector.

It's just opportunistic, we don't actively seek M&As, we do look around. This is one of the many companies we've been talking to for two or three years.


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

Brandon Dobell - William Blair

Louis, why don't you give us any color on the September strength in enrollments? Was there a particular region or program or service offering that was really better than expectations or did it snap back better that you thought it would? Or is just across the board?

Louis Hsieh

Well, I think it's across the board. It's at 198,000 enrollments up 27%; that momentum is carried into October by the way. It's a bounce-back from the Shanghai expo, and the fact that the summer quarter this year was one week shorter. So it's just a natural rebound that we always get when there is some adverse event. Chinese students need to study, so they'll come back.

But the fastest growth continues to be in the K-12 sector and overseas, so those continue to drive our growth. And we recorded 351,000 K-12 enrollments, we targeted one million for the fiscal year ending May 31. We're well on our way to shattering that.

Brandon Dobell - William Blair

And as a follow-up, at what point do you think the after-school tutoring business will migrate completely to one-to-one or small class size? Or do you think you're always going to have 10% or 50% of that business is going to be large class sizes?

Louis Hsieh

I think it's always going to be a mix. The large classes are more affordable, which we kind of own that market, the larger classes. The smaller classes are becoming more popular because obviously you get more individualized attention, and so does the one-on-ones. So it's the same thing like in a car market, you've got the large class that equal the cheap cars that are available for RMB80,000 in China. The smaller cars sort of represent the Hondas and Buicks and the like. And the smaller cars are the one-on-ones represent the Mercedes and BMWs.

And so you're always going to have that bifurcated market. And New Oriental play in all three of them. And we already lead the large and small class and we're going to take the one-on-one market on as well. Last year we've done 45,000 VIP enrollments in one year. And don't forget, our ASP is typically 30% higher than our competitors. So you can see that we're clearly taking share in all three segments.


Your next question come from the line of Adele Mao from OLP Global.

Adele Mao - OLP Global

My question is related to the computer based assessment system for U-Can. Could you elaborate a little more in terms of how this system help drive future growth, specifically for students who are deciding between New Oriental and other schools? Is this assessment system available to them? And for students who are already enrolled in your program, if you could talk about how the system helped drive revenue per student?

Michael Yu

Actually, the most difficult is the parents that decide whether to choose an after-school tutoring is because they cannot see where the level is. So we designed the assessment system in lot of subjects, actually main in five subjects in Chinese language, English, mathematics, physics and chemistry. So when they come New Oriental, they can take the assessment test first and see what their level is?

So when their parents see that their kids' score coming out that their kids' score is not ideal enough, then their immediate position is that they will let their kids to stay here in order to study.

Before the system, we don't have any powerful tools to tell parents that their kids should stay here in order to study. And as a whole, system is designed based on students' intelligence system actually. So not only we can test the students on their subject, but also can test the students what is their most talented areas, what is the strongest in their mind? Like some students have a very nice space sense and some students have a very nice time sense; some students have a very good imagination and some students have a very good logical reasoning ability.

But without the system parents do not know what is the strong point of their kids and our teachers do not know what is the strong point of the students. So when students take these tests, when we know what is the strongest talent of the students, then we can design teaching for the students according to their strong points and try to overcome their weak points.

And then during the teaching time every week or every two weeks we will be coming back to the assessment system to see students whether they make any progress or not. If they make progress, but there's still some weak points in some areas in the subject then our computer can automatically draw us those weak point content for students to repeat and repeat again until the weak point becomes student's strong point.

This system is very scientifically designed and up to now at least we have studied all the techniques of other schools or other tutoring companies and see that up to today this system is the most welcomed by students. And when we began to use the system, like last month, almost 80% of the students who took the system assessment test stay in order to study. And when they finish one period of study then they take another assessment test and then they continue to pay for the next stage of study.

Louis Hsieh

So Adele, what it does is increase stickiness for students to stay in New Oriental and create up-sell opportunities, because if they want to focus on their weak points they can do it in smaller class formats. And it is a good tool for parents to assess, as Michael said, the strength and weaknesses of their trials in different subjects.

So overall it's a great system and I think you will create much brand loyalty to New Oriental as we can now work with them for years. We have this system by year, by subject.

Michael Yu

It's a good combination of content and technology actually. And the students, later, they can do all the assessment of tests at their home with their computers.

Philip Wan - Morgan Stanley

I have a question about your deferred revenue. It went up 74% this quarter, which is very funny. And I just want to take a little bit deeper look at the deferred revenue. How much of that is actually coming from the longer durations such as the VIP enrollments, and how much is the shorter term like the premium classes, so that we can gage how long the deferred revenue turnover would be.

Louis Hsieh

The deferred revenue turnover over the last three quarters, the percent recognized in Q2 will be approximately 56%. So of our $56 million or the $100 million will come into Q2 and the rest will be recognized probably in Q3 with a little tiny bit in Q4.

Philip Wan - Morgan Stanley

Therefore is almost zero now.

Louis Hsieh

Yes, so most of it really gets recognized within 6 months.

Mark Marostica - Piper Jaffray

I wanted to ask a question related to, Michael, your comments about the U-Can growth in the quarter. And I want to make sure I heard it correctly. I thought you said enrollments were up 135% and revenue up 112%. I know those are big numbers, but normally your revenue growth exceeds your enrollment growth and I am wondering if there is something else going on there that is influencing revenue growth (more) than enrollment growth, if I am misquoting you.

Louis Hsieh

No. it is correct. The revenues are recognized as they come in. The enrollments are counted when they come in, but the enrollments use the upper two or three quarters. So it's a funny time, where right now the enrollments are so strong but they are coming into Q2 and Q3. So the revenue line should be recognized at that point. But the actual enrollment growth is phenomenal into the autumn quarter.

Because remember, one of the things we are doing Mark is, our business model is changing. We have been criticized by the investors and the analyst community for years for having a business model that is very profitable in the summer of Q1, and then we just kind of tread water the rest of the three quarters.

We are transforming our business model so that it's profitable all four quarters. As part of that transformation, we need to do marketing during the summer. So that is part of why the marketing dollars are higher; we didn't have to just do marketing; because we want to attract students for the fall quarter. Well, we did attract a lot of students for the fall quarter which are U-Can students who registered in the summer. So that is why their registration is so high. But the revenue actually get recognized partly in the summer and partly in the fall.

Michael Yu

And then some even partly in the winter.

Louis Hsieh

Yes. So some of these are one-year enrollments or three-quarter enrollments, and so that's why there is a disconnect between the enrollment number and the revenue number. So the enrollments are correct; we went from 35,000 to 78,000 non-English enrollments and a total of 182,000 enrollments total for the quarter for 12-18 year olds.

We also recorded 169,000 Kids enrollments. For the year, that's 351,000.


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

Chenyi Lu - Cowen and Company

My question is regarding the operating margin for 2011. Given the heavy spending in the first quarter this year, and also you reduced your school expansion from 100 school centers to about 60 or 70. So can you give us a view as to what the operating margin looks like in 2011?

Louis Hsieh

Well, I think last year it was right around 20%, a little bit higher than 20%. This year it should be not quite as high, because we already missed the summer. But I think you will continue to see steady improvement in Q2, Q3 and Q4 versus last year's numbers. And I think, assuming we don't again accelerate our learning center growth, you'll see a much higher Q1 in next year.

So we're not yet ready to give guidance. I want to see what Q2 looks like first and see how much our cost control has had an effect on our expenses.


Your next question comes from the line of (Gordon Lasek) from Robert W. Baird.

Unidentified Analyst

Want to talk a little bit about your teaching staff. With over 10,000 teachers, how much more difficult is it getting to attract talent, given the increased level of competition? And how much do you expect to increase salaries in fiscal 2011 and how of that expense do you expect to pass on in price increases?

Louis Hsieh

I think we increased salaries this year by 8% for Beijing, Shanghai, probably less in other cities for teachers. We always attract the best teachers is because we pay high in our markets. So despite what you are hearing from competitors in the market, we actually out-pay them. And so we're able to attract teachers from our competitors as well as from our colleges, universities and high schools. And then we train them. We keep the high quality as we make them go through this three months training program before we let them teach in our classes.

As far as 2011 teacher salaries, we don't know. We know we will be one of the highest-paying in our key markets and we will continue to attract teachers away from our competitors and retain them for our needs.


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

Ingrid Yin - Brean Murray

My first one will be about the K2 program. What is your expectation for margins of these tutoring programs long term? We understand that EDU in the investment phase now. Really in the long term, once they start to contribute meaningful revenue, what's your expectation?

Louis Hsieh

What I think is that right now they are in the 55% to 60% gross margin area. We expect that to improve as innovation in the learning centers improves, and as we are able to pass on price increases through to the students. So I would expect the gross margins around the 60% to 65% level, and I would expect operating income to be somewhere between 25% and 30% once these programs are mature.

It may be a long time before they mature though, because they are growing so fast. At a time when we add 90 to 100 learning centers a year, it's very dilutive to our business. If we add 50 to 70 learning centers, it's very accretive to our business and the margins will go way up.

The other factor is marketing spend. We don't need to spend a lot of marketing dollars going forward after we establish ourselves in the market. So if we look at, like Beijing, some of our competitors who are on the roadshows now think that their marketing dollars are low. That's because they're only in Beijing.

So in Beijing, our operating profit is well north of 45%. But in the other cities where we're growing, we spend on marketing.

Michael Yu

Yes. (Less) spending money for the future and for our expansion in the other cities because we have to try to attract new people from other cities coming to New Oriental. It's not high in Beijing. In Beijing, we spend less marketing spend than any other cities in the percentage.

Louis Hsieh

Yes. And if you take away the headquarters, we have 50% operating margins in Beijing. So you can see the potential for the businesses as we grow. But we're a nationwide company; we're not a Beijing-based company like our competitors are. So we need to grow a nationwide network, and we're doing that, but that spending doesn't last forever.

So over three to four years we will build that brand name that we can really reduce the marketing spending without much diminution to our growth. And that's when you begin to see the very strong leverage. So it's a dual spend; it's spending on marketing, it's also spending on learning center growth. You need a critical mass of learning centers in each city to serve that community.

So we are taking the cost upfront. And then we will milk this puppy over time. And I think we're ambitious; we're going into 40 cities at one time. Our competitors are typically in one city; and they're milking that one city and it goes dry. But then they have nowhere to go.

So we're thinking far ahead and trying to go into 40 cities at one time.


(Operator Instructions) Your next question comes from the line of Eric Wen from Mirae Asset.

Eric Wen - Mirae Asset

I just have a simple one. Louis, you mentioned about new competitions, and you see fewer of them. Can you comment on the pricing environment in the K-12 segment in the cities where you do go into competition against your competitors, not only now but also in the next 12 months?

Louis Hsieh

Okay. Well, let's be very clear. We don't face competition from the ones who are on the road show today, except for in Beijing. They are both Beijing-based. (inaudible) has grown to outside of Beijing as well. But we have premium-priced it even in Beijing by 30%. So because of our premium brand name, we are priced 25% to 30% above (inaudible) on one-on-one tutoring today.

And I don't see that changing anytime soon. (inaudible) on the other hand is a Beijing-based math school. They do 10 to 14-year-old math programs. So their average ASP is about $177 in their F1 prospectus. Our averages ASP in those small classes are probably close to $240. So we also price 25% to 30% premium to them.

And the reason we can do that is that we pay our teachers more than they do. So it allows us to do that.

And so if we look at our competitors, our competitors are saying a lot of big words. But you look at their real businesses, (TREDA) is a pure one-on-one tutoring school, and mostly they are pretty much nationwide. (inaudible) is pretty much a math school, a small section only in Beijing. We don't see them anywhere else. And we are premium-priced to both of them. I think we'll continue to do so.


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

Ella Ji

Just a follow up on the competition side, with everyone now getting to the after-school tutoring and expand geographically, I want to hear Michael, how do you plan to differentiate in the long term when you compete with them side by side?

Michael Yu

You mean, on the K-12?

Ella Ji

Yes. You know, K-12 school tutoring, yes.

Michael Yu

That's seems pretty simple for us. First is that our brand is much more bigger than all our competitors, and secondly that our nationwide channels, that means learning centers are much more than our competitors. We have more than 400 learning centers and we are going to have more learning centers controlled in a rational manner actually.

And then the third thing is that we are building up a system first, I mean, like U-Can Assessment System, U-Can Intelligence System and a U-Can Content System. We spent almost a year to develop the system first before we promote all these U-Can programs.

So in systems, speaking, we are actually more advanced than our competitors. And then the third, our teachers' training system is much better than our competitors. Because of our brand, we are easier to attract more able and talent teachers into New Oriental and get a better pay.

And the other thing is that I think that our management team is much more mature than our competitors' management team. We have more than 40 schools in all the other cities. And these schools had more than average speaking of more than five years' working experience and the management experience in New Oriental.

So I'm pretty much sure that if all these guys know what we are doing and where we are headed are and what we want in the future, the culture is very strong in New Oriental. So it has very attractive elements to attract all the people, especially those talented people into New Oriental.

Louis Hsieh

You should know, right, I mean, some of our competitors, the one that just filed last week, they do only one-on-one tutoring. That's a smaller segment. The other one that is on the road show and pricing this week, the 90%-plus of business is in Beijing and only 80% of that is in mathematics. So they're very narrow, very single-focused system and they do mostly just small section tutoring.

We offer everything for students, one-on-one, small section, small classes, large classes, whatever you want, all the subjects across the whole country. We don't see our competitors anywhere outside of Beijing.


Your next question comes from the line Jeff Li from Signal Hill.

Jeff Li - Signal Hill

Michael mentioned a 30% growth target. Are you expecting 30% revenue growth for fiscal year '12?

Michael Yu

At this point, yes, but we will do our budgeting at the end of '11. But the momentum is clearly at our back. As we have grown these learning centers, we are seeing increasingly very strong demand for our services. We had 780,000 enrollment in K-12 last year. We expect to do somewhere between 1 million and 1.1 million enrollment this year. That's triple to anybody else's in our industry. And the revenues from this sector will exceed US$200 million next year. So I think we're expecting continued strong growth in this area, assuming the economy and other factors hold up.


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

Ingrid Yin - Brean Murray

So the Q2 will grow faster than you expected. You talked about it's a bounce back in Shanghai from the Q1. Is it also because some of the recent investment started to pay off, for example, like a higher utilization rate? Will that momentum extend to the rest of the year?

Louis Hsieh

We think the momentum will extend. At this point, it's too early to tell though, because we need to see what the winter enrollments look like. But clearly the investments that we have made in the past year are clearly paying off. We are seeing K-12 enrollment growth well above our expectations.

And even on the revenues, it didn't look like it in the first quarter. That's because of the shortened summer. It's one week shorter, and so students didn't have much class time which affected the revenues. Also, because the Shanghai Expo, students didn't want to fight in Shanghai with all the high expenses. And many students have a fixed budget. They spend the money in Expo instead of studying this summer.

Well, they all came in this quarter. They steered off the study. After every event like the Beijing, we always have a bounce back. And we're in the middle of that bounce back today with the K-12 tutoring classes.


Your next question comes from the line of Eugene Yeoh from Deutsche Bank.

Eugene Yeoh - Deutsche Bank

I just wanted delve a little bit more into your enrollment. You mentioned that tutoring was up 140%. Can you give some idea about which were the slowest segments between domestic English test prep, adults English as well as (technical difficulty).

Louis Hsieh

I can't hear you, Eugene. You got to repeat your question please.

Eugene Yeoh - Deutsche Bank

I just wanted some idea about the first quarter enrollment growth for overseas test prep and which were the slower areas, were they Adults English and were they growing like in the first quarter?

Louis Hsieh

Overseas enrollment growth was 21%. It was 74,800 last year to 90,400 this year. And with 17% price increases, the revenues were up 38%. Adult English was slow. Adult English went from 124,000 last year to only 110,000 this year. So it was down 11%. But ASPs were up 13%. So actual revenue was up 2%. So even though we expect adult English to slow, because as teach K-12 students in English, they don't need to learn the adults anymore, as long as the growth is gradually slow, and the revenues are still up slightly year-over-year.

Domestic test prep was CET 4 and CET 6 was pretty flat, 125,000 enrollments last year, 122,000 enrollments this year. And revenue was up about 4%. So these two adults English and domestic test prep, as long as the slow down is gradual, we're okay. Together, they only represent about 22% of our business. So they'll be more than offset by the growth in K-12 in an overseas test prep and in our overseas study consulting and online businesses.


We have a follow-up question from Ella Ji from Oppenheimer & Company.

Ella Ji - Oppenheimer & Company

Could you please provide a breakdown of enrollment between larger class, small class and one-on-one class in your after-school tutoring sector?

Louis Hsieh

I don't have that. We do have it. We can provide it to you offline. I remember we have about 15,000 one-on-one enrollments this quarter, more than double from last year just in the K-12 tutoring, 45,101 enrollments overall. I believe probably 55% of our students are still in larger class format. That's greater than 20 people per class, but one-on-one and small classes are growing very, very rapidly.


We are 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

Well, again, thank you all for joining us today. Michael and I are very happy to hear your questions and please don't hesitate to contact or Investor Relations representative for any further questions. By the way, CC and I will be on the U.S. Non-Deal Road Show starting on October 25 in Boston, October 26 in New York, 27 in Chicago and 28 and 29 in San Francisco.

So we look forward to meeting some of you during our travels.


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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