Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

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

Q2 2011 Earnings Call

January 18, 2011 8:00 a.m. ET

Executives

Sisi Zhao - Senior IR Manager

Louis Hsieh - President and CFO

Analysts

Catherine Leung - Citi

Philip Wan - Morgan Stanley

Chenyi Lu - Cowen and Company

Ingrid Yin - Brean Murray

Mark Marostica - Piper Jaffray

Ella Ji - Oppenheimer

Amy Junker - Robert W. Baird

Jeff Lee - Signal Hill

Paul Ginocchio - Deutsche Bank

Brandon Dobell - William Blair

Chao Wang - Bank of America

Tracey Urdan - Samuel Hill

Operator

Good evening and thank you for joining New Oriental’s second fiscal quarter 2011 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 meeting over to your host for today’s conference, Ms. Sisi Zhao. Please proceed.

Sisi Zhao

Hello everyone and welcome to New Oriental’s second fiscal quarter 2011 earnings conference call. Our second fiscal quarter earnings results were released earlier today and are available on the company’s Web site as well as on Newswire Services. Today you will hear from Louis Hsieh New Oriental's President and Chief Financial Officer. After his prepared remarks, Louis will be available to answer your questions.

Before we continue please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the US 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 Web site at investor.neworiental.org. I would now turn the call over to New Oriental's President and CFO Louis Hsieh. Louis please.

Louis Hsieh

Thank you Sisi. Hello everyone and thank you for joining us today. I will start by taking you through the highlights for our fiscal Q2 2011 and then move to the financial results before finishing with Q&A. As you know, in Q1 2011 our business was affected by a slow down in enrollments due to disruption caused by the Shanghai World Expo and as we expected there has been a strong bounce back since the event finished, which helped drive year over year revenue growth of 56.3% to $95.7 million and an earnings increase of 65.9% to $1.8 million in the second quarter.

Q2 is typically our slowest quarter as Chinese school children go back to class for their first semester of their academic year. Nevertheless, we saw very strong year over year growth in our key business segments of K to 12 all subject after school tutoring, overseas test prep and English language training, which grew revenues by 80%, 75% and 40% respectively. Enrollments were also strong, growing by 32.2% to about 405,800 during the second fiscal quarter of 2011, demonstrating the enduring brand strength of New Oriental and the market appreciation for our convenient integrated, one-stop offerings.

Blended ASP increased as well, growing over 25% to over $250 per enrollment. New Oriental is the only truly one-stop education service provider for K to college in China with the most complete nationwide coverage and a wide range of subjects and class formats, which students can benefit from throughout their lives. We do not endeavor to direct students to one particular academic subject or class format - class formats such as one to one or one to small classes, large classes or online.

Since we offer all of the aforementioned class formats and we offer the largest selection of subjects, this is unlike many of our other training companies in China, which typically focus on one of the class formats or on one academic subject. Instead, we work with individual students to customize an academic program that best fits his or her individual needs. Furthermore, we believe our one-stop shop solution is superior to other market providers in that it offers students the convenience and continuity of remaining within the same academic system for all of their supplemental learning needs.

Our one-stop shop model also allows us to be well positioned to quickly take advantage of shifts in market trends. For example, we are currently seeing growing market demand for more personalized tutoring and enrollment in our one to one and one to five VIP classes. For the first half of fiscal year 2011 our VIP business has recorded year over year enrollment growth of more than 114% to 28,600 students and year over year revenue growth of over 240% to $55 million. These VIP classes are the primary reason for the increase in blended ASP across the business.

As you know, we have been investing heavily in the past 2-1/2 years in our K to 12 all subjects VIP programs and in fiscal Q2 we continue to expand our network and recruit the best new teachers and support staff. During the quarter we opened one new school in Luoyang, a city in Hunan province, as well as a net of 24 learning centers in 20 existing cities within our network. These new learning centers have mainly been opened in larger cities and are relatively smaller, about 1/4 to 1/2 the size of New Oriental’s typical learning centers, with between eight and 15 classrooms each.

Opening these more streamlined centers allows us to fill in the gaps in our network by targeting areas where there is growing demand for our offerings yet these areas are not large enough to cost effectively support larger learning centers. To service our expanding network and to help develop our K to 12 all subjects after school tutoring and enhance our one-stop shop product offerings, we have been hiring and training new teachers and customer service representatives.

In total, over the last 12 months we have added a net of 4700 teachers, bringing the total number to 10,800 at the end of the second fiscal quarter 2011. At the same time, we hired approximately 950 customer service representatives and marketing staff, which equates to an increase of 43%. These significant expansions to our network and head count translated a 57% increase in operating costs and expenses in fiscal Q2 compared to the same period in fiscal 2010. As we reach the final six months of our focused investment in K to 12 all subjects and VIP personalized services, we will look to further control expenses and improve utilization rates of our facilities and staff.

We are also planning to significantly shift the main criteria for performance related bonuses to profitability as opposed to a balance of revenue growth and profitability in order to better incentivize school heads and management and bring increased attention to bear on controlling costs. I would now like to turn to our performance by business segment. K to 12 all subject after school tutoring grew enrollment by more than 50% to over 174,400 and revenues by more than 80% to $30.5 million in the second fiscal quarter.

Within this segment the performance of non-English You Can all subject training was particularly impressive with year over year enrollment growth of more than 102% to 27,200 and year over year revenue growth of over 200% to over $8.1 million. Due to the increase in popularity of one to one classes, ASPs for non-English You Can increased to over $500 per enrollment. The English portion of You Can also performed well during the quarter with enrollment up 37% to over 30,700 and year over year revenue growth of over 57% to $4.7 million.

Pop Kids continues to outperform during the quarter with enrollment up about 50% to over 116,000 and year over year revenue growth of over 62% to $17.7 million. Within Pop Kids, Chinese writing, mathematics, music and arts classes, which we launched two quarters ago, have been well received in the market and we have already nearly achieved our original focused school year enrollment target of 20,000. We now believe we are on track to enroll a total of 40,000 by the end of fiscal year, double our initial estimate.

Our oldest core segment, overseas test preparation, maintains a dominant market share in China in terms of both enrollment and revenue with enrollment growth of over 38% to more than 73,500 and revenue growth of 75% to around $28.5 million. Looking specifically at the course offered, we remain market leaders for TOEFL, IO, GRE, GMAT and SAT test preparation. Over the last 12 months we have enrolled 292,700 students and recorded $136.5 million in revenue in this segment.

Our third core segment, English language training for K to 12 students and adults, also performed well, growing enrollment more than 22% to over 277,400 and growing revenues more than 40% to $36 million year over year. We continue to lead the market in this segment with approximately $194 million of revenue and enrollments of 1.386 million over the last 12 months. Please note that English language segment overlaps with the K to 12 all subjects after school tutoring metrics.

In short, fiscal Q2 was a good quarter for the company with respect to enrollment and top line performance with stronger than expected growth as we continue to take market share in all three core segments. Looking forward, we have a lot of work to do in terms of controlling expenses and streamlining our operations to increase staff facility utilization rates. Our goal in subsequent quarters is to continue extending our market share and market leading position in all three key business segments of overseas test prep, K to 12 all subjects tutoring and English language training and at the same time do a much better job in controlling expenses and increasing utilization of staff and existing facilities.

Turning to financials, for the second quarter of fiscal year 2011 New Oriental reported net revenue of $95.7 million, representing a 56.3% increase year over year. Net revenues from educational programs and services for the second fiscal quarter was $84.5 million, representing a 57.7% 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 than average selling price associated with students selecting more expensive smaller class options.

Total student enrollment in academic subjects tutoring and test preparation courses for the second quarter of fiscal year 2011 increased by 32.2% year over year to 405,800 from approximately 307,000 in the same period in the prior fiscal year. Operating costs and expenses for the quarter were $97.7 million, a 57.3% increase year over year. Non-GAAP operating costs and expenses, which exclude share based compensation expenses for the quarter, were $94.4 million, a 63.4% increase year over year.

Cost of revenue for the quarter increased by 60.3% year over year to $44.6 million primarily due to the number of increased courses and a greater number of schools and learning centers in operation. Selling and marketing expenses for the quarter increased by 58.9% year over year to $18.6 million primarily due to the promotion of new service offerings and the addition of about 950 customer service representatives and marketing staff in the past year. General and administrative expenses for the quarter increased by 52.9% year over year to $34.6 million. Non-GAAP general and administrative expenses, which excludes share based compensation expense was 31.5 million, a 70.3% increase year over year primarily due to the increased head count in the company’s expanded network of schools and learning centers.

Total share based compensation expenses, which were allocated to related operating costs and expenses decreased by 23.6% o $3.3 million in the second quarter of fiscal 2011 from 4.4 million in the same period of the prior fiscal year. Loss from operations for the quarter was $2.1 million, an 125% increase from a loss of 0.9 million in the same period of the prior fiscal year. Non-GAAP income from operations for the quarter was $1.3 million, a 62.9% decrease from US $3.5 million in the same period of the prior fiscal year.

Operating margins for the quarter were -2.1% compared to -1.5% in the same period of the prior fiscal year. Non-GAAP operating margins, which exclude share based compensation expense for the quarter, were 1.3% compared to 5.6% in the same period of the prior fiscal year. Net income attributable to New Oriental for the quarter was $1.8 million, representing a 65.9% increase from the same period of the prior fiscal year. Basic and diluted net income per ADS attributed to New Oriental was 5 cents and 5 cents respectively.

Non-GAAP net income attributable to New Oriental for the quarter was $5.2 million, representing a 5.5% decrease from the same period of the prior fiscal year. Non-GAAP basic and diluted net income per ADS attributable to New Oriental was 13 cents and 13 cents respectively. Capital expenditures for the quarter was $19.9 million primarily used to purchase two new buildings costing approximately $11.1 million combined, one in Qibing and one in Wuhan and a net add of 24 schools and learning centers in the quarter. As of November 30, 2010 New Oriental had cash and cash equivalents of $248.1 million as compared to $293.3 million as of August 31, 2010.

In addition, the company had $255.8 million in term deposits at the end of the quarter. Net operating cash flow for the second quarter of fiscal 2011 was approximately $24.3 million. A deferred revenue balance, which is cash collected from registered students for courses and is recognized proportionately as revenues as instructions are delivered, at the end of the fiscal second quarter 2011 was $137.9 million, an increase of 94.1% as compared to $71.1 million at the end of the second quarter of fiscal year 2010.

We expect approximately 55% of the $137.9 million to be recognized in Q3 of fiscal 2011 revenues. Moving on to revenue guidance, New Oriental expects its total net revenues in the third fiscal quarter of 2011, December 1, 2010 to February 28, 2011, to be in the range of $116.8 million to $121.3 million, representing year over year growth in the range of 31-36%. The year over year comparisons for the third fiscal quarter of 2011 are more difficult for New Oriental because last year’s winter holiday was longer by about one week in most Chinese provinces due to late timing of Chinese New Year, which fell on February 14, 2010, allowing our students to study for a longer period and enroll in more sessions last year.

This year Chinese New Year falls on February 3, 2011, giving students a more normal three-week winter holiday. This forecast reflects New Oriental’s current and preliminary view, which is subject to change. At this point I will take your questions. Operator.

Question and Answer Session

Operator

Thank you. Ladies and gentlemen, if you wish to pose a question please press star, 1 on your touchtone phone. If your question has been answered or you wish to withdraw you may press star, 2. Please press star, 1 to begin. In order to be fair to all callers who wish to ask a question we will take one question at a time from each caller. If you have more than one question please request to join the queue again after your first question has been addressed. And our first question will come from the line of Catherine Leung with Goldman Sachs. Please proceed.

Catherine Leung

Hi. Can you please elaborate on the specific steps you’re taking to improve the utilization of your staff? For example, would this include offering a smaller number of classes so that more students would sign up for a particular class or any other more details you could share? Thank you.

Louis Hsieh

Thanks Catherine. I think there are a number of things we plan to do. I think right now is we were kind of in rapid growth trying to see if we could become the market leader in the K to 12 business and the VIP business in the last 2, 2-1/2 years. So what we did was we put revenue growth ahead of other items. And so right now as you know, we have added the 20 learning centers from New Wave and 24 net of our own.

Those will take time to fill up as it takes 2-3 years for a learning center to mature. So our goal is to slow down the hiring of teachers and staff until the utilization rates go up. For instance, each customer service representative today that handles these one on one and one to five students, we have about 14,000 enrollments and 150 customer service reps. That means each one is servicing about 14 or 15 students. They could easily service double that number of students so we’re going to slow down the number of customer service reps until the utilization rates go up.

The same is with the learning centers so even though we added net 24 learning centers, the capacity of the learning centers we added now are actually much smaller than the ones we have added in the past. Thus, the actual square footage is only akin to adding only 12 or 13 learning centers. So we’re going to slow down the learning center growth and only target them until the existing learning centers begin to fill up more in the larger cities.

Now in newer cities we’re going to continue to open up large learning centers and continue to grow the business. But in more mature cities we want to force utilization of the current capacity. Remember 240 learning centers are less than 2, 2-1/2 years old. They’re not mature yet. So we want to force utilization of those learning centers at higher rates before we open a lot more learning centers. So the ones we’re opening are now targeted smaller ones that will fill up quicker.

Other things we’re doing to incentivize is we are sort of freezing hiring for the next three months pending except for new teacher hires, which we need. But other than that we’re going to freeze hiring. It requires the approval of the COO and the head of HR for any non-essential hiring essentially. We are going to I think change the bonus structure. So right now it’s currently more geared toward revenue growth than profit growth. Next year we plan to change it so that profit becomes the key motivator for our school heads and our management.

And so probably 75-80% of their target bonus number will come from profit metrics, not from revenue metrics. So we’re doing a number of things. We just had three days of management meetings among schools to figure out other ways to control costs. We’re going to integrate and use IT services more so we are shifting a lot of our registrations online. So I think in Beijing 30% of our registrations are now online. That means we don’t have to keep hiring a lot of registration staff.

We have hired some 400 or so teaching assistants to help so that we don’t have to hire as many teachers. They’re not quite as expensive and they do all the grading, they do all the administration of tests for the students. So we are doing other ways to increase utilization of the current staff and the current facilities that we have. I don’t know if that answers your question Catherine.

Catherine Leung

Yes it does. That was very detailed. Thank you.

Louis Hsieh

So we are doing a lot of things. It just takes time. It’s because we overbuilt the last two years. It doesn’t get absorbed in one quarter. So the focus is really on cost control going forward. We’re very comfortable with our market position. We are clearly taking market share across the board in all our key segments. So we will continue to grow revenue and to grow enrollment but we need to get the recipe right.

We always have this problem in new businesses. It takes us two or three years to understand all the metrics and get the exact mix correct. We have the most complex business of the education companies that you follow in China.

Operator

And our next question will come from the line of Philip Wan with Morgan Stanley. Please proceed.

Philip Wan

Hi Louis. Thank you for taking my question.

Louis Hsieh

Hi Phil.

Philip Wan

I have a question about your VIP program. First of all, do you have any near term or medium term targets for the VIP business in terms of enrollment and revenues?

Louis Hsieh

Well, whatever target I tell you, we’ll exceed it. Go ahead. Sorry. Your second question was?

Philip Wan

Yes. So obviously it’s becoming a key growth driver for the company and could you give us some more color on this margin and what do you expect going forward given this strong pricing power? Thank you.

Louis Hsieh

Yeah. I think for the VIP business we really started it in large scale last year. It’s still in the ramp up phase so in the first half of the year we already have 28,600 enrollments, 55 million in revenue. So I would expect this to double in the next two quarters so it should reach over $100 million in revenue in this business in this fiscal year with enrollments around 53-58,000 or so.

The average price here is over $2000 US per enrollment now already, right? So we don’t expect to raise prices much. What we expect to do is as the utilization - each of our teachers on average for one on one is only teaching four students per quarter. We believe that they can actually handle six or seven. So this is another area that we think we can get a lot of utilization from. We can have the teachers teach more classes.

We have a lot of teachers that have spare capacity. So I think long term this business is quite profitable for us because we change so much more than our competitors do and our cost structure isn’t that much higher. I would expect gross margins in the range of over 60% as this business matures in the next year or two and I would expect operating margins around 25% or so in this business as it matures.

Philip Wan

Okay. Very helpful.

Louis Hsieh

Yeah. It’s already 20% of our revenue Philip. And I think it will only grow because the market - it’s not us setting the market. The market is demanding one on one services. So that’s just where the trend is going. We’re just like I said, our one-stop shop allows us to follow trends and adapt much more quickly than our competitors, right? So our competitors will try to sell you whatever they have on their shelf. We won’t try to direct you to buy one thing. We’ll let you buy whatever you want as long as you buy it from us.

Operator

And our next question will come from the line of Chenyi Lu with Cowen & Company. Please proceed.

Chenyi Lu

Okay. Thank you for taking my question. I have a question regarding your operating expense. I know that the company will try to enhance the utilization rate going forward so can you give us the operating margin, what you see over the next few quarters especially for 2011?

Louis Hsieh

I think for 2011 the next two quarters we’re still sort of feeling the after effects of the rapid expansion from the first quarter of this year and all of last year. So assume that takes one or two quarters but I think you will begin to see margin improvement every quarter starting in Q3. And I think next year you’ll definitely see margin expansion as we keep the cost control pressure on our management team. So I would expect next quarter - I don’t know for sure Chenyi.

It depends on how good we are at cutting costs. I would expect it to be better than last year’s Q3 - I mean this year’s Q2 for sure. But I mean it should start showing improvement every quarter by 100 to 200 basis points. And then going forward into fiscal year ’12 I think that’s where you’re going to see much better improvement in the cost structure and the operating margin because if we don’t open as many large learning centers then there won’t be a cost drag. And the learning centers from last year are going to hit maturity next year. So I think that the cost drag will be gone.

Also I think if we better utilize our teachers and we also continue to increase prices, ASPs were up over 25%. In You CAN, right, it’s already popped. You Can non-English already topped $500. This time last year it was 300 and something. So you can see that we have several levers to play with.

Chenyi Lu

Okay. Great. Just a housekeeping question - can you give us guidance as to stock based compensation expense going forward given that this quarter?

Louis Hsieh

Yes. Stock based was lower because some options expired during the quarter. I would expect Q3 to be similar to this quarter and then in Q4 it should start wrapping up again depending on how many grants we do at the end of the quarter. So it will be like 17 million for the year and then next year I don’t know because it depends on what the grants will look like for next year. But remember I told you three years and one are gone. So every year we have one that comes in and one that goes out. So stock based comp should be somewhere between $16-20 million a year yet our revenue keeps (continuing) to ramp. So the percent that’s actually SBC is going to go down every year.

Chenyi Lu

Okay. Thank you. That’s all my questions.

Louis Hsieh

Thank you Chenyi.

Chenyi Lu

Thanks.

Operator

And our next question will come from the line of Ingrid Yin with Brean Murray. Please proceed.

Ingrid Yin

Hi Louis. Just congratulations on the quarter. My first question will be about the expense going forward as previously discussed. Really the target number for learning centers for next quarter in fiscal 2011, can you provide some color?

Louis Hsieh

Yeah. I think the number of learning centers is not as material as the size of the learning centers. So to give you an example, our typical learning center, the old traditional learning centers were typically about 2500 square meters. The new ones we’re building, more than half of the ones this year, the small Pops and the VIP centers and the You Cans are only about 600-1000 square meters. They’re only 1/4 to 1/2 the size of the old ones.

So I think if you look at the old learning centers, we’re going to still do what we said before. We’ll add 60-70, which means it may be only 30 normal learning centers and maybe 50 or 60 small learning centers, I mean these new smaller learning centers we use to fill in. As you guys know from reading the newspapers and visiting China yourselves, traffic is really, really bad in China. And so we still get a lot - the number one compliant about New Oriental is not our price or our quality. It is our convenience.

It’s that we don’t have learning centers close enough to people’s homes. And so as we go into the big cities we have the center of hitting the most popular areas first. Now we’re using the fill in strategies in cities like Beijing and Shanghai where we’re hitting areas that aren’t quite as populated but still have one or two schools. So building these smaller learning centers, these learning centers of about 600-1000 square feet are more similar to our competitors’ size. So the net capacity will be about 60-70 learning centers of the old size, which may look like it’s 100. But the actual net square footage add is actually closer to 60-70.

Ingrid Yin

Yeah. I guess the real question is when do we expect to see accretion leverage?

Louis Hsieh

That’s what we’re working on. You will see it. If we are successful in reducing costs like I believe we will and the focus of the management team is first on reducing costs, you will begin to see it next quarter a little bit. You will see more of it in Q4 and you’ll definitely see it next summer.

Ingrid Yin

Okay. Great. Thank you.

Louis Hsieh

So six months - it’s not years away. It’s close. We are working hard on reducing costs. One of the reasons why we haven’t reduced costs as much this quarter is because culturally it’s not appropriate to be letting people go right before Chinese New Year or at the end of the Christmas or end of the calendar year. So we do have some layoffs coming - not a lot but we have some coming but we’ve been nice about it and we’re going to sort of wait until after Chinese New Year.

Operator

And our next question will come from the line of Mark Marostica with Piper Jaffray. Please proceed.

Mark Marostica

Hey Louis. Just a follow up on that last point, you mentioned some layoffs coming. Can you talk about the areas that you’ll be targeting and it may be a little bit sensitive to talk about the quantity but just whatever color you can give us sir, would be helpful.

Louis Hsieh

Yeah. I think we’re trying to integrate some of the functions, right? So there are for instance, we have a lot of people - we have a marketing team in every city now. We don’t need that many people. I mean we don’t need people doing design or designing things for marketing in every city. We can do it in Beijing and send it out and just have people distribute it in the local cities.

So you can see cutting marketing staff. We have a lot of duplication as far as IT between Koolearn and our headquarters. So you can streamlining in IT staff. I mean the number of IT staff isn’t going to go down but we’re not going to hire more people. We’re going to use the Koolearn staff to integrate into the main staff. Koolearn is our online platform. So you’re going to see things like that. The online registration system is more and more students are using online registration now.

So as that grows we don’t need to hire or we can begin to let go of some registration staff people. So it’s things like that. We are also targeting - I don’t want to give the percentage but low performers. So New Oriental does not have a culture of every year letting off the poor performers. We’re trying to start that now. So the low performers of every year, I won’t tell you what percentage, we’re going to ask the school heads to let them go. Otherwise they just sit around and sit around and they build and build over years and years.

It’s just like the investment banks, Mark, right? You’ve got to cut the bottom 5% or whatever every year. GE does the same thing. We’ve never done that. New Oriental has just gotten to be perfectly honest, too fat. So we need to take some of the - we need to streamline our operations and that is the number one focus. We have made some management changes to do that. That was one of the reasons why we promoted Chenggang Zhou to Executive President of Domestic Business. He’s very good at operations and streamlining.

Chenggang Zhou who is the COO has just been put back to Beijing school. He’s good at running expense control. He ran Beijing school for many years. So we are taking it seriously. It’s just that Q2 was not the appropriate time because it’s just before Chinese New Year. You don’t want to be seen in China as taking and laying off people just before Chinese New Year.

Mark Marostica

Thank you.

Operator

And our next question will come from the line of Ella Ji with Oppenheimer. Please proceed.

Ella Ji

Thanks. Congratulations Louis on a strong quarter. You mentioned that you are going to emphasize on expenses control. I want to know what are your thoughts on your selling and marketing expenses going forward?

Louis Hsieh

Well, actually we did control marketing expenses this quarter. It was actually 20% down from last quarter. It’s the headcount. So as a year over year comparison you have 950 more staff than you did last year. We don’t need that 950. They’re not fully utilized in my view. And so marketing expense we did actually control a lot in Q2 and we’ll continue to control it in Q3 and hopefully into Q4. The issue is the headcount and it’s because we changed our business model.

So it’s not the apples to apples comparisons will look much better starting in Q1 this year because last year we added 950 more staff to marketing. So actually a lot of it is staff costs, not real marketing dollars. We’re also more target marketing using more effective channels like online, less expensive channels like online than on TV and radio. So we are beginning to get our marketing. We also have a new marketing head. So we are taking the steps who are more cost conscious on reducing the costs.

We spent a lot on marketing in the last two or three years because we’re building a new brand in You Can, right, and we’re rolling out VIP. Now that we have done that for the last couple of years we can begin to trim back on actual marketing spend.

Ella Ji

Right. Yeah. I just want to know (with all that) you’re spending on those new brandings, do you feel that you’re already on stage with where you can slow down the real marketing dollars in this area?

Louis Hsieh

We did. We already slowed down by 20% year over year last quarter versus Q1. And you saw the numbers, we saw a still 56% increase in revenue. So this quarter we continue to control the actual out of pocket marketing expense. The headcount is still bloated. It’s still too big. But the actual marketing dollars are actually being controlled now and that’s what we told you we’d do last quarter. We have done that.

It’s just that the marketing staff will also even we don’t - let’s say we lay off zero marketing staff. That capacity would be absorbed anyway in the next two quarters because I would expect the next two or three quarters our VIP numbers to again double. So then they will be handling 25-30 students per customer service rep, which is what their capacity is. But some of the design people in the different schools we don’t need. There is duplication of effort. So we need to better streamline those efforts where we have a lot of duplication.

Ella Ji

Got it. Thanks. And I also want to know for the new learning centers that you opened in the last 12 months, how has the fill up rate been trending? How is that comparing to your old learning centers during their first 12 months of opening? Thanks.

Louis Hsieh

Well, it depends on what kind of learning centers. The Pop Kids and the You Can learning centers are filling up very quickly. So we expect some of them to hit maturity in two years instead of three years. I think what happens though is when you open new learning centers we actually cannibalize the old learning centers. So there is a cannibalization effect.

So that’s another negative when you open too many learning centers at one time is that cannibalize the existing centers in that same city. That’s why I think a moderate pace of 60-70 learning centers per year is appropriate. But that could mean 100 but it’ll mean only 30 large ones and 60-70 small ones, right? But I think that’s an appropriate number. So we are seeing very quick take up in the learning centers and that’s why we’re opening some of these smaller ones.

As you can see by the numbers, VIP and Pops are just booming. So the one on one learning centers are filling up quickly. The kids learning centers are filling up quickly and the You Can are filling up quickly. The older centers are same as before. They fill up 1/3 in their first year, get to 50-55% in the second year, get to 60-65% in the third year and that’s about where they cap out. So there has been no change in the old centers. The newer centers are filling up faster though.

Ella Ji

Great. Thank you very much.

Operator

And our next question will come from the line of Amy Junker with Robert W. Baird. Please proceed.

Amy Junker

Hi. Thank you. Louis, can you touch a little bit - I’m going to move away from costs for a minute to talk about revenue, which obviously came in significantly above your guidance for the second quarter. And I’m curious when you last reported you gave us some initial trends in September. It looks like it ramped up from there. So can you just talk about where was the biggest surprise versus your guidance? Was it purely in the enrollment numbers? How should we kind of interpret the conservatism of your third quarter revenue guidance? And can you just help us understand what is built into that revenue guidance on enrollment versus price increases? Thanks.

Louis Hsieh

Thanks Amy. That’s a good question. I mean last quarter we had sort of had 25-27% enrollment increases in the first month. That began to accelerate in October and November and so it is a very strong bounce back from the Shanghai World Expo. And remember we also had H1N1 last year. So it was an easier quarter to compare against. The revenue number was higher in the quarter primarily because of VIP. The one on ones is wildly exceeding our expectations, right? And so it’s going to be $100 million business this year.

It’s going to be approximately 20% of our revenues this year. It’s almost from scratch last year so the business is really picking up. That was the biggest surprise. I think going into Q3 our revenue guidance is 31-36% or 116-121 million. I think we are - the initial trends are very strong in Q3. The issue is that Q3 this year is one week shorter. So remember in the summer the Q1 was one week shorter as well because last year Q1 we had a very difficult comparison. It was a four-week holiday last year. This year is a three-week normal holiday.

So it’s because of the difficult comparisons that we were a little bit cautious on trying to say revenue would be that high. Last year our revenue was up 36% in Q3 because of the extra week. So I’m not as concerned about the revenue growth. I think 31-36 is doable for us. I think I’m more concerned about some of the Street numbers on profit because the one extra week of classes actually adds a lot to the bottom line. It’s probably between $4-5 million to the bottom line.

Amy Junker

And so just to clarify that because someone asked earlier about the margins and you had indicated you expect to see 100 plus basis points of margin expansion. Are you anticipating seeing that in the third quarter?

Louis Hsieh

I think what we’ll do - most likely what we’ll do is our old game. We outgrow revenues and we miss our margins because this quarter is already half over and so Chinese New Year is February 3. We don’t want to be laying off anybody until after Chinese New Year. So you won’t see the effects really of some of these cost cutting measures until Q4. You’ll see a little. I think Q3 we’ll probably outgrow on revenues. That’s what we typically do, right? And so I think your number Amy and one other is kind of out there as far as net profit. I think you’re over 21 million. I think to be honest if it’s my opinion if I had to call it today, I’d say we’d be between $18-19 million US in net income on a GAAP basis.

Amy Junker

Great. Thank you. That’s helpful.

Louis Hsieh

Okay. So I think it’s typically what we do is we’re a little bit conservative on revenue guidance because we’re not as you know from covering us the last two years, we’re not as great at operators. We’re not as streamlined and efficient as we need to be and that’s because it’s never been our focus as much. It is now but it hasn’t been as we were growing this business.

Operator

And our next question will come from the line of Jeff Lee with Signal Hill. Please proceed. Mr. Lee, your line is open. Please check your mute feature on your phone.

Louis Hsieh

Jeff, are you there? You know what it must be? It must be too early in California.

Operator

And our next question will come from the line of Paul Ginocchio with Deutsche Bank. Please proceed.

Paul Ginocchio

Thanks. It’s not too early in California.

Louis Hsieh

Hey Paul. How are you?

Paul Ginocchio

Good. First, can you give us any more color on the change in how you’re being compensated, how much more important do margins and profitability become versus what maybe the percentage was previously?

Louis Hsieh

No. I’m pre-empting it because we haven’t done budgeting yet. Budgeting comes in March and April as you know. Our fiscal year ends in May. This year revenue growth was the number one criterion. It was more than 50% of the compensation on bonus. But they need to hit profit as well. So more than half of the schools have missed their profit number so they’re not going to get compensated well in bonus. So we’ve saved some money just on bonus payments, right?

The second issue is going next year, the senior management early discussion is we want 75% of the KPI charged basically to profit margins. It will vary by school because every school is at a different stage of development. Beijing is going to have a much higher profit margin target than a school like Qibing or a school like Laotsu that is newer or that doesn’t have as attractive a market. So we’re going to step profit targets for each city based on the past and what we think they can do. But the profit measure is going to be - the early indication is at least 70 if not 80% of the KPI for the next year’s bonus number.

Paul Ginocchio

That’s very helpful. Great. Just real quick - you’ve got 78 centers already done. Your target for the year was 100. Do you think that number goes higher or you’re just completed?

Louis Hsieh

But it’s not. We don’t have 78 done. 20 of them were acquired.

Paul Ginocchio

Right.

Louis Hsieh

Right. So we have 33 and 24. We have 57 done.

Paul Ginocchio

Okay.

Louis Hsieh

Yeah. So we’ll probably add - we’ll probably be very close to 100. Like I said, most of these newer ones are tiny. I mean they’re the same size as our competitors’. They’re the same size as (Ishway Dar) or (Shertsu) or some of these other companies’ learning centers. They’re tiny, right? They’re not - they’re 1/4 or 1/3 the size of our regular learning centers. So they’re going to grow quickly.

Operator

And our next question will come from the line of Brandon Dobell with William Blair. Please proceed.

Brandon Dobell

Thanks. Louis, in kind of connection with that last question, how has kind of regional and city school head turnover been? And do you expect kind of changes in compensation and changes in kind of marketing directives to help that or hurt that retention?

Louis Hsieh

The changes have been made by us. So we moved Chenggang Zhou back to Beijing school head because he’s very good at operations and he also runs Vision Consulting, which I think our consulting business in two or three years will become our second biggest business behind Beijing school. So I mean that’s how valuable he is on the operations side. We have had the normal sort of four or five turnover in school head since last year. I don’t know the exact places and we are studying replacing a couple of more school heads.

So Laotsu school head was replaced this year and there are a couple more we are looking at as well. CI as well - CI was actually promoted to Vice School Head of Beijing school because we want him. He’s very good to come in and control costs at Beijing school. So we are taking those kinds of steps. We do have a brand new marketing VP s they’re going to control marketing costs. We are doing a lot of things. It’s just they don’t show up over night. And especially given the timing of Chinese New Year, we don’t want to be seen as - it’s the same in the US. You don’t want to be seen as laying off people just before Christmas.

Brandon Dobell

Okay.

Louis Hsieh

Right. So we are taking it seriously. We are making profitability the key KPI. That has never been the case at New Oriental. It’s always been revenue growth and enrollment. This will be the first year ever that profit is going to be more than 50% of a school head’s compensation on their bonus.

Brandon Dobell

Okay. And in terms of marketing?

Louis Hsieh

And you know also we’re always sort of studying and looking at improving Shanghai school. It’s had a difficult last couple of years.

Brandon Dobell

Right.

Louis Hsieh

Right. Brandon, you’re the other one that is really high on profit.

Brandon Dobell

Yes I am.

Louis Hsieh

So you’re like at 21 or 23 million for this quarter. I think that’s not doable for us.

Brandon Dobell

Got it. And then with a question on marketing strategy, how much are you able to just use like a single message or a single kind of brand focus in the different cities and all the different service lines you have going right now? Is there any risk that you’re getting too fragmented on the marketing message because you’ve got so many brands? Or are you able to tie them all together and get some cost leverage on what you’re spending on local cities?

Louis Hsieh

That’s the $60 million question Brandon. That’s what we’re trying to do. We’re trying to streamline it so that Beijing headquarters takes more of the sort of general messaging and all the artwork and then the local schools will instead of having staff of 10 people in marketing or 12 or 14, we’ll only need staffs of five or six. So that’s exactly right. And you multiply that by 40 schools, right - it’s a couple hundred people, 200-300 people. It’s significant. So you’re exactly right. The goal is that we don’t want to lose the local flavor yet we don’t want a huge number of duplication of effort. Right now every school has their own marketing team. They’re doing their own design, which is ridiculous.

Brandon Dobell

Okay. Thanks.

Louis Hsieh

And so that’s one of the areas that we are going to fix and it may take us a little bit of time. But that’s an area. Another one is a simple one like registration system. As more and more people register online we don’t need as many registration centers. We’re going to save a lot of money on registration staff and registration centers over time because more and more people are moving toward the Internet.

In Beijing it’s over 30% are enrolling online for brick and mortar classes. So we’re trying to use IT to help us as well. We also want to use IT to help us in teacher training. We used to train all the teachers in Beijing/Shanghai. That’s not doable now with how big we have gotten. So we use the Internet. We use videoconferencing to train teachers now. So we’re trying to streamline our operation. Any business we do it takes us two or three years. We’ve always had that issue. When we went to adult English 14 years ago, it took us two or three years to get the recipe right. When we moved to Shanghai and Wuhan and Guongjo, we left Beijing City in 2000, it took us two or three years to get the recipe right.

And so that’s why when we started You Can and the VIP business we said give us two or three years. It’s going to take us that long to figure it out. And so we’re two years and six months into it. We’ve got to figure it out quick.

Operator

And our next question will come from the line of Chao Wang with Bank of America. Please proceed.

Chao Wang

Hi Louis. Thanks.

Louis Hsieh

Hi Wang Chao. How are you?

Chao Wang

Hi. How are you? You just mentioned that going forward you’d do more small sized learning centers in more convenient locations. But I just wonder how these small sized margins look like compared to your (larger ones)?

Louis Hsieh

Yeah. Obviously they’re not as good, right, because they’re more similar to our competitors’ margins, right, because that’s what they’re building. But we don’t need - like it’s sort of the built in treasury, right? We already have big learning centers in the key largest population areas in most of the major cities now. That’s what we’ve been doing the last two years. But at the same time we still miss smaller communities, smaller suburbs or smaller districts within these large cities.

And so strategically we’re going to put - we ideally would like to be within 10 or 12 or 15 minutes of almost every middle and high school and elementary school in that city. And it doesn’t make sense to put in a 3400 square meter, four-story learning center if there is only one school there nearby. So it makes more sense to put in a targeted 800 square meter learning center like the size of our competitors’ and only have eight to 15 classrooms there, right? Have a couple VIP seats and some small classes and then some big classes in there.

So we are experimenting. We don’t have it quite right yet but we’re trying to target a learning center for the size of the particular surrounding schools that are there. So what we typically do is build a huge school first. That’s usually a building in a city block like we have in Beijing. Then as we spoke out, we have a spoke system. We spoke out to learning centers. Usually we build the big ones first. They’re between 2500 and 3500 square meters, right? They’re big. They’re usually two or three floors of a building.

And then they usually have 20-30 classrooms. Then as those begin to fill up there are certain areas in between that we missed and those are the ones that we’re filling in now in Beijing and Shanghai that are having the 800 square meter ones. They’re small.

Chao Wang

I understand.

Louis Hsieh

Yeah. So there’s like a double hub and spoke system. Start with the school and then do large learning centers and small learning centers.

Chao Wang

Yeah. So can I say because of the competition?

Louis Hsieh

It’s not because of the competition. It’s because we have already covered the big areas. So now we’re going to cover - we want to get more penetration within each city, right? So we want to get more penetration. I think if you read some of the reports now you’ll see that I don’t really want to talk about it on this call. I just don’t think - they target different things, right? They target different things. It’s not because of the competitors.

Chao Wang

My second question is that it looks to me that ASP growth is very strong this quarter. So do you think it’s sustainable going forward?

Louis Hsieh

Well, its’ not sustainable for long, right?

Chao Wang

I mean the appreciation.

Louis Hsieh

Really depreciation is nothing. It’s like 2%, right because we use 6.67. For the P&L it’s 6.68. And so last year it’s 6.82 or 6.83 so it’s not much. Actually we understated in the earnings release the actual ASP. It’s actually higher. But I think going forward it is not sustainable. I believe that it depends on the shift toward one on one mix. So I believe it will be above 20% for the next two or three quarters. But long term obviously it’s not sustainable.

Chao Wang

Okay. Okay. Thanks.

Louis Hsieh

I mean one on one is not going to become our whole business.

Operator

And our next question will come from the line of Tracey Urdan with Samuel Hill. Please proceed.

Tracey Urdan

Hi Louis.

Louis Hsieh

Hi Tracey.

Tracey Urdan

Could you talk to the source of growth in the after school tutoring segment? I’m wondering to what extent you’d see this market as continuing to expand. Are we still in the business of consolidating away from individual teachers to share or are we in the stage now where you’re actually taking share away from other corporate entities? And kind of where do you see the market in that progression?

Louis Hsieh

I think this market is similar to the English language training market 14 years ago when we went into it meaning that with English in China in 1996 was dominated by small mom and pop shops. And so it was very, very, very, very fragmented. And then New Oriental began to open learning centers and taking out of these smaller shops and moving it into larger centers with more consistent quality across the center.

Similar to what Walmart does to local retailers, right? So we’re like Walmart but with a Tiffany price. So we offer one thing under one roof for them and so we’re doing the same thing now to K to 12. K to 12 got an extra boost when the government three years ago decided to make it illegal for schoolteachers to teach their students after school on school premises. That’s the way students usually learned. And so that created a large market opportunity for us and for our competitors. For the first few years obviously it’s going to be a real estate game, right? It’s going to be a raise to see who can capture the most share.

The truth is the market is plenty big for all of us. And so we just want to make sure as we have been telling you and investors is we want to make sure that we continue to be the market leader, that we pull away from the crowd and that’s exactly what we’re doing. I think there is plenty of room for all of us in this market. It’s very early.

Tracey Urdan

Okay. I’m struck by how you stopped talking specifically about Gaotao test prep and you’re speaking more broadly about after school tutoring. And I’m wondering to what extent do you see your business being driven outside of the normal bounds of the Gaotao market into something that extends beyond that maybe into high school testing.

Louis Hsieh

We already do high school testing, right? That’s the Saocao. So we do that anyway. But don’t forget the Gaotao or the Saocao is only one test. That’s a $500 ASP to us. That accounts for one or two quarters of study. After school tutoring from age six to age 18 is a 12-year business with the same student. So would you rather have a client or a customer one pop for $500 or do you want them for 12 years coming to you every quarter and taking two or three classes? Right?

So the business model, that’s why we’ve been pushing this one-stop shop. We are your education partner from age six all the way through college where we want to be your partner. It’s the recurring revenue of these students from age six to age 22 to 25. And I mean it’s a much better business model than just you come in, you take test prep and you go, one and out, right - one and gone. We want recurring revenue multiple quarter, multiple year, multiple decade. And more and more so multiple generation.

Tracey Urdan

Right. The question I’m having a hard time asking and I apologize is understanding this market, how many new - some of the test prep market is well established and longstanding. And it strikes me to some of this growth that you’re seeing is pulling new dollars into tutoring earlier and earlier or do I have that wrong? Is this just parents have always spent this money and it’s really just about where they’re spending it versus how it used to be? Or is it in fact the case that this market is expanding and some parents are putting their children into tutoring situations earlier and earlier in their lives?

Louis Hsieh

I think it’s both Tracey. I think that the market has always been there but it’s always been a secret market where people pay high school teachers or elementary school teachers or college students on an individualized basis, right? I think because of new regulations it’s put it out into - (Yerinto) and others of our competitors are putting it into a learning center environment. And that is causing it.

And as China gets wealthier and wealthier, parents are spending much more on after school tutoring. So you’re exactly right. It’s also going to a much younger age. So it’s not just for Gaotao test prep and it’s not just for Saocao. It’s for every year by every subject. So the market is expanding at a very high rate. At the same time the business model is changing because it’s moving toward a learning center environment from these individualized one on one transactions. It’s similar to what Walmart did in the retail business.

Cities used to be littered with mom and pop corner shops. Walmart moved it into a larger format more consistent, high quality format and that’s what we’re doing. And that’s where the market is going. Parents want their kid to take more after school tutoring at a much younger age and they’re willing to pay higher dollars for smaller classes. That’s where the trends are moving. So it’s both Tracey. That’s a good answer.

Operator

Ladies and gentlemen, we are now approaching the end of our conference call. I will now turn the call over to New Oriental’s President and CFO Louis Hsieh for closing remarks.

Louis Hsieh

Again, thank you everybody for joining us today. If you have any further questions please do not hesitate to contact me or any of our customer/investor service representatives. Bye-bye.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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

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

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

Source: New Oriental Education & Technology Group, Inc. ADR CEO Discusses Q1 2011 Results - Earnings Call Transcript
This Transcript
All Transcripts