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

Q1 2011 Earnings Call

April 27, 2011 8:00 am ET

Executives

Sisi Zhao – Senior Investor Relations Manager

Louis Hsieh – President and Chief Financial Officer

Analysts

Catherine Leung – Goldman Sachs & Co.

Philip Wan – Morgan Stanley

Mark Marostica – Piper Jaffray

Ella Ji – Oppenheimer & Co.

Chenyi Lu – Cowen and Company

Jeff Lee – Signal Hill Group LLC

Tom Dillon – William Blair & Company

Chao Wang – Bank of America Merrill Lynch Global Research

Eric Wen – Mirae Asset Securities (NYSE:HK) Limited

Vivian Hao – Credit Suisse

Operator

Good evening, and thank you for standing by for New Oriental’s Third Fiscal Quarter 2011 Earnings Conference Call. At this time, all participants are in a listen-only mode. After management’s prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. 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, ma’am.

Sisi Zhao

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

Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, our results may be materially different from the views expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. New Oriental does not undertake any obligation to update any forward-looking statement, except as required under applicable law.

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

I’ll now turn the call over to New Oriental's President and Chief Financial Officer, Louis Hsieh. Louis, please.

Louis Hsieh

Thank you, Sisi. Hello, everyone, and thanks for joining us today. I will start by taking you through the highlights for our fiscal Q3 2011 and then move on to the financial results before finishing with Q&A.

We’re pleased to report strong results for this quarter and particularly excited that we are reporting excellent performance on both the top and bottom lines. Especially pleasing is the growth in our GAAP profit margin, which improved to 17.6% from 15.5% in the year-ago period, which reflects a successful implementation of the expense control initiative that we outlined last quarter.

We placed at the end of the Q2, we placed a very strong emphasis in Q3 on improving utilization of our existing facilities and staff, and scaling back to expenditures on new facility, staffing and marketing. In addition to improving utilization of our existing facilities, these efforts have enabled us to increase profits by 68.1% year-over-year for Q3 on top of a very healthy revenue growth of 48.6% year-on-year.

A core focus for expense control during the last quarter has been a prudent approach to expanding our facilities. In Q3, we only added one new school in Nantong city, Jiangsu province and a net of eight learning centers in seven existing cities. Whereas in the previous three quarters, we had built 43, 35 and 24 new schools and learning centers respectively. As of February 28, 2011, we had a total of 456 schools and learning centers nationwide versus 447 in the previous quarter.

While we have slowed down the pace of expansion, this should not be interpreted and mean that we are missing out on the market growth opportunity. Having very successfully extended our network of schools and learning centers during previous quarters, we have ensured that we already have a very strong presence in the key markets where we want to be.

So our focus in Q3 for the coming quarters is on improving our utilization and improving [class] offerings in these facilities it will enable us to improve operating efficiencies.

In Q3, we have also kept a firm hand on headcount increases, in particular of non-teaching staff. Naturally, we continue to focus on hiring, training and retaining the most talented teachers in the industry to ensure that we consistently provide the best-in-class service quality at New Oriental students have to come to expect from us. But as we do so, we have also been very conscious of the need to improve internal efficiencies so that we control the number of non-teaching staff we hired. As a result of this effort, in Q3, we added a net of 4 -600 employees, of whom the vast majority or about 470 were teachers.

This emphasis on achieving HR efficiency extends to existing staff as well as new hires. In Q3, we effected more than 1460 terminations, both voluntary and voluntary. At the end of the quarter, we had a total headcount of about 21,300 including about 11,300 teachers.

Another important driver of our improved margin last quarter was our strict control over marketing expenses in Q3. Marketing cost totaled $18.3 million, which is down significantly from $23.3 million in the first quarter of fiscal quarter 2011, and also less than the $18.6 million we spend in Q2. Of our total marketing spend last quarter, only about $7.5 million was non-headcount related or direct marketing or direct brand promotion spending and this represent an increase of only 12% or approximately $6.7 million in the same period last year.

But we have very effectively reigned in spending across our business. We have been careful to do so in a way that improves efficiency without impeding growth. In fact, I am pleased to note again that we are reporting stellar top line growth of 48.6% for this quarter, driven by excellent performance right across the key business lines.

I think it speaks volume about the enduring strength of New Oriental’s brand, but even as we eavesdrop on spending on marketing and network expansion, we never or less increase enrollments by 17.8% year-over-year. We had approximately 490,200 enrollments in Q3 2011 compared to approximately 416,000 in the same period last year.

In particular I would like to highlight that we had recorded over 1.6 million enrollments in the first three quarters of 2011 fiscal year and are poised to exceed 2 million enrollments for the first fiscal year, for the full fiscal year, a significant milestone for the company. To the same three fiscal quarters of 2011, we have recorded an additional 159,000 paid online enrollments that is poised to exceed 200,000 paid online users for the full fiscal year.

This reflects how our customers continue to recognize the quality of the training environment that New Oriental provides as well as our unrivalled breadth of services with our one-stop-shop strategy. Let us quickly break down these numbers and look at the performance in our fastest growing business line.

Our overseas test preparation segment maintains strong momentum with year-over-year enrollment growth of more than 33% to over 73,100 and year-over-year gross revenue growth of about 55% to over 43.4 million last quarter. We remained a dominant player in the overseas test preparation market in China with approximately $152 million in gross revenue and over 311,000 enrollments in the 12-month period ended February 28th, 2011.

Our K to 12 all subject after school tutoring business recorded year-over-year enrolment growth of more than 35% to over 290,400 and very encouraging year-over-year gross revenue growth of over 70% to over $46 million in the quarter. We are pleased with the progress we're making with the business and we expect more than 1 million enrolments in K-12 during fiscal year 2011 ended May 31.

Under this umbrella, our non-English U-Can all-subjects business now almost 3 years since its launch, continues to experience extremely strong growth and demand.

In Q3, we saw year-over-year enrollment growth of more than 83% to over 66,900 students and year-over-year gross revenue growth of over 133% to over $18 million. We are the leading service provider in the K-12 all-subjects after school tutoring market in China, with approximately $173 million in gross revenue and approximately 996,500 enrolments in the 12-months period ended February 28 of 2011.

And finally I’d like to draw particular attention to our VIP personalized courses, which are getting traction incredibly quickly across many subjects. Revenue, our existing position is China's most trusted private after school education provider. We have been ideally placed to adopt our existing service offerings to suit the smaller classroom environment to take advantage of this opportunity. We now offer classes on a range of subjects to small class [subjects] between 1 and 5 students. And I'm pleased to say that pickup has been very strong.

Year-over-year enrollment growth by more than 68% to over 15,700 students and year-over-year gross revenue growth of over 140% to about $31 million in the quarter. In the 12-month period ending February 28, our VIP personalized courses recorded over $104 million in gross revenue and over 58,300 enrolments.

As a result of the success of our VIP offerings, we have been able to increase blended ASPs by approximately 30% to over $250 per enrollment.

In addition, our online education business and our overseas consulting business continue to grow strongly with year-over-year revenue growth of 50% and 130% respectively.

Although revenue contributions remain below 5% of our total, we are encouraged by the fantastic progress we’re making in these segments. These platforms which are complementary to our business provide our students with additional services and benefits from the enrollments cross selling opportunities of our business model.

Our other two major business segments saw modest gross revenue growth in the quarter. The gross revenue was up approximately 7% for adult English and 1.4% for College English Test Prep or CET 4 and CET 6 tests.

To sum up, our results for Q3 are very encouraging. Our strong performance across our core business lines drove excellent top line results and stringent cost control efforts have been reflected in exceptional growth in the bottom line.

In the quarters ahead, we will strive for a balanced approach of rapid expansion to capture the enormous market opportunity in front of us, and at the same time, remain vigilant on expense control to realize operational efficiency.

Turning to the financials. For the third quarter of fiscal year 2011, we reported net revenues of $132.5 million, representing a 48% increase year-over-year. Net revenues from educational program and services for the third fiscal quarter were $122.6 million, representing a 48.6% increase year-over-year. The growth was mainly driven by an increase in the number of student enrollments in academic subjects tutoring and test preparation courses and higher average selling prices arising from student selecting more expenses smaller class options.

Total student enrollment in economic subjects tutoring and test preparation course in the third quarter of fiscal year 2011 increased by 17.8% year-over-year to approximately 490,200 from approximately 416,000 in the same period of the prior fiscal year.

Operating costs and expenses of the quarter were $111.3 million, a 47.4% increase year-over-year. Non-GAAP operating costs and expenses, which exclude share-based compensation expenses for the quarter were $108 million, a 52.8% increase year-over-year.

Cost of revenues in the quarter increased by 55% year-over-year to $54.9 million, primarily due to the increased number of courses and the greater number of schools and learning centers in operation.

Selling and marketing expenses for the quarter increased 32.5% year-over-year to $18.3 million, primarily due to the addition of over 900 customer service representatives and marketing staff in the 12-month period ending February 28, 2011.

General and administrative expenses for the quarter increased by 44.9% year-over-year to $38 million. Non-GAAP general and administrative expenses, which exclude share-based compensation expenses were $34.9 million, a 61.1% increase year-over-year, primarily due to increased headcount as we expanded our network of schools and learning centers.

Total share-based compensation expense, which were allocated to related operating costs and expenses decreased 30.8% to $3.4 million in the third quarter of 2011 from $4.9 million in the same period of the prior fiscal year.

Income from operations for the quarter was $21.2 million, a 55.5% increase from $13.6 million in the same period of the prior fiscal year. Non-GAAP income from operations for the quarter was $24.8 million, a 32.8% increase from $18.5 million in the same period of the prior fiscal year.

Operating margins for the quarter were 16% compared to 15.3% in the same period of the prior fiscal year. Non-GAAP operating margins, which exclude share based compensation expense for the quarter, were 18.5% compared to 20.7% in the same period of the prior fiscal year. Net income attributable to New Oriental for the quarter was $23.3 million, representing a 68.1% increase from the same period of the prior fiscal year. Basic and diluted net income per ADS attributed to New Oriental was $0.51 and $0.60 respectively.

Non-GAAP net income attributable to New Oriental for the quarter was $26.6 million, representing a 42.4% increase from the same period of the prior fiscal year. Non-GAAP basic and diluted net income per ADS attributable to New Oriental was $0.69 and $0.68 respectively.

Capital expenditures for the quarter was $9 million, primarily used to add [Fun schooling] of eight learning centers. As of February 28, 2011 we have cash and cash equivalents of $348 million as compared to $248.1 million as of November 30 of 2010.

In addition, we had U.S. $190.5 million, $0.6 million in term deposits at the end of the quarter. Net operating cash flow for the third quarter of fiscal year 2011 was approximately $40.1 million. A deferred revenue balance, which is cash collected from registered students for courses and is recognized proportionately as revenue as the instructions are delivered, at the end of the third quarter fiscal year 2011 was $150.7 million, an increase of 115.9% as compared to $69.8 million at the end of the third quarter of fiscal year 2010.

Turning now to the financial results, for the nine-month ended February 28, 2011. For the first nine-months of the fiscal year 2011 we reported net revenue of $420.5 million, representing a 40.3% increase year-over-year.

Total student enrollments in academic subjects tutoring and test preparation courses in the first nine months of fiscal year 2011 increased by 16.8% to approximately 1,600,500 from approximately 1,370,500 in the same period of the prior fiscal year, let me read that.

Total student enrollments in academic subjects tutoring and test preparation courses in the first nine months of fiscal year 2011 increased by 16.8% to 1,600,500 from approximately 1,370,500 in the same period of the prior fiscal year.

Income operations for the first nine months of fiscal year 2011, was $85.1 million, representing 15.5% increase year-over-year. Non-GAAP income from operations for the first nine months of fiscal year 2011 was $96.7 million, representing 11.7% increase year-over-year.

Operating margin for the first nine months of fiscal year 2011 was 20.2%, compared to 24.6% in the same period of the prior fiscal year. Non-GAAP operating margin, which excludes share-based compensation expenses, for the first nine months of fiscal year 2011 was 23%, compared to 28.9% in the same period of the prior fiscal year.

Net income attributable to New Oriental for the first nine months of fiscal year 2011 was $87.5 million, representing a 21.5% increase year-over-year. Basic and diluted net income per ADS attributable to New Oriental for the first nine months of fiscal year 2011 amounted to $2.29 and $2.24, respectively.

Non-GAAP net income attributable to New Oriental for the first nine months of fiscal year 2011 was $99.1 million, representing 16.7% increase year-over-year. Non-GAAP basic and diluted net income per ADS attributable to New Oriental for first nine months of fiscal 2011 amounted to $2.59 and $2.54, respectively.

Moving to our outlook for the fourth quarter of fiscal year 2011, we expect total net revenue in the fourth quarter of fiscal year 2011, March 1, 2011 to May 31, 2011 to be in the range of $114.3 million to $118.6 million, representing year-over-year growth in the range of 32% to 37%. This forecast reflects our current and preliminary view, which is subject to change.

At this point, I will take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Catherine Leung. Please proceed.

Catherine Leung – Goldman Sachs & Co.

Hi, congratulations on the strong quarter. My question is on your cost, so to clarifying your balancing rapid expansion with expense control, going into the fourth quarter, is the company more focused on improving utilization and by adjusting the fixed cost still top of the past year or are you carrying out your expansion ahead of the summer quarter? And related to this, I assume the terminations you mentioned happened towards the end of the third quarter after Chinese New Year, so how much real would the full quarter impact be from these reduced costs? Thank you.

Louis Hsieh

The second part of your question Catherine is that they didn’t have that much impact on Q3 yet, because you are actually right. Both the terminations came after the Chinese New Year. So they will reflected more slowly in the Q4 quarter and in May 31. And your first question relating to the expansion plan, as we are doing the budget for fiscal year 2012 right now we are probably going expect to expand learning center growth about 70 to 85 learning centers. And we will gear up for the all important summer quarter this year. But it won't be the same as last year in Q4 where we added 45 learning centers and schools.

This year we are going to look at much more closely at utilization in the center in the cities that already have significant (inaudible) not utilized. So we won’t be adding as much as we did last year. At the same time, we will look at areas where there’s utilization is constrained because we’re growing so rapidly especially in the newer city. So you want see the 40 number. You’ll most likely see something between 15 and 25. And then going further there will be that kind of clip of 15 to 25 centers per quarter as we sort of try to maintain a more balanced approach to our cost expenses as well as our expansion.

Operator

Your next question comes from the line of Philip Wan, Morgan Stanley. Please proceed.

Philip Wan – Morgan Stanley

Hi, Louis, thanks for taking my questions. Very quickly, could you provide us any margin guidance for the next quarter? And also looking forward to fiscal year 2012, you think that we may see an easier comparison with the first quarter this year, or what kind of growth rate do you expect and it would be great if you could provide any color on the breakdown between enrollment and ASP growth going forward? Thank you.

Louis Hsieh

Thank you, Philip. We don't provide margin guidance on a quarterly basis, so I will defer that. I think as you can see that the margin trend is upward. So we are confident that we will, margins will begin to trend upwards from here versus year-over-year comparisons. As far as the ASP and enrollment breakdown going forward, this year ASPs are much higher due to the fact that fastest growing segment of our business is VIP which is one to one to one to five. And these have, average US$1700 to US$1900 ASPs which is driving the ASP up well over 30% on a year-over-year basis on a blended basis.

Going forward, I would expect revenue growth, we’re doing budgeting now so I don’t, and you don’t know this sure we are expecting revenue growth north of well over north of 30% for next fiscal year and of that let’s say 30%, 35% in revenue growth we would expect about 15% to 16% enrollment increases and 15% to 16% price increases, the ASP increases. This should be right half and half. If anything the ASPs will probably grow up a little bit faster than the enrollment.

Operator

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

Louis Hsieh

Mark, are you there?

Mark Marostica – Piper Jaffray

Yes, I’m here. Sorry I had you on mute. Nice job on the quarter, Louis. I wanted to touch on the selling and promotion spending in the quarter and specifically you are spending on direct brand promotion which obviously was a lot slower than revenue growth. Can you talk about your budget for direct brand promotion spending in the coming quarter? Should we expect it to continue to be at these, low levels of growth relative to the rest your selling and promotion spend?

Louis Hsieh

I wouldn’t expect it to be 36% lower than our revenue growth but our budgeting does call I mean like I said is I have been telling the street that most of the increases inside the marketing for the whole year has been hiring as we change our business model from overseas test prep in large classes and adult English to K to 12 model that requires customer service reps especially if we do VIP instruction, where a lot of these personnel that are being hired are in the marketing department.

So I would expect brand promotion expenses to grow, but at a much slower pace than revenue. So if revenue growth at 30% I said brand motion expenses not to exceed 80% of that growth or about 24% or 25%. And like I said the direct brand promotion expenses actually are not that much. Most of the increase is actually just due to advertising rates going up, it's not even like we are advertising more, it's revenue the same or low or less. It's just purely rates have gone up.

So I would expect most of our expenses to grow at a slower rate than revenue, which is why we expect margin expansion in fiscal year 2012. And as was pointed earlier by [Pillipe] we do have easier comparison versus the summer. You guys have understand that we added about a net over 110 learning centers in the last four quarters, the second half in next year. And so just go down learning center growth and utilization increases given the strong demand for our programs the margins are expected to go up.

Operator

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

Ella Ji – Oppenheimer & Co.

Thank you. Congratulations Louis. Could you talk about what’s your current utilization rates for your learning centres opened more than 12 months?

Louis Hsieh

To be honest we don’t (inaudible) that close because it depends on how you define utilization. But Q3 utilization is quite high right, because it’s one of our, it's our second busiest quarter behind the summer. Q4 utilization which is even lower than Q3 just because it doesn't include the winter and Chinese New Year break. But I can tell you that utilization rate has gone way up in the last quarter from last year I mean versus Q2 because of the winter break also because we added only nine net schools and learning centers.

So it's easily over 50% now. But we have only the potential to reach 70% because our school so many times have shut down during school hours when Kids are at school. So I think as we are getting closer to full utilization but as you know we never get there.

So, the ones that have been opened longer than 12 months would typically have utilization rates greater than 50% especially as we open smaller ones. The larger ones that we opened after 12 months would probably be about one-third or 40% utilization after one year. And it will slowly grow over the next two years to about 65% to 70% utilization rate.

Operator

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

Chenyi Lu – Cowen and Company

Great, thank you. I have just one or two questions. Regarding your U-Can program, I know this quarter has been again very strong. Can you give us a view of non-English U-Can program in 2012? And also can you give us an update on your Kids math in the Chinese course in terms of momentum? Thank you.

Louis Hsieh

Yeah our Kids math and English, I mean Chinese courses are getting much, are growing very rapidly. We had 10,400 enrollments in Kids math and Chinese in the quarter, excuse me, which brings the quarter to almost 30,000 – 29,800 in the first three quarters since their launch. This is math and Chinese classes and art classes for kids 6 to 12. We expected only 20,000 enrolments for the whole fiscal year so we’ll probably double that to 40,000. I'd expect this business to grow very rapidly in the years ahead just like U-Can did two and a half years ago.

So we’ll follow that kind of same pattern of about 100% growth for a couple of years. As far as the out look for U-Can for fiscal year 2012, I don't have the number yet because we are doing, as I said we’re doing budgeting right now because it's our end of our fiscal year May. I would expect U-Can to grow at least 50%, non-English U-Can at least 50% It’s been growing closer obviously to 100% so that’s probably quite a consecutive number. But I don’t want to be aggressive when we haven’t finished the budgeting process yet. Thank you, Chenyi.

Operator

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

Jeff Lee – Signal Hill Group LLC

Congratulations on the quarter Louis.

Louis Hsieh

Thanks Jeff.

Jeff Lee – Signal Hill Group LLC

You’ve had rapid growth in VIP since you’ve rolled it out like big sequential increases in enrollments of several thousand students. No sequential increases have sort of leveled out over the past three quarters, so going forward do you expect more, bigger potential increases going forward or is it just sort of leveled off because its not a brand new offering anymore.?

Louis Hsieh

No I would expect VIP enrollments to continue to grow very rapidly. I don’t think they’ve leveled off at. I think they’re going over 50% on a year-over– year basis with ASP growing as well. So you can see the revenue is up over 140% in the VIP’s sector. Typically if you kind of compare Q3 to Q1, it’s not a fair comparison because Q1 is our biggest quarter. So I would expect VIP to continue to grow rapidly and it accounts for about 22% of our revenue today. I would expect that could be well north of 25% in the next fiscal year. So it is probably the fastest growing segment of our business and we’ll continue to grow.

Operator

Your next question comes from the line of Tom Dillon, William Blair. Please proceed.

Tom Dillon – William Blair & Company

Good morning, Louis

Louis Hsieh

Hi, Tom.

Tom Dillon – William Blair & Company

How many cities do you plan to move and expand this year and then with traffic in Beijing, how many other cities or how in other major cities, how do you plan to change utilization all that much?

Louis Hsieh

Tom, I think for next year, we are probably going to move into three or four new cities where we went into three cities already this year, are going to three to four new cities in fiscal year 2012 like there was still setting that in our budgeting process. We will continue to expand fastest in the cities outside of the major cities like Beijing, Shanghai where we have decent coverage today.

So the fastest growth in our business will continue to be the second and third tier cities, outside of Beijing and Shanghai. That’s where the demand is the strongest and that’s where our learning centre growth will continue to grow. And part of our focus for next year is that we’ve grown so fast from last year with over 110 net apps learning centres we want to begin to fill those so the utilization rate was low. At the same time, we don’t want to stop growing too, still has another 75 to 85 learning centers. And a balanced approach I think is much more sustainable than the rapid expansion than harvest rapid expansion and harvest touch (inaudible) used by many of our competitors.

Operator

Your next question comes from the line of (inaudible), SIV. Please proceed.

Unidentified Analyst

Thank you for taking my question. Could you please comment on the competitive landscape? How is EDU positioned in over (inaudible) after school due to in training, particularly given competitors will have gone public and continue to invest in these areas? Thank you.

Louis Hsieh

That’s a good question. I think for us, you need to understand and I know the analyst can understand this. The market opportunity is huge. According to [ITC], it’s over $24 billion now. So we position ourselves with our superior brand name and our nationwide brand name, with the only nationwide brand names known across China in the sector, working overseas (inaudible) and in K to 12.

We were always positioned at the top where we are premium priced with premium service and a premium brand name. So we are typically, we don’t try to go after the whole market. We’re also positioning ourselves, vis-à-vis our competitors as one-stop shop, where students can come and they can pick one-on-one classes, one to small, one to large and online. We offer all formats as well as all subjects. So we come to a one-stop shop is where we’re positioned.

We have 30,000 or more competitors in China. So one of them is even one quarter our size. So we face strong competition in every city that we have schools and learning centers at. But most of the strong competition is actually from local competitors, which you guys haven’t even heard of because they haven’t gone public yet. So we compete against some of the more recent entrants in only a specific area like VIP or in a specific area city like Beijing. So we do not really compete head-to-head with anybody nationwide. We compete against very strong local players. It’s sort of like Walmart we have to target.

Operator

Your next question comes from the line of (inaudible), Robert W. Baird. Please proceed.

Unidentified Analyst

Hi Louis, thanks for taking my question. Could you just help me understand, I guess, at what level of mature learning centers should you be able to withstand the margin pressure from opening new centers? I mean do you essentially need to reach 300 to 350 mature centers and if so when do you think you’ll have a large enough space to withstand to come a normalized rate of openings going forward? Thanks.

Louis Hsieh

I think we are there now, so I think with 456 learning centers by another two quarters from now, three quarters of them will have already been sort of “mature”, which means they are over two or three years old. So I think we are right off the cups right now of the critical mass that sort of new openings won’t really impact our margins that much, unless we go nuts and open 200.

So I think it’s a good pace and as far as our competitors have opened new learning centers, it depends on how many learning centers they have opened versus how many they have. For us at 450, we could easily open a 100 again next year and not impact the margins that much. We probably will not just because we want to continue improve utilizations, we will hold it to 75 to 85. But at this point we have the most difficult times as well as margin pressure, last two years we added over 200 learning centers, on a base of only 200. So that was what was putting down was putting the margin pressure on over the last few quarters or last year and a half.

In addition, we are also rolling out brand new businesses in non-English U-Can and also VIP businesses for the K to 12 sector. Those put tremendous resource grains on our business by making us open a lot of learning centers as well as hiring a lot of staff ahead of the revenue. And like I said when we did this 2.5 years ago, it give us three years, it was now three years.

So now it is time for us to basically put up our shadow. And we are trying our best to rationalize the business to make it more efficient and streamline it. At the same time, contrary to the concern on the Street, it has not really slow down our top line growth which was the big worry if we begun to rationalize costs.

Operator

Your next question comes from the line of Chao Wang, Bank of America. Please proceed.

Chao Wang – Bank of America Merrill Lynch Global Research

Hi, thanks for taking the question. Just one quick one, could you provide us with guidance on share-based compensation for the next couple of quarters? Thanks.

Louis Hsieh

For Q4, it should be quite low also, it’s $3.4 million this quarter, something in the same range for next Q4, but Q1 again will have another set of option grants. So it’ll replenish itself, so it’ll go up again in Q1 from the $3.5 million level. I don’t have that number yet because we haven’t granted those share-based comp, we used to do it at the end of the year after the fiscal year is done, so we will have a better picture in Q1. I did not expect share-based compensation to as a percent of revenue will continue to decrease as it has for the last three years.

Operator

Your next question comes from the line of Eric Wen. Please proceed.

Eric Wen – Mirae Asset Securities (HK) Limited

Hi, Louis. Thanks for taking my call and congratulations on the good quarter. I have two questions. The first question is deferred revenue continued to be grow very strong starting from the spike last quarter. Could you tell us where that deferred revenue continue to come from in which in whether it’s the English or in one of the your VIP private instruction business? And I have two follow-up questions. Thanks.

Louis Hsieh

The deferred revenue balance is in all time high $150 million this quarter. Actually, it’s not as big as you think. Remember last year, Chinese New Year occurred in February 14th, this year occurred February 3rd, that two weeks make a big difference, because last year there wasn’t much bigger deferred revenue, students finished Chinese New Year holidays early March went enrolled students in classes. That means the revenue has actually recognized in Q4, or this year because as I see over the normal period of February the 3rd students went back to school around February the 17th and then enrolling classes so distorted higher than it looks like its 150% growth, it’s really not that high.

Having said that, actually the deferred revenue balance is still a very high number even without that Chinese near timing effect. And so most of that is really related to VIP and you can for Q4 which is the biggest businesses in Q4 the one we are in today. We are – we do have a big backlog of $150 million, I would expect more than half of it to be recognized between 50% and 55% in the current quarter today. Any follow-up question there?

Eric Wen – Mirae Asset Securities (HK) Limited

Yes, sorry I missed your last part. You’ve said how much of your deferred revenue is already booked in the current quarter?

Louis Hsieh

I think it will be over 50% some of between 50% and 55% closer to 55%

Eric Wen – Mirae Asset Securities (HK) Limited

Understand, okay. My second question is, you seems to have a very unique offering in the K-12 business, which is a VIP maximum of 5. How do you reach your target customers as you compete against both (inaudible) but you are probably the most expensive most high-end product that how do you market the product differently compared to your competitors.

Louis Hsieh

I think it's been a long process for us because, I think the way we compete is our brand name is second to none in China. And so students would typically come to us if they can afford us, that’s where we are looking, its all like Mercedes and BMW in China they can afford it they usually come to New Oriental. So we actually don’t really try to do anything to use rate dollars see how we do is just market our own brand name, it just has a premium brand, but it’s the same strategy we used for our businesses, we make sure we have the best features as we hire and train them and we paid them the best.

At the same time, we spend a lot of money and developing the best contact. We also have a computerized testing system that second and none in China. We think it’s a best product out there for K-12 right now which we spend three years developing. So, I think we have a superior offering I think we have superior teaching and that’s what feels our premium brand name which allows us to charge more.

In addition Eric as you know, you visited our Beijing facilities in other cities that our facilities typically are at a level of much higher than our competitors. So it commands a premium pricing.

Operator

Your next question comes from the line of Vivian Hao, Credit Suisse. Please proceed.

Vivian Hao – Credit Suisse

Hi Louis good evening. Hi congratulation for quarter.

Louis Hsieh

Thank you.

Vivian Hao – Credit Suisse

I just have two quick questions, first is what’s your current making marketing budget by advertising format public shares are divided by offline versus online. And also do you see increasing pressure from raising products by your in certain local market such as Tsinghua in Beijing and also (Inaudible) et cetera?

Louis Hsieh

We’ve always had those competitors I mean (inaudible) had been around for as long as (inaudible) they don’t, like said we secure the market they played a much lower point and we do either much the market is clearly segmented and we are at the high end most of them are middle or low end. So (inaudible) hasn’t changed at all. As far as our brand promotion expenses it is moving more and more online. We find the young people obviously as you all know, we are spending more and more time online so the way to reach them is the target them online and that’s what we are doing

Vivian Hao – Credit Suisse

Yes.

Louis Hsieh

So most of our, probably I would say, of our, most of our expenses, more than half or very close to half now are done online. And that’s where the trend is going is to refuse students online through the major sites like Baidu, SINA, SOHU, Tensen, those sites where a lot of students hang out, we are targeting those sites.

Operator

Your next question comes from the line of Catherine Leung, Goldman Sachs. Please proceed.

Catherine Leung – Goldman Sachs & Co.

Hi, I just have a follow-up question. For the summer quarter, is the seasonality affected in any way by VIP process now being a much greater proportion of your revenue?

Louis Hsieh

It should not affect sort of the year-over-year comparisons although the growth rate will be high because the VIP, as you know, the ASPs, each VIP ASP is equal to 10 regular ASPs. So I think the Q4, you should expect a lower enrollment growth because as I said, the enrollment came into Q3. But you shouldn’t, I mean, the growth rate should still be intact because of the huge deferred revenue balance. All it means is that students pre-register for Q4.

So I wouldn’t expect any difference. I think over time, you will see that Q3 and Q4, the winter and the spring become a much bigger part of our business than they have in the past because as you all know, the Glasgow was given in June and the (inaudible) given in June or July each year. So the six months before that is Q3 and Q4 for us, and that’s the prime test preparation season.

So I would expect Q3 to Q4 to continue to outperform, probably at the expense of Q1. Q1 will continue to grow, but it’s driven mostly by overseas test prep and summer preparation. But it also carries this for good of these excess learning centers from Q3 and Q4 for the U-Can that aren’t quite as full during the summer as students take a break. So the business will continue to trend towards Q3 and Q4. Q1 should outperform this year because of the easy comparisons versus last year, as was mentioned earlier.

Operator

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

Ella Ji – Oppenheimer & Co.

Hi, some follow-up questions. First, I want to ask about the margin outflow for the long-term. If you’re doing those cost of controls, but also VIP process are representing a higher percentage of revenue, we actually have lower margins. So in the long-term, do you think your operating margin can go back to your historical high above 20%?

Louis Hsieh

I believe it can because we have two things working in our favor. One is our pricing power. So we’ve been able to raise prices and you know pricing, raising prices higher than the level of your cost growing will obviously drive margin expansion. That’s number one.

Number two is utilization. So we still have a lot of excess capacity across our network. As that begins to sell off, where we have this giant mass or base of 450 learning centers that are mature and your incremental adds are under 100. Then that will also drive very positive margin expansion. So basically price increases and utilization would drive margin expansion.

At the same time, you’re right, the fastest growing business, VIP today has about 55% gross margins. So it is lower than, and also Kids is same thing, at about 55% gross margin and those two are two of our faster growing business lines. But in the quarter, we raised Kids prices significantly. I think it’s like 15% or so. So we’re beginning to get pricing power even in the Kids side of the business, which is usually the most competitive. So I think as we goes over 18% in the last quarter.

So we would expect if we can get continue to see pricing power in these VIP, and just say we've got few prices over 30% on a year-over-year basis. Then I think that were more than offset the fact that the mix is moving towards lower margin because those lumpy lower margins for that. So I would expect it to get over 20% in the next couple of years in operating margin and we are up 16% this year and we have move to 18%, 19% hopefully next year if we execute well and then go back to historical numbers hereafter.

Operator

Your next question comes from the line of Vivian Hao, Credit Suisse. Please proceed.

Vivian Hao – Credit Suisse

Hi, just quickly understanding your plans to penetrate further into more lower secondary cities. What’s the general ASP level in this regions compared with the top tier cities. Maybe in other words do you see that ASP tends to be just down in the long run?

Louis Hsieh

The ASPs are lower for non-VIP the level is about 25% to 30% lower than for cities like Beijing or Shanghai. For VIPs it’s about 50% lower, but at the same time the costs are commensurately lower. The teacher’s salaries are much lower in the secondary cities as our rental cars. So the profit margins of those (inaudible) might just still be north of 20% when those cities are mature. The other thing to remember is these are just little Beijing’s and Shanghai’s from 20 years ago. There are going to grow up into Beijing’s and Shanghai’s as far as they are basically where the growth in China is today. The growth is migrating away from the Eastern seaboard toward the middle and western parts of China, which is what the government planners want.

So we would expect a fastest growth in middle and west and we’re positioning ourselves for long-term growth in these areas. We are seeing a rise in adult English again, well all these products because the factories and personnel move to the middle and west of China. So do the jobs, when the jobs moved out and you'll speak English as investment goes into these cities. So I think is that these cities are similar to Shenzhen, Guangzhou, Beijing 15, 20 years ago and we are well positioned to capture that and be the leader in the second and third tier cities, that’s where the growth is going to be in China over the next 20 years.

Operator

We have a follow-up question from the line of Ella Ji, Oppenheimer.

Ella Ji – Oppenheimer & Co.

Yeah, I'll follow up another question also about long-term growth perspective, I know that you have a new website xds.cn coming online recently. So far trend is education market has been mostly breaking model off line tutoring services. So Louis, do you see in the long-term there may be some shift towards them online offerings, do you think that market is now attractive?

Louis Hsieh

I think it's very attractive. I think the only thing is that, it has lower ASPs and I think it's mostly target at the lower end of the market currently. Our ASPs are probably among the highest in China online and it's only like US$650 [across], but it's doubled in the last three or four years. So it's going very rapidly and we are the largest K to 12 online site in China. So we are well positioned if this market picks up, but if you ask Chinese kid their first choice and their parents the first choice is one I want instruction. So it is like if you ask somebody what kind of car they want, the first choice probably BMW or Mercedes. If then if they can't afford that then they move down and they move down to small sections of 15 to 20 students. If they can't afford that they move to large classes of 40 to 100 students. If they can't afford that then they will go online

So I think is right now our online is more supplementary, additional questions and some courses online as well. But it's typically, it is last market you can scale it, but it typically has lower price points and it's not as effective. Usually money is not the issue for our high end students. What the issue is, is time. And how fast given the limited time can they learn the materials. And obviously in this kind of format the fastest way to learn is one-on-one. And that's why you are seeing the ones who can afford it, no one-on-one.

Operator

Your next question comes from line of (inaudible) Lee, (SIV). Please proceed.

Unidentified analyst

Hi, Louis, thank you for taking my question again. Just a follow-up question on the revenue growth, I think it's already late April. Can you give us some color on the first quarter revenue growth? I think last year the year-over-year top line growth is 29% in the first quarter of 2011. I have another follow-up question, thank you.

Louis Hsieh

I would expect because Q1 was weak last year. You would expect Q1 this year to be much, much stronger than that. I would expect easily over 30% topline growth for Q1. But we haven't had the budget yet. And its Q4 is tracking obviously very well. Given the ballooning differed revenue balances. So, Q4 is tracking fine. We don't have much visibility in Q1 yet. But given how we performed supportively last year because of the expo and our own through rapid of expansion, I would expect Q1 to be quite good, much better than that this year barring any kind of pandemic or other external event that we didn’t anticipate.

Unidentified analyst

Okay, thank you. My other follow-up question was about the CapEx. I think this quarter is $9 million which is primarily due to the addition of new learning centers. So basically the CapEx for learning center is close $1 million. This seems to be an up tick increase from previous quarters. So, can you please give us any color on that?

Louis Hsieh

Yeah. It’s really not. I think the learning centers are more expensive than the past just because of inflation in China in the schools. But most of that $9 million CapEx is actually refurbishing (Inaudible) because don’t forget we have now 450 or 400 plus existing learning centers. Many of them are more than three or four years old which means they need new decorations. So a lot of that is actually is refurbishing that’s bigger and bigger base of learning centers. But CapEx as a percentage of revenue should go down overtime. We also bought two buildings this year as you know in Chengdu and then in Kunming because the opportunity was there and it’s cheaper than actually renting.

So $11 million or $12 million of that for the year is actually building purchases. So I would expect CapEx to be $30 million to $35 million, $30 million, $35 million next year real CapEx, which is a declining part of our business. Its only, it’s less than 5% so staying in that 4% to 5% range that it has been historically. So it’s really not going up at all.

Operator

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

Louis Hsieh

Thank you. Again, thank you for joining us today. If you have any further questions please do not hesitate to contact me or any of our investor relations representatives. Have a good day.

Operator

Thank you for your participation in today’s conference. That concludes the presentation. You may now disconnect, and have a great day.

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