New Oriental Education F2Q08 (Qtr End 11/30/07) Earnings Call Transcript

Jan.15.08 | About: New Oriental (EDU)

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

F2Q08 Earnings Call

January 15, 2008 8:00 am ET

Executives

Sisi Zhao - Manager, Investor Relations

Louis T. Hsieh - Chief Financial Officer, Director

Analysts

Mark M. Marostica - Piper Jaffray

Adele L. Mao - Susquehanna Financial Group

Scott Schneiber - Oppenheimer

Trace Urdan - Signal Hill Group

James Mitchell - Goldman Sachs

Brandon Dobell - William Blair

Alex Xu - Brean Murray Carret

Catherine Leung - Citigroup

Anindya Chatterjee - Jefferies & Co.

Marisa Ho - Credit Suisse

Operator

Good evening and thank you for standing by for the New Oriental second fiscalquarter 2008 earnings conference call. (Operator Instructions) I would like tonow turn the meeting over to your host for today, Miss Sisi Zhao, New OrientalInvestor Relations Manager. Please proceed.

Sisi Zhao

Hello, everyone and welcome to New Oriental's second fiscalquarter 2008 earnings conference call. Our second fiscal quarter earningsresults were released earlier today and are available on the company’s websiteas well as on newswire services. Today, you will hear from Louis Hsieh, ourCFO. After his prepared remarks, Louis will be available to answer yourquestions.

Before we continue, please note that the discussion todaywill contain forward-looking statements made under the Safe Harbor provisionsof the U.S. Private Securities Litigation Reform Act of 1995. Forward-lookingstatements involve inherent risks and uncertainties. As such, our results maybe materially different from the views expressed today.

A number of potential risks and uncertainties are outlinedin our public filings with the SEC. New Oriental does not undertake anyobligations to update any forward-looking statements except as required underapplicable law.

As a reminder, this conference is being recorded. Inaddition, a webcast of this conference call will be available on New Oriental'sinvestor relations website at http://investor.neworiental.org.

I will now turn the call over to New Oriental's CGO, Louis Hsieh.Louis, please.

Louis T. Hsieh

Hello to all of you on the call and on the webcast and thankyou for joining us today. I am pleased to report that New Oriental posted solidresults for the second fiscal quarter of 2008, with strong top and bottom linegrowth. I would like to take you through some of the highlights in the quarterbefore moving to the second quarter and six-month financials.

As you may know, our second fiscal quarter corresponds withthe beginning of the Chinese school year and as a result is typicallycharacterized by a sharp drop in enrolment from the summer quarter.

We are pleased to report that despite seasonality, weexperienced healthy revenue growth in all our key segments, which led to a42.4% year-over-year net revenue increase and our net profits this quarter grew77% over the same period a year ago.

During our second fiscal quarter, we continued our strategy offoregoing short-term profits in favor of rapidly expanding our leadingnationwide network by establishing a net of 34 new schools and learning centersin the first half of our fiscal year 2008. That’s compared to 19 schools andlearning centers for the entire fiscal year 2007.

In order to staff our rapidly growing physical network, weadded over 900 teachers and staff in the first half of our fiscal year 2008. Inaddition to increasing our G&A spending, primarily due to headcountincreases, we also continued to rapidly increase our marketing spending, whichduring the second quarter grew by approximately 50% year over year, in order todrive strong student enrolment and revenue growth. We expect to continuebenefiting from this rapid expansion strategy in the quarters and years tocome.

In the second quarter, we were able to beat top lineguidance and the main drivers behind our revenue growth was the strong rise instudent enrolment for our leading language training and test prep and overseastest prep courses for the year-over-year increase from 217,000 students to over257,000 students this year second quarter.

Also driving revenue growth this quarter was enrolment inour overseas test prep program and POP kids English program, which increasedmore than 30% and 50% respectively over the same period last year.

We continued our pilot program in mathematics in a half adozen cities and are pleased to report we had over 3,800 enrolments in the fallquarter, usually a slow period when students go back to school.

As the private education trade in China expands to studentsat younger ages, we are recognizing -- we recognize the potential in providingfamilies with full-time enrolment options for pre-school aged students. In thefirst fiscal quarter, we began our kindergarten business and I am pleased toreport that our first operational kindergarten opened officially during thesecond quarter in Beijing.

Looking forward, we expect the trend to continue withfamilies beginning their children’s education at younger ages and we plan toleverage our leading brand name in English language to provide competitiveoptions to this highly fragmented area.

In general, Chinese parents are name brand buyers and theeducation of their child or children is the top priority in their lives. Whenselecting pre-schools for their one child, parents will typically consider thefollowing criteria: known brand name, clean and safe environment, qualityprograms with English language training a definite plus -- kids learn Mandarinat home, typically -- convenience, and price.

We believe that our New Oriental Star branded kindergartenswill be an attractive offering in this competitive fragmented market.

As our enrolment continues to rise, we realize theimportance of providing our growing number of students with course content thatmeets the highest standards. Aside from developing content in-house, weconstantly seek out collaborations with leading domestic and internationalcontent providers.

During the second quarter, we announced two new strategicagreements with premier content providers, ETS and Heinle ELT, a part ofCengage Learning, formerly Thomson Learning.

Our agreement with ETS, students enrolled in New Oriental'sTOEFL preparation course will now have access to ETS’ online program whichfurther solidifies our dominant position in TOEFL test preparation.

And under our agreement with Hienle ELT, Hienle ELT willwork with New Oriental's instructors to develop a line of localized Englishlanguage training materials, including text book and video programs andInternet based content for use in New Oriental's iEnglish brand courses and byNew Oriental's [inaudible] online platform.

Also, we continue making good progress in upgrading ourBeijing elite learning centers with a DynEd software model. As we announcedlast year, the upgrade to DynEd’s international state-of-the-art Englishlanguage training software in elite English courses will provide teachers witha platform by which they can track the progress of each student. The softwarewill also help reduce operating costs as students will spend the first stagesof the courses using the software and only at a later stage will teachers beneeded for in-class instruction. We expect to expand our elite English with DynEdsoftware in other cities in 2008.

Now I will walk you through the contributions to our secondfiscal quarter results and some financial highlights. Please note that certainfigures I will talk about are non-GAAP, including all measures that are givenexcluding share-based compensation expense. You can find a reconciliation ofthese figures in the financial tables at the end of the press release.

Our second fiscal quarter 2008 total revenues were RMB240.6million, equivalent to $32.6 million, an increase of 42.4% over the secondfiscal quarter of 2007. Revenues from our educational programs and servicescomprising our language training and test preparation courses and primary andsecondary education programs, rose 37.9% year over year, driven by an increasein new student enrolments in language training and test preparation courses.

Overall, operating costs and expenses for the quarter wereup 43.3% year over year. Of these, costs of revenue increased by 35.5% yearover year, mainly due to the increased number of courses offered to a largerstudent base and a greater number of schools and learning centers in operation.

Selling and marketing expenses increased 49.9% year overyear, due to the brand promotion expenses and headcount increases. In addition,as you are aware, China’s inflation rate has been rising for the last year andwe are feeling the stress of wage inflation for teachers and staff as wecontinue to compete for the best personnel.

G&A expenses increased 52.6% year over year, primarilydue to increased headcount as the company expands its network of schools andlearning centers.

Operating margins for the quarter was negative 0.5%,compared to positive 0.2% in the corresponding period of the previous year.Excluding share-based compensation expenses, operating margins for the quarterwas 5.8% compared to 4.5% in the corresponding period of the prior year. Thisincrease was primarily due to the improved operating efficiency as revenuegrowth outpaced the growth of operating costs and expenses.

Total share-based compensation expenses for the quarter wasRMB15.3 million, equivalent of $2.1 million. Of this amount, approximatelyRMB2.4 million was recognized as cost of revenue, RMB0.5 million was recognizedas selling and marketing expense, and RMB12.3 million is general andadministrative expenses.

Net income for the quarter increased to RMB14.5 million,equivalent of $2 million, an increase of 77% from the second fiscal quarter of2007. Net income excluding share-based compensation expenses increased toRMB29.8 million, equivalent of $4.0 million, an increase of 83.6% from thesecond fiscal quarter of 2007.

Basic and diluted earnings per ADS were RMB0.39, equivalentof $0.05, and RMB0.37, equivalent of $0.05 respectively. Excluding share-basedcompensation expenses, or non-GAAP, basic and diluted earnings per ADS wereRMB0.79, equivalent of $0.11, and RMB0.76, equivalent of $0.10 respectively.Each ADS represents four common shares.

Moving to our balance sheet, our total cash and cashequivalents as of November 30, 2007 were RMB1.8248 billion, equivalent to$247.1 million, an increase of 4.6% from August 31.

Capital expenditures for the quarter was RMB12.3 million, theequivalent of $1.7 million.

Net operating cash flow for the quarter was RMB63.9 million,or equivalent of $8.6 million.

Financial results for the six months ended November 30, 2007-- before I give guidance, I would like to take a brief look at the comparisonbetween the first six months of fiscal 2008 and the first six months of fiscal2007.

Student enrolments in language training and test prepcourses grew 25.8% year over year to 698,200 approximately. Net revenues wereup 42.5% year over year to RMB852.6 million, equivalent of $115.4 million. Netincome was up 56.1% year over year to RMB270.5 million, the equivalent of $36.6million. Non-GAAP net income was up 59.6% year over year to RMB298.5 million,equivalent of $40.4 million. And our operating margins went from 30.2% in thesix months ended November 30 2006 to 31.4% in the six months November 30 2007.

I will now read you New Oriental's financial guidance forthe third fiscal quarter of 2008. Please note that the following outlookstatements are based on our current expectations. These statements are forward-lookingand actual results may differ materially.

Total net revenue in the third fiscal quarter 2008 that runsfrom December 1, 2007 to February 29, 2008, are expected to be in the range ofRMB311.2 million, equivalent of $42.1 million, to RMB326.5 million, equivalentof $44.2 million, representing year-over-year growth in the range of 22% to28%.

Please note that New Oriental's third fiscal quarter 2008revenue growth will be especially challenging when compared to the third fiscalquarter of 2007, which showed year-over-year net revenue growth of 51.3%. Thecompany’s third fiscal quarter 2007 benefited from the late timing of ChineseNew Year in 2007, which fell in the third week of February 2007, allowingChinese students an extended winter break and a longer period of time to studyin language training and test prep courses. This will not be the case in 2008,as the Chinese New Year falls on the first week of February, a more typicaldate for the Lunar New Year celebration.

In addition, many schools throughout China, including thosein Beijing, have decided to shorten the 2008 winter break for students by oneweek or more, in return for extending the 2008 summer break by a correspondinglength of time. This is in order to allow Chinese students time to study andenjoy the Olympic Games that will be in Beijing this summer.

Furthermore, we expect to see continuing margin pressurefrom wage inflation as we continue to rapidly grow our business. We also expectstock-based compensation expenses to increase significantly beginning nextquarter as we grant options and restricted shares to retain our talentedteachers, school heads, and management.

New Oriental typically grants options and restricted sharestwice a year, in February and in August, and this year’s grants are expected tobe significantly larger than 2007 because the large batch of incentive shareswere granted in early 2006 before our IPO, and those shares are subject tothree-year vesting which will conclude in the next year or so. The grants in2008 will in part replace the 2006 grants to retain our top management andteachers.

Notwithstanding these numerous challenges and factors, wecontinue to see surging demand for educational programs and services in thecurrent quarter, and we expect to continue to execute on our strategy andcontinue to deliver strong growth in top and bottom line financial results forour shareholders, particularly on a non-GAAP basis.

As of Q2 2008, our deferred revenue balance is RMB278.8million, representing a 52.6% increase compared to the same fiscal quarter lastyear. Deferred revenue balance, which appears on the current liabilitiesportion of our balance sheet, represents the course fees and school feescollected from students who will take the classes in subsequent quarters,essentially a measure of backlog and a good indicator of current demand.

Before moving on to your questions, I also want to mentionthat as far as we know, we have not as yet been negatively impacted by theeconomic slow down and related events in the United States given that virtuallyall of our revenues are derived from the China market. Moreover, we continue tobenefit from the strengthening RMB, given that virtually all of our revenue arein RMB and are translated into U.S. dollars for financial market reportingconvenience. In addition, the strengthening RMB helps our students who wish tostudy abroad as it makes it less expensive for them.

Once again, thank you for participating in our earnings callfor the second fiscal quarter of 2008. At this point, I am happy to take yourquestions.

Question-and-AnswerSession

Operator

(Operator Instructions) And your first question comes fromthe line of Mark Marostica from Piper Jaffray. Please proceed.

Mark M. Marostica -Piper Jaffray

Thank you and good evening, Louis and Sisi. I wanted to askyou a question about the big jump in revenue per enrolment this quarter. Ithink it was up a little over 20% year over year. What drove that jump? Andperhaps if you could delineate between test prep and English languageinstruction it would be helpful.

Louis T. Hsieh

I think overall, ASP increases were north of 15% this lastquarter and in overseas test prep, it was higher than 15%, so it was thehighest driver. And also, as you know, Mark, we have continually been moving tosmaller size classes, which means the ASP will naturally be higher becausethere’s fewer students in the class and they are priced that way. So those twofactors together made ASP increases north of 15% for the current quarter.

Mark M. Marostica -Piper Jaffray

As a follow-up, would you expect that rate of ASP increaseto affect the other quarters of the fiscal year?

Louis T. Hsieh

We have always sort of guided around 10%, 10% to 13% ASPgrowth, so we will continue to say probably conservatively 10% to 13%, althoughit seems that we have exceeded those numbers the last few quarters.

Mark M. Marostica -Piper Jaffray

Great. I’ll turn it over and hop back in the queue.

Operator

Your next question comes from the line of Adele Mao fromSIG. Please proceed.

Adele L. Mao -Susquehanna Financial Group

Louis, could you discuss a little more in detail related toyour marketing expense ramp-up, given intensified competition out there? Whatare the new marketing initiatives that you have put in place and would youexpect further ramp-up in marketing expenses in the quarter as they comeparticularly before Olympic Games and when the high season, the summer vacationseason for students comes around?

Louis T. Hsieh

That’s a good question, Adele. Thank you. For New Oriental,the marketing expenses are several -- the increase is about 50% year over yearand that’s really a result of adding personnel and also advertising in morecities. Because at this time last year, we were in about seven or eight fewercities, as I recall, so we have to advertise in more cities.

The second thing is the advertising actually costs more thisyear because of all the companies in China that are competing for theadvertising space and you’ve seen a lot of companies IPO-ing in the advertisingspace in China, from China. Actually, the ad rates have gone up so that hasnaturally increased our marketing spend. And then the factor that we’vementioned in the past has been that private equity has injected a lot of moneyin education companies and several of them have listed in the United States aswell. And they are also spending aggressively using those funds to market.

So we need to meet those challenges by spending a lot ofmarketing ourselves, and so you saw it increase. You wouldn’t just -- justadvertising spend is also in headcount increases in the marketing team.

In addition, we are -- this quarter we don’t expect as big aramp-up in marketing spend versus last year. Last year we spent about 30, 38million in Q3. We will spend more than that but it won’t be the same 50%increase.

Q4 traditionally for us is a very heavy marketing spend andwe’d expect it to be another ramp-up in marketing because Q4, as you’ll recall,is the March/April/May quarter, and that sets up our summer quarter,June/July/August, which is our key, our most important quarter. So we willprobably curb a little bit of the advertising spending in Q3 and ramp it up inQ4.

Now remember, part of the 50% increase in Q2 was because wewere trying to drive the strong student growth for Q3, which is what we are innow. So all that spending for Q2 is really meant to set up Q3, which is oursecond-strongest quarter. And you saw some of the benefits of that in ourbacklog in the deferred revenue side where it was up to RMB278.8 million, up52% year over year. Remember last year was record year for us, so it is paying off in student enrolments.

Adele L. Mao -Susquehanna Financial Group

Great. That’s very helpful. Thank you.

Operator

Your next question comes from the line of Paul Keung fromOppenheimer.

Scott Schneiber -Oppenheimer

It’s Scott Schneiber from Oppenheimer. Just following up onlooking ahead to the spend lines, you’ve mentioned that there’s been wageinflation so the cost of new hires, and you had a lot of new hires in the firsthalf, I think 900, was putting some pressure on and then obviously you justmentioned that advertising spend is creeping up. And thanks for the second halfdiscussion, but are we going to see you creeping to new levels longer term, ordo you think that you can drive the scale and compensate for these inflations?

Louis T. Hsieh

I think we’ve been quite successful in raising prices higherthan our costs are going up, so we would expect to do that in the near-term. Wedon’t know, of course, about the long-term but in near-term, we would expect,given that we do have some pricing power to increase ASPs at a higher rate thanwage -- wage inflation is between 6% and 10% a year and as you know, we’ve beenable to increase prices between 10% and 15% year over year. So we’d expect tocontinue to do that in the short term.

Scott Schneiber -Oppenheimer

Thanks.

Operator

Your next question comes from the line of Trace Urdan fromSignal Hill.

Trace Urdan - SignalHill Group

Louis, I’m wondering if you could speak a little bit aboutthe announcement you made regarding the introduction of Chinese languagecourses and I presume now you have all of the pieces necessary for the Chineseentrance exam test prep and I wondered if you could maybe talk about your plansin that market a little bit.

Louis T. Hsieh

That’s a great question. The Chinese language program thatwe have now is on our [inaudible] side and it’s mostly directed actually atforeigners who want to learn Chinese or -- it’s not as much the Chinese grammaryet, so we expect to roll out Chinese grammar classes targeted at the nationalentrance exam over the next year.

In that market, Trace, we would hope to be more aggressivein entering that market in the next year. I would prefer to do it throughacquisitions but we will also go it alone if we can’t find suitable acquisitiontargets who are willing to be acquired by New Oriental.

We believe that’s a very lucrative market going forward. Wealready trained 200,000 plus high school students in the English portion ofthat and we just began to offer mathematics, as you know, the last couple ofquarters, and we’re beginning to see good traction there.

We will offer Chinese language next year but we are stillmissing some of the other subjects, such as Chinese politics and history, someof the specialized subjects like in chemistry or physics or other subjects, sothe ideal way for us would be to acquire our way into that business.

Trace Urdan - SignalHill Group

Are there any well-scaled businesses in that market rightnow?

Louis T. Hsieh

No, they are mostly local businesses. Because of the waythat the Chinese national entrance exam is set up, each province has a slightvariation on that exam, so there is strong local players. It is just like mostof the education markets in China, they are highly fragmented and very local.So our ideal would be to acquire a leading player in several of the largemarkets and then [certainly consolidate] that and build a brand around that togrow that business.

Trace Urdan - SignalHill Group

Thank you.

Operator

Your next question comes from the line of James Mitchellfrom Goldman Sachs. Please proceed.

James Mitchell -Goldman Sachs

Could you just talk a little bit about the February stockgrant and perhaps a very rough quantification in terms of the P&L impact,and also in terms of the share count?

Louis T. Hsieh

As you know, James, I’m not good with [inaudible], so Idon’t know the P&L impact yet. But I think what this stems from is that inJanuary and February of 2006, before our IPO, we had 8 million shares, so about2 million ADS, shares -- sort of a massive grant to the employees, to about 350people within New Oriental -- you know, the top management on down to theteachers and school heads. And then what happened was that they are three-yeargrants, so they expired at the end of this year. So what we need to do is inorder to keep the people, we need to have another -- not quite as large a grantas in 2006 but a large enough grant.

And as you know, because of the performance of our stockprice and the volatility, the stock-based comp charge is much higher now thanwhen we were a private company. So we would expect the stock-based comp overthe next quarter -- it will hit us in Q3. we’ll be probably double, if a littlebit not higher than what it is today and today it is about $2 million aquarter. So we expect that to double and then the effect will be felt for acouple of years, because we are layering two years of stock grants together.And then they will begin to subside a little bit in about 18 months from now.

I don’t know the exact quantification, James, but it willprobably be well over -- it will probably double what the stock-based compcharge is today.

James Mitchell -Goldman Sachs

That’s exactly what I needed. No need to break out the --

Louis T. Hsieh

But we are also moving to a combination of restricted sharesand options, which will actually -- short-term, it will hit the P&L harderbecause restricted shares take the full value of the shares. But they also --they have a minimum impact on dilution, and so the board has decided to go witha combination of restricted shares and options.

James Mitchell -Goldman Sachs

Great. Thank you.

Operator

Your next question comes from the line of Brandon Dobellfrom William Blair. Please proceed.

Brandon Dobell -William Blair

Thanks. Louis, maybe going back to the ASP question, youmentioned overseas test prep up a little bit more than 15% in ASPs. If youcould maybe disaggregate the benefits you guys saw from reducing the classsizes, how much of the year-over-year ASP increase in total was driven by that?

And the same kind of question -- on the gross margin thesedays, or on the rest of the operating expenses, how do I think about what theclass size reductions are doing to other gross margins or operating expensesand how far along are you in that process of getting those class sizes downinto more manageable levels?

Louis T. Hsieh

Good question. Thanks, Brandon. To be perfectly honest, theprice impact of year-over-year classes is about 10% on average. So it’s exactlythe same class, so the fact that we -- our ASPs went up over 15% this quarteryear over year, much of it is driven by the overseas test prep side, which wasup well north of 15%, very close to 20%. And then the remaining impact is dueto the smaller class sizes.

We are going to begin to get data on the actual number of progress-- we’re collecting it now, Brandon -- on the number of classes that are ofcertain sizes. So I don’t have the exact reduction but I know that overall,it’s about 8% or 9% per year of classes are going to the smaller size format ofbasically 20 or 30 students versus 50 to 70 students.

Brandon Dobell -William Blair

Thank you.

Louis T. Hsieh

Okay. And on the gross margin impact, we would expect it tobe slightly -- probably slightly negative to the gross margin but notmaterially.

Operator

Your next question comes from the line of Alex Xu from Brean Murray. Please proceed.

Alex Xu - BreanMurray Carret

Thank you. Good evening, Louis. I have a quick question onyour learning center -- it looks like so far in this fiscal year, you arealready at 34 learning centers, already exceeding the total number of lastyear. Do you have some sort of updated target in terms of how many learningcenters you want to get by the end of this fiscal year, and as well as theschools? And also, in terms of those learning centers, what kind of learningcenters are they? I mean, in the old -- a year ago, probably your learningcenters were more focused on the test preparation. But are these new learningcenters different in terms of their configuration, or maybe they are morefocused on the other side of business, like high school kids English orsomething like that?

Louis T. Hsieh

That’s a great question. We have added 34 schools andlearning centers this year. I think 31 learning centers in three schools versus19 -- in the first half versus 19 for all of last year, so you are right, weaccelerated that.

Our target, at the beginning of this year we challenged theschool heads to open between 40 and 50 learning centers and of course, weguided conservatively as we didn’t think they’d be able to do it. So we guided20 to 25 learning centers for the year.

Now that we’ve already opened 31 in the first two quarters,and I think we’ll continue to open aggressively, we will probably raise thattarget to the original 40 to 50 for the fiscal years over the next -- soanother 15 or 16 schools and learning centers over the next two quarters.

And the school count remains the same. We would expect toopen four to six new schools. We’ve opened three already in the first half, soone to three more in the second half of the year.

Now, on the composition of learning centers, it’s a mix.Some of the learning centers, four of the learning centers in this quarter wentinto Shanghai, so it now has 25. And those are typically large learning centerswith a multiple purpose.

But the fastest growing number of learning centers goingforward will be kids, and probably next year beginning will be elite learningcenters, which are smaller. So you are absolutely right that the configurationis smaller and they are meant to be located closer to areas where our studentswould be, particularly in the kids and high school area. And these willtypically be learning centers that are about two to three stories and will haveroom for about 20 class rooms, with a couple of large class rooms and the otherones smaller to accommodate 20 or 30 students.

Alex Xu - BreanMurray Carret

Just a follow-up then; if this new configuration of thelearning centers, do these new ones cost more or less compared to your oldones?

Louis T. Hsieh

They cost less because they are smaller but they are alsobeing offset because as you know, the price of rent -- I mean, the rent cost,lease costs in China are going up, especially in places like Shanghai andBeijing and others. So even though they should cost less because of rentinflation, they do cost a little bit less but not as much as we’d like. Theyare still going to cost $80,000 to $120,000 to set up.

Alex Xu - BreanMurray Carret

Okay. Thank you.

Operator

Your next question comes from the line of Catherine Leungfrom Citigroup. Please proceed.

Catherine Leung -Citigroup

Good evening. Thank you for taking my question. Could youmaybe discuss the impact of the Olympics and what you are doing -- I know youmentioned earlier your marketing spend in relation to the ramp up to theOlympics, but in terms of structuring your classes, maybe we could see somekind of shift of students taking the classes earlier rather than during theOlympics month? And if so, would you see -- have more student volumeconcentrated in those two months of the first quarter of fiscal year ’09 andhence would you need to increase your staff headcount or your teacherheadcounts to accommodate that type of capacity increase or volume increase?

Louis T. Hsieh

That’s a good question and we are addressing it. The way itturns out is that the Beijing Government helped us a little bit with this bylengthening the summer recess, so the kids in Beijing will actually get outearlier by a week or so in June than they normally do. And so we areaccommodating that by doing exactly what you said, Catherine, and offering moreclasses earlier in the quarter so that we will have more classes in June andJuly than normal, and we’ll have fewer classes in August for the reason thatthe Olympics are in August. So that’s exactly what we plan to do.

The other thing that we got some good news from the BeijingGovernment is that it appears that the traffic patterns, you know, the streetswon’t be shut down and our classes will be allowed to continue to operate inBeijing during that time. We are planning also to move our summer camp and ourclassrooms to areas that are not the high traffic patterns of the OlympicGames, so we’ll move it to learning centers outside, on the outskirts of Beijingor in areas away from the Olympic Stadium area.

Thirdly, we are going to shift some of our summer camps toother cities like Shanghai and others to stay out of the way, especially inAugust, of the Olympic tourists and the traffic. So we are doing -- we aretaking a number of measures to address the Beijing Olympics and we are -- atthis point, we are not -- we don’t see a material negative impact for theOlympics but it is still a little bit early to tell.

Catherine Leung -Citigroup

Okay. Thank you.

Operator

You have a follow-up question from Adele Mao from SIG.Please proceed.

Adele L. Mao -Susquehanna Financial Group

Louis, could you update us what your thoughts are withrespect to acquisitions, particularly whether you continue to view theacquisition of a degree program a priority? And what type of multiples can weexpect right now out there in the market?

Louis T. Hsieh

M&A is an area that we’ve been telling investors andWall Street that we’d like to pursue. And we haven’t, to be perfectly honest,we haven’t been as successful with it as we would hope, and there’s a number offactors we’ve talked about in the past calls, private equity funding, prices,et cetera.

And also, to be perfectly fair, there is a -- in NewOriental we do seem to be able to have a mentality to try to do it ourselves.So we are still aggressively looking at M&A targets and I think the focushas moved to more in the Gao Kao area or the national entrance exam that webelieve is a market we’d like to address.

And also, it continues to be in the four-year college areawhere we would still like to buy one college in Beijing or Shanghai, so thoseare our two immediate focuses and we are still looking at acquiring sort of ourcompetitors in many of the large cities as well.

But you know, it sounds like we’ve been saying this forseveral quarters now. We have not yet closed a significant M&A transaction.

Adele L. Mao -Susquehanna Financial Group

I see. Could you just share with us -- you know, you arelooking at one college or university in Shanghai or Beijing. Will this begeneral college, university programs or something more related to specializedvocational training -- something with a --

Louis T. Hsieh

It’s not a vocational -- it’s the -- the couple that we arelooking at are four-year colleges but they are smaller ones, so they haven’t --they have capacity to grow probably 20%, 25% in student enrolment each of thenext three to five years and they are growing and they are profitable. So those-- the ideal one for us is to buy a four-year degree college that is focusedmore on business degrees and others but is a full four-year program that isaccredited by the government. But one that isn’t at full capacity yet, sotherefore we have the flexibility to grow the business and so it is notdilutive to our shareholders. So ideally, that’s what we are looking at and wehave a couple of targets.

But the valuations -- it always comes down to valuation andwe haven’t agreed because remember, when we buy a college, it’s much moreexpensive than buying a school because we need to buy the land and thebuildings, and so the price tag becomes quite high day one. And those land andthose buildings don’t really generate any revenue, right? It’s the -- so justlike in our learning center model, we always prefer to lease than to buy. So ifwe buy a school, we actually have to buy the buildings and the land, so it’sgoing to be -- it makes it much less attractive.

Adele L. Mao -Susquehanna Financial Group

Thank you.

Operator

(Operator Instructions) Your next question comes from theline of Anindya Chatterjee from Jefferies & Co.

Anindya Chatterjee -Jefferies & Co.

Good evening. The question is the number of new hires thatyou’ve done for your teaching staff, how many of those are for non-Englishtraining courses?

Louis T. Hsieh

I don’t have the breakdown, to be perfectly honest. I knowthat we added a net of 100 or so teachers this quarter and 350 or so inpersonnel total for the quarter. Many of those people were actually on theteacher side. Our sales and marketing is growing significantly and so isG&A as well, to staff the learning centers and the schools. And we are alsohaving growing teachers in other languages as well.

But the net is I think of the 300 and something we added thelast quarter, 124 or so were teachers, net teachers.

Anindya Chatterjee -Jefferies & Co.

Okay, thanks. Another -- actually, a different question,follow-up question is on the Beijing Olympics, what is the best case and worstcase scenario in terms of your costs and enrolment in terms of impact of theOlympics? Do you think that advertisement costs would actually come down afterthe Olympics are over? Or which specials would start [inaudible] after theOlympics? And on the other hand, do you think actually enrolment, despite theresetting of the summer base, the school base, do you think enrolments willactually suffer because of the Olympics?

Louis T. Hsieh

We don’t know, to be perfectly honest, right now. I thinkthe -- well, we are hopeful that it won’t because if you think about it, thestudents need to take the classes, so we don’t think -- we believe that theBeijing Olympics will obviously not be a positive for our business but we don’tthink at this point -- and the information we get from the government is quitepositive that it won’t be as big a disruption to our business and thegovernment is actually helping us by moving the summer holiday this yearearlier by one week.

So the Olympics is only two weeks, so it is two weeks inAugust and we are getting one week back in June, so there is a net differenceof one week, if you think of it that way.

As far as advertising and other disruptions, I don’t knowwhat advertising dollars will do after the Olympics. Obviously our colleaguesat Focus Media and others will tell you that they are not going down after theOlympics, but I don’t know. I’m not -- I don’t set the price.

I do think that our cost structure is not necessarily drivenby the Beijing Olympics. It’s really the wage pressures are coming from theinflation in China. If you remember, the last reported TPI increase in Chinawas 6.9%, which I think is like a 10-year high. So we are suffering from theexact same inflation pressures that everyone else in China is, from materialsto personnel to food, et cetera. But we’ve been very lucky in being able tocope with it by having some pricing power to increase our ASPs at a rate higherthan our cost of salaries.

Anindya Chatterjee -Jefferies & Co.

Thank you.

Operator

Your next question comes from the line of Brandon Dobellfrom William Blair. Please proceed.

Brandon Dobell -William Blair

A quick follow-up for you, Louis; you mentioned deferredrevenue up about -- I think about 53%. I just want to make sure I understandthat in the context of the revenue guidance. I know there was some timingissues this quarter that skewed that a little bit but how do I think about thatdeferred revenue guidance and how that revenue on the balance sheet will flowthrough the income statement the next couple of quarters?

Louis T. Hsieh

I think most of it will show up in Q3, so we are reallyencouraged because of the amount of money we spend -- as you know, Brandon, weincreased sales and marketing spending by 50% in Q2, the quarter we justreported. And you see the benefits again in Q3 where deferred revenue was upfrom 169 million a year ago or so -- sorry, 170 to -- almost a 53% increaseyear over year, so we are very encouraged by that number because most of thatrevenue will be recognized in the current quarter, which is our Q3.

And even last year we were saying that given that last yearthe Chinese New Year had an extra week-and-a-half or two weeks, it was in thethird week in February, we were expecting a very challenging quarter this yearfor Q3, because last year was such a good quarter. And then the government alsodecided to shorten the -- in Beijing and other cities, shorten the winterquarter by about a week and add it to the summer.

So all those things working against us, you know, we werevery pleased with the deferred revenue number that shows even higher growththan we’ve ever seen in this particular quarter.

So we are quite encouraged and we guided at 22% to 28%,which is about 3% lower than we normally would guide but that’s only becauselast year was so strong.

Brandon Dobell -William Blair

Thank you.

Operator

Your next question comes from the line of Marisa Ho from CreditSuisse. Please proceed.

Marisa Ho - CreditSuisse

Can I get a quick word on the composition of the otherincome item on your P&L, please? Is there any particular reason that causedthe item to increase quite a bit on a year-on-year basis?

Louis T. Hsieh

It’s interest income from the $247 million we have.

Marisa Ho - CreditSuisse

All right, excellent. And apart from that, there’s no otheritem like government subsidies or any unusual items?

Louis T. Hsieh

No, no, nothing unusual.

Marisa Ho - CreditSuisse

Great. Thank you.

Louis T. Hsieh

We just have a lot of cash, which I think will lead to thesame question -- we want to buy companies and if we can’t, we need to return itat some point to the shareholders in the form of a share buy-back or some otherform.

Marisa Ho - CreditSuisse

Thanks.

Operator

At this time, I am showing you have no further questions. Iwould like to now turn the call back over to Louis.

Louis T. Hsieh

Thank you very much. I just want to thank everyone again forjoining us today on the call. If you have any further questions, please do nothesitate to contact myself or any of our investor relations representativeslisted on the press release. Thank you.

Operator

Thank you for your participation in today’s conference. Thisconcludes the presentation and you may now disconnect.

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