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New Oriental Education & Technology Group Inc. (EDU)

Q4 2012 Earnings Call

July 17, 2012 8:00 AM ET

Executives

Sisi Zhao - Senior Investor Relations Manager

Louis Hsieh - President &CFO

Analysts

Philip Wan - Morgan Stanley

Chenyi Lu - Cowen & Company

Jeffrey Meuler - Robert W. Baird & Co

Steve Zhang - Macquarie Funds Group

Mark Marostica - Piper Jaffray

Ella Ji - Oppenheimer & Co., Inc

Trace Urdan - Wells Fargo Securities

Eric Wen - Mirae Asset Securities

Anita Chen - Jefferies & Co

Brandon Dobell - William Blair & Company

Chao Wang - Merrill Lynch

Fei Fang - Goldman Sachs

Kevin Tan - Joho Capital

Jin Yoon - Nomura Securities

Operator

Good evening and thank you for standing by for New Oriental’s Fourth Quarter and Fiscal Year 2012 Earnings Conference Call. At this time, all participants are in listen-only mode. After management’s prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. If you have any objections, you may disconnect at this time.

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

Sisi Zhao

Hello everyone, and welcome to New Oriental’s fourth quarter and fiscal year 2012 earnings conference call. Our financial results for the period were released earlier today and are available on the Company’s website as well as on Newswire services.

Today, you will hear from Louis Hsieh, New Oriental’s President and Chief Financial Officer. After his prepared remarks, Louis 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 statements, except as required under applicable laws.

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 will 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. This is been another successful year for New Oriental and I’m pleased to report that we’re moving into a new fiscal year in a stronger position than ever before.

Over the last 12 months we’ve extended our undisputed leadership position in China’s private education sector and put even more distance between New Oriental and our competitors in terms of brand recognition, market share, service quality and reputation and we’ve achieved this far successfullysorry, it was a tooling up our business to take advantage of major growth opportunities in new geographies and fast growing segments.

Our results for the first fiscal year speak to its success; student enrollments hit 2.4 million, up 15% year-over-year. Revenue grew 38.3% year-over-year to $771.7 million and in spite of heavy investment and expansion with net of 177 new facilities, bringing our total to 664. We delivered a very impressive increase in GAAP net income of 30.4% to $132.7 million and non-GAAP net income increased 32.5% to $156.8 million.

I would like to spend a couple of minutes talking about the key drivers of this growth and highlight some of the exciting trends that we’re building on. First and foremost, I want to address the tremendous growth opportunity beyond China’s Tier-1 cities. This has been a major factor in our success in fiscal year 2012 and I’m confident this will be a vital engine of our growth in fiscal year 2013 and beyond.

As we’ve stated previously that in addition to enhancing our market leading brand name and maintaining the highest standards in teaching and content quality. One of our other primary goals is to establish New Oriental as the number one or number two language and test prep tutoring service providers for K-12 in every one of our lucrative and fast growing city markets.

To achieve this strategic imperative, we must invest in growing learning centers at a rapid pace to achieve critical mass and economies of scale, which will drive long-term sustained and increasing profitability.

In fiscal year 2012, second and third tier cities achieved about 43% of revenue growth, contributing around 48% of our total revenue, whereas Beijing and Shanghai collectively recorded about 29% revenue growth and accounted for about 37% of total revenue.

The cities around Beijing like [Shijiazhuang and Zhangjiakou] are good examples of an emerging paradigm within student attitude. Previously many students from these cities would take – would have traveled to Beijing during the summer and winter break to take classes at one of boarding schools in the capital. But now New Oriental has branches across these cities where we offer the same or comparable premium standard education that a student can get in Beijing. So, now more and more students choose to stay in their home town, taking New Oriental courses locally instead of traveling into Beijing during the holidays. A similar behavior and it is occurring with New Oriental Shanghai schools and in the surrounding areas.

Looking longer term, I believe we have only began to scratch the massive opportunity of these fast growing markets. Over the next fiscal year, we will continue to aggressively invest in penetrating these lower tier cities and in fiscal ’13 we intend to open over 200 new learning centers. The vast majority of them will be small centers, 300 to 700 square meters, designed for our VIP and K-12 classes, rather than large scale test prep courses.

The vast majority of these centers will be located in cities outside Beijing and Shanghai, where they obviously means a significant CapEx outlay upfront. The smaller centers typically are profitable in the first year of operation as they fill up more rapidly. We will endeavor to manage that expansion carefully in order to ensure that these centers will not have a long-term drag on margins.

Furthermore, we expect most of our small centers will be at mature levels of utilization within two years compared to the average 3 to 4 years it takes for larger center to ramp up.

To be clear, we’re still nowhere near the limits of expansion in the Tier-1 cities. We are confident that we will continue to expand – to experience robust growth here, its just not blockbuster levels and are seeing it in some other smaller cities. Well, growth in our traditional business lines like Adult English and CET 4 and 6 test prep are slowing in Beijing and Shanghai. We continue to see great potential to grow some of the other business lines such as K-12 overseas test prep and VIP in Beijing and Shanghai.

Looking more broadly at the performance across our business lines, the key takeaways from fiscal year 2012 and are – these are continued success in developing winning product offerings to changing learning habits and quickly dominating in these new markets.

In a strong year – it’s been a strong year across the board, our VIP personalized classes have been our star performer. In fiscal year 2012 VIP’s classes, our year-over-year enrollment growth of 61% and year-over-year revenue growth of over 71% to about $207 million. This illustrates the enormous demand for more personalized classes both in the Tier-1 and lower tier markets.

And crucially, only New Oriental has the branding power and track record to command a premium fees that these courses command. So I’m very confident in the long-term prospects for this segment.

Our K-12 all subjects tutoring school business also had a great year. We recorded year-over-year enrollment growth of 25% to over 1.3 million students and year-over-year revenue growth of over 52% to $294 million. Again, despite the strong performance last year, we see continued growth potential in this segment.

It is clear to us that market demand is shifting towards VIP and K-12 segments. So we’re very encouraged that we have had such a strong market presence here in a relatively short period of time.

K-12 and VIP accounted for 37% and 27% of revenue in fiscal year 2012 respectively, versus 33% and 21% respectively in fiscal year 2011. Please note that these figures reflects some over lap as many of our K-12 students are also taking courses in the VIP format of one teacher to one student – up to one teacher to six students.

There are of course lower margin offerings, but these are also the segments with the best long-term growth opportunities, particularly in the low tier cities. Having said that, we continue to deliver robust growth in the overseas test preparation business, a segment where New Oriental remains the clear and undisputed market leader. Enrollments in fiscal ’12 increased 7.3% year-over-year to over 340,000, while revenues jumped 43% to $238 million.

Outside the classroom we’re also rapidly expanding our Vision Study Consulting business to help students study overseas, continue in China as a – probably be more affordable for more families than we’ve already positioned. Sorry, let me start that again. Outside of the classroom we’re also rapidly growing our Vision Overseas Study Consulting business.

Interest in studying overseas continues to increase in China as the possibility becomes more affordable for more families and we’re ideally positioned to capitalize on the existing dominance in Chinese test prep – overseas test prep, naturally these students who seek our advice and counseling. Vision Consulting record a year-over-year revenue growth of approximately 85% to about $42.5 million in this fiscal year.

Before we get into the G&A, a quick review of some financial highlights of the quarter and the year. The detailed numbers and figures are available in the press release. Looking enrollments as I’ve mentioned, for the full fiscal year grew at a very encouraging 15% as our new learning centers ramped up to matured level of utilization.

I wanted to highlight that the relatively low enrollment growth of 7.7% in the fourth fiscal quarter was expected as I flagged last quarter the Chinese New Year had a early holiday, students enrolled for their spring courses at the end of the third fiscal quarter, which naturally means that the enrollments in a little lower in the following quarter. As you’ll recall, student enrollments grew by 21.8% in Q3 last year, primarily due to a spike in spring registrations in February following the early Chinese New Year.

Operating margin for fiscal 2012 was 15.2% compared to 17.1% in the fiscal 2011. Non-GAAP operating margin, which excludes share-based compensation expense for the fiscal quarter was 18.3% compared to 20.1% in 2011. We are encouraged that we maintain a healthy operating margin despite an aggressive pace of investment and plan to slow down the pace of investment into next year.

For the fourth fiscal quarter, general and administrative expenses increased by 55% year-over-year to $71.8 million. Non-GAAP G&A expense, which excludes share-based compensation expenses was $64.1 million, a 49% increase year-over-year. This is primarily due to increased head count inline with our expansion during the quarter.

We opened 56 new learning centers in the quarter and also continued to meet investing content and new programs development offerings as well as in improving teacher quality.

I’m pleased with our performance this year, 2012. Over the last 12 months, we demonstrated it clear that New Oriental is proactively and creatively managing our business to achieve long-term and deliver long-term value for our student – shareholders. This is not a Company that is content to coast along on its reputation alone. This is a Company that’s working hard to sustain its market dominance for years to come.

Moving into fiscal year 2013, we’re very confident that New Oriental is ideally positioned for sustained long-term growth in the immediate term, we’re conscious that China faces some macro headwinds.

After many years of double-digit growth, there are signs that the economy is decelerating. While education is a very resilient discretionary spending category for Chinese consumers, we do expect that this slow down will have some limited impact on our business. However, we believe that the growth potential for New Oriental is enormous as we push into untapped markets outside of Tier-1 cities and our offering to suit changing learning habits in China.

Clearly there are some downward pressure on margins as we’re in a transition period in investing and lower tier cities to capture. The growth opportunity in addition to student preferences, are shifting towards lower margin offerings. However, I’m confident that this is the correct strategy to position us for sustained long-term growth.

Looking at guidance for the year ahead, we currently expect total revenues in the first quarter of fiscal year 2013 to be in the range of $342.7 million to $356.3 million, representing year-over-year growth in the range of 26% to 31%, respectively.

The forecast takes into account slower growth in Beijing and Shanghai. The macroeconomic slow down I just mentioned, and the expected like of RMB currency translation benefit seems to have halted and in some cases reversed in periods vis-à-vis the U.S. dollar. The forecast reflects New Oriental’s current view, preliminary view, which is subject to change, the SEC investigation.

On July 13, 2012 the Company was informed the U.S. Securities and Exchange Commission that issued a formal order of investigation caption in the matter of New Oriental Education and Technology Group, Inc. The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education and Technology Group Company Limited, a variable interest entity of the Company and its wholly owned subsidiary into the Company’s consolidated financial statements. The Company intends to fully cooperate with SEC in its investigation.

The Company’s outside independent auditors, the Deloitte Touche and Tohmatsu have not has yet completed the audit for the year ending May 31, 2012. However, Deloitte continues to believe that the Company’s historical financial statements are appropriate.

Please note, that in light of the sensitivity – sensitive nature of the SEC investigation, I will not take any questions or comment further on the situation in the Q&A session, other than to reiterate that we intend to fully cooperate with the SEC in this investigation.

At this point, I will take your questions. Operator, please begin.

Question-and-Answer Session

Thank you. (Operator Instructions) The first question comes from the line of Philip Wan from Morgan Stanley. Please ask your question.

Philip Wan - Morgan Stanley

Hi, Louis. Thanks for taking my question. My first question is about your first quarter guidance, which appears soft. Could you please elaborate a little bit more on which business lines are slowing down and why? And also could you share with us your full-year expectation in terms of enrollment and ASP growth for the year? Thank you.

Louis Hsieh

Okay. For the first quarter, there are several seasons why the guidance is a little bit lower than normal. One is that – one reason is that Beijing and Shanghai have begun to slow down as we mention in there. In fact in RMB terms Beijing and Shanghai only grew 24% and 20% last year, respectively. Well, if I don’t give you a U.S. dollar translation benefit, the growth rate has really slow down from 29% down to 20% or so. So, that will take the slow down.

The reason for that is a lot of the old – the cities around Beijing and Shanghai are cannibalizing them because the quality of New Oriental education in those cities is quite good and so students are finding it no longer necessary to travel to Beijing and Shanghai to take those classes. So that’s one factor.

Second factor is relating to the fact that – our investment today is in cities outside Beijing and Shanghai as the growth rate is much higher. So we expect those to continue to grow rapidly. Third factor is last year we had a very strong Q1. Remember revenues were up 41%, profits were up 45%. And so that makes it very challenging on year-over-year comps, so we just try to be a little bit more conservative. And so those are primary the reasons, foreign currency translation, some slow down at Beijing and Shanghai as you know Beijing and Shanghai both have new school heads. So there is going to be a transition period and then the issues with managing – with the cannibalization.

And the fourth factor obviously is the slowing Chinese economy. I think that even though we seem very resilient, we’re still growing 30%-70% a year. Its still not – which is not immune from a slowing Chinese economy, especially consumer discretionary spending.

As far as guidance for the year, I think our revenue guidance was somewhere be probably similar to our first quarter guidance, 25% to 30% -- 26% to 31% and I think the profit guidance is the one that’s difficult because we’re expanding so rapidly and as we enter into lower margin businesses we haven’t got the efficiencies down yet. We need another one or two quarters to fix the efficiencies and get the margins turning the right way.

So I think as we got 25% or 30% probably on the top line and somewhere between 22% and 25% on the bottom line. And as I said – that’s our preliminary view. As far as enrollment increases, we increased the $2.4 million or 15% last year. I would expect that number to come down a little bit, given the larger base and a slow down in the general economy. So I would expect us to grow enrollment somewhere in the – probably 10% to 15% range. So that will take us about 2.7 million enrollments.

Philip Wan - Morgan Stanley

Okay. You mentioned a slow down in Beijing and Shanghai, is that mainly for the overseas test preparation?

Louis Hsieh

Well, its partly overseas test prep. It’s really is more the summer camps under the boarding schools. So in the past we used to have 1000s of students who would paid us like RMB 5,000, RMB 6,000, RMB 8,000 to come into Beijing for 10 days and study the CET-4, CET-6, SAT, a whole bunch of tests. But as we’ve been successful in growing, like I said – you will get Shanghai. Our Shanghai school is very good, but our Hangzhou school and Suzhou school are just as good. So, students who used to come from Hangzhou and Suzhou to go to Shanghai to take test, no longer are traveling there. So the margins for this business is actually quite high, instead of RMB 5,000 per student, if they stay home in Hangzhou or Suzhou their ASP is 1000. And so its -- we’re a victim of our own success, but it’s the right thing to do, it’s you can’t ask – it just shows you our quality is getting quite good across the country, same thing as we explained in Beijing.

And so I think that that’s just a – it’s a factor. I think Beijing and Shanghai truly without sounding too bad have been mismanaged in the last couple of years and so we’re hopeful of the new management teams in place there, we’ll also begin to drive growth especially the K-12 and the overseas test prep business as well.

So I think as Beijing and Shanghai still have a long way, but they’re growing on a RMB terms in the low 20s whereas the rest of the network is growing in the high 30s low 40s. So the emphasis has to be on the Tier-2 cities. We are already so big in Beijing and Shanghai. We’re over $200 million a year in Beijing over about $100 million in Shanghai. The base is getting so large, it’s just getting – we’re [carrying] ourselves out.

Philip Wan - Morgan Stanley

Okay. And then quickly on the VIP business; you provide cash revenues for the year and I just wonder how does that compare to revenues that you actually recognize during the year?

Louis Hsieh

Well the cash revenue is when they signup for the course. So a lot of the cash revenue gets put into deferred revenue as it gets paid out over the course of the year. Some of that cash revenue never gets recognized because of students who cancel, just before the class starts. So it’s a good proxy for demand, but it’s not a one-to-one.

Philip Wan - Morgan Stanley

Do you have roughly the level of cancellation as a percentage of totals?

Louis Hsieh

It’s very low. It’s like 1% or 2%.

Philip Wan - Morgan Stanley

Okay. And lastly; could you also provide the recognized revenue for the year, so I can get a comparison against your cash revenue?

Louis Hsieh

The recognized revenue for the year is $771 million. I don’t know what the total gross revenue was. Total gross revenue will be up 4% higher, it’ll be also – don’t forget we pay business tax.

Philip Wan - Morgan Stanley

No, I mean for your VIP business?

Louis Hsieh

Oh – I don’t have that breakdown sorry. Sisi can try to get that for you.

Philip Wan - Morgan Stanley

Sure. Thanks.

Operator

Thank you for your questions. Your next question comes from the line of Chenyi Lu from Cowen & Company. Please ask your question now.

Chenyi Lu - Cowen & Company

Hey, thank you. I have two questions regarding your school expansion in 2013; you’re talking about its going to be over 200 new learning centers. Can you give us a breakdown as to the schedule of the school expansion? Are you going to be more focused on second half of fiscal year 2013? That will be my first question. And then after that I’ve got another question.

Louis Hsieh

Yeah. I mean, ideally if I could do it, I would want expansion in Q2 and Q4. The reason is that, Q2 is kind of a slow quarter, if you add the learning centers then you can wrap them up by the way in Q3 during the winter. And also in Q4, although it’s a busy quarter, Q1 is busier, so if you can wrap up the expansion in Q4 and then do it in Q1, but it doesn’t work that way. So we end up expanding relatively the same all year around. I think the total capacity add for this year will be much slower than last year, even though the numbers look higher that’s how we’ve quoted them in square meters.

Last year we added net 177 learning centers; each one was about 1,050 square meters on average. That’s means we added 200,000 square meters of space taking our total space to 900,000 square meters. Well this year, even if we added 200 or something learning centers, were of higher number. We’re unlikely to add more than 150,000, 160,000 square meters. So the net add is actually much lower, which means that I think is that, it won't be as negative to margins as last year.

And so that’s how we kind of manage these, so that they become profitable quickly and then that way the margin picture will turn relatively quickly. So we just need another quarter or two.

Chenyi Lu - Cowen & Company

Well my next question also relates to the operating margin, just to be able to – what you just answered. So, can you give us a view to operating margin in 2013 would that be the year also you’re going to bottom and then you’re going to [technical difficulty] with fiscal year 2014?. Thank you.

Louis Hsieh

I think the difficulty is; we will bottom sometime in 2013. Unfortunately it probably won't be Q1. So if it’s not Q1 which is the current quarter rent, well Q1 is 60% of the profit, it will be hard – it will make a dent in the rest of it. So we believe we will bottom sometime in Q2, but so – if you go to quote year-over-year comparisons, it’s just hard to get better, but Q1 will not because we added 177 learning centers and like a 100 and something in the two quarters before hand and those haven’t filled up yet. And as we mentioned earlier, the pick-up has been a little bit slower than we thought, right. The new enrollments are not as fast as in past years because of the economic slow down in China.

Chenyi Lu - Cowen & Company

Okay. So do you expect the margin going to – on an annual basis to be flat or probably slightly down year-over-year in 2013?

Louis Hsieh

We’re going to fight like hell to get it flat or out, but we haven’t been winning this one the last year, year and half but we do our best. But like I said, we’re also fighting our own school heads because the – and legitimately so, I think we’ve taken a different picture, we're focused on profit, but in cities that are high profit margin and growing really fast, we’re not going to slow down the learning center growth. So for example, city like Hangzhou, Hangzhou has like 30% profit margins and if he wants to add learning centers he can be as welcomed to do it, because he’s got such a high profit number, you’re not counting corporate overhead. The same is Xi’an.

So there’s all cities that are really well managed that are growing like crazy, I am not going to slow them down. Some cities that are not as well managed and if do want to have learning centers; those are ones who’re going to target to try to slow down the learning center growth.

Chenyi Lu - Cowen & Company

Okay, thank you. That’s all my questions.

Operator

Thank you for your questions. The next question comes from the line of Jeff Meuler from Baird. Please ask your question.

Jeffrey Meuler - Robert W. Baird & Co

Yeah, thank you. Louis, I guess, could you just go over the impact that Chinese New Year had on Q4. I understood why it negatively impacted Q2 and while that Q3 may have been artificially high, but could you just kind of clarify on the impact on Q4?

Louis Hsieh

Yeah, what happened with Chinese New Year is that, it occurred on January 23rd. So if you look on a revenue basis, the timing was too early. And so instead of running two sessions during the winter we really only ran one session. So that had a negative impact on revenues and profit for Q3. That’s the warning we had.

Now there was another impact though on the enrollments. So what happened during Q3 is that because Chinese New Year was so early and the cut-off for our Q3 is February the 28th. The students come back early, because they left early for Chinese New Year, so they come back in the middle of February.

That means when they come back they have two weeks before our quarter ends to signup for their spring classes. And that’s why you saw a 21.7% jump in enrollments in Q3. Those enrollments were actually for Q4. And so when Q4 came along, the students that are already enrolled during the Q3 period for the Q4, therefore student enrollments in Q4 were only 7.7%. If you blend the two together you’re right at 15% again.

Jeffrey Meuler - Robert W. Baird & Co

Okay. And it sounds like if you look at the recent weeks or the last month it’s tracking up in the low double-digits?

Louis Hsieh

It is right around the low double-digits. But the problem now is that the tickets are getting high there’s a lot of VIP students, so the revenue number is actually quite high relative to the enrollment number. So as you move to smaller classes at higher priced classes the revenue number is tracking higher than the enrollment increases.

Jeffrey Meuler - Robert W. Baird & Co

Okay. And then just in terms of the recent growth kind of being slower than it was at any point during the 2008-2009 downturn excluding quarters where there was kind of unusual events. I guess could you just speak to that in terms of what's driving it, is it just this penetration rate in Beijing and Shanghai; is there anything on the competitive front, I guess, if you could just address that. Thank you.

Louis Hsieh

I think Beijing and Shanghai it is that – we're pretty mature in both cities and also we face very stiff competition in Beijing and Shanghai. The other thing is I think as people don’t feel as good, right, because the economy is not good, it’s strong. Things are really slowing. And so – yeah we just heard that the BMW sales are terrible in China this year and same with the Prada Bags and things. So, you’re seeing a across the board pull back in spending in the luxury sector and New Oriental is one of those luxury spends.

So I think we’re seeing a slight slow down although, I mean, I wouldn’t see the 31% revenue growth. So I think we're hit much less though, but we're going to get hit. At the same time as I said earlier the – we believe Beijing and Shanghai have not been managed as well. So we need – the two new school heads need time to transition, so give them six months. So that’s why Beijing and Shanghai will be under a short-term pressure.

The third issue relates to the cannibalization. As we build out the whole country, the quality of our instruction is becoming very, very good across all of China with the systems we put in, with the same content and the teacher training facility. Therefore students are finding it less and less necessary to travel to the Tier-1 cities to get the education they get in the Tier-2 cities. And so because of all these factors, now obviously they pay less in the Tier-2 cities than the Tier-1 cities, so all these factors have a dampening effect on our revenue.

However dampening – and of course the fourth one is, as you guys really highlighted is the fact that we report in U.S. dollars. So we’re no longer going to get the RMB 5% translation benefit. So if you look at it we just took down our revenue projection is 5% down, which is equivalent to the 5% we got from the translation benefits.

Jeffrey Meuler - Robert W. Baird & Co

Okay. So I guess in local currency terms, what do you view as the sustainable ASP increase given all of the mix shifts you’ve both between geographies as well as between (indiscernible)?

Louis Hsieh

Yeah, so if you look at just RMB terms I think our growth rate is 25% to 30%, so I am assuming no RMB appreciation. I think our ASP increase is about 13% to 14%, and our students about 10% to 11%. So I think that’s where you get that number.

Jeffrey Meuler - Robert W. Baird & Co

Okay. Thank you, Louis.

Louis Hsieh

Thank you.

Operator

Thank you for your questions. Your next question comes from the line of Steve Zhang from Macquarie. Please ask your question now.

Steve Zhang - Macquarie Funds Group

Hi, thanks, Louis for taking my question. In terms of the macro impact, which segment of your business are you seeing the most weakness, is it overseas test prep? I would assume that’s the – I guess, what you mentioned more and more luxurious items?

Louis Hsieh

Yeah, the overseas test prep it seems to have a little bit of lower student base, but the revenues are fantastic at 43%. So that’s telling me is that, we are getting fewer students, so we’re eluded to actually the bigger class students and the ones who are willing to pay anything or still willing to pay anything. And so the VIP of overseas test prep is not slowing down, so that’s the contrary thing, you would expect the highest paid ticket to slow down if that’s the case, people with money will still have money.

But I think you’ll see a slow down in the number of smaller class and students in the – in overseas test prep. It also could be a fact that if parents don’t feel as good, as they did in U.S. path they may not be as confident in sending their children overseas, so – or they might take lower class – lower cost alternatives the New Oriental in the test prep area, there are a lot of schools that compete with us that are priced a lot lower than we do.

Steve Zhang - Macquarie Funds Group

Okay. In terms of pricing power maybe I can get a little more granularity on this. Are you seeing less pricing power in some of the U-Can and POP Kids segments, (push) them into the macro environment?

Louis Hsieh

We have – we just really began to face this macro environment in the last three months. We are continuing to raise prices. Last year – last quarter our ASPs were up 14% on a blended basis. So, we haven’t really toned back the price measure. So we may do that if demand slacks off significantly. So we would – maybe look at that as a way to drive up more students. But as of now we’ve not really slow down our price increases.

Steve Zhang - Macquarie Funds Group

Okay. Thanks.

Louis Hsieh

Okay.

Operator

Thank you for your questions. Your next question comes from the line of Mark Marostica from Piper Jaffray. Please ask your question. Mr. Marostica, your line is open. You may [admit] yourself.

Mark Marostica - Piper Jaffray

Yes, sorry. Thanks for taking my question. Just following up on the ASP theme. I’m curious Louis, what you’re seeing in terms of ASP increases in Tier-2 cities as opposed to Beijing and Shanghai?

Louis Hsieh

Well, Tier-2 cities pricing is actually quite healthy. So its just like Beijing and Shanghai were 10 years ago. So they’re quite healthy. But what they do is because when you blend it with Beijing and Shanghai, it looks like the pricing is going down. It is what I talked about it before, but its not.

So, I think that for us the pricing is fine. The pricing in Tier-2 cities are actually quite strong. And in Beijing and Shanghai, its also quite strong, but maybe not as strong as in years past. But the blended effect is not going to look like pricing is going up that much, right, because of the – because the Tier-2s have a lower ASP than Tier-1s. Then Mark, this is something I highlighted a couple of quarters ago.

Mark Marostica - Piper Jaffray

Okay. And then on a relative basis, are you seeing more strength in VIP or K-12 in Tier-2 cities?

Louis Hsieh

It’s both. A lot of – its K-12 primarily, but then that many of their parents want them to take VIP as part – VIP is just a format, right. So a lot of the K-12 is booming in Tier-2, Tier-3 cities and then what happens is a lot of the parents want their kids to take one-on-one Physics or one-on-one Chemistry. And so they’re both doing very well, they’re basically – they work together.

Mark Marostica - Piper Jaffray

Fair enough. And then the last question, you talked about 22% to 25% profit growth, are you referring to GAAP or non-GAAP?

Louis Hsieh

GAAP.

Steve Zhang - Macquarie Funds Group

Okay, great. Thank you.

Operator

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

Ella Ji - Oppenheimer & Co., Inc

Thank you. Hi, Louis. Could you – I just want to discuss further with you regarding this macro slow down. You know it’s a little bit complicating to us that, you’re still seeing very strong growth in the VIP sector and you said you do not plan to slow down the price increases in the near-term. So what exactly, which sector or in geographically where are you seeing a slow down of demand or …

Louis Hsieh

Well you see some slow down in a number of overseas test prep …

Ella Ji - Oppenheimer & Co Inc

… or is it because of demand or because of the supply?

Louis Hsieh

Yeah, you see a continued slow down in Adult English. You see some slow down in the – in enrollment number of overseas test prep, right. And then – and K-12 is very strong, VIP is very strong. But those are our newer businesses, also they haven’t really got critical math yet. So they’re expected to be quite strong because – number one; VIP and K-12 are applicable everywhere in China, every one of our 50 cities has those. Whereas something like overseas test prep is stronger in the Tier-1 cities where there is lot of colleges. Things like Adult English are stronger in the Tier-1 cities where there is a lot of businesses. So the one that’s universal that goes across all of China is K-12 and VIP and you’ve just seen that reflecting out in the strong growth. It’s very early in the penetration of those cities.

Ella Ji - Oppenheimer & Co Inc

So, you mentioned that softness in overseas and also Adult English?

Louis Hsieh

Yes.

Ella Ji - Oppenheimer & Co Inc

Do you think it’s also because of some landscape change in competition on the market?

Louis Hsieh

Well I don’t know, we always have a competition. I don’t know if that – I don’t know of any players that challenge us in overseas test prep. I think yeah at some point the number of Chinese students can't keep growing, right. I mean, this will be going up like 30%, 40% a year and students go overseas. I don’t see that number continuing. So sometime you’re going to have to plateau out.

Ella Ji - Oppenheimer & Co Inc

Right, okay. And then in terms of your sales and marketing spending, those have been trending higher growing above the revenue growth in the past two quarters. So could you talk about your strategy in sales and marketing going forward especially now we may face slower revenue?

Louis Hsieh

For the year it’s the same, right 14.8%, 14.8% is the same year-over-year. But yeah it started off lower and worked up a bit higher. Part of that is because of the shift in Chinese New Year. Our school heads kind of panicked and started marketing more to – because they were worried in Q3. Also in Q4 it’s usually a high marketing spending quarter because we preparing for this busy summer quarter. And I think we’re spending more money in Beijing and Shanghai in marketing than in the past because the growth rates are slow there. So, I think those three reasons is why the marketing maybe a little bit higher than normal. For the whole year it is flat year-over-year, its 14.8%, 14.8%.

Ella Ji - Oppenheimer & Co Inc

Right, so what's the outlook for fiscal year ’13?

Louis Hsieh

Well, it should be lower than ’12 but – that varies depending on school and then we’ll adjust the marketing spending depending how and how the business does. And so because Beijing and Shanghai we’re not getting as many boarding students early in the quarter we spent more on marketing to get those boarding students.

Ella Ji - Oppenheimer & Co Inc

And then in terms of teachers and the staff hiring plan for next year, how does that trend year-over-year?

Louis Hsieh

The teaching, we still need to hire 5,000 teachers or so – net 5,000. So that will continue the same if we add a 100 – if we add 230 learning centers with a capacity of about 150,000 square meters, probably 1,000 more students. So we would probably add another 5,000 teachers. The key is to not add as much staff in the G&A staff. And so if we can cut the staff then our margins will go up by the way.

Ella Ji - Oppenheimer & Co Inc

Got it. And lastly I want to ask you about the corporate structure change announcement on July 11. Could you provide more details in how is that going to impact the shareholder structure for the lifting company going forward?

Louis Hsieh

It doesn’t impact it at all. What happened was, when New Oriental set up its original VIE in 2002 and then 2006 there was a lot of founders, remember New Oriental had a lot of old founders in the company, there’s like 11 of them who were the shareholders of the VIE. In the last six years since the IPO, 10 of those people have left the company. So they no longer have any shares or minimal shares of the company and they’re not involved at all in management or anything related to the company.

So last year after all the scrutiny on VIEs and on, and the frauds that were coming out of those, we took it on ourselves, saying well lets clean up our mess now, I mean lets get rid of the other 10 shareholders so we can consolidate the VIE into Michael Yu, our CEO. He had control before anyway at 53%, but making 100% because the other guys have nothing to do with the company.

There have been cases in other Chinese companies where the VIE shareholder who are disgruntled refused to sign, even though under contract they have to. So we wanted to avoid future problems by cleaning up our VIE now. But it seems like in doing that we triggered a review by the SEC which is creating the current problems for us. Because I think originally they probably thought oh, it’s another Jack Ma situation or something and its not. This is a completely above board to clean up the structure so that the old shareholders who don’t have any involvement with the company cannot influence the company. So this was – so you understand this is done with the best intentions.

Ella Ji - Oppenheimer & Co Inc

The SEC investigation is triggered by this corporate structure change?

Louis Hsieh

We don’t know – I don’t know like I said, Friday the 13th, was not a good day for me. So we don’t know all the details yet, we’re working closely with the SEC, we’re fully cooperating. We will get to the bottom of this.

Operator

Thank you for your questions. (Operator Instructions) The next question comes from the line of Trace Urdan from Wells Fargo Securities. Please ask your question now.

Trace Urdan - Wells Fargo Securities

Thanks. Louis, I wonder if you could comment on the management changes in Beijing and Shanghai and to what extent you believe that, current weakness in those markets is related to simply the management and whether that – the management transition and whether you would see that more on the top-line or whether there’s any sort of margin impact associated with that …?

Louis Hsieh

It goes with, both top and bottom line, Trace. I think lets take one city at a time. Shanghai was run by Wang Haitao, who's been with New Oriental for like 12 years. He’s an experienced manager, very, very smart guy; great teacher, but he – honestly he’s not as charismatic, not as energetic. And so the last two or three years Shanghai has not grown, its grown about 20% - 25% a year, it hasn’t kept up with Beijing even though it should, because its off a small base.

So ever since the last 2000, I think we’ve been contemplating this change, but at that time we had nobody to replace him. He’s a fantastic school head, just not a fit for Shanghai because you need somebody with more energy, more charisma. And then over the last few years there was a young guy in Xi'an named [Chen Hao] and he’s a superstar. I mean, he took Xi'an with the middle of nowhere to over 30% profit margin, not kind of cooperate overhead. So Xi'an’s profit margin is only one point below Shanghai, if Xi'an is not as lucrative a city as Shanghai.

So this guy has done 50% and 70% top and bottom line growth for four years. So he was the best young school head we had. So once he was ready, we moved him to Shanghai. And right now the department heads in Shanghai love him. So it seems to be a very good fit and he’s very aggressive, very hardworking. And so we expect good things from Shanghai in the upcoming quarters. Wang Haitao has done a great job, he’s a great administrator, he do what he knows, everybody likes him. So we moved him to Beijing and since he lacks in charisma and energy level, Michael Yu have. So Michael Yu and then Chen Xiangdong is obviously our CEO is very good at operational issues.

So the three of them together are now running Beijing school and Zhou Chenggang as well. So you’ve got our whole senior brain trust expect me running Beijing school because we’re all local in Beijing, so it’s easy. So it’s basically a shared project, I think and that’s acceptable to everybody at Beijing. And so I think this system is working. Wang Haitao, does all the administrative type thing, Michael and Chen Xiangdong, doing more of this spirit show, charismatic, strategic things. And then Yang Zhihui, who is my VP of Finance works with the Beijing finance manager to keep the cost inline. So I think this is the best system we can have to take care of our two most supporting schools.

Operator

Thank you. Your next question comes from the line of Eric Wen from Mirae Asset. Please ask your question now.

Eric Wen - Mirae Asset Securities

Hi, yes this is Eric. Yes, I just have two questions. First question is, Louis you previously mentioned that you’re into intend to grow as top-line and bottom line by both 30%, do you mean that by U.S. dollar or local currency?

Louis Hsieh

By U.S. dollar, and so I think if the RMB starts depreciating we’ll probably take it down 25%. I would have meant 30% anyway because we’re going so fast, but I think with the slow down in China, I want to give myself some room, so I think 25% -- I would say 25% to 30%, closer to 30% on the top line and probably closer 22% to 25% on the bottom line.

Operator

Thank you. The next question comes from the line of Anita Chen from Jefferies. Please ask your question now.

Anita Chen - Jefferies & Co

Thank you, Louis. I just have a following question on teachers. We’re expanding so quickly, do we've any challenge in recruiting qualified teachers and how to manage it?

Louis Hsieh

Please have that challenge and that’s why we invested heavily the last two years in this teacher training system and materials that allow 75 people to spend most of their time, almost all their time teaching – training teachers, when you train 5,000 teachers a year. So it is a challenge. That challenge and also finding good school heads is our two biggest challenges.

Operator

Thank you. The next question comes from the line of Brandon Dobell from William Blair. Please ask your question now.

Brandon Dobell - William Blair & Company

Thanks, Louis. In relation to your comments about I guess, less pricing power or all that kind of consumer discretionary slow down, do you see any change in the cost structure primarily teacher salaries or rent, do they fall in the same trend or are they still staying strong even though pricing is now weaker?

Louis Hsieh

Teacher salaries are going up, its not – it’s the same – it’s not as bad as a couple of years ago when inflation was higher. But there is an additional cost that is costing us more which is the social welfare payments. So the government is encouraging us to take up the percent we pay – the part of this – that the employees that are withheld from the salaries to pay for the social security or the retirement. And so that number has gone up a lot. So I would say probably 12% of salaries now is going to social welfare cost and that’s I think the big – it’s a negative for our bottom line.

Operator

Thank you. Your next question comes from the line of Chao Wang from Merrill Lynch. Please ask your question now.

Chao Wang - Merrill Lynch

I think – before taking my questions, firstly I noticed that gross margin actually expanded 80 bps in the quarter, although the operating declined. So does that imply utilization rate was improving while other expenses were kind of out of control? And specifically within G&A, I am wondering how much is labor related costs, and how does that ratio compare to previous quarters? Thank you.

Louis Hsieh

G&A is almost all labor.

Chao Wang - Merrill Lynch

Okay.

Louis Hsieh

With all labor – and its all labor related to opening up new learning centers that haven’t started yet. So the big increase in G&A is people working on learning centers, its been hard for learning centers before they’ve opened, right. So that’s the big cost. Gross margin was up 50 bps for the year, so we’re getting better utilization. But its being swamped by the fact that we added 177 learning centers, which means we added – you do the math, we added 3,000, 4,000 people who didn’t produce a profit this year.

Operator

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

Fei Fang - Goldman Sachs

Hi. Thanks. This is Fei Fang calling on behalf of Catherine Leung. I have a very quick question. So for your sales and marketing, how much of the growth is related to advertising spend versus head count increase? Thanks.

Louis Hsieh

Both have gone up a lot. I think the advertising for – this last quarter was quite high. Its about [real] 40%, 50%. The head count is slowing down because the VIPs at the beginning had more students per head count. But I think advertising spend in the last quarter and half really have gone up. And that’s because we were challenged in to get more students in the Beijing and Shanghai for this boarding program during the summer. And also because when business begins to slow, the natural inclination is to market more.

Operator

Thank you. Your next question comes from the line of Kevin Tan from Joho. Please ask your question.

Kevin Tan - Joho Capital

Hey, Louis. Just one quick one on Q4 revenue and enrollment growth respectively for kids, high school and overseas test?

Louis Hsieh

Q4, I just have Beijing, hold on. I’ve got to find out. Sisi, can send these to you. Is that okay Kevin?

Kevin Tan - Joho Capital

Yeah, that’s fine.

Louis Hsieh

Sisi, can you send Kevin the growth rates for those four programs. I haven’t it in separate sheet, I can’t find it right.

Sisi Zhao

(Indiscernible).

Louis Hsieh

All right.

Operator

Thank you. Your next question comes from the line of Jennifer Gao from Credit Suisse. Please ask your question now.

Jennifer Gao - Credit Suisse

Hi. Thanks for taking my question. Chen Xiangdong’s recent speech mentioned some focus for fiscal year ‘13 and it seems to me that the Company’s focus is being number one overseas test prep. Number two, Vision Overseas and number three global study tour, and then K-12 and etcetera. I’m interested to understand, I mean, how New Oriental views and positions global study tour, as it had only like 10,000 enrollment for fiscal year ’12, but contributed nicely to the top line, right. And margins I think is quite low for this business, right?

Louis Hsieh

Overseas study tour is quite high margins and its also I think it’s a very important piece as we lock the student up both basically for the study tour, for the SAT test prep, for the study consulting and it is all part of the same and the English language training, is all part of the same marketing tool. Its very popular, its high dollar, its high profit and its similar to the boarding programs in Beijing and Shanghai I was talking about. So, its similar to that. And those are slowing down and I think that’s part of the – that’s probably because our schools around Beijing and Shanghai are getting better. Its also partly because of the slow down in China in general, people don’t want to spend large amounts of dollar on travel and vacation, especially vacation for the kids to look at different colleges. They feel like that’s an expense that’s not necessary.

Operator

Thank you. Your next question comes from the line of (indiscernible) from SAC. Please ask your question now.

Unidentified Analyst

Hi, Louis. Thanks for the presentation. Again, we had another strong quarter with cash balance still growing. I remember we have a discussion earlier this year about potential use of this cash balance to return to shareholder by stock buyback when the share price is volatile. Is that still viable in this environment?

Louis Hsieh

Well, we’ve already announced the dividend. So we will look at other return of capital depending on the share price movement. We already announced the $50 million dividend, right, last time.

Operator

Thank you. Your next question is from the line of Jin Yoon from Nomura. Please ask your question now.

Jin Yoon - Nomura Securities

Hey, good morning. Thanks for taking the question. I apologize if this question has been asked before, but your expansion plan of a couple of 100 new schools and small outlets going forward, I guess what the strategy behind that considering the fact that you’re seeing cannibalization considering the fact that you’re seeing a slow down in potential pricing and these schools are not going to be profitable for 18-month plus. In this environment, is there a need to expand so aggressively in markets that are not going to be – on profit for a longer time anyways?

Louis Hsieh

I think that – I think all those statements are incorrect. I think these schools are profitable in year one. These schools are necessary because in the smaller cities, if we build a 2,000 square meter learning center it can take five or six years to fill up. These fill up within a year, year and half. That – its just the way done in these cities right now. So its just like large, large Wal-Marts everywhere.

In the smaller cities you typically have your smaller facilities. So, this is – the new model for second and third tier cities. And because in second and third tier cities, it isn’t really much Adult English and overseas test prep, that’s where you need the big centers for. So these are more VIP and Kid centers. So its exactly the model we need for this size city and that’s why we’re doing it.

Operator

Thank you. Ladies and gentlemen, we’re now approaching the end of the conference call. I will now turn the call back to New Oriental’s President and CFO, Mr. Louis Hsieh for his closing remarks.

Louis Hsieh

I just want to thank everyone for taking the time on this call. It is bit of a shocker, but I think we will do our best to pull through. Thanks everybody. Look forward to talking to you guys on the road shows. Bye.

Operator

Thank you. Ladies and gentlemen, that does conclude our conference for today. You may now disconnect. Good day.

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Source: New Oriental Education & Technology's Management Presents Q4 2012 Results - Earnings Call Transcript

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