Smaller Class Sizes: An Opportunity Or A Risk For New Oriental?

| About: New Oriental (EDU)
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New Oriental Education & Technology Group (NYSE:EDU), a company in China that offers private education services, reported quarterly earnings before the market opened on Tuesday, January 21st. The earnings report was for the second quarter of the company's 2014 fiscal year.

Net revenues for fiscal Q2 were reported at $208.3 million, up from $165.9 million during the same fiscal quarter last year. Overseas test preparation and overseas study consulting contributed a combined $77.6 million to this total,while K-12 after school tutoring contributed $83.8 million. The company in its fiscal Q1 report had estimated net revenues in the range of $202.4 million to $210.7 million.

Interestingly, fiscal Q2 net income was positive at $4.3 million, whereas during the same fiscal quarter last year, net income was $-15.8 million. Additionally, operating income was $0.7 million this quarter, up from operating income of $-26.9 million the same quarter a year ago. Comparing the first half of the company's fiscal 2014 with the first half of fiscal 2013 shows that revenues increased 19% and net income increased 63.3%.

As a private education company, New Oriental's revenue is seasonal in relation to the academic calendar. Thus, it is not necessarily cause for alarm that Q2 2014 net income of $4.3 million is lower than Q1 2014 net income of $126.5 million. Thus it is more relevant to focus on the improvement to positive net income in Q2 2014 from negative net income in Q2 2013.

However, the market was not impressed and on the day of the earnings release, January 21st, EDU decreased by approximately 2.0%. The decrease also occurred in spite of Jefferies increasing its price target for the stock from $36 to $40 on the same day. The following day, January 22nd, EDU ended the day down roughly 0.2%

Something that is perhaps capable of generating uncertainty around the company's performance could be a statement from the Q2 report and its relation to an earlier statement from EDU's annual report. In the 'Risks Related to Our Business' section of the annual report, and under the paragraph heading 'We have experienced and may continue to experience a decrease in our margins', New Oriental notes that,

...there is a recent trend that the short-term language training and test preparation markets are moving towards smaller class sizes, especially for students between the ages of five and 12. This may have resulted from discretionary income increases for families in China, which cause students to be more willing and able to pay higher course fees for the more individualized attention that smaller classes can offer. In our fiscal year ended May 31, 2013, the average class size for our short-term language training and test preparation courses was approximately 10 students per class, which decreased from approximately 13 students per class in the previous fiscal year. Although our smaller-sized classes are highly profitable, they are marginally less profitable on average than our large classes.

The fiscal Q2 report, with regards to net revenues from educational programs and services that totaled $188.5 million, said,

The growth was mainly driven by an increase in student enrollments in academic subjects tutoring and test preparation courses, as well as an increase in average selling prices resulting from price increases and an increase in the number of students selecting more expensive, smaller class options.

Thus, it appears we have a situation wherein a chunk of revenue is being driven in part by small classes that are less profitable than big classes, and, this situation is part of a trend in consumer preferences as incomes rise in China. In other words, something that was acknowledged as a risk factor for profit margins approximately six months ago has now been noted as a driving factor behind net revenue growth over the past quarter.

It is not impossible that since the time of the annual report New Oriental has figured out how to earn more profits from their smaller class formats, for instance via the price increases they mention. After all, the company also managed to improve net income year-over-year in fiscal Q2 2014 despite having 711 schools as of the end of the quarter, down from 744 at the end of the same fiscal quarter a year ago.

Overall though it seems the report has given the market (myself included) reason to pause. For the time being, it may be best to continue monitoring the situation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.