New Oriental Education & Technology Group Inc (EDU) 2011 Q2 法說會逐字稿

Good evening and thank you for joining New Oriental second fiscal quarter 2011 conference call.

At this time all participants are in listen-only mode.

After managements prepared remarks there will be a question and answer session.

Today's conference is being recorded, if you have any objections you may disconnect at this time.

I would now like to turn the meeting over to your host for today's conference, Miss.

Sisi Zhao.

Please proceed.

Hello everyone and welcome to New Oriental's second fiscal quarter 2011 earnings conference call.

Our second fiscal quarter earnings results were released earlier today and are available on the Company's 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 US Private Security Litigation Reform Act of 1995.

Forward-looking statements involve inherent risks and uncertainties.

As such, our results may be materially different from the view expressed today.

A number of potential risks and uncertainties are outlined in our public filings with the SEC.

New Oriental does not undertake any obligation to update any forward-looking statement except as required under applicable law.

As a reminder, this conference is being recorded.

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

I will now turn the call over to New Oriental's President and CFO, Louis Hsieh; Louis please.

Thank you Sisi.

Hello everyone, and thank you for joining us today.

I will start by taking you through the highlights for our fiscal Q2 2011 and then move to the financial results before finishing with Q&A.

As you know, in Q1 2011 our business was affected by a slowdown in enrolment due to the disruption cost by the Shanghai World Expo.

And as we expected there has been a strong bounce back since the event finished, which helped drive year-over-year revenue growth of 56.3% to $95.7 million, and an earnings increase of 65.9% to $1.8 million in the second quarter.

Q2 is typically our slowest quarter as Chinese school children go back to class for there first semester of their academic year.

Nevertheless, we saw a very strong year-over-year growth in our key business segment, K-12 all-subjects after-school tutoring, overseas test prep and English language training, which grew revenues by 80%, 75% and 40% respectively.

Enrollments were also strong, growing by 32.2% to about 405,800 during the second fiscal quarter 2011 demonstrating the enduring brand strength of New Oriental and the market appreciation for our convenient, integrated, one-stop offerings.

Blended ASP increased as well going over 25% to $250 per enrollment -- to over $250 per enrollment.

New Oriental is the only true -- truly one-stop education service provider for [K-12 college] in China with the most complete nationwide coverage and a wide range of subjects and class format, which students can benefit from throughout their lives.

We do not endeavor to direct students to one particular academic subject for class format; class formats such as one-to-one or one -- small classes, large classes or online, since we offer all of the aforementioned class formats and we offer the largest selection of subjects.

This is unlike many of our other training companies in China, typically focused on one of the class formats or on one academic subject.

Instead we work with individual students to customize an academic program that best fits his or her individual needs.

Furthermore, we believe our one-stop shop solution is superior to other market providers in that it offers students the convenient and continuity of remaining within the same academic system for all their supplement learning needs.

Our one-stop shop model also allows us to be well positioned to quickly take advantage of shifts in market trend.

For example, we are currently seeing growing market demand for more personalized tutoring and enrollment in our one-to-one and one-to-five VIP process.

For the first half of fiscal year 2011 our VIP business has recorded year-over-year enrollment growth of more than 114% to 28,600 students and year-over-year revenue growth of over 240% to $55 million.

These VIP classes are the primary reason for the increase in blended ASP across the business.

As you know we have been investing heavily in the past two and a half years in our K-12 all-subject and VIP programs.

And in fiscal Q2 we continued to expand our network and recruit the best new teachers and support staff.

During the quarter we opened one new school in Luoyang city in Henan province, as well as a net of 24 learning centers in 20 existing cities within our network.

These new learning centers have mainly been opened in larger cities and are relatively small, about one quarter to one half the size of New Oriental's typical learning centers with between eight and 15 classrooms each.

The opening of these more streamlined centers allows us to fill in the gaps in our network by targeting areas where there is growing demand for our offering yet these areas are not large enough to cost effectively support larger learning centers.

To service our expanding network and to help develop our K-12 all-subjects after-school tutoring and enhance our one-stop shop product offering, we have been hiring and training new teachers and customer services representatives.

In total over the last 12 months we have added a net of 4,700 teachers, bringing the total number to 10,800 at the end of the second fiscal quarter 2011.

At the same time we hired approximately 950 customer service representatives and marking staff, which equates to an increase of 43%.

These significant expansions to our network and headcount translated a 57% increase in operating cost and expenses in fiscal Q2 compared to the same period in fiscal 2010.

As we reach the final six months of our focused investment in K-12 all-subjects in VIP personalized services we will look to further control expenses and improve utilization rates of our facilities and staff.

We are also finding to significantly shift the main criteria for performance related bonuses to profitability as opposed a balance of revenue growth and profitability, in order to better incentivize school heads and management, and bring an increased attention to bear our controlling cost.

I would now like to turn to our performance by business segment.

K-12 all-subjects after-school tutoring grew enrollments by more than 50% to over 174,400 and revenues by more than 80% to $30.5 million in the second fiscal quarter.

Within this segment the performance of non-English U-Can all-subject training was particularly impressive with year-over-year enrollment growth of more than 102% to 27,200 and year-over-year revenue growth of over 200% to over $8.1 million.

Due to the increasing popularity of one-to-one class ASP's for non-English U-Can increased to over $500 per enrollment.

The English portion of U-Can also performed well during the quarter with enrollments up over 37% to over 30,700 and year-over-year revenue growth of over 57% to $4.7 million.

POP Kids continues to outperform during the quarter with enrollments up about 50% to over 116,000 and year-over-year revenue growth of over [62%] to $17.7 million.

Within POP Kids Chinese writing, mathematics, music and arts classes, which we launched two quarters ago have been well received in the market and we have already nearly achieved our original full fiscal year enrollment target of 20,000.

We now believe we are on track to enroll a total of 40,000 by the end of fiscal year, double our initial estimate.

Our oldest core segment, overseas test preparation, maintains a dominant market share in China in terms of both enrollment and revenue, with enrollment growth of over 38% to more than 73,500 and revenue growth of 75% to around $28.5 million.

Looking specifically at the course offered we remained market leaders for TOEFL, IEL, GRE, GMAT and SAT test preparation.

Over the last 12 months we have enrolled 292,700 students and reported $136.5 million in revenue in this segment.

Our third core segment, English language training for K-12 students and adults also performed well, growing enrollments more than 22% to over 277,400 and growing revenues more than 40% to $36 million year-over-year.

We continue to lead the market in this segment with approximately $194 million of revenue and enrollments of 1.386 million over the last 12 months.

Please note that English language segment overlaps with the K-12 all-subjects after-school tutoring metrics.

In short, fiscal Q2 was a good quarter for the Company with respect to enrollments and top line performance, the stronger than expected growth as we continued to take market share in all three core segments.

Looking forward we have a lot of work to do in terms of controlling expenses and streamlining our operations to increase staffing facility utilization rates.

Our goal in subsequent quarters is to continue extending our market share -- market-leading position in all three key business segments of overseas test prep, K-12 all-subjects tutoring and English language training; at the same time do a much better job in controlling expenses and increasing utilization of staff and existing facilities.

Turning to financials; for the second quarter of fiscal year 2011 New Oriental reported net revenue of $95.7 million representing a 56.3% increase year-over-year.

Net revenues from educational programs and services for the second fiscal quarter was $84.5 million, representing a 57.7% increase year-over-year.

The growth was mainly driven by the increase in the number of student enrollments in academic subjects tutoring and test preparation courses, and higher than average selling price associated with students selecting more expensive, smaller class options.

Total student enrollments in academic subjects tutoring and test preparation courses in the second quarter of fiscal year 2011 increased by 32.2% year-over-year to 405,800 from approximately 307,000 in the same period of the prior fiscal year.

Operating costs and expenses for the quarter were $97.7 million, a 57.3% increase year-over-year.

Non-GAAP operating costs and expenses, which exclude share-based compensation expenses for the quarter, were $94.4 million, a 63.4% increase year-over-year.

Cost of revenues for the quarter increased by 60.3% year-over-year to $44.6 million, primarily due to the increased number of courses and the greater number of schools and learning centers in operation.

Selling and marketing expenses for the quarter increased by 58.9% year-over-year to $18.6 million, primarily due to the promotion of new service offerings and the addition of about 950 customer service representatives and marketing staff in the past year.

General and administrative expenses for the quarter increased by 52.9% year-over-year to $34.6 million.

Non-GAAP general and administrative expenses, which exclude share-based compensation expense, at $31.5 million, a 70.3% increase year-over-year, primarily due to the increased headcount in the Company extended network of schools and learning centers.

Total share-based compensation expenses, which were allocated to related operating costs and expenses decreased by 23.6% to $3.3 million in the second quarter of fiscal 2001 from $4.4 million in the same period of the prior fiscal year.

Loss from operations for the quarter was $2.1 million, a 125% increase from a loss of $0.9 million in the same period of the prior fiscal year.

Non-GAAP income from operations for the quarter was $1.3 million, a 62.9% decrease from $3.5 million in the same period of the prior fiscal year.

Operating margin for the quarter was negative 2.1% compared to negative 1.5% in the same period of the prior fiscal year.

Non-GAAP operating margin, which excludes share-based compensation expense for the quarter, was 1.3% compared to 5.6% in the same period of the prior fiscal year.

Net income attributable to New Oriental for the quarter was $1.8 million representing 65.9% increase in the same period of the prior fiscal year.

Basic and diluted net income for ADS attributable to New Oriental was $0.05 and $0.05 respectively.

Non-GAAP net income attributable to New Oriental for the quarter was $5.2 million, representing a 5.5% decrease from the same period of the prior fiscal year.

Non-GAAP basic and diluted net income per ADS attributable to New Oriental was $0.13 and $0.13, respectively.

Capital expenditures for the quarter were $19.9 million, primarily used to purchase two new buildings, costing approximately $11.1 million combined; one in Kunming and one in Wuhan, and an add -- a net add of 24 schools and learning centers in the quarter.

As of November 30, 2010, New Oriental had cash and cash equivalents of $248.1 million, as compared to $293.3 million as of August 31, 2010.

In addition, the Company had $255.8 million in term deposits at the end of the quarter.

Net operating cash flow for the second quarter of fiscal 2011 was approximately $24.3 million.

The deferred revenue balance, which is cash collected from registered students for courses and is recognized proportionally as revenue as the instructions are delivered, at the end of the fiscal second quarter 2011 was $137.9 million, an increase of 94.1% as compared to $71.1 million at the end of second quarter fiscal year 2010.

We expect approximately 55% of the $137.9 million to be recognized in Q3 of fiscal 2009 revenues.

Moving on to revenue guidance; New Oriental expects its total net revenues in the third fiscal quarter of 2011, December 1, 2010 to February 28, 2011, to be in the range of $116.8 million to $121.3 million, representing year-over-year growth in the range of 31% to 36%.

The year-over-year comparisons for the third fiscal quarter 2011 are more difficult for New Oriental, because last year's winter holiday was longer by about one week in most Chinese provinces due to the late timing of Chinese New Year, which fell on February 14, 2010, allowing our students to study for longer periods and enroll in more sessions last year.

This year Chinese New Year falls on February 3, 2011, giving students a more normal three-week winter holiday.

This forecast reflects New Oriental's current and preliminary view, which is subject to change.

At this point, I will take your questions.

Operator?

(Operator Instructions).

Catherine Leung with Goldman Sachs.

Hi.

Can you please elaborate on the specific steps you're taking to improve the utilization of your staff?

For example, would this include offering a smaller number of classes so that more students would sign up for a particular class, or any other more detail you could share?

Thank you.

Thanks, Catherine.

I think there's a number of things we plan to do.

I think right now is we were kind of in rapid growth, trying to see if we could become the market leader in the K-12 business and the VIP business the last two/two and a half years.

So what we did was we put revenue growth ahead of other items.

And so, right now, as you know, we added the 20 learning centers from Newave, and 24 net of our own.

Those will take time to fill up, as it takes two to three years for a learning center to mature.

So our goal is to slow down the hiring of teachers and staff until the utilization rates go up.

For instance, each customer service representative today that handles these one-on-one, one to five students, we have about 14,000 enrollments, and 150 customer service reps, and with each one servicing about 14 or 15 students.

They could easily service double that number of students.

So we're going to slow down the number of customer service reps until the utilization rates go up.

The same is with the learning centers.

So even though we added a net 24 learning centers, the capacity of the learning centers we added now are actually much smaller than the ones we've added in the past.

Thus, the actual square footage is only -- is akin to adding only 12 or 13 learning centers.

So we're going to slow down the learning center growth and only target them until the existing learning centers begin to fill up more in the larger cities.

Now, in newer cities we're going to continue to open large learning centers and continue to grow the business.

But in more mature cities, we want to force utilization of the current capacity.

[Remember], 240 learning centers are less than two/two and a half years old; they're not mature yet.

We want to force utilization of those learning centers at a higher rate before we open a lot more learning centers.

So the ones we're opening are now targeted, smaller ones that will fill up quicker.

Other things we're doing to [incentivize], we are freezing hiring for the next three months pending -- except for new teacher hires, which we need.

But other than that we're going to freeze hiring.

It requires the approval of the COO and the Head of HR for any non-essential hiring, essentially.

We are going to -- I think we're going to change the bonus structure.

So right now, it's currently more geared toward revenue growth than profit growth.

Next year we plan to change it so that profit becomes the key motivator for our school heads and our management.

And so probably 75% to 80% of their target bonus number will come from profit metrics, not from revenue metrics.

So we're doing a number of things.

We just had three days of management meetings among school heads to figure out other ways to control cost.

We're going to integrate, use IT services more.

So, we're shifting a lot of our registrations online.

So I think -- in Beijing, 30% of our registrations are now online; that means we don't have to keep hiring a lot of registration staff.

We have hired 400 or so teaching assistants to help, so we don't have to hire as many teachers.

They're not quite as expensive.

They do all the grading; they do all the administration of tests for the students.

So we are doing other ways to increase utilization of the current staff in the current facilities that we have.

I don't know if that answers your question, Catherine?

Yes, that was a very huge help.

Thank you.

So, we are doing a lot of things.

It just takes time.

It's because we over-built the last two years.

It doesn't get absorbed in one quarter.

So the focus is really on cost control going forward.

We're very comfortable with our market position.

We are clearly taking market share across the board in all our key segments.

So we will continue to grow revenue and to grow enrollments, but we need to get the recipe right.

We always have this problem with new businesses.

It takes us two or three years to understand all the metrics and get the exact mix correct.

We have the most complex business of the education companies that you follow in China.

Philip Wan with Morgan Stanley.

Hi Louis, thank you for taking my question.

Not at all.

I have a question about your VIP program.

First of all, do you have any near-term or medium-term targets for the VIP business in terms of enrollment and revenues?

And then --

Well, whatever target I tell you, we'll exceed it.

Go ahead, sorry.

The second part of your question was?

Sure.

Obviously, it's becoming key growth driver for the Company, and could you give us some more color on this margin?

And what are you expecting going forward given this strong pricing power?

Thank you.

Yes.

I think, for the VIP business, we really started in large scale last year.

It's still in a ramp-up phase.

So in the first half of the year, we only have 28,600 enrollment; $55 million in revenue.

So I would expect this to double in the next two quarters.

So it should reach -- we should reach over $100 million in revenue in this business in this fiscal year, with enrollments around 53,000 to 58,000 or so.

The average price here is over $2,000 per enrollment now, already.

So it's -- we don't expect to raise prices much.

What we expect to do is, of the utilization as we -- each of our teachers on average for one-on-one is only teaching four students a quarter.

We believe that they can actually handle six or seven.

So this is another area that we think we can get a lot of utilization from.

We can have the teachers teach more classes.

We have a lot of teachers that have spare capacity.

So I think, long-term, this business is quite profitable for us, because we charge so much more than our competitors do, and our cost structure isn't that much higher.

I would expect gross margins in the range of over 60% as this business matures in the next year or two, and I would expect operating margins around 25% or so in this business as it matures.

Okay.

That's very helpful.

Thank you.

It's already 20% of our revenue, Philip.

And I think only -- will only grow, because the market -- it's not us setting the market; it's the market demanding one-on-one services.

So that's just where the trend is going.

We're just -- like I said, our one-stop-shop allows us to follow trends and adapt much more quickly than our competitors.

Our competitors will try to sell you whatever they have on their shelf.

We won't try to direct you to buy one thing.

We'll let you buy whatever you want, as long as you buy from us.

Chenyi Lu with Cowen and Company.

Thank you for taking my question.

I have a question regarding your operating expense.

I know that the Company will try to enhance utilization rate going forward.

So can you give us the operating margin, what you see over the next few quarters, especially for 2011?

I think for 2011, the next two quarters, we're still feeling the aftereffects of the rapid expansion from the first half of -- from the first quarter this year and all of last year.

So it's still going to take one or two quarters.

But I think you will begin to see margin improvement every quarter starting in Q3.

And I think in next year, you'll definitely see margin expansion as we keep the cost control pressure on our management team.

So I would expect over the next two -- next quarter, I don't know for sure, Chenyi.

It depends on how good we are at cutting costs.

I would expect it to be better than last year's Q3; I mean this year's Q2, for sure, but it should start showing improvement every quarter by 100 or 200 basis points.

And then going forward, in the fiscal year '12, I think that's where you're going to see much better improvement in the cost structure and the operating margin.

Because if we don't open as many large learning centers then there won't be a cost drag, and the learning centers from last year are going to hit maturity in next year, so I think the cost drag will be gone.

Also, I think, if we better utilize our teachers, and we also -- we continue to increase prices, but fees were up over 25%.

In U-Can already topped -- U-Can non-English already topped $500.

At this time last year it was $300-and-something, so you can see that we have several levers to play with.

Okay, great.

And just a housekeeping question; can you give us guidance as to stock-based compensation expense going forward, given that the quarter --

Stock-based, yes, was lower because some options expired during the quarter.

I would expect Q4 to be similar -- Q3 to be similar to this quarter.

And then in Q4 it should start ramping up again, depending on how many grants we do at the end of the quarter.

So it'll be about $17 million for the year, and then next year I don't know, because it depends on what the grants will look like for next year.

But remember I told you three years in one are gone.

So, every year we have one that comes in and one that goes out, so the stock-based comp should be somewhere between $16 million and $20 million a year, yet our revenue keeps coming in right [up to] the percent; that's actually SBC it's going to go down every year.

Okay, thank you.

That's all my questions.

Thank you, Chenyi.

Okay.

Ingrid Yin with Brean Murray.

Hi, Louis and Sisi; congratulations on the quarter.

My first question -- my question will be about the expense going forward as --previously as discussed.

Really, the target number for learning centers for next quarter and the fiscal 2011, can you provide some color?

Yes.

I think the number of learning centers is not as material as the size of the learning centers.

So to give you an example, our typical learning center -- the old traditional learning centers were typically about 2,500 square meters.

The new ones we're building, more than half of the ones this year, the small POPs and the VIP centers and the U-Can centers are only about 600 to 1,000 square meters.

They're only one-quarter to one-half the size of the old ones.

So I think if you look at the old learning centers, we're going to still do what we said before; we'll add 60 to 70.

Which means it may be only 30 normal learning centers and maybe 50 or 60 small learning centers, and these new small learning centers we use to fill in.

As you guys know from reading the newspapers and visiting China yourselves, traffic is really, really bad in China.

And so we still get a lot of -- the number one complaint about New Oriental is not our price, it is -- or our quality, it is our convenience.

It's that we don't have learning centers close enough to people's homes.

And so as we go into the big cities we have the (inaudible) of hitting the most populous areas first.

Now we're using the fill-in strategy in cities like Beijing and Shanghai, where we're hitting areas that aren't quite as populated but do have one or two schools, so it's really the smaller learning centers.

These learning centers are about 600 or 1,000 square feet are more similar to our competitors' size.

So the net capacity will be about 60 or 70 learning centers of the old size, which may mean -- it may look like it's 100, but the actual net square footage add is actually closer to 60 or 70.

Yes.

I guess the real question is when do we expect to see operational leverage?

That's what we're working on.

You will see it, if we are successful in reducing costs like I believe we will, and the focus of the management team is first on reducing cost, you'll begin to see it next quarter, a little bit.

You'll see more of it in Q4, and you'll definitely see it next summer.

Okay, great.

Thank you.

So it's only six months.

It's not years away; it's close.

We are working hard on reducing cost.

One thing we -- one of the reasons why we haven't reduced costs as much this quarter is because culturally, it's not appropriate to be letting people go right before Chinese New Year or at the end of the Christmas -- or end of the calendar year.

So we do have some layoffs coming, not a lot, but we have some coming.

So we've been nice about it, and we're going to wait 'til after Chinese New Year.

Mark Marostica with Piper Jaffray.

Hi, Louis, just a follow-up on that last point; you mentioned some layoffs coming.

Can you talk about the areas that you'll be targeting?

And it may be a little bit sensitive to talk about quantity, but just whatever color you can give us there will be helpful.

Yes, I think we're trying to integrate some of the functions, right?

So, there are -- for instance, we have a lot of people -- we have a marketing team in every city now.

We don't need that many people.

We don't need people doing design or designing things for marketing in every city.

We can do it in Beijing and send it out and just have people distribute it in the local cities.

So you can see a cut in marketing staff.

We have a lot of duplication as far as IT between Koolearn and our headquarters.

So you can see streamlining in IT staff.

The number of IT staff isn't going to go down, but we're not going to hire more people.

We're going to use the Koolearn staff and integrate into the main staff.

Koolearn is our online platform.

So you're going to see things like that.

The online registration system is -- more and more students are using online registration now.

So as that grows, we don't need to hire, or we can -- going to let go some registration staff people; so things like that.

We are also targeting, I don't want to give the percentage, but low performers.

New Oriental has not had a culture of every year laying off the poor performers.

We're trying to start that now.

So the low performers of every year, I won't tell you what percentage, we're going to ask the school heads to let them go.

Otherwise, they just sit around and they build and build over years and year.

Just like the investment banks, Mark, right?

You guys cut the bottom 5% or whatever in every year.

GE does the same thing.

We've never done that.

New Oriental has just gotten, to be honest -- perfectly honest, too fat.

So what we need to do is to take some of the -- we need to streamline our operation, and that is the number one focus.

We've made some management changes to do that.

That was one of the reasons why we promoted Chen Xiangdong to Executive President, Domestic Business; he's very good at operations and streamlining.

Zhou Chenggang, who is the COO, has just been put back to Beijing school.

He's good at running expense control; he ran Beijing school for many years.

So we are taking it seriously.

It's just that Q2 would not be an appropriate time, because it's just before Chinese New Year.

You don't want to be seen in China as taking -- laying off people just before Chinese New Year.

Thank you.

Ella Ji with Oppenheimer.

Thanks.

Congratulations, Louis, on strong quarter.

You mentioned that you're going to emphasize how expense is controlled.

I want to know what your thoughts on your selling and marketing expenses going forward?

Well, actually, we did control marketing expenses this quarter.

It was actually 20% down from last quarter.

It's the headcount.

So as a year over year comparison, you have 950 more staff than you did last year.

We don't need that 950; they're not fully utilized, in my view.

And so, marketing expense, we did actually control it a lot in Q2, and will continue to control it in Q3 and hopefully in Q4.

The issue is the headcount, because we change our business model.

So it's not a -- the apples to apples comparisons will look much better starting in Q1 this year, because last year we didn't -- last year we added 950 more staff to marketing.

So actually, a lot of it is staff cost not real marketing dollars.

We're also more targeting marketing-- using more effective channels, like online -- less expensive channels like online, than TV and radio.

So we are beginning to get our marketing.

We also have a new marketing head.

So we are taking the steps who are more cost-conscious on reducing the cost.

We spent a lot on marketing in the last two or three years, because we're building a new brand in U-Can and we're rolling out VIP.

Now that we've done that the last couple of years, we can begin to trim back on actual marketing spend.

Right, yes.

I just want to know, with the last two years of spending on those new branding, do you feel you are already at a stage where you can slow down the real marketing dollars in this area, or do you -- ?

We did.

We already slowed down by 20% year-over-year last quarter versus Q1, and you saw the numbers.

We saw it's still 56% increase in revenue.

So this quarter we continue to control the actual out of pocket marketing expenses.

The headcount is still bloated; it's still too big.

But the actual marketing dollars is actually being controlled now.

And that's what we told you we would do last quarter.

We have done that.

It's just that we haven't -- the marketing staff we'll also -- even if we don't -- let's say, we have zero marketing staff that capacity will get absorbed anyway in the next two quarters, because I would expect the next two or three quarters, our VIP numbers to again double.

So then they will be handling 25 to 30 students per customer service rep, which is what their capacity is.

But some of the design people in the different schools we don't need.

There's duplication of effort.

So we need to better streamlining of those efforts, where we have a lot of duplication.

Got it, thanks.

And also I want to know for the new learning centers that you opened in the last 12 months, how's the fill-up rate been trending?

How is that comparing to your old learning centers during their first 12 months of opening?

Thanks.

Well, it depends what kind of learning centers.

The POP Kinds and the U-Can learning centers are filling up very quickly.

So we expect some of them to hit maturity in two years instead of three years.

I think the -- what happens though is when we open new learning centers we actually cannibalize the old learning centers.

So there is a cannibalization effect.

So that's another negative of when you open too many learning centers at one time, is that you cannibalize the existing centers in that same city.

That's why I think a moderate pace of 60/70 learning centers a year is appropriate.

But that could mean 100, but only 30 large ones and 60/70 small ones.

But I think that's an appropriate number.

So we are seeing very quick take-up in the learning centers, and that's why we're opening some these smaller ones.

As you can see by the numbers, VIP and POPs is just booming.

So the one-on-one learning centers are filling up quickly.

The kids learning center is filling up quickly and the U-Can are filling up quickly.

The older centers are the same as before.

They filled one-third in the first year; hit the 50%/55% in the second year; hit the 60%, 65% in the third year and that's about where they cap out.

So there's been no change in the old centers.

The newer centers are filling up faster though.

Great, thank you very much.

Amy Junker with Robert W.

Baird.

Hi, thank you.

Louis, can you touch a little bit and we move away from some costs for a minute and talk about revenue, which obviously came in significantly above your guidance for the second quarter.

And I'm curious, when you last reported, you gave us some initial trends in September; it looks like it ramped up from there.

So can you just talk about where was the biggest surprise versus your guidance?

Was it purely in the enrolment numbers?

How should we interpret the conservatism of your third quarter revenue guidance?

And what -- can you just help us understand what's built into that revenue guidance on enrolment versus price increases?

Thanks.

Thanks, Amy; it's a good question.

Last quarter, we had 25.7% enrolment increases in the first month; that began to accelerate in October and November.

And so we -- it is a very strong bounce back from the Shanghai World Expo.

And remember, we also had H1N1 last year, so it was an easier quarter to compare against.

The revenue number was higher in the quarter primarily because of VIP.

The one on ones is 20 -- is wildly exceeding our expectation, and so it's going to be a $100 million business this year.

It's going to be over 20% of our -- it'll be approximately 20% of our revenues this year.

It's almost from scratch last year.

So the business is really, really taking up.

That was the biggest surprise.

I think going to Q3, our revenue guidance is 31% to 36% or $116 million to $121 million.

I think we are -- the initial trends are very strong in Q3.

The issue is the Q3 this year is one week shorter.

So remember, the summer -- the Q1 was one week shorter as well, because last year Q1 we had very difficult comparison.

It was a four-week holiday last year; this year is a three-week normal holiday.

So it's because of the difficult comparison that we are a little bit cautious on trying to say revenue will be that high.

Last year, our revenue had growing 36% in Q3 because of the extra week.

So I'm not as concerned about the revenue growth.

I think 31%, 36% is doable for us.

I think I'm more concerned about some of the Street numbers on profit, because the one extra week of class is actually the loss to the bottom line.

It's probably between $4 million and $5 million to the bottom line.

And so just to clarify that, because someone asked earlier about the margins and you had indicated you expect to start to see 100 plus basis points of margin expansion.

Do you -- are you anticipate seeing that in the third quarter or --?

I think what we'll do is -- most likely what we do is our old game; we outgrow revenues and we miss on margin, because we're -- because this quarter's already half over and so we -- and Chinese New Year is February 3.

We don't want to be laying off anybody until after Chinese New Year.

So you won't see the effects really of some of the cost cutting measures until Q4.

You'll see a little -- I think Q3 we'll probably outgrow on revenues.

That's what we typically do.

And so I think is -- but I think your number, Amy, and one other is kind of out there as far as net profit.

I think you're over $21 million.

I think to be honest, if it's my opinion, if I had to call it today, let's say we'd be between $18 million and $19 million in net income on a GAAP basis.

Great, thank you.

It's helpful.

Okay, so I think typically what we do is we are a little bit conservative on revenue guidance, because we're not -- as you know, from covering us the last two years, we're not as great as operators.

We're not as streamlined and efficient as we need to be.

And that's because it's never been our focus as much; it is now, but it hasn't been as we were growing this business.

Jeff Lee with Signal Hill.

Jeff, are you there?

Yes, well it must be too early in California.

Paul Ginocchio with Deutsche Bank.

Thanks.

It's not too early in California.

Hi, Paul.

How are you?

Good.

First, can you give us any more color on the change in the -- how you're being compensated?

How much more important does margins and profitability come versus what maybe the percentage it was previously?

Yes.

No, no, I'm preempting it, because we haven't done budgeting yet; budgeting comes in March and April.

As you know, our fiscal year ends in May.

This year, revenue growth was the number one criteria, as it was more than 50% of the compensation on bonus, but they need to hit profit as well.

So, more than half the school heads have already missed their profit number, so they're not going to get compensated well in bonus.

So we have saved some money just on bonus payments.

The second issue is going next year, the management -- the senior management discussion, early discussion is we want 75% of the KPI charged basically to profit margins.

And it will vary by school, because every school's at different stage of development.

Beijing's going to have a much higher profit margin target than a school like [Zhenjiang] or a school like Lanzhou that's [newer], or that doesn't have as an attractive a market.

So we're going to set profit targets for each city based on the past and what we think they can do.

But the profit measure is going to be at least -- the early indication's at least 70%, if not 80%, of the KPI for next year's bonus number.

That's very helpful.

You're welcome.

Great.

And just real quick on, you've got 78 centers already done; your target for the year was 100.

Do you think that number goes higher or you just complete them?

No, but it's not.

We don't have 78 done.

20 of them were acquired.

So we have 33 and 24; we have 57 done.

So we'll probably have -- yes, we'll probably get very close to 100.

But like I said, these -- most of these newer ones are tiny.

They're the same size as our competitors, but they're the same size as [Ishray Dara] or [Shreyer Suz], some of these other company's learning centers; they're tiny.

They're not -- they're one quarter or one fourth -- one quarter, one-third the size of our regular learning centers and they're doing it so quickly; sorry.

Brandon Dobell with William Blair.

Thanks.

Louis, in connection with that last question, how has regional and city school head turnover been?

And do you expect some kind of changes in compensation and changes in marketing directives to help that or hurt that retention?

The changes have been made by us.

So we moved Zhou Chenggang back to Beijing school head, because he's very good at operations and he also runs Vision Consulting, which I think our Consulting business in two or three years will become our second biggest business behind Beijing School, so that's how invaluable he is on the operations side.

We have had the normal three -- four or five turnover in school heads this last year.

I don't know the exact places.

And we are studying replacing a couple more school heads.

So Lanzhou school head was replaced this year and there's a couple more we are looking at as well; [Tian] as well.

Tian was actually promoted to Vice School Head of Beijing School because we want him, he's very good to come in and control costs at Beijing School.

So we are taking those kind of steps.

We do have a brand new marketing VP, so -- to control marketing costs.

We are doing a lot of things, it's just they don't show up overnight.

Right.

And especially given the timing of Chinese New Year, we don't want to be seen as -- it's the same as the US, you don't want to be seen as laying off people just before Christmas.

Got it, okay.

Right.

So we will -- we are taking it seriously.

We are making profitability the key KPI.

That's never been the case here in the Oriental; it's always been revenue growth and enrolment.

This will be the first year ever that profit is going to be more than 50% of a school head's compensation on their bonus.

Okay.

And in terms of marketing spend?

And you know also we're always studying -- looking at improving Shanghai School.

It's had a difficult last couple of years.

Right.

Right.

So, Brandon, you're the other one that's really high on profit.

Yes, I reckon.

So, you're like a $21 million or $23 million for this -- I think that's not doable for us.

Got it, okay.

And then with a question on marketing strategy, how much are you able to -- just to use like a single message or a single kind of, I guess, single brand focus in these different cities, all the different service lines you have going right now?

Is there any risk that you're getting too fragmented on the marketing message as you've got so many brands?

Or are you able to tie them all together and get some cost leverage on what you're spending in local cities?

That's the $60 million question, Brandon.

That's what we're trying to do.

We're trying to streamline it so that Beijing headquarters takes more of the general messaging and all the artwork, and then the local schools will all -- instead of having staff of 10 people in marketing or 12 or 14, we'll only need staff of five or six.

So that's exactly right.

You multiply that by 40 schools, right, it's a couple of hundred people; 200 to 300 people.

It's significant.

So you're exactly right.

That's -- the goal is that we don't want to lose the local flavor, yet, we don't want a huge number of duplication ever.

Right now, every school has their own marketing team.

They're doing their own design, which is ridiculous.

Right, okay.

Thanks a lot.

Right.

And so that's one of the areas that we are going to fix and we may -- it may take us a little bit of time but that's an area.

Other one is like -- is a simple one, like registration system.

As more and more people register online, we don't need as many registration centers.

We're going to save a lot of money on registration staff and registration centers over time, because more and more people are moving toward the Internet.

In Beijing, it's probably over 30% enrolling online for bricks and mortar classes.

So we'll try to use IT to help us as well.

We already use IT to help us at teacher training.

We used to train all teachers in Beijing and Shanghai.

That's not doable now with how big we've gotten.

So we use the Internet.

We use video conferencing to train teachers now.

So we are trying to streamline our operation.

Any business we do, it takes us two or three years.

We've always had that issue.

When we went to adult English 14 years ago, it took us two or three years to get the recipe right.

When we moved to Shanghai and Wuhan and Guangzhou, when we left Beijing City in 2000, it took us two or three years to get the recipe right.

And so that's why when we started U-Can and the VIP business, we said give us two or three years; it's going to take us that long to figure it out.

And so when we were two years and six months into it then we got to figure out quick.

Chao Wang with Bank of America.

Hi, Louis.

Thanks for --

Hey, Wang Chao, how are you?

Taking my question.

I just -- hi, Louis, how are you?

You just mentioned that you -- going forward, you'll use more small sized learning centers for so-called purely inconvenient locations.

I just wonder how these small-sized learning centers margin look like compared to your --?

Yes.

Obviously, they're not as good, because they're more similar to our competitors' margins, because that's what they're building.

But they -- we don't need -- like it's sort of a [fill in chart] here.

We already have big learning centers in the key largest population areas in most of the major cities now.

That's what we've been doing the last two years.

But at the same time, we still miss smaller communities, smaller suburbs or smaller districts within these large cities.

And so strategically, we're going to put -- we ideally would like to be within 10 or 12 minutes, or 15 minutes of almost every middle and high school in our [metric] school in that city.

And it doesn't make sense to put in a 3,400 square meter, four story learning center, if there's only one school there nearby.

So we -- it makes more sense to put in a targeted 800 square meter learning center like some of our competitors and only have eight or -- eight to 15 classrooms there; have a couple of VIP seats and some small classes and then some big classes in there.

So we are experimenting.

We don't have it quite right yet, but we're trying to target a learning center for the size of the particular surrounding schools that are there.

So what we typically do is build a huge school first.

That's usually a building in a city block like we have in Beijing.

Then, as we spoke out with the hub and spoke system, we spoke out the learning centers, usually we build the big ones first.

They're between 2,500 and 3,500 square meters.

They're big.

They're usually two or three floors of a building.

And then they usually have 20 to 30 classrooms.

Then as we -- as those begin to fill up, there's certain areas in between that we miss and those are the ones we're filling in now in Beijing and Shanghai that are having the 800 square meter ones.

They're small.

Okay, understood.

Yes, so it's like a double hub and spoke system; start with the school, then do large learning centers and then small learning centers.

Yes, so can I say because of the competition?

Not because of the competition.

It's not because of the competition, it's because we've already covered the big areas.

So now we're going to cover -- we want to get more penetration within each city.

So we want to get more penetration and I think if you read some of the reports that are out, you'll see that -- I don't really want to talk about competitors on this call.

I just don't think - they target different things, right.

They target different things.

Yes, okay.

It's not because of the competitors.

The second question is that it looks to me that ASP growth is very strong this quarter.

So do you think it's sustainable going forward?

Well, it's not sustainable for long, right.

How much (multiple speakers) renminbi appreciation?

Renminbi appreciation is nothing, it's like 2%, because we use 6.67 for the P&L and 6.68, and so last year, it was 6.82 or 6.83, so it's not much.

It's -- actually, we understated in earnings release the actual ASP increase, it's actually higher.

But I think going forward, it is not sustainable.

I believe that it depends on the shift toward one on one mix.

So, I believe it will be above 20% for the next two or three quarters.

The long-term obviously is not sustainable.

Okay, okay.

Great.

One on one is not going to become our whole business.

Trace Urdan with Signal Hill.

Hi, Louis.

Could you talk to the source of growth in the after school tutoring segment?

I'm wondering to what extent you'd see this market as continuing to expand.

Are we still in the business of consolidating away from individual teachers the share, or are we in the stage now where you're actually taking share away from other corporate entities?

And where do you see the market in that progression?

I think this market is similar to English language training market 14 years ago when we went into it, meaning that it used -- it was -- English in China in 1996 was dominated by small mom and pop shops and so it was very, very, very, very fragmented.

And then New Oriental began to open learning centers and taking it out of these smaller shops and moving it into larger centers with more consistent quality across the center, similar to what Wal-Mart does to local retailers.

So we're like Wal-Mart, but with a Tiffany price.

So we offer everything under one roof for them and so we're doing the same thing now to K-12 as well.

K-12 we got an extra boost when the government three years decided to make it illegal for school teachers to teach their students after school on school premises.

That's the way students usually learn and so that created a large market opportunity for us and for our competitors.

So the first few years, it's going to be -- obviously, it's going to be a real estate game.

It's going to be a race who can capture the most share.

The truth is the market's plenty big for all of us.

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

Okay.

I'm struck by how you've stopped talking specifically about Gaokao test prep and you're speaking more broadly about after school tutoring and I'm wondering to what extent you see your business being driven outside of the normal bounds of the Gaokao market into something that extends beyond that, maybe into high school testing or --?

We already do high school testing, that's the Zhongkao, so we do that anyway.

But don't forget, the Gaokao -- the Zhongkao is only one test; that's a $500 ASP to us.

They come for one or two quarters and they study.

After school tutoring from age six to age 18 is a 12 year business with the same student.

So would you rather have a client -- a customer, one pop for $500 or do you want them for 12 years coming to you every quarter taking two or three classes?

So as a business model that's why we've been pushing this one-stop shop, we are your education partner from age six all the way through college where we want to be your partner.

It's -- more so it's the recurring revenue of these students from age six to age 22 to 25, and it's a much better business model than just you're come in, you're take our prep, you go.

One and out; one and gone; we want recurring revenue multiple quarter, multiple year, multiple decade and more and more so, multiple generation.

Right.

The question I'm having a hard time asking and I apologize is understanding this market, how many new -- there's some of the test [for that] market is well established and longstanding and it strikes me that some of this growth that you're seeing is pulling new dollars into tutoring earlier and earlier, or do I have that wrong?

Is this just that parents have always spent this money and it's really just about where they're spending it versus how it used to be?

Or is it, in fact, the case that this market is expanding and some parents are putting their children into tutoring situations earlier and earlier in their lives?

I think it's both, Trace.

I think it is the market's always been there, but it's always been a secret market where people pay high school teachers, or elementary school teachers, or college students on an individualized basis.

And I think it's because of new regulations, it's put it out into a learning -- New Oriental and others, our competitors, are pulling it into a learning center environment and that is causing it -- and as China gets wealthier and wealthier, parents are spending much more on after school tutoring.

So you're exactly right, it's also going to a much younger age.

So it's not just for a Gaokao test, and it's not just for Zhongkao; it's for every year by every subject.

So the market is expanding a very high rate.

At the same time, the business model is changing, because it's moving towards learning center environment from the individualized one on one transactions.

It's just it's similar to what Wal-Mart did to the retail business.

Cities used to be littered with mom and pop corner shops.

Wal-Mart moved it into a larger format, more consistent high quality format, and that's what we're doing.

And the market, that's where the market's going; parents want their kids to take more after school tutoring at a much younger age and they're willing to pay higher dollars for smaller classes.

That's where the trends are moving.

So it's both, Trace; a good answer.

Ladies and gentlemen, we are now approaching the end of our conference call.

I will now turn the call over to New Oriental's President and CFO, Louis Hsieh for closing remarks.

Well, again, thank you everybody for joining us today.

If you have any further questions, please do not hesitate to contact me or any of our customer investor service representatives.

Bye, bye.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.