New Oriental Education & Technology Group Inc (EDU) 2012 Q3 法說會逐字稿

Good evening and thank you for standing by for the New Oriental third fiscal quarter 2012 earnings conference call.

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

After management's prepared remarks, there will be a question and answer session.

Today's conference is being recorded.

If you have any objections you may disconnect at this time.

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

Hello, everyone, and welcome to New Oriental's third quarter of 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 US Private Securities Litigation Reform Act of 1995.

Forward-looking statements involve inherent risks and uncertainties.

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

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

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

As a reminder, this conference is being recorded.

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

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

Louis, please?

Thank you, Cynthia.

Hello, everyone, and thank you for taking the time to join us today.

As you have seen from our earnings release our third quarter performance was disappointing and unacceptable to us.

While our net revenues were affected by the early timing of Chinese New Year which flows through to the P&L, negatively impacted our profit margins as well, now profit margins were also affected by our efforts to increase penetration in the K-college segment in our 50-city school network that we compete in with the addition of 81 learning centers in the quarter.

We will strive to do better and are committed to maintaining a strong balance between growth and profitability in the quarters ahead.

I will now walk you through the details of our third quarter.

First, as we predicted in January, this quarter's financial results were negatively impacted by the early timing of Chinese New Year festival in 2012.

Chinese New Year fell on January 23 which was a couple of weeks earlier than usual.

Thus our normal two-week early session before Chinese New Year was shortened by just to one week.

Thus many students who would normally sign up for New Oriental's training courses during one or both sessions before and after Chinese New Year elected not to enroll in the early session but instead enrolled in the second session after Chinese New Year or chose to wait until the spring quarter which has a longer course duration.

Consequently, student enrollments and net revenues for the first two months in the first quarter -- in this third quarter were soft.

You may recall that in the third quarter of 2009 when the Chinese New Year fell on January 26, our performance was similarly affected.

Encouragingly, we've seen a strong bounce-back in enrollments and deferred revenue in February as students signed up for spring courses in order to prepare for the major exams in the summer such as the college entrance exam or gaokao and the high school entrance exam or zhong kao.

The back-loaded demand drove enrollments for language training and test preparation courses in the quarter to approximately 596,100, an increase of 21.6%.

Furthermore, as of February 29, 2012, our deferred revenue balance was $239.8m, an increase of 59.2% year over year.

This level of deferred revenue implies strong financial performance for the next fiscal quarter.

In order to take advantage of the strong demand for our services and the hugely promising market in China, we accelerated the implementation of our fill-in strategy of building small learning centers in the 50 cities where we already have a presence.

During the quarter, we opened a net 81 learning centers in about 25 existing cities.

About 50% of the new facilities are small-sized learning centers under 500 square meters, and about 20% are medium-sized learning centers, between 500 to 1,000 square meters.

In the past six months, we've added a net of 120 learning centers in total with over 80% of them outside of Beijing and Shanghai.

We also hired approximately 4,200 teachers and staff in the past half a year.

These expansionary efforts resulted in a significant decline in our non-GAAP operating margin to 21.4% for the nine-month period year to date as compared to 23% in the year ago period.

We recognize the importance of balancing growth and profitability and we'll manage the pace of learning center and staff expansion accordingly in the quarters ahead.

However, management made the decision to carry out the rapid expansion and increased G&A spending based on the following considerations.

First of all, as the market leader, New Oriental is committed to enhancing the Company's leading brand name through hiring, training and retaining the best teachers, developing the best teaching and course materials and providing the best customer service.

We must continually invest in improving our teaching and course materials to sustain our number one brand-name position in China.

Second, we are working on becoming the number one or number two player in the K-college tutoring market and test prep market in each of the 50 cities we compete in.

To attain that goal, we must invest in each city to achieve the critical mass of learning centers which helps us to become a credible player in each market and to achieve economies of scale advantages.

We continue to see enormous demand potential outside of Beijing and Shanghai and we're acting quickly to establish our market-leading position in these lucrative fast-growing markets.

We believe the short-term pressure on margins will be replaced by long-term market leadership and financial returns in due course and we continue to place emphasis on operational efficiency and network optimization as we believe the impact can be offset over time by higher ASPs and higher utilization rates of each center.

Once again we're very confident that New Oriental's strategic expansion in the fast-growing cities will lead to a long-term sustained market leadership and profitability.

Thirdly, short-term financial targets are tertiary in importance behind being a leading brand and having a top market share.

Our target 30% top- and bottom-line growth each fiscal year has been achieved (technical difficulty) target in each of the past five years since we have been a public company.

We hope to do so for a sixth consecutive fiscal year in 2012.

Across our business lines our key growth drivers continued their strong momentum in the third quarter.

Our overseas test prep programs recorded year-over-year enrollment growth of about 10% to about 80,500 and year-over-year gross revenue growth of over 26% to $55m.

Our K-12 all subjects tutoring business recorded year-over-year enrollment growth of about 30% to 371,500 and year-over-year gross revenue growth of about 48% to $69m.

I particularly want to highlight the VIP personalized courses continue to maintain the most rapid pace of growth among our business lines with year-over-year enrollments up more than 62% to 25,500 and year-over-year cash revenue growth of over 73% to about $53.5m in the quarter.

This result demonstrates the huge demand for the Chinese market for our premium quality VIP courses.

Our Vision Overseas Study group consulting business continues to outperform with year-over-year gross revenue of approximately 55% to over $7m in the quarter.

Following our efforts to promote the online course regiSatiadhion, we continue to invest to keep up with new technologies and learning trends.

As Chinese students increasingly use Apple, Android and Windows mobile devices to access the Internet and social networking sites to interact and learn we are excited to announce that we are investing in a multi-year multimillion dollar per year IT initiative to create and distribute mobile apps and tools to allow our students to access our content and learn through their mobile devices.

Through the new initiative we will be able to better target the students for our market programs and services and allow them to register and view our offerings from their mobile devices.

In the long run, this investment will increase students' stickiness to our courses and improve the efficiency and efficacy of learning methods and course regiSatiadhion.

to declare a special dividend of $0.30 per ADS.

The cash dividend will be paid on September 29, 2012 to shareholders of record at the close of business on August 31, 2012 with an ex-dividend date of August 29, 2012.

The aggregate amount of the dividend payment is approximately $50m which will be funded by surplus cash on New Oriental's balance sheet.

New Oriental generates an increasing amount of free cash each year as a result of our highly profitable and CapEx-light business model.

The Company's senior management and Board of Directors are very cognizant of the need to create superior shareholder value.

We will assess the cash needs of the Company and we'll consider returning a portion of excess cash to investors from time to time in the form of share buybacks and/or special cash dividends.

You may recall that between 2008 and 2010 we have in aggregate repurchased approximately 5.6m shares of our ADSs for approximately $93m from the market which demonstrates our inclination and history of returning capital to investors.

Before moving to the question session, I would like to go through some financial highlights.

Net revenues from educational programs and services for the third fiscal quarter were $156.5m representing a 27.6% year-over-year growth.

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

Total student enrollments in academic subjects tutoring and test preparation courses in the third quarter of fiscal year 2012 increased by 21.6% year over year to 596,100 from approximately 490,200 in the same period of the prior fiscal year.

As I mentioned, the strong bounce-back in February was the driving force behind the high enrollment increase.

Operating costs and expenses for the quarter was $157.9m, a 41% increase year over year.

Non-GAAP operating costs and expenses, which excludes share-based compensation expense, for the quarter was $152.3m, a 41% increase year over year.

Cost of revenue for the quarter increased by 30.9% year over year to $71.9m, primarily due to the increase in the number of courses being offered and the number of schools and learning centers in operation.

Selling and marketing expenses for the quarter increased by 52.9% year over year to $28.1m, primarily due to brand promotion expenses.

General and adminiSatiadhive expenses for the quarter increased by 52.3% to $57.9m.

Non-GAAP G&A expenses which exclude share-based compensation expenses were $52.3m, a 49.8% increase year over year, primarily due to the increase in headcount in the Company, expanded network of schools and learning centers to a net of 31 (sic - see press release) facilities in the quarter and invest in content and new program development offerings as well as in improving teacher training resource.

Total share-based compensation expenses, which were allocated to relating operating costs and expenses, increased by 67.6% to $5.6m in the first quarter of fiscal 2012 from $3.4m in the same period of the prior fiscal year -- third quarter, sorry.

The increase was primarily due to a replenishment option grant to replace an expiring option grant from 2008 to retain key senior management team members.

Income from operations for the quarter was $16.6m, a 21.6% decrease from $21.2m in the same period of the prior fiscal year.

Non-GAAP income from operations for the quarter was $22.2m, a 9.6% decrease from $24.6m in the same period of prior fiscal year.

Net income attributable to New Oriental for the quarter was $22.4m, representing a 3.7% decrease in the same period of prior fiscal year.

Basic and diluted earnings per share attributable to New Oriental was $0.14 and $0.14 respectively.

Non-GAAP net income attributable to New Oriental for the quarter was $28m, representing a 5.3% increase on the same period of prior fiscal year.

Non-GAAP basic and diluted earnings per ADS attributable to New Oriental was $0.18 and $0.18 respectively.

Capital expenditures for the quarter were $25.2m, which was primarily used to purchase three floors of a building in Guangzhou to be used for that school's headquarters, costing approximately $9.6m, and to add a net of 81 new learning centers.

As of February 29, 2012, New Oriental has cash and cash equivalents of $408m as compared to $379.2m as of November 31, 2011.

In addition, the Company has $49.4m in term deposits and $300.4m in short-term investments as of February 29, 2012.

Net operating cash flow for the third fiscal quarter was approximately $66.9m.

New Oriental's deferred revenue balance, which is cash collected from registered students and courses recognized proportionately as revenues when instructions are given as of February 29, 2012 was $239.8m, an increase of 59.2% as compared to $150.7m as of February 28, 2011.

For the first nine months of fiscal year 2012, New Oriental reported net revenues of $578.4m representing a 37.6% increase year over year.

Total student enrollments in academic subjects tutoring and test preparation courses in the first nine months of fiscal year 2012 increased by 17.2% to 1.875m from approximately 1.6m in the same period of prior fiscal year.

Income from operations for the first nine months of fiscal year 2012 was $107.4m, representing a 26.2% increase year over year.

Non-GAAP income in operations for the first nine months of fiscal year 2012 was $124m representing a 28.2% increase year over year.

Operating margin for the first nine months of fiscal year 2012 was 18.6% compared to 20.2% for the same period of prior fiscal year.

Non-GAAP operating margin, which excludes share-based compensation, for the first nine months of the fiscal year was 21.4% compared to 23% for the same period of the prior fiscal year.

Net income attributable to New Oriental for the first nine months of fiscal year 2012 was $116.4m, representing a 33.1% increase year over year.

Basic and diluted net income per ADS attributable to New Oriental for the first nine months of fiscal year 2012 amounted to $0.75 and $0.74 respectively.

Non-GAAP net income attributable to New Oriental for the first nine months of fiscal year 2012 was $133.1m, representing a 34.3% increase year over year.

Non-GAAP basic and diluted net income per ADS attributable to New Oriental for the first nine months of fiscal year 2012 amounted to $0.86 and $0.85 respectively.

Turning to our outlook for the third fiscal -- fourth fiscal quarter of 2012, New Oriental expects total net revenues in the fourth quarter of fiscal year 2012 from March 1, 2012 to May 31, 2012 to be in the range of $182.7m to $189.6m, representing year-over-year growth in the range of 33% to 38%.

The 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).

Your first question comes from the line of Catherine Leung of Goldman Sachs.

Hi.

My question is really on if you can discuss how you're pacing your network expansion to attain your long-term market share goal, particularly in terms of accelerating -- deciding to accelerate the expansion this quarter versus spreading it out more evenly and if the expansion is affected by the seasonality of your faster-growing business lines?

Thank you.

Thank you, Catherine.

For us, I think if you think about the seasonality in our business it makes sense to add more learning centers in Q2 and Q3 of each year, meaning in the fall and in the winter, and that way we can take advantage of the busy season which is really the winter, the spring and the summer.

So if you look at Q2 we added 39 learning centers because that is the slow season but it's preparing for the winter and the spring.

And in this quarter we added 81 so bringing it to 120 for those two quarters.

That pace will slow going into Q4 and Q1.

It doesn't make a lot of sense to add too many learning centers in the summer because Q2 is usually a slow quarter.

So you'll see us add more centers in Q2 and Q3 than we do in Q1 and Q4.

Having said that, the reason we're expanding so fast is because we're seeing explosive growth outside of Beijing and Shanghai and so to take advantage of that right now we have between zero and 10 learning centers in most of these cities and our largest competitor in each city which would be the local small player will usually have between 10 and 30 or 40 learning centers.

So we're playing catch-up.

If we want to be credible and be the number one or number two player in every market that we play in we've got to get to a critical mass size.

And so it's because of strong demand and because we want to get the economies of scale in these cities outside of Beijing and Shanghai that we're expanding so rapidly.

There is a significant early mover advantage in these areas.

It's easier for us to establish a learning center and get a brand new student than it is for us to pull an existing student from another school that is already there.

So for us it's a race to get as many flags planted in each city as possible to reach critical mass and then to improve the operating margin of that city.

Does that answer your question, Catherine?

Yes, thank you.

Thank you.

Your next question comes from the line of Chen-Yi Lu of Cowen and Company.

Thank you.

I have a question regarding the operating expense trend going forward.

Given the spending more in sales and marketing this quarter for branding purpose and also for more teachers to support the school expansion, can you give us a view in terms of operating margin in 2012 and also fiscal 2012 and fiscal 2013?

Thank you.

Yes, fiscal 2013 I don't have the numbers yet because we're going through budgeting now.

Fiscal 2012, because of the early timing of Chinese New Year and probably the more rapid expansion these last two quarters, the margin will probably come in -- GAAP operating margin somewhere around 15% to 16% maybe.

And then I think -- I know I've said this before but I do believe we are troughing on margins and the management team is committed to slow down the pace of learning center growth for the next two quarters.

And so I think you'll see some benefit in Q4 and certainly by Q1 you'll see the benefit of the slowdown in hiring and the slowdown in new learning center growth.

So I'm very optimistic that 2013, barring any kind of disaster, will be a good year for New Oriental.

So basically the margin should not be lower than in 2012.

If you say you're going to slow the expansion can you give us a view as how many learning centers you plan to open for (multiple speakers)?

Well, I think what we're going to do now is we're going to start changing it to the number of capacity because remember a large learning center is usually 1,000 to 2,000 square meters, a small one is only 200 to 500.

So if we give you the absolute number it's not going to be as meaningful.

So if you think about our network of 608 learning centers today, 300 of them approximately are large, they're larger than 1,000 square meters.

Then you have another 55 schools which are also large, the school is the largest building typically in the city.

So you have 355 large ones.

We have approximately 120 medium-sized learning centers and 80 small ones.

The 80 small ones that are 200 to 500 [square meters] have all been built in the last two or three quarters.

So going forward you're going to see more of these small and medium-sized learning centers than you will of the large learning centers.

So what we'll try to do is start giving you more capacity increase based on square meters increase.

And I think that number will somehow come out to approximately 100,000 square meters or so is a ballpark number.

So equivalent to 100 large learning centers.

Okay, great, thank you.

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

Yes, thank you.

Louis, can you talk about cities outside of Beijing, Shanghai where you feel you've already reached critical mass and what margins look like in those cities?

Well, I think there's only a couple that we've hit critical mass outside of Beijing and Shanghai, most notably will be cities like Wuhan.

And I think in those cities, if you don't count corporate overhead, the operating margin is somewhere between 20% and 25%.

We believe that in most Tier 2 cities when the number of learning centers begins to slow significantly the operating margin will go into the 20s for that city, between 20% to 25%.

For Beijing and Shanghai it's over north of 35%.

And the only difference -- the biggest difference is that Beijing and Shanghai have the biggest dose of overseas test prep which is our most profitable business.

The second reason is Beijing and Shanghai have a slightly higher ASP, about 30%.

You know the costs are higher in Beijing and Shanghai, the ASP premium is actually even above that.

So for those two reasons Beijing and Shanghai are the most profitable.

But any city in our network when it hits critical mass should have over 20% operating margin because every product line outside of books and the private schools should have over 20% operating margin.

Okay, thank you.

And just as a follow up, and it may be a little early to ask this question, but can you talk about any visibility that you might have on the all-important August quarter?

It's too early for the August quarter but I think the August quarter, there seems to be a slight pent-up demand in overseas test prep; that seems to be the big quarter for that.

And because -- and the reason I say that is because overseas test prep was light in Q3, the other time to study for it is the winter holiday.

Because of the shortened Chinese New Year holiday I have a feeling that if it's similar to 2009 you'll see a big bump in overseas test prep during the summer as students who didn't study in the current Chinese New Year holiday deferred it until Q1.

Okay, thank you.

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

Hi, Louis, thanks for taking my question.

My question is regarding your VIP business which has become a key growth driver for the Company.

Among your VIP enrollment I'm wondering how much of them belong to K-12 and also overseas test prep respectively?

Also to understand the margin profile better how does the margin for a mature VIP center compare to a small or large class center?

Thank you.

Can you repeat the last part of the question, Philip, regarding the center?

Yes, I want to compare on a mature basis, what kind of margin can your VIP center achieve as compared to a small or large class center in Beijing or Shanghai.

Okay.

Well Beijing and Shanghai are going to have higher margins.

I think the first part of your question, about 25% of our VIP enrollments are overseas test prep.

Those have a very, very high ASP and a very, very high profit, they're probably over $3,000 a class.

The other -- probably 60% of our -- 50% to 60% of our VIP students are K-12.

And then you add English language in there probably 60% are K-12 or English related.

So that's the majority of the VIP.

The margin for VIP the way New Oriental does it is higher than our competitors by far because half of our enrollments are really VIP 1-5 and then other half are one-on-one.

So remember 1-5 is five students per class, each student paying approximately $1,000.

So it's not the one-to-one where the student pays $2,000, it's 5-1 where students pay -- four or five to one where students pay $4,000 to $5,000 to one for one student.

So our margin profile in a mature center will easily be over 20% operating margin for our VIP program in any city assuming it gets relatively full.

It means when the center is full or 60% to 70% full the margin profile will be over 20%.

So the margin will be very similar to even the large class (multiple speakers)?

No, nothing will be similar to the large class; the large class will be the highest.

But it will be similar to a small class.

Okay, thanks, Louis.

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

Hi, thank you.

First I want to clarify regarding the learning center expansion.

Louis, did you just say you seek to increase the capacity by 100,000 square meters?

Right, that's sort of our target, it's a nice round number, somewhere between 90,000 and 110,000 square meters.

That's equivalent to 100 1,000-square-meter learning centers.

So most likely what that will mean is we'll probably have 30 or so 1,500-square-meter centers and probably 100 small centers.

Okay.

And how long do you plan to achieve that target?

Well, I think that will be an annual target.

So you'll probably see most likely if the school heads will listen to us, we'll basically slow down learning center growth in Q4 and Q1 and we'll pick up again in Q2.

That's the right pattern, because if you think about it the strongest demand cycle is Q3, Q4 and Q1.

So the time to get capacity on line is in the summer Q1 and in the slowest quarter, Q2.

The problem with getting too much capacity on line in Q2 is it makes the fall quarter negative operating margins.

So it's a very delicate balance.

So that's your like annual running rate for capacity expansion?

Correct.

So my question is in order to achieve leading positions in all the cities how long do you expect to keep in this growth mode (multiple speakers), three years or --?

I think we could easily do it for the next 10 years unfortunately.

But you know, Ella, it won't matter soon because right now we have about 250 mature learning centers and in three years the percentage of -- so we only have about 40% of our centers are quote-unquote mature, that means they've been around for more than three years.

In the next three years that number will go from 40% to 65% if we continue the current expansion pace.

And then over the next six years that number will go to 75%.

So you can see that over time the number of mature centers that are generating on average 20% operating margin is going to trump and overtake the new learning centers.

So then the number -- as long as we add between 100 to 120 learning centers a year it won't impact the margins much.

Sure.

And then my next question is regarding your margins.

Although operating margins are down, but I actually see gross margins are up year over year.

And it's the same case for the past few quarters.

So could you please give us some color, because my understanding is expenses such as learning centers rental payments are recorded in the cost of revenues?

So, I'm just wondering why you're still seeing improvement in gross margins.

Because we didn't increase salaries as much for teachers this year as we did last year.

So you're seeing -- like last year we increased teachers' salaries by 11% 12%, this year it was 8% to 10%.

So you see some margin advantage.

Also you're seeing the effect of the older learning centers getting filled up.

When they fill up the rental cost goes down because there is more students to defer the cost base.

So you'll see the gross -- and also we are just raising prices above what our costs are going up.

So I think it's a very healthy sign.

And the reason that the margin, the operating margin goes down is because when we add so many learning centers, like 120 in six months, each learning center has like 10 to 15 employees.

So those people are basically getting paid and the learning center is not profitable yet.

That's what drags down the operating margin.

Okay.

Thank you for the color.

Your next question comes from the line of Brandon Dobell of William Blair.

Thanks, Louis.

Just two questions on mix.

First in the overseas test prep business, maybe the mix between the different test prep programs you offer, so GMAT or IELTS or TOFEL.

And is there one area that's growing a lot faster, and is that area that particular test more expensive for the kids to take from you?

And the same kind of question within tutoring, I guess I'm just trying to get a better feel for the mix within those two segments and how we should think about the ASPs in terms of both pricing and mix.

Okay.

Good question, Brandon.

On the overseas test prep IELTS and TOFEL together are about two-thirds of overseas test prep.

And they are each growing about 50% year over year in revenues, and about 15% or so enrollment per year.

So I think the price of IELTS and TOFEL now is like $700 and something per class, so that's [$750] per class.

So that's the scale of size.

The rest -- but the fastest growing part of overseas test prep is actually SAT.

And so as we add SAT, ACT and AP test for high school that -- and that's growing very fast.

And the other one that's growing quite fast is GRE and GMAT.

So those are -- but I would say SAT is the fastest growing.

Although it's small it's like 35,000 enrollments it's [growing] over 50% a year typically, so I think that's the margin profile.

Do you -- what was the second part of your question, Brandon, sorry?

The same kind of question within the all-subjects tutoring, is there a particular kind of grade or subject that's a higher price point for you guys (multiple speakers).

Yes, well, for us the higher price point is the one-on-one tutoring program.

And most of the one-on-one tutoring program students either want English or they want science.

So that's where -- those are the very high price points there.

And the highest price point in the VIP is really the -- is the -- in the U Can also is probably the over -- is the SAT one-on-one tutoring.

That's $3,000 to $5,000.

So I think those are the higher price points.

Within the U Can subjects, English is still number one obviously because it's the most important subject.

Math is number two and then it's followed by physics, chemistry and the lot.

Now physics and chemistry will typically have a higher ASP than mathematics because more of those students want to take small class or one-on-one.

You know those are more difficult conceptually.

Okay.

(Multiple speakers).

But the encouraging thing is for our middle and high school students, right, if you think about when we started this U Can program three and half years ago, the hurdle for us was whether our brand would extend to non-English classes.

Well, now, non-English part of U Can is 60 -- is almost 65% of revenue and one-third English; it is two thirds other things.

So that shows you the powerful brand of New Oriental extends outside of the English classes.

Okay.

And then that final question I want to make sure I understood your comments about fiscal 2013 margins.

It kind of sounded like the next couple of quarters could still be a little rough comparing to the previous year, but that the back half of 2013 should start to see some margin expansion or am I -- (multiple speakers).

Well, I don't look that far ahead.

What I think is going to happen is because we added so many learning centers in Q2 and Q3 there is a period where those learning centers are going to fill up, and that will probably be Q4.

The margins will still be a little bit depressed in Q4, but revenue growth should be very strong in Q4.

So that the number -- but anyway we always try to get you guys 30% top and bottom line growth.

Top line is never a problem, so the bottom line we've got to make sure we maintain.

We are at 33% net income margin, net income growth so far this year.

We want to make sure we are well above 30% for the whole year.

Okay.

So that's one thing.

On the -- what's going to happen is I think Q2 -- Q1 and Q2 if we don't open a lot of learning centers in Q4 and Q1 it will begin to work its way through the system by Q2.

So -- and it depends on how many we add in Q2 and Q3 that would determine what the margins on the backend look like next year.

But I have a feeling that we will become more steady state between 100 and 140 centers, occupying about 90,000 to 100,000 square meters.

And I think if we do that every year the margins will trend up.

Okay, great.

Thanks, Louis.

Your next question comes from the line of Eric Wen of Mirae Asset.

Hi, good evening, Louis.

Thanks for taking my questions.

Eric.

I just have a simple question that if I divide your sales marketing costs over your cash revenue, which you also mentioned in your press release, I got roughly about the same level over the last two years.

Can you comment on what's the sales marketing cost per cash revenue, which is like how much money you would spend to get $1 of your revenue by sales marketing?

How this is going to trend over the next few years for the company?

Thanks.

Well, I think our marketing is changing.

I think historically, and I think it's consistent this year, we are spending approximately 7% of our total revenue on promotion expense, not counting sort of marketing people but just direct advertising on TV, internet and things like that.

The reason I don't know the number going forward is because more and more of the marketing is going online.

And that's part of what our iPad, iPhone initiative is, is we want to begin to target the sites that students spend most of their time at, and then target, more target their needs and send ads to them.

So I think it's that it's moving more online, but I would say the percentage of 7%, it's been the same for five or six years, so I don't really see that changing.

I think marketing expenses were high this last quarter because the school heads were a little bit panicked, given that the early timing of Chinese New Year our enrollments were actually very poor in January, they were down 17%.

That's why we had cut our guidance for the -- we had a low guidance for this quarter.

Then, with that extra marketing, the enrollments for February were crazy, they were up like 58%.

So -- but then, so a lot of it is Chinese New Year timing.

But I think the enrollment -- the extra marketing actually paid off, and it helped us to be in a very good position in this fourth quarter.

Thanks.

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

Hi, Louis.

Thanks for taking my follow-up question.

Just about your comment about controlling the pace of investment and also balancing the profitability, given the decentralized operations for New Oriental is there any plan to better control the pace of investment for the school heads in your regional operations?

Yes, I'm not -- I mean honestly you know our system is not so centralized it's more decentralized and that's part of our problem.

That's why I'm -- I find out about expenses that go off the rail after they've gone off the rails.

And you've know that for many years.

That's part of our problem in New Oriental is the finance team usually sees things after they've already been spent.

And so what happens is -- that's why I always ask you guys as investors and analysts is don't look at a one quarter snapshot, because when we over-expand like this quarter in Q3, they you'll see us under-invest in the next couple of quarters to make up for it.

So over a whole year period it all works out.

So that's why I said don't panic when we have one bad quarter, don't panic when we overinvest in one quarter, because then when we see it then we will correct it.

I wish I could correct it on the spot, but there are so many contractors and so many school heads, there is 55 -- we have 29,000 employees.

I can't keep track of what these guys are doing.

So the -- and some school heads don't really worry so much about the budget because they've already missed it.

If they've missed it then it's in their incentive to miss it big, so then they can get a bigger bonus the next year by adding capacity.

So we have all these dynamics in place, it's not as -- I wish it was more centralized.

We do have budgeting that is centralized.

But it's because we depend so much on the school heads that's one of our weaknesses in managing the cost.

And so sometimes -- whenever you see an overspend in one or two quarters, you'll see an under-spend the following two quarters.

So over the long term it works fine, but in the short term it's quite bumpy.

Just a quick follow up, how about the hiring plans, given your 100,000 square meters network expansion for next (multiple speakers).

Well, we are going through budgeting now, but for Q4 as [Stephen Yang] our Vice President of Finance, what I told everyone last week is stop hiring.

Okay.

So, except for teachers, except for teachers I told him to stop hiring.

And so I think you'll see a slowdown in employment growth for the next -- this Q4 and probably into Q1 and then it will pick up again.

We can always slow down for one or two quarters, because the -- we just -- we need to keep expanding to keep our market position.

So I think we'll finish this year right around 29,000 to 30,000 headcount, which is like 8,000 add that's a lot.

But about 16,000 of those, or 17,000 will be teachers.

Going forward the number of new teachers will be much higher than the number of other staff.

So we were just joking before the call, we are paying a consultant a lot of money to tell us exactly what we already know.

(Operator Instructions).

Your next question comes from the line of Anita Chen of Jefferies.

Thank you, management.

Can you elaborate the headcount number of this quarter including full-time and part-time teachers?

And what is utilization rate of the current quarter.

Thank you.

Sure.

We have a total of 15,500 teachers at the end of the quarter.

Of those teachers full-time is 7,000 which mean there 8,500 part-time teachers at the end of the quarter.

Our utilization rate is still not that high.

And that's part of the reason why we are adding more learning centers, because especially in Tier 2, Tier 3 cities you have to have a critical mass of teachers and they don't get enough hours unless you have enough students to cover them and that's why we need more learning centers.

The teachers move around from learning center to learning center.

And what they care about is getting more hours.

So I would say our utilization in Q3 was not very high because the first week of the quarter was -- the first half was slow because Chinese New Year was so early that students didn't want to sign up for a one week course, they normally get a two week course.

And so the utilization was probably quite low, normally it would be about 60%, 55%, 60% in this quarter, it's probably a little bit lower than that because of the timing of Chinese New Year.

Okay, thank you.

Your next question comes from the line of Chao Wang of Merrill Lynch.

Morning, Wang Chao.

Maybe his question was answered.

Chao, your line is open.

Hi, good evening.

Hi, Wang Chao.

Hi.

I have two quick questions first one is by opening 80 centers this quarter, how much one-off expenses are recorded?

Of the $25m in CapEx about, probably $10m or $11m of it is for the new center openings.

I mean in the P&L how much cost expense is one-off?

Oh, each -- I don't know the exact amount per learning center.

The total cost provision is about $50,000 to $70,000 for a small one and over $100,000.

But it's the headcount that comes in, so I don't know how -- which -- when during the quarter they came in.

But we added 180 learning centers, and you've got an extra 800 to 900 people in the system plus teachers that we are paying full time salaries to.

Okay thanks.

Right, so whatever that averages out, I don't know the exact amount.

Sure.

The second one is regarding Vision Overseas Study Consulting, what is the margin level of that business for both (multiple speakers) margin and (multiple speakers)?

The margin is very high, it's well into the 20s on an operating margin basis.

It's a very profitable business.

I just -- I don't know how long term it is.

Because I think that, Wang Chao, at some point Chinese kids like other regions will figure out how to do it themselves.

They won't need us to do that.

Okay.

But I think the profit margin is very high, if you think about students paying $7,000, $8,000 $10,000 for guidance and an SAT test prep class.

And so I think the margin is quite high; it's well into the 20s.

Okay, got it.

Thank you very much.

Yes.

Your next question comes from the line of Jeff Meuler of Baird.

Yes, thanks for taking the question.

Hey, Jeff.

Louis, can you just talk about the implications for, I guess, brand promotion spending as you grow more in the Tier 2 cities and pursue your fill-in strategy there.

Because on the one hand I would think the ad buys would be cheaper than Beijing and Shanghai, but maybe your brand is not quite as well known or you don't have as strong a position yet in those cities.

Yes, I think our brand -- that's a good question, Jeff, our brand promotion expense are really trending towards online.

So actually it won't matter what city it's in.

The only difference will be in the Tier 2 cities the TV buy will be cheaper, because it's not Beijing and Shanghai TV shows.

So in that case it will be cheaper.

But I think as most of our market now is moving online, and so there -- because the web is all over China there is no delineation of local versus other areas.

You'll see that -- so it all depends on -- ad buys will depend on how much Baidu and Sina and Tencent and those companies increase their ad rates.

So I think it's going to --if you assume they are going to increase some 10% to 15% that's what -- and then we'll probably increase our shift of our ad buys toward online from the traditional media.

Okay, and then I guess this is related to that but just a follow up on the initiative around the mobile tools.

Is it more for advertising or is this learning tools that you guys are rolling out on the different mobile platforms?

Oh, so we want to do -- we want to have a [mobile] strategy, because as you guys know Chinese students are the earliest adopters of smartphones.

Every Chinese child wants a smartphone and iPads and things like that.

And so we want to make sure that we are on those mobile devices.

And they are going to learning from those.

They are going to start registering for classes online with their credit cards, and then through their mobile devices.

They are going to start accepting learning tools and listening to their courses through their mobile devices.

And so we want to have the tools and the applications.

And also we want to market to them directly.

We want to know what sites via their mobile devices that students visit and target market them.

And so it's --.

Thanks, Louis.

Yes, so it's a combination of all those.

Okay, thank you.

Your next question comes from the line of Paul Ginocchio of Deutsche Bank.

Hey, Louis, good morning.

Just to go back to the margin question, I think you were pretty clear saying that margins would go up annually if you slowed down your growth.

I just want to be -- if you kind of factor in the mix impact of going towards one-on-one and VIP, and in going to the second and third tier markets, you -- just to confirm you still think you can grow margins even with that sort of negative mix impact as long as you slow down growth a little bit but still deliver the 30% top line?

Correct.

I believe that the key is the number of new learning center openings, because that's what brings in a lot of headcount that don't produce anything in that quarter.

And so if we can -- even the smaller cities will have 20% operating margins when they're mature, so everything is in our favor, the bigger we get the more economies of scale we get in Tier 2 and Tier 3 cities.

And so as the utilization improvements in each of these cities we will get higher margin even though we are moving toward a one-on-one format.

Don't forget we are raising prices on one-on-one and Kids at a higher rate.

Those are our two lowest margin products.

So I think it is -- so the key thing is utilization, and the key is new learning center openings.

So if you look at the period of Q2 last year through Q1 of this year, one full year, we only added 86 learning centers in that four quarter period.

Our operating margin gap went from 16.5% to 19.5% in those four quarters.

You can see it directly, as soon as you slow down learning center growth, the margins went up 300 basis points, no other change.

And so if you think -- so it doesn't take much to go even a little bit lower than that.

Let's say we open up 80 learning centers the margin would be 20% right away.

So we probably won't do that for a while.

And then even over time, Paul, as the old learning centers mature the margin will trend up by itself.

That will be partially offset, you're right, by the fact that the move is towards smaller and smaller classes.

But we also intend to keep increasing the price in smaller and smaller classes, so then the margin degradation impact is much less.

Perfect, thank you.

Your next question comes from the line of Charles Cartledge of Sloane Robinson.

Hi Louis, congratulations on the results.

Thank you.

So you got what you wanted, Charles.

That's what I was referring to actually.

A dividend.

I wanted to ask you about the dividend.

You said previously in the last call that we done on the last result you delineated how much cash you could broadly define as excess cash.

And we discussed the taxation that may apply to funds remitted out of China.

Could you address -- you did say it was a special dividend, but how should we think about the excess cash generation in the business which could be throwing off more than $50m a year?

Well, it's clearly throwing out more than double that a year right now.

Okay (multiple speakers).

Right, and so I think is that what we would like to do and we discussed in the Board, is -- you guys know it took me two years to get this dividend passed, so you should give me a little bit of a break.

I (multiple speakers)

Is that we want to look at every year the cash generation of the company around budgeting time, around this time.

We also want to look at the cash needs of the company with vis-a-vis acquisitions or vis-a-vis buying buildings.

Like we just bought our Guangzhou headquarters building, we have three floors of it so we can have -- stable headquarters there.

So we look at those different needs.

Let's say next year we generate $100 -- I'll just throw out a number, $150m of cash.

If we used $20m to $30m to buy buildings and we don't -- and we have a couple of small acquisitions I can see us conceivably paying out whatever is left, half or a little bit more in another special dividend or some share buybacks.

On the taxation side we get taxed at 5% to 10% of the money that we remit to you guys.

Thank you.

And could I ask also on the Northeast China schools, you said that they've been performing badly in the last call.

Have you been able to turn them around or is it too early?

And then finally as you move onto the internet what we've seen with other businesses in China and I'm sure elsewhere is that as the internet disintermediates the physical world it can compress pricing.

And I was wondering if you've thought about that.

We did and that's why you don't see us being the big proponent of putting everything online.

But it's not just that.

It's not only us, it's what students want.

We have to follow what students want.

So I think it will have a low -- I mean our average ASP online is about $80, our average ASP on the ground or in the classroom is $300 so it does have that effect.

And I think the delivery costs are obviously a lot lower too.

And so, depending what content you put online, what content you leave off line.

I don't think -- I think students always prefer to learn one-on-one if they can and then small class.

So one -- online will have -- always have a presence and a growing presence, but it won't replace the classroom, so it will be a mix, and, yes, so it will have a dampening effect on ASPs if more --.

But you know right now is we don't count the online ASPs to you guys, right?

That's a separate group.

We don't -- even students we don't count.

So of the 2.4m of students that should be added the online students 2.7m, 2.8m students.

So we don't really count the online students.

We do count them in revenue obviously, but not in our classroom mix.

What was the first part of your question, Charles?

I'm just getting (multiple speakers).

The Northeast China schools.

Oh Northeast China schools, three of them have turned around Shenyang, Dalian and Harbin are doing well.

Changchun is still having some difficulties.

But that's because the school head there, that quit a year ago, took some people with him and started his own school.

And so it's -- this is the soap opera that is New Oriental.

And so Changchun got hit harder than the other three schools where we made school head changes.

So I think it will recover.

There is actually a funny story there.

I don't know if I should say it on air, but it -- so I won't say it on this.

If you want to ask me later I can tell you the story.

All right, thank you very much.

But it's very common in Oriental to have a school head quit a year ago, and then over the next six to nine months he is plotting to take teachers and take -- start his own school.

So that's what happened.

Thank you.

Your next question comes from the line of Jin Yoon of Nomura Securities.

Hi, this is Ruby sitting in for Jin Yoon.

I just have a quick question.

Can you give some color on kind of the developments on your MaxEn classes?

Yes.

MaxEn is progressing slowly.

I would say the enrollment for Q3 were a little bit disappointing.

It was like 140 and 150 so we had 300 enrollments the last two quarters or so.

It is progressing though.

Q3 is not a big quarter for that kind of English.

I think it's mostly Q4 and Q1 is a better time for that.

So we still have the five centers.

We haven't added any more.

They are still in the pilot phase.

So it will take us some time to get the formula correct.

The right number of classes, the teachers in place and then to give the students the experience that we expect.

So it's moving along.

It's (multiple speakers).

(Multiple speakers) add any new centers?

Yes, it's not a blockbuster, it's not a fast pace but it's moving along.

Okay, I see.

So in the next two quarters do you plan to add any new centers for MaxEn?

No.

I think if we do we won't go above eight for the whole year, right now we have five.

But I think even though the next three are subject to getting some traction in the first five centers.

I see, thank you.

Thank you, Ruby.

Thanks, Ruby.

Your next question comes from the line of Vina Satiadhi of [Moon Capital].

Hi there.

Can I just check as well on the income tax rate?

This quarter it's quite low at 5%.

Is that like some special kind of one-off gain that will benefit?

And what's kind of full-year guidance?

Is it still within -- you mentioned before like 11%, 12% range?

Over where -- I couldn't hear you.

Say that -- what are you referring to?

The taxes or what?

Income tax rate, income tax rate.

Yes.

The income tax rate will come out probably about 8.5%, 9% this year and will be even much higher next year, so about 11%.

Okay.

And on the cash balance are they all in renminbi right now and that's in onshore?

And have you (multiple speakers)?

I think there is $65m is offshore, which is $50m we are going to use to pay the cash dividend.

But, yes the majority, $680m of it is on shore.

Okay, and in local banks?

Yes, in local banks in about -- yes they are all in the local banks.

Yes, they are used for working capital in our different schools and then we have a lot of short-term deposits.

We have no risky investments.

They are all principal-protected investments.

Okay, great.

Okay, thank you.

Thank you.

We are now approaching the end of the conference call.

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

Okay.

Well, thank you, everybody, for taking the time to join us today.

We hope to see you at future earnings calls.

Have a good day.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now disconnect.

Good day.