New Oriental Education & Technology Group Inc (EDU) 2013 Q2 法說會逐字稿

Good evening and thank you for standing by for New Oriental's second quarter of fiscal-year 2013 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.

Sisi Zhao.

Thank you.

Please go ahead.

Hello everyone and welcome to New Oriental's second quarter of fiscal-quarter 2013 earnings conference call.

Our financial results for the period were released earlier today and are available on the Company's website as well as newswire services.

Today you'll hear from Louis Hsieh, New Oriental's President and CFO.

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 Securities 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 statements 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.

And thanks everyone for joining today's call.

We once again posted healthy revenue growth this quarter.

Our bottom line was performance was lower, however, largely as a result of a slower performance in Beijing and Shanghai, as well as cost and expense overhang following the aggressive network expansion we undertook in the last few quarters of fiscal year 2012.

As we flagged last quarter, we are now focused on pursuing a Harvest the Market strategy, meaning our priority is to maximize utilization in our existing network.

It's important to note that in the four quarters prior to Q2 of this year, during our Occupy the Market phase of our expansion, we added a net of 238 learning centers compared to just 86 in the four quarters before that.

Headcount during that period increased by almost 10,000, from approximately 24,500 to 34,300, so this gives you a sense of the cost pressure we're dealing with.

So although it will take some time to fully realign our cost structure and bring ourselves back to more acceptable levels of profitability, we are confident, as ever, in the strength of the New Oriental offering and we're confident about our long-term future.

In fact, our Occupy the Market strategy seems to have achieved its intended purpose -- benefiting New Oriental's market position; making us number one or number two in most key geographic markets where we have been established for over five years; and deterring most of our public and private company competitors from entering our key geographical markets or slowing their expansion plans.

Before we go through the business lines I want to first give you a bit more color on our bottom line for the quarter.

In line with our Harvest the Market strategy we added a net of a just 18 new schools and learning centers this quarter.

Beginning in late October 2012, all new learning center openings require the approval of my finance department and we will strictly control the number of new center openings.

Almost all the 18 learning centers opened in the quarter occurred before the new approval process.

During the quarter we have started a strict headcount review, school by school and department by department, in an effort to reduce staff costs.

During the quarter we were able to reduce headcount by around 1,500 staff.

While this will in long term -- while this will aid long-term efficiency, we incurred additional severance costs in the short term related to these reductions.

In our next two quarters we'll look to reduce headcount by another 1,000 to 1,500, mainly on the administrative side, which will mean additional severance expenses.

It will take a couple more quarters for these measures to bear fruit on the bottom line.

Another reason for the slower bottom line this quarter was the continued slowdown in Beijing and Shanghai.

There are a few reasons for this.

As I said, as our network outside these cities have grown, many students who would previously have attended our classes in Beijing or Shanghai are now opting to go to the New Oriental learning centers in their local areas where they can get a comparable level of education.

So there is one factor.

A second is that we're still working on integrating the new management teams that we've put in place in Beijing and Shanghai.

We're confident that we're making progress here, but it's going to take a couple more quarters before we get to where we want to be.

And on top of that we're also seeing increased competition in these largest two cities, so it's a tough market in Beijing and Shanghai right now, but we are balancing this out by investing in tier-two and tier-three cities.

And, finally, we also incurred further costs related to the SEC investigation of around $3m in the quarter.

We do not anticipate material further costs incurred related to the SEC in coming quarters.

Obviously, the bottom line isn't where we want it to be, but we're encouraged that the revenue growth continued to be solid.

Total revenues increased 30.4% year over year to $165.9m in Q2, which is seasonally the slowest quarter for New Oriental.

Total student enrollments increased 7.2% from a year ago, largely as a result of continued slowdown in Beijing and Shanghai.

Now let's go to the latest developments of our various business lines.

The K-12 all-subjects after-school tutoring business remained a highlight.

Enrolments grew 14% year over year and gross revenues were up over 50%.

The New Oriental brand is especially strong in this segment and parents are willing to pay premium prices for the premium education only New Oriental can provide.

Overseas Test Prep was slightly lower -- sorry, was slightly down this quarter.

Enrolments decreased 7% year over year and gross revenues were up 22%.

This was largely attributable to the slowdown in Beijing and Shanghai I just mentioned.

Furthermore, we are facing new competition from many private international schools and classes promoted by some public schools, especially in Beijing and Shanghai.

On the positive side, up to the end of last week in this current quarter, Q3, Overseas Test Prep enrollments have increased approximately 15% and cash revenue [up] approximately 37% for the quarter to date.

So this is an encouraging bounce back.

Our VIP personalized services classes showed encouraging growth, with enrollment growth of about 25% year over year and cash revenue growth over 38%.

There's still some work to be done here in terms of utilization and our focus going forward will be to bolstering the one-to-five offering, one teacher to five students, where margins are better.

Our strong brand will give us some room to increase ASPs, particularly in our Kids offering.

Our Vision Overseas Study Consulting business was a real highlight again this quarter, with revenue growth of 97%.

To position ourselves to benefit from the huge long-term growth potential we're seeing here, we plan to invest aggressively in Q3 to rollout Vision Consulting across more large cities throughout China.

We expect this to put some cost pressure on our bottom line, but we feel it is the right time to invest to capture this huge market opportunity and we're seeing strong demand across the market.

So looking forward, as I said, we think it's going to be a tough couple more quarters to bring our costs and expenses structure back to line and return to better levels of profitability.

This means continuing to implement our Harvest the Market strategy, focusing on utilization of our existing network, reducing headcount and looking to reduce costs in less profitable areas of our business.

While we're seeing, increasingly, competition from much of the market, top-line growth should remain strong and we expect continued business growth in areas like K-12 and Overseas Test Prep and Overseas Study Consulting.

In short, while the market is undoubtedly more competitive New Oriental is very much a premium player in this industry in the breadth of our offerings, depth of our expense -- sorry, expertise and broad and deep geographic footprint.

Thanks to our Occupy the Market strategy we are well positioned for the long term.

Before we move on to the Q&A I want to quickly go through some of the key financial metrics for this quarter.

You can, of course, find most of these in the press release.

Selling and marketing expenses for the quarter increased by 42.5% year over year to $34.3m.

This was primarily due to increase in the number of customer served -- service representatives and brand promotion expenses.

General and administrative expenses for the quarter increased by 62.1% year over year to $77.7m.

This was primarily due to increased headcount as we expanded our network of schools and learning centers in the four quarters prior to Q2, and the investigation-related expenses accrued in the quarter.

As I've mentioned, we reduced headcount in the quarter by around 1,500 and we look to improve efficiency and will reduce that further in the next couple of quarters.

Operating margin for the quarter was negative 16.2%, compared to negative 2.5% in the same period of the prior fiscal year.

Operating margins were significantly impacted by the substantial cost and expenses overhang due to the heavy investment in learning-center expansion in the past few quarters.

Net loss for the quarter was $15.8m, compared to net income attributable to New Oriental of $3.3m in the same period of the prior fiscal year.

This was due to the factors outlined earlier in my prepared remarks.

Turning now to the guidance for the next fiscal quarter, we expect total net revenue in the third quarter of fiscal-year 2013 to be in the range of $212.4m to $220.9m, representing year-over-year growth in the range of 25% to 30%.

This excludes the impact from the disposal of our ELITE English business.

Compared to our reported net revenue for the third quarter of fiscal year 2012, which includes the revenue from ELITE English business, growth is expected to be in the range of 22% to 27%.

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).

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

Please ask your question.

Hi, Louis and Sisi, thanks for taking my questions.

My question is about your Overseas business.

As you mention, you see intensifying competition.

Could you elaborate a little bit more on where -- do you see tougher competition in large-class format, or smaller class, or one-on-one format?

And if it's more difficult to compete in one-on-one due to other reasons, and if that's the reason, can New Oriental sustain the pricing power, given a more competitive environment?

Thank you.

Thank you, Philip, good questions.

The competition in Overseas Test Prep is not in the large classes.

It's really in the small and one-on-one classes.

And, as you've known us for years and many of you know, some of our own teachers have left New Oriental to start competing schools.

The barriers to entry are lower when you do small classes and one-on-one.

Some of our teachers, if they take away just five students, it pays their whole salary.

So you can imagine that there's a lot of good teachers who are starting their own business in the one-on-one and in small class where brand is not as big a factor.

In the large class we still obviously dominate.

So that's where the competition is coming from.

There's a second leg of competition, where middle and high schools throughout China have set up affiliate programs with international schools, so they're actually getting paid to send their public school students to those other schools.

They get paid by those schools or they're a profit share and so that is also hurting New Oriental's business.

Because as the public schools realize that more and more of their students want to go to college internationally or graduate school, they're offering international classes on weekends and evenings in competition with New Oriental through affiliated programs.

And they're obviously encouraging their students to go to their schools.

So those two areas of competition have put a damper on our Overseas Test Prep business.

Having said that, we've seen a very strong bounce back in this third quarter.

So enrollments, as I said, up to the end of last week were up 15% and revenue -- cash revenue up 37% for the first almost two months of this quarter.

So I think the margin remains healthy.

Also, Philip, remember that the Overseas Test Prep business as the number of students leaving China has slowed.

I think last year 390,000 or so, according to the Ministry, left China; that's only 15% growth.

Whereas in prior years the number of students leaving China was over 20%, so I think the market overall has slowed a little bit the growth rate.

And so I think those are the primary challenges we face in the Overseas Test Prep business.

So do you expect New Oriental to sustain the pricing power as we've seen in the past couple of years?

And do you have any specific strategy to overcome the two increasing competitions that you've just mentioned?

Yes, I think we will sustain the pricing power that we have enjoyed for the last 10, 15 years.

And I think what we'll do is that we will continue to do what we have been doing, which is to distance ourselves and become a more premium product.

So in the one-on-one and one-to-five space we will continue to raise prices and we'll actually hope that some of those students will actually pick the large-class offering.

Many students, their parents will not sacrifice in this area, so they'll always pick New Oriental as the best brand provider.

So if we price -- continue to raise prices we expect some students to actually switch to the large classes.

In addition, for some of our best teachers we are raising salaries, Philip, to keep them from trying to spin off on their own and compete against us.

So I think is that -- we're working on that.

Also we're working to increase utilization in the Overseas Test Prep centers, the one-on-one and the small class, to improve profitability.

So we're doing all that at the same time.

I'm not so worried about the Overseas Test Prep business.

Like I said, it's our bread and butter and it will continue to grow.

The market remains quite healthy.

And the Overseas Study Consulting business is booming, with revenue growth between 60% and 80% year over year.

So I think we're well positioned here.

Thanks, Louis.

Thank you.

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

Please ask your question.

Yes, thank you.

I guess, Louis, could you just talk a little bit more about what you're doing specifically in Beijing and Shanghai in terms of a turnaround plan?

And I know that you have a new management in place and some of the recent trends have been more encouraging, but as you talk about the increased competition and the students staying in their local markets, instead of traveling to Beijing and Shanghai to take courses, it sounds like those might be longer-term headwinds.

So I guess any additional specifics that you could talk about in terms of a turnaround plan, especially beyond just expense adjustments, if you're doing anything to stimulate stronger enrollment growth.

Yes, thank you, Jeff, that's -- those -- that's a very good question.

In Beijing and Shanghai -- Beijing is not really that problematic.

Beijing still had 26% revenue growth in the quarter.

Shanghai is the more problematic one and that's been the case for three years now.

And so with Shanghai, as you know, and Beijing both, we've put in new school heads and management teams, so they need some time to integrate and to mature.

I think what we've also done is we've moved -- Zhou Chenggang, who used to run Shanghai School and is our COO and runs Vision Consulting, is spending a lot more time in Shanghai with the new Shanghai school head.

Also Chen Xiangdong, our President of Domestic business, and Qiang Hao, so two of our most senior five people are spending -- focusing their time on Beijing along with Michael, our CEO.

So you've got three of our five most senior people spending almost all their time focusing on Beijing and then another couple focusing on Shanghai.

So I think that we're confident that Beijing will get turned around relatively soon.

Shanghai may take a bit longer, but I think we have the right pieces.

We are looking at doing more marketing in Beijing and Shanghai.

We're looking at increasing, like I say, some of the teacher pay to prevent some defections in the Overseas Test Prep area.

We are increasing the utilization.

So Beijing's issue is really not revenue.

Beijing's issue is more utilization and profitability.

So if we increase the utilization that will help Beijing significantly.

We are also spending some money on Beijing and Shanghai on marketing.

Even though many of the students are staying in their localities we think we can still pull some back into Beijing and Shanghai during the winter and the summer holidays.

So they're spending some money on summer camp marketing and winter camp marketing for Overseas Test Prep, which -- so hopefully that will improve their top- and bottom-line performance.

So we're doing all these.

At the same time we're also reducing headcount, especially in Beijing headquarters' side, to increase profit.

So Beijing is an issue of profitability.

Shanghai is an issue of growth and profitability.

So Shanghai is the more wounded of the two.

So Beijing we're quite confident will be fixed relatively soon.

Shanghai is the one that will take some more time.

Did that answer your question, Jeff?

It did, thank you very much for that.

And then in terms of expense-base inflation versus ASP increases, if you strip out mix, so what are underlying ASP increases if you normalize for mix?

And then how does it compare to what the expense-base inflation is if you strip out a lot of the one-time things that are going on, the severance expense and the legal expense, regulatory expense etc.?

Yes, I think our enrollments have accelerated in this current quarter.

So the thing is that if you look at it for year to date our enrollments are probably up 11%, a little over 11%, and price increases up about -- on an apples-to-apples basis about 14%.

So that's why you get 25% revenue growth just organically, not counting the mix difference, because the mix takes it up to 30%.

So that's what we're seeing.

As far as expense costs, like I said, we're seeing salary inflation typically in line with what it's been in the past years, of probably 10% to 12%, but the issue relates to other costs, right, social welfare costs and others, which takes it up to about 13%, 14%.

So rent is stable at around 10% to 12%.

So it's really -- our ability still remains to increase costs.

What's dragging us down is that we just over expanded.

It paid off, right?

We got our intended target of occupying the market.

We are number one or number two in almost every market that we've been there for more than five years, which is what our target was.

We are growing very nicely in all those cities outside of Beijing and Shanghai, the tier-two, tier-three cities, so we achieved our objective with the Occupy the Market strategy.

We probably did overkill.

We probably added 206 -- 238 learning centers in a four-quarter period is just too much.

As I told you in the past, if we add 80 to 100 learning centers a year we typically -- it will be margin accretive.

When you add 238 it's going to destroy your margins in a big way.

And so that's why we -- what I tell people [it is] -- it's like our -- we're -- we've been on a learning center binge and now we're in an overhang period.

So we will probably be here for another two quarters.

So I think by Q4 or Q1 that excess capacity will have been absorbed and so it will be like -- if we almost add no learning centers for the next two quarters it will take us back to a rational path.

Okay, thank you, Louis.

Thanks, Jeff.

Thank you.

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

Please ask your question.

Yes, thank you.

Louis, could you give us some more color as to where exactly you're going to take cost out of the business?

Will you be looking to close learning centers selectively, if so, how many?

And then just more details around exactly where the costs are coming out.

And then if you could -- if have a goal in mind in terms of how much cost you're trying to take out of the business that will be helpful as well.

That's a work in progress, Mark, but I can tell you what we're doing.

We are taking costs out in several areas.

We are closing unprofitable learning centers.

So we have -- we are going center by center, school by school and looking at the number of employees in each school and we have a revenue target per employee.

And so schools that don't meet those [on the] profitability side will have to cut employees.

So that's one side.

So that's why I expect another 1,000 or 1,500 to be cut by the end of this fiscal year in May.

Now you have to remember that many of these employees have actually signed contracts through to the end of the fiscal year, so we really can't let them go yet.

That's why it hasn't been more accelerated.

The other thing is that severance costs we have to pay one to two months for every year they've been employed, so those costs are significant, $6,000 to $10,000 per employee, so those are -- it's a very expensive cost if you do it too quickly.

So those are the things that we're faced with.

We are closing unprofitable learning centers.

I would expect to close 15 to 25 learning centers that are unprofitable.

And so that's an ongoing review process.

I don't have a specific number in mind as far as a cost-out, because I think if you take out too much you end up [reduced as well].

We're looking more at utilization.

So the other side is that because we're not opening up any more learning centers, other than in very fast-growing cities that are almost fully utilized, we would expect that, as revenues continue to grow 30%, 35% year over year, there's no capacity increase.

If no capacity increase, then obviously the utilization will go way up and that will take the profitability up.

So that's our strategy, is to reduce headcount, improve utilization and close down unprofitable learning centers.

Okay, thanks for that.

And then one follow up.

Deferred revenue growth saw a big jump this quarter.

Can you talk about the composition of deferred revenue this last quarter compared to a year ago, just to help us understand how that deferred revenue gets recognized into revenue?

Yes.

About $278m is deferred revenue; it's up by 37% or 38% year over year.

Half of it, about 51%, will likely get recognized this fiscal quarter, Mark, and then the rest will be deferred into Q4 and into Q1.

So demand is -- as you know, revenue is not our problem.

(Multiple speakers) a year ago.

Yes.

Versus a year ago -- a year ago is probably a little bit -- slightly higher.

It's 53% or 54% was recognized and that's because there's more and more students signing up for multiple quarters.

And, as you know, as the one-on-one business grows it would also add to the deferred revenue number.

Now, we are trying to rationalize the growth of one-on-one, meaning that we prefer students that take one-to-five classes than to take one-on-one because they're more profitable.

We also are going to -- because we're going to stop -- or really severely curtail learning center growth the one-on-one centers would actually increase utilization, which would increase our profitability.

So the fact we're not opening up more learning centers will reduce the one-on-one growth and then, hopefully, will -- would improve utilization and will push students toward one-to-five, so that's our goal.

Great, thank you.

Thanks.

Thank you.

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

Please ask your question.

Thanks.

So, Louis, how much of revenue in Beijing and Shanghai school comes from the Overseas Test Prep?

In Beijing it's higher.

Beijing it's -- I think it's probably around 50% or more.

I think that will change over time as U Can does better.

That's why I said I'm not worried about Beijing, because in Q2 the revenue was still even 26% growth despite the fact that Overseas Test Prep was down; enrollments 7%, even though enrollments were up 22 -- revenue was up 22%.

And, as you know, the enrollments are quite strong so far this quarter in Overseas Test Prep, which benefits Beijing the most.

Shanghai it's -- I think it's slightly less than 50%, but, like I said, Shanghai has to work through other issues.

All right.

And then -- so I see that your Beijing and Shanghai schools' revenue grew 20% in the quarter, but bottom line declined 50%.

Can you give us some colors why the margins at Beijing and Shanghai schools suffered so much in this quarter?

Is there anything in particular?

And do you expect this declining bottom line to continue?

I don't expect it to continue.

Actually, Shanghai actually lost money during the quarter, so I obviously don't expect that to continue.

So I think the cost pressures in Beijing and Shanghai relate partly to headcount, where the revenue -- the headcount increased but the revenue did not over the last year; revenue up 20%, but headcount was up much more than that.

I also think the -- like I said, the fact that the Overseas Test Prep was weak during the quarter had a big impact on the profitability in Beijing and Shanghai for the quarter because, as you know, the utilization rate during Q2 is the lowest of the year.

And because of the prior expansion it hits the hardest in Q2.

So I don't -- now that we've controlled the cost of -- [and] the speed of learning center openings I don't expect this to repeat itself.

I think they both will see much better profitability pictures going forward.

How many learning centers did you open in Beijing and Shanghai in the past year?

I don't have that.

Sisi, do you know that exact number?

I don't know the exact number, but it should be probably around 10 in each city.

10 to 12, yes.

But, see, you have that and then you have the Overseas Test Prep business which -- where the enrollments were actually down in the quarter, year over year, and so those -- with more centers, more people.

And Shanghai actually revenues only up 4% -- what is it?

Shanghai in the quarter was only up in revenue approximately -- let me get the right exact number.

Revenue in the quarter was up -- revenue was only up 4% in Shanghai.

So when you have the number of headcount go up and you have centers go up, but the revenue only goes up 4%, it crushes your profitability.

So, like I said, Shanghai is going through a transition.

It has a new school head, it has new department heads, and they need time.

They can't walk in and fix things in one quarter or two.

It's going to take longer.

Right, okay, got it.

And then, regarding your margins, I think last quarter I get a sense that we expect -- we are expecting margins improvement since the 3Q of this year, but you just mentioned improved margins in a couple of quarters, probably toward the end of this fiscal year.

So could you elaborate on that?

Is the cost and expenses -- the impact from the past expansion is that being bigger and longer than you originally expected?

Yes, it's bigger and it's longer than I originally expected.

And it's also -- the severance costs are actually higher, right, because -- so -- and because a lot of these employees have signed contracts through the fiscal year end, meaning May, if you let them go now you have to pay them through May anyway, plus their severance costs.

So, actually, the severance costs are quite high.

So we're staggering the reductions between Q2, Q3 and Q4, so it is taking longer, Ella.

And also, like I said is, the learning center binge of adding 238 learning centers in four quarters, the impact is much greater on our bottom line than it should have been.

The truth is, I think a lot of the problems happened in Q4 and Q1, especially in Q1, where we added 89 new learning centers.

And I think that was the time that, honestly, Michael and I were distracted by the Muddy Waters and SEC stuff.

And I think we took our eye off the ball a little bit, so now we're paying the price.

So we're working as hard as we can to fix the situation, but it'll still need one or two more quarters.

So, you're right, we originally were hoping to see the worst of it in Q2 and turn around in Q3.

I think that's been delayed one or two quarters.

Okay.

It's harder to cut the -- take the cost out than I was hoping for originally.

Got it, thank you.

That's all my questions.

Thank you, Ella.

Thank you.

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

Please ask your question.

Yes, a couple of questions just on the Shanghai side of the business.

So can you expect that business -- I mean, obviously, the business has been in trouble over the last few years.

Can you expect that business to actually bounce back without incurring, I guess, pricing -- with the same level of pricing leverage that you have in other areas because you may have to do more discounting or whatsoever because of the fact that competition in that market is a lot more severe; or increase your headcount; or in sales and marketing or expenditures to entice the students back into that market?

Can you bounce that business back without -- with the same margin profile as some of these other cities?

The second question is regarding your expansion.

I know that you guys expanded 200 some-odd schools over the last year or so.

Can you shut down these same schools as quickly as you opened them, or there are cost implications that don't allow you to do that?

Because I assume that most of these new schools that you opened are the main reason for the cost structure.

So given the fact that they're not going to be profitable in the near 12 to 18 months anyways, is it easier for them to shut down as quickly as you opened them?

Thanks.

Really are good questions.

On Shanghai the answer is I don't know, Jin, because Zhou Chenggang used to run Shanghai School, so he's been dispatched back there to help Qiang Hao fix Shanghai School.

There's a whole brand new team there.

I don't expect us to go down in -- as far as pricing, ever, so I don't know how fast we'll take it up.

I think Shanghai is quite competitive, especially at the mid end, so I think if we don't -- we have to be at the premium end.

So just a matter of -- the pricing I will leave up to them, the people on the ground there, to figure out what's the best strategy to increase market share again.

As far as your question on the learning centers, it's a good point.

I think we expanded too fast over the last year and now we're going center by center looking at utilization.

In some of the newer centers we do have breakage clauses in the leases which means we still have to incur a big cost of six months' rent.

So that's -- it's these breakage costs and severance costs that are killing our bottom line this quarter and into the next two quarters.

That's why I did anticipate what the cost is to rationalize this business and so it is a big problem.

We are trying to combine some of the centers, the ones that we've added, and we're letting some leases expire which are up for expiration from four or five years ago.

And then we're just using the newer learning centers to take that capacity.

So we're managing it the best we can, but you're right, the breakage costs are quite significant and it's not easy to close a learning center that was just opened a year or a year and a half ago.

So the ones that are just no chance we'll eat the six-month breakage costs.

The ones that are expiring we'll try to combine centers nearby to save costs.

We're doing everything we can, like I said, to get over this learning center binge that we were on for a couple of years, right?

It doesn't solve itself in one or two quarters, it takes some time, so we're in the overhang -- in the hangover period.

Great, thanks, Louis.

Thank you.

(Operator Instructions).

Your next question comes from the line of Steve Zhang from Macquarie.

Please ask your question.

Hi, Louis.

Just going on your utilization, can you talk a little more about what your utilization is right now compared to a year ago and, perhaps, where you hope to be by the end of the year?

Yes.

I think our utilization for Q2 this last quarter was an all-time low.

It's embarrassing.

It was below 25%.

And so I expect Q3, obviously, to be much better than that and I would expect even our slow quarter, Q2, to be somewhere north of 35%.

And that's why I think -- if you figure it out, right, if we keep revenues growing at 30% plus a year and we don't add any more capacity that will take care of the utilization question next year.

It's the 238 learning centers we opened that is the big problem and the 10,000 headcount we added.

And so it takes a year or two to absorb that.

Into Q3 I would expect utilization to be probably in the -- north of 40%, 45%, and obviously our summer is our best utilization period, which is usually north of 60%.

So this utilization is the focus.

We want more students in the seats.

We want more classes being opened with full students, so that's why utilization is our number-one focus.

Okay.

And, just follow up, are you still planning to keep your net adds within 20 schools, or are you thinking about reducing that [number]?

We actually have fewer learning centers today than we did as of November 31 -- November 30.

That's how strict the control on keeping -- on the learning center increase.

We're not allowing any learning centers unless the school is really booming, is really doing well.

If Xi'an wants to open a learning center I'll let them; their profit margin is super high.

Any other center we are not letting them open learning centers, unless their utilization is really high.

So that's why we're tracking the utilization very closely now.

You need to understand that it took a crisis for finance to take control of that process.

It used to be that any VP could approve a learning center opening and so school heads would just go to the VP they had a good relationship with and get approval.

And they would just keep opening learning centers.

That was the easiest way for them to meet the revenue numbers and to expand their footprint, which is what our target was for them, is to be number one or number two.

So they thought the [bigger] profitability would take care of itself.

It didn't work out that way.

So now finance has control of new center openings and we are being very -- we've taken that away from operations and so we are being very strict.

Like I said, the 18 that were opened last quarter there -- I think all of them were opened before we took that approval process over.

So we basically approved maybe one or two new openings since then for the last couple of months and we've closed -- we've let eight or 10 close.

So we actually have fewer learning centers today, two months into Q3, than we did at the end of Q2, in November.

So you can see that we're -- finance is much tougher to deal with for the school heads than their neighborhood vice president was.

Okay, thank you.

Thank you.

Your next question comes from the line of Fei Fang from Goldman Sachs.

Please ask your question.

Hi, Louis, thanks for taking my question.

Regarding the ASP increase, across all the segments the trend has been very strong, so how long do you think the momentum will last, especially as you execute the Harvest the Market strategy, meaning probably the upside for enrollment growth could be limited?

Can you give a medium-term ASP increase guidance?

I think it will continue about the same.

I think part of the way we get the profit margin up is I want to increase prices, especially at the Kids level.

I think we've got to make each of our profit -- each of our product lines a high-profit model.

So I think we will continue to take prices up on a blended basis in the 16%, 17% range, so 14% for apples to apples and higher than that because of mix.

So I don't see any slowdown in that.

I think the key is -- to just slow down is to increase utilization.

If we do that -- we don't have a demand problem, right?

Our enrollments, even with these price increases, are still going back up again.

We had a slow quarter in Q2, but they're rebounding in Q3.

So I think it's not a demand problem.

It's a cost problem for us.

And I think the way we get the cost issue under control is utilization and control the learning centers so there's no expansion.

We still have pricing power, is my point.

Understood.

So can we just briefly talk about the cost side as well?

I notice that the increase of your sales and marketing expense has been outgrowing the revenue in the past few quarters.

So do you think it was partially driven by a business mix shift toward the more sales-driven one-on-one business and --?

That's exactly what it is.

That's exactly what it is.

So, if that's the case, can we assume that sales and marketing will structurally outgrow revenue going forward?

No, because [we're] trying to push more people to one-on-five.

We're trying to curtail the one-on-one growth to -- so -- because we don't want to open any more learning centers, so the problem will take care of itself in the fact that one-on-one students will have to go to the existing centers.

And because we're not opening up new centers that will mean that the growth will slow down on its own and will push -- it will increase the utilization in the existing centers, which is we won't be adding a lot of more sales people -- sales and marketing there, because we're not adding centers, right?

So that will take care of itself.

Thank you, Louis.

Yes.

Thank you.

Your next question comes from the line of Vivian Hao from Deutsche Bank.

Please ask your question.

Hi, Louis, thank you for taking my question.

First of all, is a question on your guidance.

So like for like you are guiding about 22% to 27% growth, but if I remember correctly last year was an abnormal seasonality of a shorter winter break between Chinese New Year and also New Year.

But you are indicating the enrollment growth has recovered to 15% (multiple speakers).

The Overseas Test Prep.

Yes, just trying to understand if it's on easier comps why the guidance is so within this moderate range.

This is my first question.

Well, I don't think 30% growth is moderate.

If you look at our competitors they're growing, what, 15%, 20%, whatever the other ones have announced.

So I don't think it's moderate.

Number two is that, don't forget, it's a double-edged sword.

Chinese New Year was early last year.

Because of that, actually, the enrollments for Q2 were impacted.

So if you think about it last year the enrollments from Overseas Test Prep were frontloaded Q2.

That's why we have 7% enrollment decrease this year, right?

So it is a double-edged sword.

Because it was January 23 was Chinese New Year last year.

This year is February 10.

The later Chinese New Year actually hurt Q2 enrollments, right?

So it goes -- it cuts both ways.

That's why I always ask you guys don't look at it on a quarter by quarter, look at it year over year, right?

So don't compare quarters, because the timing of certain holidays affects the timing of certain enrollments.

So Q3 should benefit, meaning there's nothing wrong with Overseas Test Prep by enrollment popping back up, because Q2 was down.

Q2 was down because last year Chinese New Year was so early, so it pushed the enrollments into Q2 of last year.

Does that make sense?

Okay.

Yes.

So you understand that's why if you take year over year it's fine, if you take the whole year.

Don't just look at one quarter.

That's why I tried to explain to you during the script part of this call that we saw a bounce back already.

So it's not -- you can't write the overseas business off as dead.

It fell last -- it fell this Q2 because last year Chinese New Year was early, so the enrollments came in early, which means -- and so Q3 was weak because Q2 was stronger.

This year is the exact opposite.

So overall if you look at it, it's the same.

We're still seeing strong growth in overseas.

Okay, --

Okay.

-- right.

My second question is in terms of your center rationalization you're saying that the key focus is on utilization improvement.

So do you think -- do you think that the students will naturally go from one center to the other EDU because you combine it, or there will be certain permanent loss of traffic because of closing down of some of the unprofitable centers?

I think there will be a permanent loss.

I expect -- I fully expect a permanent loss of some students because of inconvenience, but that's better than running a whole bunch of unprofitable centers because they're cannibalizing each other.

So, like I said is, our -- I don't think our Occupy the Market strategy was wrong.

It was correct, because we occupy the whole national market in the big cities; we have the position we want; we have the long-term brand name; the long-term market position we want, being number one or number two in each city.

I think we overdid it.

I think we -- when we went into it -- 238 centers in one year is too much.

It was my decision last year we would open 120, as I told you guys.

It's just unfortunately I didn't have control of that process last year.

I do now.

So you'll see us -- so we'll go from one way where we opened too many centers, 238, to go the other way where we open probably less than 50.

And over two years that will take care of itself.

Yes.

So, yes, the long answer is yes, Vivian, I expect some permanent loss, but honestly I don't care.

I got to get this -- the profit margin up.

Okay, great.

Thank you.

Thank you.

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

Thank you again, everyone, for joining in today's call.

If you have any further questions please feel free to contact me or any of our investor relations representatives.

Thank you.

Thank you for your participation in today's conference.

This concludes the presentation.

You may now all disconnect.

Good day.