New Oriental Education & Technology Group Inc (EDU) 2013 Q3 法說會逐字稿

Ladies and gentlemen, good evening and thank you for standing by for New Oriental's third quarter of fiscal year 2013 earnings conference call.

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

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

Today's conference is being recorded.

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

I would now like to turn the call over to your host for today's conference, Miss Sisi Zhao, New Oriental's Investor Relations Director.

Miss Zhao, please go ahead.

Hello, everyone, and welcome to New Oriental's third 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 on newswire services.

Today you will hear from Louis Hsieh, New Oriental's President and Chief Financial Officer.

After his prepared remarks, Louis will be available to answer your questions.

Before we continue please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the US Private Securities Litigation Reform Act of 1995.

Forward-looking statements involve inherent risks and uncertainties.

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

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

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

As a reminder, this conference is being recorded.

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

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

Louis, please?

Thank you, Sisi.

Hello, everyone, and thank you for joining us today.

First, the entire New Oriental family would like to extend our warmest wishes to all the victims and those affected by the devastating Sichuan earthquake.

We have donated CNY2m for the earthquake relief fund to help victims and assist reconstruction efforts.

New Oriental stands ready to do more as needed.

Before we discuss the results, I would like to make a correction.

There's an error in the earnings release that was released some hours ago.

Under Michael Yu's quote in the second page in the release it says New Oriental's Chairman and Chief Executive Officer commented, We are pleased to report solid results for the third fiscal quarter with substantial top line growth of 28.6% which was well above the guidance range of 22% to 27% growth.

That's incorrect.

The guidance range is actually 25% to 30%.

The 22% to 27% excludes the ELITE business.

So it should be at the high end of the guidance at 28.6% which is within the 25% to 30% guidance that we've given.

So we apologize for that error in the earnings release.

Now going to the third quarter, our results for the third quarter are encouraging and I am particularly pleased that after a tough few quarters we are now seeing some very solid operating leverage and implementation -- and improvement in key areas.

As you know, since last October we have been committed to reducing costs and improving operating efficiency through our network.

We are now seeing those efforts starting to pay off with a healthy improvement in GAAP operating margin to 10.8% this quarter compared to 10.2% in Q3 of last year.

But I'm also encouraged that this improved bottom-line performance has not come at the expense of revenue growth.

We have maintained a very healthy balance between efficiency and expansion and as a result our revenues are up 28.6% year over year and above or at the high end of our guidance range of 25% to 30% growth.

Reducing costs.

These results demonstrate that our pivot from our previous Occupy the Market strategy to our Harvest the Market strategy which was announced on our fiscal year 2013 Q1 earnings call last October is starting to bear fruit.

At the core of the strategy is an emphasis on raising operating efficiency and improving profitability.

During Q3 we further reduced our headcount by approximately 1,200 to about 31,600 employees and we expect to decrease headcount by another 300 to 600 during this Q4.

This means we will end the fiscal year with approximately 10% fewer employees than the number we had before we pivoted to the Harvest the Market strategy which clearly demonstrates how committed we have been to reducing overheads and driving efficiency.

In the same vein, over the last quarter we reduced the number of learning centers in operation by 11, closing 22 underperforming centers and opening 11 new centers in fast-growing markets.

Learning center expansion is now strictly controlled from headquarters and now openings must have my finance department's approval to ensure that we are only opening in locations that make financial sense.

In Q4 we expect to close another eight to 10 more learning centers -- underperforming learning centers while opening a small number of new centers in other profitable locations.

In our peak Q1 2014 quarter during the summer we will probably open very few new centers, if any at all, because we intend to focus on maximizing utilization during the all-important summer season.

I want to make clear though that we are absolutely not sacrificing market share expansion in search of profitability, far from it.

In fact, thanks to the success of our Occupy the Market strategy we are on track to be number one or number two in all of our key geographic markets.

Importantly, we are now focused on building up our utilization rates in those key markets and driving profitable growth.

We recorded very healthy revenue growth this quarter, driven by continued improvement in ASPs and encouraging signs of turnaround in our two largest markets.

In Beijing and Shanghai, the management changes we implemented several quarters ago are already having an impact.

Senior management has been very focused on improving the performance of our schools in these two crucial markets.

I'm pleased to say that for our schools in these two cities combined revenue is up 17% and net income up 9% in Q3.

We still have some ways to go to get things right but the progress so far is very positive.

On a blended basis ASPs have improved 14% this quarter.

This is encouraging, particularly when you consider that much of our growth is now coming from cities outside of Beijing and Shanghai where ASPs are lower.

Thanks to our premium brand, New Oriental is still able to command a premium price versus our peers in these markets but obviously in less economically developed cities the price point is for the most part lower than in Beijing and Shanghai.

This has a depressing effect on the ASP growth.

This strict fiscal discipline and strategic pivot towards Harvesting the Market throughout Q3 has driven strong margin improvement.

This is the first time in six quarters that we have grown year-over-year operating margin but I'm very confident that we have plenty of room for further and faster improvement in the quarters ahead.

First, we are still carrying through some of the costs associated with our school closures and headcount reduction and we'll continue to see some impact from these through the end of the fiscal year ending May.

Second, utilization rates are now well below optimal although they are improving.

So when our classrooms in our new learning centers fill up you will naturally see this transiting into a better performance on the bottom line.

All in, I'm confident that the 12% GAAP operating margin that we have seen over the last four quarters prior to this Q3 release represents the floor.

From here, I believe we can grow margins even more quickly in the coming quarters and we should be able to increase operating margins by at least 200 or 300 basis points by the end of fiscal year 2014 in May.

Turning to enrollment, we experienced a slight decrease in this quarter but it's important for you to understand that this is not a trend.

First, you have to remember that we have closed around 30 learning centers over the past two quarters.

Each of these facilities probably had an average of around 1,000 or 2,000 student enrollments each year.

Second, enrollments in our legacy offerings of Adult English and CET4 and 6 domestic test prep continued to decline in the quarter and are down approximately 26% year over year as well to approximately 87,000 compared to 117,000 in the year ago period.

And the third and most important factor is the later timing of Chinese New Year holiday this year.

As we noted in the release, the holiday was later in 2013 than in 2012.

Therefore, a significant portion of spring enrollments were pushed into the Q4 quarter.

Those of you who have been following New Oriental for a number of years will be familiar with this effect.

When Chinese New Year occurs early, spring semester starts earlier and we get a nice bounce in enrollments in Q3.

When it falls later, enrollments get pushed back into Q4.

If you look back to last year, for example, when Chinese New Year was two weeks earlier on January 23 2012, we experienced a 22% growth in enrollments in Q3 and just 7.7% in Q4 of last year.

As evidence of this effect, in the first six weeks of our fourth quarter we recorded a noticeable 14% increase in enrollments year over year and 34% increase year over year in cash receipts.

That's cash collected in advance for enrollments.

So as I've said, it's important to look at Q3 and Q4 enrollments combined rather than split them out because the timing of Chinese New Year often confuses the case.

If you strip out the seasonal factors for this year, we're still looking at a very healthy organic growth rate of 6% to 9% in a period of learning center contraction.

If we add our total 80 to 120 learning centers per year, that's a normal pace, the enrollment growth rate would likely be a healthy 10% to 13% or 3% or 4% higher than the organic rate.

Turning to our individual business lines, we continue to see strong and healthy growth across all our core offerings.

Our K-12 all subjects after school tutoring business continued to impress.

We recorded very healthy gross revenue growth of over 44% year over year during the third quarter.

Our VIP personalized class business also did well with year-over-year cash revenue growth of about 29%.

I want to highlight once again that we hold a significant price advantage over our peers in the VIP personalized classes which is a big help in our operating margin in the segment.

And in overseas test prep and overseas study consulting we remain the dominant market leader in China.

As I mentioned last quarter, we have been rolling out our overseas study consulting services in more schools and centers where we already provide overseas test prep and we're very encouraged by the obvious synergy and cross-selling potential between these two businesses.

This quarter, we recorded combined revenue of over 22% across these two lines.

Finally, as I mentioned just now, the popularity of our legacy businesses in the lines of Adult English and domestic test prep is waning.

We have long expected this fall-off since the success of our K-12 and overseas test prep segments will obviously cannibalize the Adult English and domestic test prep segment markets.

While this quarter's drop-off in enrollments was sharper than the previous quarters, we are encouraged that the decline is being more than offset by growth in enrollments and revenues from our other business lines.

Before I move on, we'd like to reiterate that we haven't yet seen any material negative impact from the spread of the H7N9 virus in China and we are hopeful so long as there are no cases of human-to-human transmission the impact on our business will be minimal.

Those of you who were with us through H1N1 and SARS will remember that once significant instances of human-to-human transmission were discovered, the Chinese government issued orders banning large gatherings of people and closing education establishments.

If this does happen with H7N9, and we hope it doesn't, past experience suggests that we will obviously see some short-term impact for one or two months while the restrictions are in place but that we will also experience a healthy rebound afterwards once students are allowed to go back to class and pent-up demand is released again.

Finally, let me give you some more color on some of our key financial metrics for this quarter.

Selling and marketing expenses for this quarter increased by 14.5% year over year to $31.6m, primarily due to the increase in the number of customer service representatives.

I do want to flag that this growth in selling and marketing expenses is well below the rate of revenue growth of 28.6% and actually 8% down on selling and marketing expenses from Q2.

This is in line with our goal of driving improved efficiency across the network.

Furthermore, the actual brand and marketing promotion expense for the quarter declined approximately 13% year over year to approximately $11.1m.

General and administrative expenses for the quarter increased by 29.6% year over year to $72.2m, primarily due to increased headcount.

Again though I want to highlight that G&A expenses are down 7% quarter on quarter which shows how our efficiency measures are taking hold.

Also do remember that we're carrying through some costs associated with the closures and headcount reduction -- closure of learning centers and headcount reductions as we still have more room to improve here.

As I highlighted already, operating margins in the quarter were -- GAAP operating margin in the quarter was 10.8% compared to 10.2% in the same quarter last year.

On a non-GAAP basis operating margin for the quarter was 13.8% compared to 13.5% in the same period last year.

Capital expenditures for the quarter were $16.1m.

This was primarily invested in the opening of 11 new learning centers which I've mentioned above.

Also we purchased one floor or a building in Changsha that we're using as the headquarters for the city's operation.

Before we move to the Q&A session, let's quickly review our current expectations for Q4.

We expect the total net revenues in the fourth quarter fiscal year 2013 to be in the range of $232.8m to $242.2m.

As you may recall, ELITE English contributes revenues of approximately $4m to the fourth quarter of fiscal year 2012 and we disposed of the business end of the first quarter 2013.

So if you strip out the impact of the disposal of the ELITE English business we are forecasting year-over-year growth in the range of 23% to 28%.

Compared to our reported net revenue for the fourth quarter fiscal year 2012 which includes revenues from ELITE English our projected year-over-year revenue growth for the fourth fiscal quarter will be in the range of 20% to 25%.

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

At this point I will take your questions.

Operator, please begin.

Thank you.

The question and answer session of this conference call will start in a moment.

(Operator Instructions).

Your first question comes from the line of Tian Hou from TH Capital.

Please ask your question now.

Hi, Louis and Sisi.

I have a question regarding the learning centers closure and open.

So I would like to know among the 30 centers that you have already opened so what's -- that you just shut and closed.

What's the criteria for shutting them down and where are they located?

So for what reason you shut them down?

So that's number one.

Also related to learning centers, you're also opening more and so what is on an ongoing basis what is the plan for how many you want to continue to shut down, how many you want to open?

That's the question.

That's a very good question Tian.

Thank you.

What happens now is that we -- the finance department and the HR department jointly do an analysis of every learning center in New Oriental, so all 700-plus learning centers.

We look at learning centers.

The ones we look to close are the ones that have been underperforming for one or two years or we don't believe will ever become profitable.

So that's the criteria we look at based on the performance of the learning center to date and whether it's ramping according to what a typical learning center will do.

In that case we will go to the school head and ask for those centers to be closed and they'll have an opportunity to answer and make a case whether they should or should not be closed.

So those are how we came up with the -- we've closed 30 in two quarters.

We probably have another 10 to go.

So we'll probably end up closing about 40 to 45 learning centers for the year.

And then in most of those -- the learning centers in all cities, including Beijing and Shanghai, any area where the learning center is underperforming as far as utilization or as far as the ramp-up in enrollments, they've been open for several years and still not profitable, let's say.

On the how we open up new learning centers is that we look at utilization of the whole city and of each learning center around there.

So the fast-growing cities that have high profit margin and have high growth rates we will allow them to open learning centers to capture the market.

So most of the learning centers that are being opened now are in tier two and tier three cities, they're not in tier one cities.

So we'll look at -- as far as going forward we'll probably end up this fiscal year, we have 733 now, we'll probably end up somewhere around 730, 729 or 730 for the fiscal year so it means we've added zero almost for the whole year.

And next year we will probably open no more than 50 of which we probably won't open them in Q1.

The ideal for us is to open them in the slow season of the fall and then some in the winter and spring, but not in Q1, the summer.

So that's why we're expecting in the next three quarters to be very highly profitable.

That's why we're confident the operating margin is going to go up quite fast.

Thank you.

That's very helpful.

Thank you for your question.

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

Please ask your question now.

Hi, Louis and Sisi.

Thanks for taking my question.

My question is about your VIP business.

Could you comment on how much contribution in terms of revenue and movement for this quarter?

And then also looking forward, as you mentioned previously that New Oriental would probably like to control the growth of one-on-one and focus more on the small to large class format, but how effective could you do so if the demand in China is indeed shifting towards the one-on-one?

Well, I don't think we want to control the one-on-one growth, Philip.

What we want to do is we don't want to open up any more learning centers in one-on-one.

So we want to make them as part of other learning centers together.

Therefore a student can take one-on-one but what happens is that if they want to stay in the one-on-one course it's going to fill up quicker because we're not opening up a lot of new centers.

So they will have to -- in the locations we have they'll fill up there.

The second thing is that we are increasing the price in one-on-one so it's more cost effective for students to select a small class and large class offering.

But we're giving incentives to the learning center because operating margin is the key metric for the school head to encourage more large class and small classes filling up.

So that's how we -- you can call it control the growth of one-on-one.

I think of it more as that we're not -- we opened up almost 500 one-on-one centers in the last three years.

Once we stop doing that, the utilization will go up.

When utilization goes up obviously the enrollment growth rate will go down.

So utilization will go up, that means the margin will go up.

What about the contribution for (multiple speakers).

It's about 30% of revenue for the quarter.

The enrollment is much less because the ASPs are so high.

I don't know the exact percentage of enrollments were of VIP but it's much lower than -- it's probably -- it's normally about 7% or 8%, Philip.

Okay.

Thanks, Louis.

Thank you for your questions.

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

Please ask your question.

Good morning or good evening.

My question is related to the expenses that you're carrying forward that are tied to learning center closures and headcount reduction.

Could you give us a sense of those expenses, Louis, and when you expect them to peter out?

I think they should peter out, Mark, by the end of this year, so Q4.

I think the total amount -- I don't have a breakdown by quarter because it's a fluid process -- will be somewhere between $4m and $5m for the whole process and that it should not occur again next year.

We are looking at though some closure and some reduction expenses each year.

I would like to make it a policy of New Oriental that we let go of the bottom 3% or 5% of performers each year.

So we're discussing that right now.

So if that's the case then we will have other severance costs on an ongoing basis.

But for this one restructuring I think the costs should be finished by the end of Q4.

Okay, thank you.

And then one follow-up, regarding utilization, could you talk about what your utilization was that you experienced in the quarter and then your goals going forward?

Thank you.

For utilization we changed the way we measure it so I think the current way is actually much more accurate which is that we look at every seat and every time it can be open.

In the past -- in past years we would measure utilization that if a class opened we would count it as a utilized class, the whole class, even if it's only half full or one quarter full.

Now we count it by every seat that's in that classroom.

So the utilization rate obviously goes way down.

So our total physical real utilization rate is somewhere around 20% or 25% and so it's very low.

That's why we can afford -- we believe we can afford not to open learning centers for the rest of this year on a net basis and also through Q1 of this year and still maintain the high 20% to 25% revenue growth.

Thank you.

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

Please ask your question.

Thank you.

Congratulations, Louis and Sisi.

So with regard to your performance at Beijing and Shanghai schools, it's good to see revenue growth rebounded but it seems that net income is still growing slower than revenue.

I wonder if you can talk about the margins outlook at these two schools and when do you think the margins will also achieve year-over-year improvement?

Yes, that's a good question, Ella.

I think the margins will improve in Q4 and Q1.

So they'll improve immediately now.

The reason the margins -- the profit margin was low was because Beijing and Shanghai had a lot of learning centers that were closed.

So we added 17 learning centers last year and it was too high so some of them were closed.

Also Beijing and Shanghai had more of the impact from Adult English and the CET4 and 6 decline and those are typically larger classes and higher margin.

So those I think is beginning to subside and so I think Beijing is set up for substantial margin improvement in the quarters ahead and that will drive the whole Company because Beijing is so critical to our business.

Shanghai is still work in progress.

As we said in the script, it's actually -- it's encouraging.

So we believe that Shanghai is getting better and the margin will also improve starting in this quarter and for sure in Q1.

So barring some kind of disaster from a pandemic Q1 is set up to be a very strong quarter, even for Beijing and Shanghai.

Great, thank you.

And if I can sneak in one more.

I know you have close to $900m of cash on balance sheet and you just announced a $50m share buyback but any thoughts with regard to another dividend?

Yes.

We discussed that yesterday and I saw your note and you jumped the gun on us.

I think, as you know, in periods where the share price is low we will probably do a buyback.

I, as one of six Board members, am committed to pay a dividend this year.

But we would like to look at the Q4 results.

So what the Board decided to do was look at after Q4.

If results are decent then we will most likely declare a dividend as well, one equal to or larger than last year's.

But it's not done until it's done.

The issue again as a sticking point is the tax that you have to pay to take the money out of China.

So we'll start with -- so we'll do what Apple does but we'll do it in two steps.

We'll do a buyback first and then a dividend instead of doing it together.

And ours it'll probably be -- instead of being $100b we'll do -- ours will be $100m to $110m total between the two.

So (multiple speakers) smaller still.

All right, thank you.

But, as I said, you can't hold me on that until we get Board approval, because this is just me talking.

I, of course, want to pay a dividend; I don't think we can use the money more efficiently.

And I'd like to reward our shareholders for sticking with us.

But -- so, (multiple speakers) is after the Q4 earnings -- after the Q4 earnings, we'll have a Board meeting, and that will be one of the top items on the Agenda.

Thank you for your questions.

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

Please ask your question now.

Hi, Louis.

I just have a follow up in terms of your school expansion plans in FY'14.

So it seems like your competitor is are also planning to start [re-expanding] -- (inaudible) one of your largest competitors -- to restart re-expanding in the second half of their fiscal year.

Is there a reason for this, or do you see that this is a necessary move considering how the landscape is shaping out to be?

I think, for us, is we have already gone through that expansion, right?

We've gone through adding 500 learning centers in three years.

So I think because you've had a prolonged expansion phase, we can have a longer harvest phase.

I think I know which competitor you are talking about.

I think as they had a one-year expansion phase, followed by a one-year contraction.

I think in their situation I think it is because their key market of Beijing, because of a government policy change, has made that business stop growing, or shrink.

And so, therefore, they have to seek growth in other markets.

We don't have that problem, so we have -- our other markets we've already established in 50 cities.

We have all but 120 learning centers outside of Beijing and Shanghai.

So we have 80% of our network outside of Beijing and Shanghai already.

We don't need to grow those kind of numbers.

So we -- in an ideal world we would add 80 to 100 learning centers a year, which means that if we had 80 to 100 learning centers that's about 80,000 to 100,000 enrollments a year.

So that's why the enrollments look low, because this is pure organic growth in existing learning centers.

And we are cutting learning centers.

So if you look at it in a normal year, we probably organically grow about 8% enrollments; another 4% from new learning center growth.

So that's why the number looks low for this year is because we've added no learning centers, in fact we are cutting learning centers and, basically, enrollments are falling, because the students are going away, because we closed their learning center.

That will not happen in future years.

So the knock on our numbers this time, your student enrollment decreased.

Of course they decreased, we closed 30 learning centers and we added none, essentially, for the whole year.

So in a normal year like last year we added 200 learning centers.

That's why the enrollment numbers were so high.

So that's why we sacrificed -- basically we sacrificed the -- we want to get operating margin.

So we sacrificed some growth for that operating margin expansion, and I think it's the right balance.

Okay, sure.

So that means the linearity of your operating margin going forward would be more loaded in the first half of fiscal '14, and the expansion won't be as apparent in the second half next year?

I think you'll see a huge expansion in Q4, Q1 and Q2 of next year, for this next quarter, Q1 and Q2 because they were quite poor last year, right, to be honest.

They were not good, because we added large numbers of learning centers in those three quarters -- sorry, in Q3, Q4 and Q1 of last year.

Therefore, I think this year, because we are not adding any learning centers, we are actually net zero, because of the closures.

Then that means that you'll see what this business model really looks like, which is a much higher operating margin than 12%.

Our target operating margin should be 18% GAAP, 21% non-GAAP, over the next couple of years.

Okay, great, thanks.

Thank you.

Thank you for your questions.

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

Please ask your question.

Hi Louis, this is a great quarter.

Congratulations.

First question is regarding your deferred revenue.

So on the balance sheet the deferred revenue has declined sequentially from about 38% or 39% in the past three quarters, to right now it's about 23% year on year in 3Q.

So how much of the decline was related to the Chinese New Year timing, versus say the controlled expansion of the one-on-one format?

Thanks.

Yes, most of it is related to the CNY exchange, Fei.

So if you look at the first six weeks of this quarter, revenue receipts were up about 34%.

So really the -- it's probably most of it is due to the CNY effect, and then there is a significant effect due to the controlling of one-on-one as well, as you call it controlling.

Because one-on-one students usually pay for two or three quarters in advance, so they pay a much larger amount so it builds up the balance.

Over two quarters it builds up the balance of the deferred revenue.

So I think is that, like I said, it's probably slightly more because of the Chinese New Year effect, but the one-on-one slowdown is -- intentional slowdown on our part, is also having an effect.

I think the revenue for Q4 is shaping up quite healthy.

I think overall we'll still grow 20%, 25% total and higher than 23% to 28% if you exclude the ELITE business.

Understood, thanks Louis.

Second question, regarding the margin expansion for the quarter, what is some of the rationale for management to control advertising budgets, and even cut the spend?

And what impact should we expect on revenue growth in the medium term, say after 1Q next year?

Well, just remember, if you are not opening new learning centers you don't need to spend money on marketing.

So, contrary to what you guys -- some people believe, most of the marketing spending is when you open new learning centers.

So if you are not opening any learning centers or you're only opening 11, the market spend automatically goes down.

New Oriental's word of mouth is so strong and the brand name is so strong, existing learning centers fill up on their own, we don't really need to spend a lot of money marketing.

It's for the new ones.

So that's the reason.

It's not that we intentionally cut it.

It's because we are not opening up learning centers, so there's no need to spend a lot on marketing.

Understood, thank you.

Yes.

Thank you for your questions.

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

Please ask your question.

Hi, good evening.

Thanks for taking my questions.

Firstly is a follow up on the previous one as well.

Given that Beijing and Shanghai margin was actually down, so I'm wondering if the margin improvement is from other schools or from the headquarter level.

And secondly I remember you mentioned in last earnings call that you are facing competition from international program of public schools.

So wondering any updates on that front.

Thank you.

Yes, I think the margin is declining in Beijing/Shanghai.

I think you'll see a margin pickup in Q4 and Q1, especially in Beijing.

Shanghai may be not as much.

And the reason is because Beijing had some restructuring costs and now I think most of those are gone.

And I think the business in Beijing is improving, so we closed some learning centers there.

In Shanghai, we closed learning centers as well.

I think the margin should improve but Shanghai has more management-related problems, whereas Beijing I think was just an overbuild.

So I think that's what -- the second part of your question, sorry, Wang Chao, was related to --

Actually, the first one I'm asking whether the margin improvement is from other schools' performance, or from headquarter level there, because --

Oh, it is from -- it's from other schools' improvement and also the restructuring, the fact that we have -- almost 2,800 fewer employees now than two quarters ago.

So it's operating efficiency.

So we are not adding -- in past years we were adding a lot of revenue ahead of the -- I mean a lot of cost ahead of the revenue opening learning centers.

We are not doing that any more.

So you are getting a better sense of the real margin of the business of each learning center as it goes up.

Got that.

The second question is regarding competition from international program of public schools.

Oh yes.

The one -- yes, that is still ongoing, especially in the northeast of China.

I think these things have a way of working themselves out, meaning that they do have a short-term negative impact on us.

But I think the parents will realize, maybe too late in this year's case, that the quality of those public school programs is not as good as New Oriental's English or overseas test prep.

They're just not as good.

And so I think is it will be a typical, what's happened in past incidences where schools have tried to this, there'll be a rebellion by the parents and they'll send their kids to our school anyway.

The quality is just not the same.

Do you actually expect any cooperation opportunity with those public schools?

We do.

Where -- in most cities we do have cooperation with public schools.

But some of them, I guess, in ways -- to make extra money, they will go through these kinds of exercises of setting up sister schools.

Whether it's in line with the policy or against the policy, they do it anyway.

And then I think -- but the parents, and they kind of coerce the parents to send their kids to that program.

But the ones that they're hurting are actually the kids, because their programs typically are not as good as -- the teachers are not as good and the content is not as good as New Oriental's.

And so I think a lot of the parents will see through this and I think they have.

And many of them will come back, even against the wishes of the school.

Understood, thank you.

Yes -- this happens to us all the year -- all the time.

It's just this time it's a bigger group in a bigger region in the whole Northwest -- Northeast.

Yes.

Thank you for your questions.

The next questions comes from the line of Vivian Hao from Deutsche Bank.

Please ask your question.

Hi, Louis.

Hi, Vivian.

Congratulations on the quarter, hi.

Just -- so based on your current experience, what's the breakage cost on a per-center basis, I guess including the major -- the lease and also severance?

This is my first question.

And then second question is in terms of the centers that you have closed, I understand a lot of them are probably mixed centers, with all divisions, say VIP or Test Prep, together with K-12.

So how do you deal with the partially disfunctioning divisions?

Are you going to close them down, or -- it just sounds difficult to cut it off?

Yes, those two questions first.

Yes, that's a very good question.

There isn't an average per-center center closing, because each center has a separate lease.

So the breakage cost of each lease are different; some are six months' rent; some are one year rent, some are not breakage or one or two months' rent.

So it varies by the size of the center and also by the terms of the lease.

As far as the employees that are released from that center is the same thing, some of them have employment contracts, some do not.

The ones that do not typically we pay a one- to two-month severance for every year they've been at New Oriental.

So it varies a lot by the school, the learning center side, the city, the employee contract.

So there's no average.

That's why I just give you a ballpark number, about $4m to $5m for the whole thing, for the whole year, okay?

So we can't do (multiple speakers).

$4m to $5m?

Yes, $4m to $5m.

Okay.

Now, as far as the -- how you break off a part of a learning center, we typically if we close a learning center we'll get some of the students to go to nearby learning centers.

But we will lose some permanent students because they don't want to take the trouble of going -- travelling to another learning center; they go to a competitor.

And that's why the enrollment numbers are not trending in the low teens.

It's because of that breakage cost -- the enrollment.

It's not because our business isn't doing well.

It's because we -- some of the students are actually leaving us because we are closing the learning center that they are used to going to.

This effect will also end by the end of this year.

So we'd expect enrollments to -- as we begin opening learning centers again, to go back up into the 10% to 12% growth range in the years ahead.

This is a funny year because as you close learning centers you actually lose students, and that's why the enrollment number looks lower than normal.

But -- we're not opening centers, so this is an abnormal year.

Understood.

Okay.

(Inaudible).

Final question is on recording from last quarter there was -- is there any update on the Shanghai School Head issue, is that fully resolved, or --?

Yes, the Shanghai School Head has been changed nine months ago.

He is now replacing many of the department heads.

So you've got almost a whole new management team in Shanghai.

And so you -- and I think he is making a lot of progress.

I think Michael just talked to him recently and Michael -- yesterday Michael was saying that he is pleased with the things that are happening in Shanghai.

So we would expect Shanghai to do better in the quarters ahead.

In terms of margins?

Yes.

Okay, thank you.

Because the closures have happened.

The learning centers have already been closed, so the breakage -- so this year has all the breakage costs in it.

Right, right.

Okay.

Thank you.

Thank you for your questions.

Next questions comes from the line of Cynthia Meng from Jefferies.

Please ask your question.

Oh, hello.

I have a few questions.

Firstly, I'm just wondering what is the revenue contribution from Shanghai and Beijing this quarter, and their respective revenue growth.

And secondly, do you know whether there are any guidance on your ASP growth rate for next year.

And lastly I'm just wondering what is the difference in the operating margin between first tier cities and second- to third-tier cities?

Thank you.

Yes, I think Beijing growth rate in the quarter was 17%; Shanghai was 9%, for this third quarter.

As a percentage of revenue, Beijing was 23% and Shanghai was 9%.

And then for the profit margin for the quarter Beijing was 34% operating margin and Shanghai was 20%.

Does that answer your question?

Yes, thank you.

Yes.

And the second question on ASP growth for next year?

I would expect it to be similar to this year, probably real ASP growth about 12% to 13%.

And then because there's still a shift for smaller classes the overall effect will be about 15%, 16%.

And we expect enrollments to grow probably 10%, so we'll get again 20%, 25% growth next year.

Yes.

That's the current expectation based -- the budget's not finished yet.

Sp the budget we will probably expect somewhere between 20% and 25% growth.

But we want to sacrifice some growth in the name of getting our margin improvement.

Yes.

And the last question on the operating margin between first tier cities and second- and third-tier cities?

Thank you.

Well, some of the second- and third-tier cities have much better margin than Shanghai.

So the profit margin -- just to give you a few examples.

Yes, the profit margin of Xi'an School was 32% this quarter.

The profit margin of which one -- give me a few minutes.

The profit margin of Chongqing School was 28%; profit margin of Shenzhen was 20%.

So many of the schools -- Shenyang was 27%.

So, many of the schools have much higher operating margin than Shanghai.

Okay, thank you.

Thank you for your questions.

Next questions comes from the line of Trace Urdan from Wells Fargo Securities.

Please ask your question.

Thanks.

Louis, I want to go back to the share buyback and first of all ask are there extraordinary costs associated with the repatriating those dollars in order to execute the buyback?

This one there is not, because it is -- well, there is a little bit, but it's the final amount of our retained profit before the new tax came into effect in 2008.

So these are all the historical retained profits of New Oriental coming out, CNY300m, with $46m.

So that's paid for, no tax.

We just got the money yesterday.

We just got it approved two days ago.

So that -- now -- so that's what I said.

The fight at Board level being the dividend.

The dividend, we would have to pay the 5% or 10% tax.

We have no more way of getting tax-free money out.

So that means that we would have to pay the tax and that's why that's the fight we have to have at the Board level at the end of Q4.

Got it, okay.

And then --

The Board (multiple speakers).

-- so the Board's obviously not happy with the stock price, so I wonder if you guys have a debate, or if you can discuss the issues that would be associated with leaving the US market and re-listing in an Asian market.

And whether that's something that comes up at the Board level.

That has come up at the Board level.

It came up a lot during the Muddy Waters issues in the fall, and we went as far as talking to all the investment banks -- several investment banks about it.

And it seems -- and our accountants and lawyers.

It seems like they would not be difficult for us to re-list in a venue like Hong Kong.

So it certainly has come up as -- and I am getting questions on this, as has the privatization issue and everything else.

So those are things that we have explored and we hold those in our back pocket.

Got it.

Okay, thank you.

Thank you.

Thank you for your questions.

Next questions comes from the line of Charles Cartledge from Sloane Robinson.

Please ask your question.

Hi, Louis, congratulations on a good quarter.

Thank you.

The -- just to follow on from your earlier comment.

You likened New Oriental to Apple in so far as you have stranded cash, which the previous questioner also mentioned.

So Apple, as I understand it, has a lot of cash overseas, but would have to pay, just like you would, to repatriate that.

But their solution, as I read in the paper this morning, is to borrow money in the US against that cash overseas.

And I was wondering if you had explored that option also, as I think another Chinese company has also done.

I.e.

borrow money in the US against cash held onshore China --

Yes, we are looking at that.

Which would -- okay.

Yes, we are looking at that Charles.

Is there any apparent obstacle?

Well, the only obstacle, honestly, so far, has been you guys.

Because all of a sudden when we talked of -- when there's talk at all about a convertible bond or a -- doing the same thing, taking a loan offshore and collateralizing it with CNY in China, then everyone says well, does that New Oriental $800m is fake?

And so it's not, so we -- so we've tabled that for this year because of all the Muddy Waters incident and then the cloud over our VIE structure and our cash.

The cash is real; it's not fake; it's not [there] but -- because some shareholders have said well, why are you -- you don't need to borrow money; if you could take it out, take it out.

Even -- it saves us money to actually borrow it because we can earn 4% or 5% interest in China in CNY, and we get the CNY appreciation.

It's actually not a bad thing to do.

So we have looked at it and we can do it, as far as I know.

There's no restrictions, so we held off this year because of the cloud of Muddy Waters from last year.

We want to demonstrate our cash --

(Multiple speakers).

Yes, our cash it not fake; it's real so we don't need to borrow against it.

I'm kind of confused by that.

No one would lend you unless they had proof that the money was real on the other side.

So --

That's correct, just like a convertible bond (multiple speakers).

So, on the contrary --

I agree, but it --

Well, I don't know -- yes.

We should probably debate this offline --

Yes.

-- but I prefer a strict bank loan, as opposed to a convertible bond, which dilutes equity holders.

Yes, but this is a sensitive year because of the Muddy Waters thing.

So we thought we would be prudent to hold off on that.

Right.

And so that, I take it, might be something that's up for debate at the Q4 result Board Meeting?

Correct.

Okay, thank you.

It is a lower cost of -- way out, Charles.

You're right, it's a lower-cost way of --

Yes.

-- getting money out.

I agree with you.

So we have explored it.

Okay.

Great, thanks.

Thank you for your questions.

You have a follow-up questions from Steve Zhang from Macquarie.

Please ask your question now.

Oh hi, and thanks for taking the follow-up.

Just quick question on the enrollment growth.

If we are looking -- I wonder if you have any same school or same learning center year-over-year enrollment growth, excluding the closure of the learning centers.

We don't have it with the closures, because the closures -- some of the students actually stay in the network.

We will have it probably more near the end of this year.

We have growth rate by enrollment by city.

So, you can ask Sisi for that, if you want to.

I don't want to go -- I don't want to read that off in this venue.

Okay, thanks, Louis.

Yes, thanks.

You can follow up with Sisi and she can get you some of those numbers.

Okay.

Thank you.

You also have a follow-up questions from Ella Ji from Oppenheimer.

Please ask your question.

Yes.

Louis, what is the revenue of the Vision Overseas Consulting in this quarter?

Do you have the numbers, Sisi?

I don't have it at hand.

For this quarter right?

Yes, what was the growth rate?

The growth rate --

And then the amount.

-- 60% revenue growth, year over year.

6%?

Ty.

6%?

Ty.

60%?

Because I'm seeing these books and others line on the revenue growth is a lot lower than previous quarter.

Is there any particular reason?

Actually books revenue is lower than average, yes.

So, is this just a -- is there any particular reason, or is this related also to the enrollments being pushed to (multiple speakers) quarter?

I think part of it's a timing difference.

I think it's part of the same timing difference, Ella.

Because what we're --

Okay.

-- what Sisi's reading to you is the enrollments for the quarter, which some of them are -- the actual revenue was recognized in the quarter versus the enrollment, which will come in -- some of them will come in next quarter.

Some of the actual profits.

Okay.

It's a timing difference.

Okay.

You should always take Q3 and Q4 together, whenever there's a Chinese New Year that's not right in the middle between January and February, remember you should always take it -- you take the average of the two quarters combined.

Yes.

All right, thanks.

Thank you for your questions.

The last questions comes from the line of Peter Kennan from Black Crane Capital.

Please ask your question.

Thanks very much.

Hi, Louis and Sisi.

Just a quick question on declining -- the trend in number of students per class, or class size.

I presume on smaller class sizes the gross margin, or increment margin is lower.

To what extent has that been in part a cause behind operating margin decline?

And where do you see that trend going forwards, versus the trend of increasing utilization that obviously works against that in a positive fashion?

I think you are going to see both go up, Peter, as the utilization goes up.

So when utilization of a learning center goes up, the gross margin also goes up.

So the gross margin looks like it's a little bit lower this quarter, because our accountants have us reclassifying some of the expenses from the G&A line to the cost of revenue line, in the COGS line.

And so it looks -- it's just an adjustment for this year.

So the real -- the actual gross margin stayed -- relatively stayed flat, around 60%, 61% for years.

As the smaller classes get fuller -- as we -- utilization goes up, the gross margin will go up.

The operating margin decline was mostly due to, you are right, the fact that we are going to smaller classes, but also because of the heavy expansion.

The 500 learning centers we added in three years is really what did it.

It's the headcount associated with that and the low utilization rate.

Once you -- we stop opening learning centers, the utilization rate will start going up and then the classes will start filling up, all those margins will go up.

Okay.

What do you -- maybe you can't disclose this, but what sort of margin difference is there across products by size of class?

Obviously (multiple speakers).

Well, it's not by the size of the class; it's more by -- we do it by group.

So like Overseas Test Prep has our highest margins, it's well over 30% on the operating margin side.

The U Can business in Adult English will be in the mid-20s.

The ones that are -- the two that are low right now is Kids' English and one-on-one, outside of Overseas Test Prep.

And those are in the high single digits, low double digits.

But that's because of utilization.

And so if the utilization goes up in the kids' -- right now we have like 13 kids per class.

The classrooms have 25 seats.

If you had 18 students all of a sudden --

Yes, okay.

I'm with you.

-- all of a sudden.

You get it, right?

All of a sudden --

Yes.

-- the revenue -- the margin goes from 11% to 16%, 18%.

And one-on-one the same thing.

If you have 50 seats and you only have 10 of those seats full, once you get to 25 seats full the margin goes way up.

Yes.

Well, with a one-on-one class, utilization is always 100% of the class (inaudible).

No, no, but don't forget it's assessed a classroom rental fee, and so the more seats that are full, the less the classroom rental fee, the burden -- so it makes a big difference.

Okay.

Also it goes to the fact of the consultants, the marketing consultant that -- customer service rep for the one-on-ones.

If they're handling 25 students as they are capable of, thee margin goes way up.

If they're only handling six or seven students, as they are now, the margins are very low.

So it takes time for those to fill up.

Once the utilization goes up, the margin is actually still quite high, at least 15%, 20%.

Right, okay.

All right.

Okay?

So the two issues are really intertwined?

Correct.

Yes.

Okay, thanks (multiple speakers).

So that's why you are going to see a rapid increase in operating margin, because as utilization goes up we are not adding a lot of learning center employees ahead of the revenue.

And as utilization goes up, the margins will all go up, across the board.

Okay, thank you.

What we're concerned about was that if there's a more rapid than expected decline in revenues which we have not seen yet.

So that's what we are keeping our fingers crossed on.

Exactly.

Thank you for your questions.

We are now approaching the end of the conference call.

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

Okay.

Well, we just want to say thank you for everyone for taking the time to be on this call.

And if you have any further questions, please do not hesitate to contact me or any of our Investor Relations representatives.

Have a good day.

Thank you, ladies and gentlemen.

That does conclude the conference call for today.

Thank you for your participation.

You may now disconnect the line.