New Oriental Education & Technology Group Inc (EDU) 2014 Q1 法說會逐字稿

Ladies and gentlemen, good evening, and thank you for standing by for New Oriental's first fiscal quarter 2014 earnings conference call.

(Operator Instructions).

Today's conference is being recorded.

If you have any objections, 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 proceed.

Hello, everyone, and welcome to New Oriental's first fiscal quarter 2014 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 statement, except as required under applicable law.

As a reminder, this conference is being recorded.

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

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

Louis, please.

Thank you, Sisi.

Hello, everyone, and thanks for joining us today.

We are pleased to report another strong quarter of significant bottom line improvement, driven by healthy growth on the top line, and operational efficiency improvements across our network.

For the third consecutive quarter, we're posting strong operating margin expansion, which, yet again, demonstrates the success of the Harvest the Market strategy, which we began in November of last year.

The current fiscal year 2014 is shaping up to be a tale of two halves.

In the first half, which is the first quarter just finished and the second quarter we are currently in, we have been focused on delivering operating margin improvement and increased profitability.

And that's paying off, as you can see from today's results.

We have been driving better efficiency and utilization across the network, and this is translating into excellent bottom line growth.

The second half of the fiscal year, covering the winter and spring quarters, we expect to see stronger revenue and enrollment growth.

This will be the peak season for our K-12 after-school tutoring business, and particularly our U-Can middle and high school tutoring businesses, which prepare students for the all-important gaokao, or college entrance exam, and zhongkao high school entrance exam.

And with the planned addition of 20 to 30 new learning centers, we would expect that revenues and enrollments will see robust growth during this period.

We also anticipate continued operating margin expansion, albeit at its lower rate than in the first half of the fiscal year 2014.

First, looking at Q1.

Our overall performance for the quarter was encouraging.

Thanks to our emphasis on network efficiency, we recorded excellent bottom line performance, which more than offset slower than normal revenue growth.

On the top line, revenues grew at a slightly slower rate than we had hoped for, at 15.7%, or just slightly below the low end of our initial expected range of 16% to 21%.

It's important to note, though, that we achieved this despite lower than normal growth in student enrollments, and the closure of 18 underperforming learning centers in the quarter.

I will come back to the enrollment dynamics in a moment.

But I want to highlight here that the first fiscal quarter is the seasonally strongest quarter for our most profitable overseas test prep business, but it's not a peak quarter for our rapidly growing K-12 after-school tutoring business.

In the last fiscal year, our K-12 business contributed about 35% of our total revenue in the first fiscal quarter, compared to about 45% to 50% in the second, third and fourth quarters.

It's also important to note that, while June was a relatively slow month for us, we experienced a nice bounce back in demand in July and August, which has contributed to a strong deferred revenue balance of $323.7 million, at the end of the first fiscal quarter.

This represents an increase of 32.9%, as compared to $243.6 million at the end of the first fiscal quarter 2013.

I am also pleased to say that the strong demand has carried into September and the first half of October, where we have recorded a noticeable 8.3% increase in enrollments year over year, and a 23% increase year over year in cash receipts, or cash collected in advance for enrollments for this six-week period.

Looking at profitability; in the first quarter, we achieved dramatic improvements.

Operating margin expanded by 470 basis points to 34.9%.

Operating income grew 33.4% to $135.5 million.

And net income rose by 31.9% to $126.5 million.

This is obviously very encouraging.

In the second half of the fiscal year, we will shift our focus a little bit, and plan to invest in opening 20 to 30 new learning centers to take advantage of strong demand in particularly profitable areas and drive top line growth further.

Our school heads are focused on improving teaching quality and operational efficiency right now, so they will only choose to open learning centers in locations where it makes obvious financial sense for us to do so.

In particular, we'll be looking at opening in locations that will allow us to take advantage of the peak in demand for our rapidly growing K-12 all-subjects tutoring offerings.

The planned addition of 20 to 30 new learning centers and their associated expenses should not prevent us from achieving continued operating margin expansion in the back end of fiscal year 2014, albeit at a more moderate pace.

Let me return to Q1 enrollments for a moment to provide more color on the dynamics here.

In the first fiscal quarter, student enrollments grew by 2.3% to approximately 919,400.

It is important to note that there is a number of factors dampening the growth rate in the first quarter.

First, we continue to experience a slowdown in our legacy adult English and domestic college English test preparation business lines, which saw enrollment decreases of 14% and 6% respectively year over year.

As Chinese students learn English at a younger age, they no longer need to study English when they reach adulthood.

This is a trend we have highlighted for several years now.

Second, we maintain very strict control over the pace of our expansion and actually closed 18 underperforming learning centers, opening just 5 new learning centers during the quarter.

So there's a net reduction of 13 learning centers versus a net add of 62 learning centers in the same quarter of last year.

Given that we actually had fewer learning centers at the end of the quarter, it's very encouraging that our current growth in enrollments is primarily coming from improved utilization at existing facilities driven, in particular, by demand for our K-12 offerings.

Third, we continue to see market demand shifting towards smaller classes and VIP formats.

As a result, enrollments in our large class formats have declined by about 80,600 from 429,900 in the first fiscal quarter 2013, when large classes represented approximately 45% of all educational service enrollments, to about 349,300 for the first fiscal quarter of 2014, representing approximately 36% of overall educational service enrollments.

Over the past three years, we have obviously very successfully tooled up our business to take advantage of fast growing demand for smaller class sizes, as you can see from the rapid growth for our K-12 and VIP offerings.

In fact, small class and VIP format enrollments for completed classes actually grew approximately 19% for the first fiscal quarter.

Finally, our Shanghai school continued to underperform during the first fiscal quarter with enrollments declining by about 12%.

Over the next few quarters, we expect to see stronger enrollment growth driven by K-12 after-school tutoring enrollments.

It should ramp up in the second, third and fourth quarters as students prepare for final examinations at the end of autumn and spring semesters and for the critical gaokao and zhongkao exams in early June.

As I mentioned earlier, we'll be opening a select number of new learning centers in the coming quarters to take advantage of this peak exam period.

Breaking down the performance across our individual business lines, we continue to see healthy growth across all our core offerings in the first fiscal quarter, and particularly in our overseas test prep, VIP and K-12 all-subjects tutoring businesses.

Our K-12 all-subjects after-school tutoring business achieved gross revenue growth of 24% year over year for the first fiscal quarter, even during a non-peak quarter for this segment.

This is encouraging and, as I mentioned earlier, we expect revenues enrollments to improve considerably in the next several quarters, driven by students preparing for end of term examinations at the autumn and spring semesters, as well as the gaokao and the zhongkao.

Our overseas test prep and overseas study consulting businesses continues to perform well, with recorded combined revenue growth of over 15% across the two lines for the first fiscal quarter.

I want to highlight here that overseas test prep enrollments increased by 5% this quarter, so even though our legacy large class style overseas test prep classes are experiencing a slowdown, we're actually continuing to capture the large market demand for overseas test prep with our newer, smaller class formats.

We're obviously the dominant brand in this space so we are very well positioned here.

Finally, our VIP personalized class business recorded about 24% year over year cash revenue growth in the first fiscal quarter and this segment continues to perform very well.

Let's move to some of the other important financial metrics for the first fiscal quarter, in addition to revenues, which we've already discussed.

Selling and marketing expenses for the first fiscal quarter increased by 8.2% year over year to $42.7 million.

This is consistent with the very encouraging maturation of our school network, which I mentioned earlier.

The schools that have been open for two to three years are now increasingly able to rely on word of mouth and repeat business to drive enrollments, which is very healthy.

In line with this, actual brand and market promotion expenses declined approximately 3% year over year to $19.8 million in the quarter.

In addition, general and administrative expenses for the quarter increased by 1.7% year over year to $77.9 million.

Headcount at the end of August 2013 stood at about 30,050, a reduction of more than 600 from the previous quarter.

This strict control of sales and marketing, G&A and headcount expenses contributed to our impressive operating margin improvement of 470 basis points, compared to the year ago period.

As I highlighted previously, quarterly operating income increased 33.4% year over year to $135.5 million.

Operating margin for the quarter amounted to 34.9%, compared to 30.2% in the same period of the prior fiscal year.

On a non-GAAP basis, operating margin for the quarter was 36.2%, compared to 32.2% in the same period last year.

Again, this is pleasing because it demonstrates how we're delivering on our promise to generate sustained profitability for our shareholders.

Capital expenditures for the quarter were $8.6 million, compared to $21.3 million in the same period of the prior fiscal year.

They were primarily attributable to the opening five new learning centers and renovations of older existing learning centers.

We generated approximately $143.3 million in free cash flow for the quarter compared to $95.3 million in the year ago period, representing an increase of over 50%.

One point I would like to add here is that, going forward, we intend to significantly ramp up our investment in R&D.

Continuous improvement in teaching quality and course material quality are of paramount importance in New Oriental, and we never stop investing in these twin endeavors.

We obviously have a very strong cash position and we are confident that by routing some of this to support our industry leading groups of R&D talents we will drive even more improvements in our product offerings and teaching quality.

In particular, we will be investing heavily in ways to drive even closer integration of our online and offline offerings, and also in systems that will improve the overall quality of New Oriental learning experience for our students.

So the full fiscal year 2014, we currently expect to ramp up R&D expenditures in these areas to approximately $10 million or more.

Before moving on to the Q&A section, let me quickly talk about our expectations for the second quarter of fiscal year 2014 as well as our full fiscal year.

As I've said earlier, the emphasis for the first half of fiscal year 2014 will be on continuing to drive profitability, and in the second half of the year we'll refocus on driving top-line growth.

With that in mind, for the second quarter of fiscal year 2014, we expect total net revenue to be in the range of $202.4 million to $210.7 million representing year-over-year growth in the range of 22% to 27%.

Looking at the full year, our forecast for revenue growth in fiscal year 2014 of between 18% and 22% remains in place.

However, in light of the significant improvement we have recorded on operating margin in the first fiscal quarter, and sustained results we are seeing into the second quarter, we have raised our GAAP operating margin target for the fiscal year 2014 to a range of 16% to 17%.

This represents a 320 to 420 basis point improvement from the year ago period and compares to our previous target of 15% to 16% or 220 to 320 basis point improvement.

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

At this point, I will be happy to take your questions.

Operator, please.

Thank you.

(Operator Instructions).

Timothy Chan, Morgan Stanley.

Maybe could you elaborate more on your second quarter sales guidance?

How much growth is due to organic growth versus adding new centers?

And related to that, could you maybe comment on your utilization rate trend to this quarter.

Thank you.

Thank you, Tim.

Yes, our guidance in Q2, much of it comes from the deferred revenue balance of $332,000 or so -- $332 million, sorry.

More than 50% of that will be recognized in this second quarter.

The enrollment growth so far is around 8.3% and I would expect that to be approximately that amount.

Price increases will be about 10% to 12% and then the mix shift towards smaller classes will continue, which will add about 5% or so.

So as far as the utilization rate for the summer, it will range between June, July and August of between 11% and 15%, which is about 100 to 200 basis points higher than last year, so we're getting some operational efficiency.

And that number should continue to go up.

In learning center openings for Q2 so far, we've opened less than 10 and it's middle, late August so far.

Thank you.

That's very helpful.

Mark Marostica, Piper Jaffray.

Louis, I'd like to explore your comments on more integration between online and offline.

Could you give us some more color regarding your strategy on online and whether you plan to ramp up a full online offering and, looking forward, if online should begin to contribute, your proportion of revenue going forward?

That's a good question.

Thank you, Mark.

Our online strategy actually is in flux, right?

It's changing because we have -- I think all of our divisions are working on online offerings.

And so we're coordinating between all of them, not just Koolearn, which is our online website, but our K-12, our Kids, every department in New Oriental is working on integration of online and offline and we're coordinating that all together.

So it's two kind of online/offline coordinated.

One is to partner with Internet leaders in China to jointly develop programs that will work for both sides.

I don't want to go too much into that until we've developed it further.

Second thing is to make all our classes have an online component so when students want to do their homework, they can do it online, they can do it from their mobile devices.

They can listen to classes from their mobile devices; they can do homework and take exams from online or offline.

They can do social networks with their classes, with their teachers.

So it's a number of different things that just allows students to be more productive and use their mobile devices as well as their PCs as well as when they're in the classroom.

So it's just a way to give students a much richer experience when they come to New Oriental.

It also will set up more barriers to entry for us, vis-a-vis our competitors.

So it's a heavy investment that we're making.

And, as I mentioned in the call, that we've placed over $10 million.

Last year, that number was closer to $2 million to $3 million so you can see there's a threefold increase.

And that's why Michael has mentioned in speeches in the past that online/offline integration is one of our key focus areas, going forward, and so we're putting our money where our mouth is.

Thank you.

Ella Ji, Oppenheimer & Co.

Louis, I wanted to follow up with your guidance, so you are seeing enrollment to pick up but you around 8% from 2.3% in this quarter.

In which segment are you seeing the growth being accelerated?

Well, for us, Ella, almost all our enrollment growth comes from K-12.

Last year our adult English was down in enrollments, overseas test prep was down year over year in enrollments, so all the growth came from K-12, which is about 12% to 14% enrollment growth.

And so I think this year will be something similar; K-12 will drive basically most of our enrollment growth.

It will be a little bit better this year than last year because last year we added 62 learning centers in Q1.

This year, we actually did not and so that's what hurt the Q1 enrollments.

But Q2, we begin to start adding some learning centers, 20 or 30 for the rest of the year.

That will also help our enrollments as well as the utilization increases, organic growth in the existing cities.

So we would expect the enrollments begin to pick up, especially at the end of Q2, going into Q3 and Q4 because, as we highlighted, June is the time for the gaokao and the zhongkao and students usually -- the K-12 sector, those sections really peak in Q3 and Q4, which is the winter and spring.

So we would expect, as we prepare for that, that we would see faster enrollment growth during those quarters, mostly driven by K-12 and VIP.

Okay.

If I can sneak in one more?

Can you also talk about the sizes of the 22 serving centers that you are planning to open and where are the locations of these centers?

Are they in tier one cities or in lower tier cities?

Well, they're mostly in fast-growing cities like [Zhejiang] and [Changsha], [Chengdu] cities like that.

Beijing and Shanghai have actually declined in learning centers, so from last year Shanghai is actually down 10 learning centers and that's part of why its enrollments are down.

And Beijing is down 15, although Beijing is doing quite well now; Beijing is really growing very fast now.

So I think as most of the growth will be K-12 learning centers.

The size will probably be between 800 and 1,500 square meters, so they're usually three floors of a building near a middle high school or elementary school cluster.

And they will mostly be used for K-12 small class, a couple of large class and then one-on-one format.

If you think about it, actually our enrollments in small classes is actually up between 15% and 20% year over year.

So all the shrinkage is coming from the large class and that's market driven.

That's not our preference.

The market is saying that as parents and families have more money, they're electing for more expensive smaller classes and one-on-one formats.

And so we've actually tried to control the growth of our one-on-one to slow it down because, as you know, one-on-one doesn't have as high a margins.

So we're actually just doing our best to slow down one-on-one.

We're happy with the growth in small class, and I think the large class format is going to decline, regardless of what we do, so we'll focus more on one-on-one and small class, going forward.

Just a quick follow-up.

So as we're now seeing the market demand shift to smaller and VIP classes, what do you think about your current capacity at your learning centers?

Do you think you may have too many larger size classes, but not enough small classes, or do you think your capacity is okay?

Well, we spent the last year, [remember], closing down 84 or so underperforming learning centers so we are looking at -- and we're also retrofitting some learning centers to turn large classes into small classes.

So I think we're not perfect.

We're not ideal, but I think we're getting better in the large class/small class format so I think we're getting it closer to right.

At the same time, don't forget, our large classes are still used for overseas test prep, adult English and other classes and, even if they sit empty 90% of the time, the 10% they're used is actually quite cost effective.

Okay.

Thank you, Louis.

Thank you for answering my questions.

Jiong Shao, Macquarie.

I stick to the one-question rule.

It looks like Shanghai continues to be a drag on your business.

Could you talk about, remind us what are some of the issues in the past; what have you done; what are you going to do to turn the situation around?

Thank you.

Yes, thank you.

Thank you, Jiong.

Shanghai, the enrollments were down again from 64,000 down to 56,000 in this quarter.

Partially that's due because we've closed 10 underperforming learning centers in the last year in Shanghai.

The main problem in Shanghai actually started four years ago when we did not roll out U-Can in Shanghai like we did in the other cities, so Shanghai fell behind from day one in U-Can.

And so Shanghai, for the longest period, has relied on overseas test prep in adult English.

Well, overseas test prep is slow.

The number of Chinese students leaving is slowing; it's a market driven phenomenon.

And also, the adult English, as you know, we've been harping about it for years now, is slowing.

So Shanghai is only dependent now on overseas test prep and POP kids English for growth.

It's missing the biggest growth driver, which is U-Can, the middle and high school business.

And so what we've done about it is, as you know, we replaced the school head a year and one-quarter, almost a 1.5 years now, May of last year, and we brought in our best young school head from Xi'an School where he had rolled out U-Can phenomenally well.

He also brought his team with him, so he has slowly replaced, I think, every department head in Shanghai School with his own people and with new hires.

We also brought in the Group Marketing Director from our whole Group in Beijing and moved him to Shanghai.

So we have a brand new team in place as of six months ago, when the team came into place.

And even though Q1 was not good, they were actually down 5% in revenue, minus 12% in enrollments, this quarter they're flat in revenues, still down a little bit in enrollments.

And the anecdotal event is that Q3, Q4 are shaping up to be much better for Shanghai.

As they pick up K-12, especially U-Can, they'll basically begin to grow, so I think it depends on the success of U-Can in Shanghai.

They were four years late in rolling it out aggressively.

Thanks, Louis, for the comments.

Clara Fan, Jefferies.

I've got a question on the number of centers.

I'm just wondering, have we completed the process of closing down our unprofitable centers?

How many centers do we plan to open in second quarter?

The new guidance of 20 to 30 new centers for the remaining of this fiscal year, so it's implying a 7 to 17 centers addition for the whole fiscal year 2014, which is lower than the guidance before.

So I'm just wondering the reason why and what's the implication on enrollment?

Would that mean still this similar 5% to 6% enrollment growth for this year because of better utilization?

Thank you.

Thank you, Clara.

I think for us, you're correct.

We did close net of 13 in Q1, which is actually more than I thought.

We didn't know we still had that many, 18 underperforming centers.

So we've opened between 5 and 10 centers so far in October.

I expect to be another 5 or 10 before the quarter ends at the end of November, and I will expect to open another 10 to 15 for the rest of the fiscal year, probably mostly in Q3 during the winter quarter.

So the number will come out probably a little bit lower, but you have to remember that we have been trying to digest this overcapacity for a year, since November of last year.

And so the fewer centers we open, the higher our profit actually is.

So I think is that we are motivating our school heads; more than 50% of their financial component, actually probably close to two-thirds or more, comes from their ability to raise operating profit margin.

So I think is that they're motivated to make sure they're running as lean and as profitable as possible.

But having said that, there are a number of cities that are actually growing very well and so we want to continue to open learning centers there.

So we don't know the exact number because it depends on demand and the request from the individual school heads, but I will expect the number to be a little bit lower than our initial guidance at the beginning of the year because we -- it's not because we're opening centers, it's because we closed more than we thought.

But so we're almost done with closing down profitable centers?

Yes, we are, but some centers become unprofitable as you go on as well.

So even though we're not opening more new ones, some of them become less profitable and we may consider closing a few more, but not too many.

As far as your question on enrollment growth, 2.3% is low.

I would expect Q2, Q3 and Q4 to be much higher and I would expect to finish the year with somewhere between 6% and 8% enrollment growth.

And then next year, assuming demand holds up, we will probably open 80 -- 60 to 100 learning centers, in which case then enrollments will really begin to ramp up.

Also, at that point, I think the adult English and the large class dampening factors on our enrollments will begin to abate a little bit.

Because adult English, and college English test prep, is now about 12% of revenue where it used to be 25% to 30%, so its effect is getting less and less each year.

And I think, as we open up more learning centers next year, we won't have such a strong profit focus, then I believe the enrollments will pick up.

I see.

So am I right to assume that the 6.8% enrollment growth versus less center openings means improving utilization?

Yes.

Utilization is going up a couple of percentage points year over year per quarter, so it is going up.

I would like it to go up faster, but it is going up.

The reason it's not going up so much is because, as Ella mentioned earlier, is the number of large classes we have, but they're still cost effective so we still keep them.

So they sit empty most of the time, but when they're used they're actually quite profitable.

So I would expect 6% to 8% enrollment growth.

I expect to continue to raise prices about 10% to 11% a year, 12%, and I would also expect the continued shift towards smaller classes and VIP format to add another 3% to 5% to the revenue line.

So that's why we continuously guide right around 20%.

If you look at the 15.7% revenue number we have for Q1, and then the guidance for Q2 of 22% to 27%, if you middle that and you combine the two quarters, we're almost at 20%.

And that's going into the busy period of Q3 and Q4 where, for the last three years, we have really outperformed on revenue, as we highlighted, with the K-12 gaokao and zhongkao tests that are coming up.

So we would expect to be very comfortable with our guidance of 18% to 22% and, hopefully, it will be at the higher end of that range.

Thank you.

Fei Fang, Goldman Sachs.

I just have a quick question on the sales and marketing expense.

This is the second quarter of single digit growth in the sales and marketing expense, so what drives the savings [and] what will be the guidance for the upcoming quarters.

And also, in the long-term, how should we model the cost line?

It's a great question.

I think for sales and marketing, we've been saying for years that it mostly comes from word of mouth.

The reason we spent on sales and marketing and promotional expenses in the past is when we opened new learning centers.

So the reason the expenses are going down is because we're not opening learning centers.

So you'll see it go up a little bit when we open more learning centers because you usually advertise at the beginning to attract your core base of students to that learning center in the neighborhood.

So I would expect sales and marketing expenses for promotional expenses to continue to decline as a percent of revenue for the rest of this year because we're only opening 20 to 30 learning centers, so it won't be high.

I think next year it should go up a little bit, but it's always been, promotional expenses have always been [in the range of] between 6% and 8% of revenue.

The reason it looked like it was going up in the past years is because we shifted our business model to VIP formats with the one-on-one tutoring, customer service [reps] were counted in sales and marketing.

So if you take those out, it's been pretty consistent between 6% and 8% and it's going down now because we're not opening learning centers.

There's no need to be promoting when you're not opening new centers because most of our business comes from word of mouth anyway.

That's helpful.

Thank you.

Tian Hou, TH Capital.

So the question is really related to the different size of your class, as which you said in the opening remark, and the demand is much more shifting towards the small and VIP classes.

So the first question would be, what's the [breakdown] for big class, small class and VIPs, or how many students could be in the big class, small class and VIPs?

That's number one.

Number two, what is the current composition for these three different class sizes, the size of the class?

So that's the question.

Okay.

Thank you, Tian.

We define VIP as one to one through one to six, so that's VIP.

Small class for us is 6 students through 40 students and large class is 40 students and more.

So far, this last quarter, large classes account for about 36% of completed classes where the students were actually in the class, that's how we count large, small, so it's different from enrollment where students are new signups coming in.

I think 4% came from one-on-one or VIP and so then that means that almost 60%, about 60%, comes from small class, which means 6 students to 40 students.

So going forwards, what this percentage could be?

I think one-on-one will continue to grow a little bit.

So I could see one-on-one becoming [popular], VIP becoming 5% to 7% of enrollments.

I would expect small class, 40 and under, to continue to grow and so they will probably come up to 70% of classes.

And big classes will still be about one-quarter or 30%; [that's how it works out] if the trend continues.

I see.

So there's another issue, it's seasonality.

In the past, in terms of growth, Q1 could be the highest growth in terms of enrollments and now we're shifting to K-12.

So I understand the growth factor in Q3, Q4, one is (inaudible), one is [zhongkao] and gaokao, so what is the seasonality driver in Q2?

Q2 is also just picked up a little bit by K-12.

So K-12, when students go back to school, when they go back to their primary schools, they usually don't take the whole quarter off.

Some do, but some don't.

So Q2 is also driven by the same as Q3 and Q4, but just not quite as strong.

Q1 is weaker because Q1 is a big adult English and college, domestic college, English exam quarter.

In both those enrollments are flat or down.

Adult English is way back.

And so that's why Q1 is -- also Q1 last year has a difficult comp because Q1 last year we opened 89 learning centers and we closed 27.

So it has very difficult comps this year.

So that's why we have had that very early.

And also the last question, as you're shifting the composition of your classes from big class to small and VIP, how the margin is going to trend?

That's why we're doing it slowly, because obviously the big class has the highest margin.

And so that's why we've been very careful when we go to the small class and VIP, that we do it in a way that is still very profitable.

And so that's why -- our VIP is not all one-on-one.

Half the enrollments are actually one to two, through one to five, or six.

So that's one thing.

Our small class pricing -- our small class is 40 students, whereas our competitors' small classes are 15 students or 20 students.

So we're trying to get higher margins.

That's why we have the highest margins in the industry.

Our operating margins are the highest by far among our Chinese peers.

It's because we're trying to do it in a way that doesn't kill our profitability, and so we're doing it slowly, and we're pricing a little bit higher.

And what happens when we do that is we sacrifice enrollment, because we price ourselves out of some people's affordability.

And that's a conscious choice.

That's what you've always heard me say, well Wal-Mart can give you the choice, but we're Tiffany priced.

We're priced above the market with the highest price.

And so it's that tension of raising prices versus going to a lower profitability, small class, business model.

I see.

That's very helpful.

That's all my questions.

Thanks, Louis.

Vivian Hao, Deutsche Bank.

My first question, I think, is a follow-up of Tian's question, so given this mix shift, what's the impact on margins?

Specifically, shall we expect the gross margin might be under pressure in the future versus most of the margin improvements should come from operating leverage?

And secondly, please allow me to ask a second question because this is really a long queue, your competitor, TAL Education, posted a 25% year-over-year growth in their enrollment, mostly driven by their outside Beijing/Shanghai new markets, versus our expectation is probably low to mid-teens percentage enrollment.

Apart from the base effect, do you see there's intensifying competition outside Beijing/Shanghai and nationwide new markets?

Yes, your first question, operating margin, I'll go first, then I'll tackle the TAL question.

Operating margin, I think, it's a constant tug of war between -- if we improve utilization and we increase prices, that will drive up operating margin.

So one of the reasons our enrollments are actually not so strong in Q1 is we actually raised the price of POP kids English by over 20%.

So enrollments are actually down year over year.

And that was an attempt to improve the profitability.

So we sacrificed enrollments.

We've been saying this for one year now, that we're willing to sacrifice some growth and some enrollments to gain that operating profit margin advantage.

And you saw that this quarter.

So there's no free lunch.

So I think it will be a tug of war between utilization increases and price increases, versus the formats coming down to smaller-sized classes.

So that's number one.

Number two on the TAL question, they posted a really strong set of numbers.

But they're basically, if you think about it, they're not on the scale we are.

They're four times smaller than we are.

So if you look at TAL that was four years ago we were posting similar, if not higher, numbers when we were expanding into the 50 cities.

They're only in 15 cities.

So they're at a different stage in their growth.

Their base is very small.

The total revenue is around [$90 million] this quarter, and for the whole year is less than our one quarter.

So they're off a lower base.

And second is that I think their growth is off a very low base outside of Beijing/Shanghai.

I think outside Beijing/Shanghai only represents about 30% of their revenue whereas, for us, outside Beijing revenue is at 65%.

So they're at a stage about three years or four years earlier where we were four years or five years ago.

So they're just at a different scale.

When we started rolling out K-12 we were growing 30%, 40% a year in enrollments as well.

So it's just a different stage of development.

Once they get to 50 cities, and they have 1.6 million enrollments, then it'll be much more difficult to grow 25%.

Okay.

It's just a different scale.

You can't really compare the two.

They're one-quarter our size.

So mostly it's a base effect?

Yes, it's a base effect, because we're in 50 cities.

We've been there for four years.

They just arrived outside of Beijing, Shanghai, a couple of years ago.

They're only in 15 cities, so their base is very low.

We have 1.6 million students.

If you take away the online students, there are 500,000, 600,000.

I'm just guessing, but it's a much smaller number.

Okay.

Thank you.

Trace Urdan, Wells Fargo.

I wonder if you can maybe expand on the TAL question a little bit and just talk about competition more generally and maybe to the extent that it's different between your mature markets in the large cities and some of the newer markets that you're moving into.

Yes, I think for us it's pretty much the same.

In the big cities, Peking is actually doing really well now in K-12, so it's growing very rapidly, probably around 25%/30% in revenues and enrollments are increasing.

Shanghai, you know we've had trouble.

I think a lot of our competitors also have had trouble in Shanghai, so Shanghai's just a tough market.

Outside of Beijing/ Shanghai, we're actually growing very fast.

If you look outside of Beijing and Shanghai into our middle or kids' business, in our middle and high school business, our enrollments are up over 20% for the last 12 months.

So it's Beijing and Shanghai are the slow points and I think, outside of that, -- and if you look at the small class format and the one-on-one format, which is what TAL offers, we're actually growing enrollments well over 20% and we're off a bigger base.

I appreciate that, I just (multiple speakers)?

So what happens is, we get dragged down by our adult business and our overseas business as far as enrollments goes because of our big base.

I was just asking a broader question about how we should think about where we are in the evolution of the market and what it looks like (multiple speakers)?

I think the market's still growing --

Yes, go ahead.

Yes, the market's still growing; it's still growing 13% or so a year according to IDC.

I think the market is shifting towards smaller classes and tiering.

So what we're trying to do, I think some of the better players like TAL and Xueda and ourselves are trying to differentiate ourselves from the many, many local competitors.

And that's why I said generally, we really want to invest in R&D to give offerings that our competitors can't really keep up with.

But we already the 7 million question assessment database, so we can deliver questions from any point across our network.

We wanted to integrate more online and offline offerings to give students a much more richer experience.

Those are things that our competitors can't easily do because it requires a lot of investment and you need a big student base to spread that cost across.

The other thing that's happening competition wise is with tiering.

So we are using the highest priced premium offering in each of our markets, so we are very expensive.

We're the Mercedes or BMW or Rolls Royce of our markets.

And then we are willing to give a lot of the middle market and low end market because we just can't get a high margin by playing -- we can't be all things to all students.

And so we've chosen to be at the very highest end, whether it be one-on-one, whether it be small class or whether it be large class or online.

So we're just priced higher than everyone.

We believe we deserve it because we have a higher quality offering.

And then we will sacrifice enrollments and revenue to get that higher margin, and that's why we have the highest margin in the industry by far.

Okay.

Thank you.

Yes, so just tiering out, it's just like any other large market.

You're going to have some high-end players, middle-end players and low-end players.

And in the education market, it's a very fragmented market, as you know, Trace.

So we have hundreds of competitors in every city, so we've chosen that we can't have a low margin 5% to 10% operating margin business.

We have to be in the 15% to 20% range.

In order to do that, we have to play at the high end.

We have to sacrifice a lot of enrollments and revenue in order to collect the high profit revenue.

Got it, thanks.

[Tien Ding], (inaudible).

Basically, I want to look at the ratio between the enrollment growth and the learning center growth.

So if I compare the first Q 2012 against first Q 2014, the learning center grew by almost 50%, but the enrollment growth is about 15%.

So can you help us to understand will the enrollment catch up?

Will organic enrollment growth catch up?

How much enrollment growth, organic enrollment growth [mix back] from the existing learning centers?

Well, like I said, that's not a good way to analyze that at all.

You know the last two years, we're opening up small VIP centers.

They're small, so you're not comparing apples to apples.

The older learning centers, before we entered the K-12 market, were large ones.

And the K-12 ones were, mostly at the beginning, a lot of them were small.

So of course, they're not going to have the same capacity or the same growth.

The organic -- as you look at it now, you already see that we have fewer learning centers than we did last year and our enrollments are up 2.3%/2.4%.

So I think our school heads are learning how to manage this smaller learning center format.

And it's also, you need to understand, that our utilization has gone up a couple of percentage points and where the enrollment growth has slowed it's in the large class.

That's the business.

There's nothing we can do, that's the market.

So if you look at our future, who cares about the past, if you look at our future, it's going to be small class and one-on-one, and in that format, we're growing 19% enrollment and we're growing over 30% in revenues.

So we will keep the large class legacy businesses because it's still very profitable.

It's actually more profitable than the small class ones.

So we'll keep it; we're not going to throw it away.

But our growth drivers really come from K-12, especially U-Can middle and high school and overseas test prep, and those are moving to a smaller format.

So our smaller format enrollments, if we begin to break it out, you'll see that our smaller class formats and one-on-one are actually growing very, very fast, and that's really the future of this Company.

It's just we have a big base from the legacy large class business.

I understand.

But I'm not going to throw it away because it's very profitable.

Got it.

And just another question, yesterday, there is the news that Beijing is thinking to reform the English exam for the college entrance exam by reducing the weighting.

How do you think it will impact the ETOs in Beijing?

Yes, that's a very good question.

That is a policy that's in flux, but I think the current manifestation is that they will reduce the English portion from 150 points on the gaokao down to 100 points.

And they'll allocate those points to Chinese and to mathematics.

So it's obviously not a positive development for New Oriental.

I don't think it will affect us too much because English is still 100 points out of 750, so it's still very significant, about 13%/14% of the total score.

The second thing is that, more practically, how are these people going to find jobs if they don't speak English?

It's proven that the students who are quite good at English will get a paycheck that's much higher than if your English ability is not good.

The other change in the test is that it's going to push -- my understanding is they're going to emphasize the actual use of the language, English, and not just taking exams.

So I think in that case, that will actually help us because our whole language training format is to teach kids practical English, how to use English language in your daily life, not just to take an examination.

So I think the one side, the fact that they're lowering the weighting is obviously not helpful to us.

The fact that they're emphasizing more practical English will help us.

Also, there's talk about not letting a lot of primary schools starting English until after third grade.

That will probably help us as well because, if they're not learning it in school, most parents will send their kids to our centers.

So I think there's pluses and minuses to it.

I don't think it, in the long run, will have too much of an impact plus or minus.

Got it.

Thank you.

We are approaching the end of the conference call.

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

Again, thank you for joining us today.

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

Hope you guys have a wonderful day.

Thank you very much.

Thank you.

Ladies and gentlemen, that does conclude our conference for today.

Thank you for participating, you may all disconnect.