New Oriental Education & Technology Group Inc (EDU) 2014 Q2 法說會逐字稿

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

(Operator Instructions).

Today's conference call 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, Miss Sisi Zhao, New Oriental's Investor Relations Director.

Miss Zhao, please proceed.

Hello, everyone, and welcome to New Oriental's second 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.

We'll 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.

I'm very pleased to report a stellar set of quarterly financials in our seasonally slowest period, with strong top-line and bottom-line growth, driven by very encouraging enrollment trends and efficiency improvements across the network.

We began to pivot towards our Harvest the Market strategy in November 2012, with an expectation that it would deliver a greater utilization improvement and operating margin and increased profitability.

Today's results demonstrate yet again how this approach is reaping rewards.

In fact, since the pivot in November 2012 we have recorded very strong margin expansion in GAAP operating margin, reaching 17.4% in the last four quarters compared to 12% in the previous four quarters.

We raised our GAAP operating margin guidance last quarter to 16% to 17%, and we are well on our way to exceeding that target for the full fiscal year 2014 ending May 31.

We will strive for balanced, healthy top-line growth with improving margins, albeit at a slower pace than the past year with respect to margin improvement in the quarters ahead.

On the top line, we recorded solid revenue growth of 25.6%, driven primarily by a very impressive 11.8% increase in student enrollments.

This is obviously very encouraging, particularly when one considers that we actually ended the second quarter with 711 learning centers and schools, 33 fewer than the year-ago period.

This really highlights how we are gaining traction across the learning center network and benefiting from the network expansion efforts we undertook from 2009 to 2012 to build our K-12 after-school all-subjects tutoring and VIP businesses.

I'm particularly pleased to note that we recorded a 16% increase in enrollments for our K-12 all-subjects after-school tutoring business.

This is a very important business line for us, so the growth trajectory is very positive and underlies our success in capturing market share in this fast-growing segment.

The other major contributor to our improved enrollments is actually domestic test prep for the CET4 and CET6 college English exams.

This is a segment where we have experienced a slowdown in recent years.

What we've seen, however, is that the new change in the test format introduced in December 2013 has made the exam more challenging by adding in translation, dictation and comprehension questions.

We're now seeing students coming back to New Oriental because they recognize that our premium brand offers the best preparation for the new and more difficult exam.

It's too early to tell if this is a long-term trend, but we'll keep you posted.

We're also pleased to record such strong revenue growth while actually experiencing slower growth in ASPs, which grew only 9.5% year over year in the quarter as we shifted our product mix toward larger class size courses.

As you know, our goal is to cap our VIP class offerings at around 30% of overall revenues to ensure that we can maximize the efficiency of our learning center network.

Looking at the bottom line, in the second quarter we achieved dramatic improvements.

Operating income grew to $0.7m from a loss of $26.9m and net income rose to $4.3m from a net loss of $15.8m last year.

This is obviously very encouraging and again underlies how we are benefiting from organic growth as well as efficiency initiatives we have worked hard to implement over the past year.

As you know, we are focused on broadening efficiency across the network, improving our utilization rates, getting the right headcount mix and managing our expenditures appropriately.

So these bottom-line numbers are a direct result of that approach.

Looking at our network, in the second quarter we opened 11 new learning centers in nine fast-growing -- in high-profitable markets and closed 13 learning centers, including 6 underperforming ones.

To meet the seasonally higher demand -- market demand for K-12 after-school tutoring in the coming winter and spring quarters, in the second half of the fiscal year we will continue to open some new learning centers in fast-growing cities.

We'll maintain our focus on operational efficiency and will open learning centers in locations where it makes obvious financial sense for us to do so.

Moving to a breakdown of our performance across our individual business lines, we continued to see healthy growth across our core offerings for the second fiscal quarter, in particular in our overseas test prep and K-12 after -- all-subject after-school tutoring businesses.

Our K-12 all-subjects after-school tutoring business has achieved gross revenue growth of 26% year over year for the second fiscal quarter.

This is encouraging as we enter the seasonally busy winter and spring quarters when students prepare for end-of-term examination at the end of spring semester as well as the Zhongkao and Gaokao high school and college entry exams in early June.

Our overseas test prep and overseas study consulting business continued to perform well.

We recorded combined revenue growth of over 28% across the two lines for the second fiscal quarter.

Our domestic test prep business performed well this quarter.

This business line achieved gross revenue growth of over 30% year over year for the second fiscal quarter.

The national English exams have undergone quite a few format change, making them much more difficult starting from December 2013, as mentioned earlier.

Thus more students registered for our domestic test prep in the second fiscal quarter to get better prepared for the new format.

Finally, our VIP personalized classes business recorded about 24% year-over-year cash revenue growth in the second fiscal quarter.

We intend to cap the percentage of revenue generated from our VIP offerings to about 30%.

This will help to improve our operating margins since larger classes typically have higher margins.

While I talk about our business lines, I do want to highlight some of the important progress we've made in developing our online offerings.

We're very excited about the potential of the online segment for New Oriental.

This is an industry where high-quality content and premium branding power will drive success, so obviously we believe New Oriental has a significant advantage vis-a-vis our peers.

There are two primary pillars to our online education offerings.

The first pillar involves integration between our online and offline offerings to improve the learning experience for our students and drive cross-selling opportunities.

So, for example, we have recently started to roll out of our online interactive learning platform.

This platform, which covers all of our major product lines, enables students to go online after class to do exercises and quizzes, interacting with teachers in real time.

We believe the new online interactive learning platform will tremendously enhance the learning experience for our customers and create new revenue streams with online value-added services and may also bring online-to-offline traffic to generate more enrollments and revenues.

We have also recently started a pilot program to broadcast some of our most popular test preparation classes.

Paying users can log on to the live broadcast on our official website or on Koolearn.com platform, and they can also watch streaming videos of classes at any time.

Our pilot program is already proving quite popular, with thousands of registrations within a few days of launch, and we're very optimistic about the potential here.

We believe that the new type of offering will increase our productivity and utilization of educational resources, such as our content and teachers.

Our secondary strategic focus online involves our purely online learning products.

As you know, we already have a very mature and successful online learning platform called Koolearn.com.

We now offer over 2,000 online courses for teenagers and adults on Koolearn, including language training, test preparation and vocational training.

And I'm pleased to say that Koolearn is already the number-one player in this market, growing rapidly at over 30% annually and highly profitable.

We have also recently developed a suite of mobile and web game-based learning applications aimed at providing an enjoyable English, math and Chinese reading learning opportunities for children aged two to eight, branded Donut.

This suite of products is now being rolled out very quickly.

Most of the applications are currently free to download but include various in-app purchase options that would allow us to improve monetization.

The content is updated monthly, which ensures user stickiness.

Finally, we continue to explore opportunities to work together with large-scale Internet companies to further develop our online offerings and we will keep you posted on this effort.

Looking at our acquisition strategy, as you have seen from our release earlier, we signed a definitive agreement to acquire a kindergarten in Changsha that has over 10 kindergartens and 3,000 students in 2013.

The aim of this acquisition is to increase our presence in the preschool market and ultimately support our POP Kids and U-Can middle and high school tutoring business lines.

We will be consolidating the kindergarten's financial results in New Oriental's results in the fiscal quarter when the transaction is completed.

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

Selling and marketing expenses for the second fiscal quarter increased by 7.1% year over year to $36.8m.

The schools that have been open for two or 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 2% year over year to $13.5m.

In addition, general and administration expenses for this quarter decreased by 5.6% year over year to $73.4m.

Headcount at the end of November stood at approximately 29,900, a reduction of 3,000 from the same period last year.

This strict control of sales and marketing, G&A and headcount expenses contribute to our impressive operating margin improvement of 1,650 basis points compared to the year-ago period.

As I highlighted previously, quarterly operating income increased 102% to $700,000.

Operating margin for the quarter amounted to 0.3% compared to negative 16.2% in the same period of prior fiscal year.

On a non-GAAP basis operating margin for the quarter was 2.9% compared to negative 12.1% in the same period last year.

Capital expenditure for the quarter was $7.2m compared to $16.2m in the same period of the prior fiscal year and were primarily attributed to the opening of 11 new learning centers and the renovation of older existing learning centers.

We generated approximately [$21.8m] (corrected by company after the call) of operating cash flow for the quarter compared to $4.3m in the year-ago period, representing an increase of over 400%.

Now let me quickly talk about our expectations for the third quarter fiscal 2014.

For the third quarter we expect total [net revenues] (corrected by company after the call) to be in the range of $260m to $270.9m, representing year-over-year growth in the range of 19% to 24%.

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

As always, we want to thank you for all your support of New Oriental.

At this point I will take your questions.

Operator, please?

(Operator Instructions).

Ella Ji, Oppenheimer.

Yes.

Louis, congratulations on a very strong quarter.

I wanted to ask you regarding your online education initiative.

Do you expect to roll out purely online live courses in larger scale in the near term?

Can you also discuss your price strategy for such courses?

Thank you, Ella.

We do.

We have live classes now, so some of the -- like CET4 classes and others in Q2 were done live.

So we have a -- we do have the ability to have hundreds of thousands log on at the same time.

So we already have that.

We expect the pricing to be significantly below what our offline pricing is.

But obviously volume will make up for it.

So you would expect discounts of probably around 50% or so or more for the online classes.

Did that answer your question?

We'll continue to roll out more and more popular classes online.

The margins are quite high.

Our online business for trailing 12 months is already approximately $30m, with 19% operating margins.

So it's actually already a very profitable business.

That's good to know.

Do you also expect to roll out courses in the overseas test prep and K-12 sectors?

Yes.

So we would expect more and more classes to have an online as well as offline format.

If you think about it, we're only in 50 cities in China today.

The ability to roll out across the country will increase our reach many-fold.

So we'll be able to increase the distribution.

And obviously online has a high profit margin.

And I think there's no other company well positioned as we are with our brand name to take advantage of this fast-growing market.

I look forward to that.

My next question is regarding -- you discussed you will spend $10m on R&D this year.

So I wonder if this is still on budget.

And is this $10m spending already kicked in in your P&L?

Yes, it's already kicking in, and it's been used mostly for online/offline integration as we mentioned.

We want students to be able to work off their mobile phones and tablet device as well as PCs in order to access our content, to talk to teachers live and to -- ability to do quizzes and homework online.

So all that initiatives and the content development and transition and the infrastructure is being spent now.

And should we expect this to be evenly distributed in the coming quarters?

It should be evenly distributed.

It should be a little bit front-loaded as we build up this presence online.

And then it would begin to tail off and become hopefully more of a steady expense stream.

Got it.

Thank you, Louis.

I'll get back into the queue.

Thanks, Ella.

Jiong Shao, Macquarie.

Thank you for taking my question and congrats on a very good result.

Thank you.

Yes.

You talked about last quarter the two halves of the year; first half about margin expansion, second half about revenue growth acceleration.

Could you talk about where we are in that process?

Is that still the case?

And related to that, you give the full-year guidance in terms of the enrollments and revenue growth for the full year.

Given the enrollments the last quarter appear to be pretty solid, better than your full-year guidance, any change for your full-year enrollment and revenue growth guidance?

Okay.

Thank you, Jiong.

I think for us Q3, the reason it's not 20%, 25% revenue growth, is because we didn't open as many learning centers as we wanted.

We actually wanted to open 20 to 30 learning centers.

We actually were a negative 2 for the quarter because we closed 6 underperforming ones.

So I think is that in Q3 also is overseas test prep and English quarter.

Q4 should be quite good.

But I think Q3 will be good but not as good as Q4 this year is our expectation, because Q4 has been over-performing each of the last three years because the Zhongkao and the Gaokao are in June.

So we -- the deferred revenue coming into Q3 is good so we expect a solid Q3, but the revenue growth we expect would be -- should be higher in Q4, which is the historical trend the last several years.

As far as enrollment goes, there's no change.

We guided 5% to 7% enrollment growth for the year, basically organic, and right now we're 5.7%.

So we would expect to be -- hopefully try to be conservative and leave it at 5% to 7% for now.

Okay.

Just a quick follow-up.

Now the margin expansion, you clearly did an amazing job in Q2 for your margins.

Do you feel like the low-hanging fruit or the bulk of the improvement for the year is done and going forward it's all about revenue growth, or you feel like further margin expansion may still be (multiple speakers)?

I think you'll see some margin expansion but it'll be small.

It won't be the big numbers.

So I would expect right now we're 22%-plus operating margin for the first half.

It's a 700-basis-point -- 790-basis-point improvement over last year.

I expect the second half of the year to be closer to 100 basis points, because last year, in Q3 and Q4, we already had substantial expenditure cuts -- expense cuts.

So we were already rationalizing the business.

So I expect less in the operating margin improvement.

But we'll finish the year somewhere between 17%, 18%, well above our guidance at the beginning of the year of 15% to 16%.

So -- but I would expect healthy revenue growth and continued margin expansion, although the margin expansion will be at a slower rate.

Okay.

Great.

Thanks for the comments.

Thank you.

Fei Fang, Goldman Sachs.

Hi, Louis.

Thanks for taking my question.

So in the past few quarters, [accounting] margin has been very impressive.

And a lot of the strength was actually from savings from the sales and marketing expense.

So first, can you elaborate on the details of the savings?

And also once you're back on the expansion track, which cost item we will see more meaningful pick-up?

Thank you.

Yes.

I think -- thank you, Fei.

I think the sales and marketing has the savings because we weren't opening learning centers.

When we don't open learning centers, all the business comes from word of mouth, almost all of it.

So we don't need the marketing because of our strong brand name.

So our brand promotion expenses were only 6.5% of revenue this quarter versus 8.3% last year.

So you can see that.

As we open new learning centers in locations we're not at, we'll have to spend a little bit more on marketing.

But brand promotion expenses traditionally have been very low in New Oriental.

It's been around 7% of total revenue.

So that shouldn't change.

So you won't see a meaningful pick-up, but you'll see a small pick-up on the expense side.

The other thing I would like to highlight which is unrelated, and I apologize, I should have mentioned this earlier, is the Beijing School is actually doing exceptionally well.

Beijing revenue was up about 35% in Q2 and its strength continues into Q3.

And it's doing particularly well in the K-12 after-school tutoring segment.

So this is our largest market and it's going -- K-12 grew about 40 -- over 40% last quarter in Beijing.

So we expect continued strong growth in Beijing, which should be much stronger than we expected going into this year.

So that, I think, will also help the margins because Beijing's our highest-margin school.

Thank you, Louis.

Thank you.

Trace Urdan, Wells Fargo.

Thank you.

Hi, Louis.

You all have had a pretty significant presence in online for quite some time.

I wonder what the -- why the added emphasis in particular now?

Is there something happening in the market or is it being driven by now having more time and attention in your own business to devote to online?

Can you elaborate there as to why we're hearing more about online opportunities today?

Yes.

To be honest with you, Trace, it's because we're getting more questions from the investment community on it.

And that may be because our competitors are talking about it more and so we feel the need to address it as well.

As you said, you're right, we've been the leader in K-12 online for years.

We have over 8m registered users, over 170,000 paid users, about $30m of revenue with about $5m in trailing net profit in the last 12 months.

So we're by far the -- we don't really hype it.

But now, as you look around China, you see a very strong trend to young kids and teenagers and college students all running around with mobile phones and so we know that they prefer to do their exercises online.

And so we've made a conscious effort over the last 12 months to really spend on R&D to make our online platform and mobile learning the best in China.

So it is a new initiative at New Oriental to spend R&D dollars and make it much more -- much better experience for our students.

But the talk about it has been spurred by questions from the investment community as well as from our Internet competitors who talk about their education businesses online.

I see, okay.

And then I wonder if you could maybe elaborate a little bit further about the strategic benefits of the kindergarten acquisition because it seems to run counter to the trend that we've seen over the last couple of years to shed non-core assets and so can you just maybe be a little bit more specific about where you see the benefits?

Is there a brand associated with this kindergarten that's going to benefit your core business?

Yes.

I don't want to talk to specific names because the deal hasn't closed yet.

This is the leading kindergarten in Changsha so if you do your homework you can find out who it is.

And it's a highly profitable business.

It's growing and has a very strong brand name and we think it will be a good feeder into the kids' business.

And pre-school education seems to be an area that Chinese parents are willing to spend a lot of money on, especially for private good kindergarten and preschool services.

So it is not core like K-12 or overseas test prep but I think it is still a good bolt-on for -- there's good synergies with our kids' business so that's why we're looking at it.

And it's not very expensive so I think it will be an accretive acquisition over time.

Great, thank you.

Thank you.

Philip Wan, Morgan Stanley.

Thank you for taking the questions.

My first question is about your VIP business.

You mentioned that your intention to cap the VIP sales contribution to be 30% and I just wonder how are you going to do so if demand (inaudible) from large class to VIP?

And I have a second question to follow up.

Yes, thank you, Philip.

That's a good question.

The way we cap the VIP classes is that we stop opening VIP learning centers.

All the growth comes from organic within the existing VIP network.

We're still opening learning centers for small and large classes, more emphasizing those formats.

Also we're giving special bonuses to our teachers for the larger -- if they fill their classes.

So we've actually seen a trend in Q2 which is also helping the margin where our class size is beginning to go up again.

So this shows you the utilization -- improves utilization as well as improves our margin and so we are encouraging and selling the students to take small classes and large classes at the expense of VIP although we still offer VIP.

So you see in VIP we've sort of capped it this last quarter of about 24% growth in revenues year over year.

What's the enrollment for VIP for this quarter?

Sisi, do you have that?

The growth?

(multiple speakers) which is enrollment.

Enrollment is 29,000.

29,000 (inaudible).

Thank you.

And then my second question is regarding your Shanghai operation.

You mentioned Beijing has been doing very well this quarter and could you comment on the progress of your Shanghai operation?

Yes, Shanghai had a good quarter in Q2; revenue was up 6%.

But it still -- it's early days for its K-12.

For its middle school U-CAN business.

As you know Shanghai was late and was not effective in rolling it out three or four years ago.

So I think it's still not where we want it to be but I think it's better than it was and Q1 was sort of the bottom point for Shanghai; it's beginning to improve.

So Q2 was a nice quarter, Q3 is more flattish, it hasn't had the pick-up that we want in Shanghai yet.

But Beijing is more than making up for it so it's buying Shanghai some time.

Thanks for the color.

Excuse me?

Tian Hou of TH Capital.

Hi, Louis and Sisi.

The question (technical difficulty) a good quarter so the question is regarding your new opening plans for the second half of the year.

So you have been through a process of gradually shutting down a lot of your non-performing centers and what is the opening plan for the second half of the year?

I guess you have already finished cleaning up of the non-performing centers and now is the time to open some new centers so how many do you expect to open for the second half of the year?

That's the first question.

Second question is regarding the Chinese New Year.

So every year since Chinese New Year falls in different timeframe and it seems like sometimes it's a positive impact, sometimes a negative impact.

So I wonder what the impact this year could be?

And that's it.

That's the two questions.

Thank you, Tian, those are good questions.

For the learning center openings I would target 20 to 25 learning centers for the second half of the year.

The problem we have is that we gave the KPIs to our school heads based on profit and they're doing such a good job in increasing their profit and so we are going to set up a new program where we're not going to punish them for opening up learning centers on the cost side.

So we will try to spur more learning center openings in fast-growing cities the next couple of quarters and that will balance out our revenue and margin improvement both.

So remember our goal is to grow revenues at 20% to 25% and have some margin improvement going forward.

As far as the impact of Chinese New Year, Chinese New Year this year is sort of January 31, it's a week or so earlier than last year.

It shouldn't -- the break is about the same period of time, it shouldn't have a big impact, but if there is one it will probably be negative, it won't be a positive impact on third quarter.

But it shouldn't be -- it's not like it's too early or too late so I think it will be probably neutral to slightly negative.

Okay, thank you, Louis.

Thank you.

Clara Fan, Jefferies.

Hi and thank you for taking my questions.

I've got two questions.

First of all for -- as you just mentioned we are looking at a net center opening of 20 to 25 centers for the second half of this year and with an assumption that next fiscal year will be back to probably the normal rate of 60 to 70 centers.

Should we expect a significant improvement in enrollment going forward because this year we only look at around 5% to 7%?

And also secondly, can you give us some updates on what's the competition like now from the local competitors?

Are they easing a little bit or still intensifying?

Thank you.

Thank you, Clara.

On the enrollments and learning center growth, we would expect to go back to our normal rate of 60 to 80 learning centers next year which of course will increase our enrollment growth.

So the reason that enrollment growth is slower this year is because we've been reducing learning centers.

But you're absolutely correct; 60 to 80 will add probably 4% to 5% to the enrollment side in the K-12 area particularly if we go back to normal growth cycle.

As far as the competition goes in cities, the competition has always been quite intense but we continue to gain market share across the board.

So like in Beijing we're particularly encouraged because we're a latecomer to Beijing yet we're the largest in K to college by far in Beijing.

We're the largest in Shanghai as well and our goal is to be number one or number two in every city we go into and we're well on our goal to -- on the road to reaching that goal in cities we've been in longer than five or six years.

So I think the competition remains strong on a local basis with some strong local competitors in every city.

I don't think intensity has really increased or decreased but it's still quite formidable.

Can I have a follow-up question?

Sure.

Just quickly on -- you mentioned that the overseas test prep and consulting business recorded a 25 -- 28% year on year growth.

I want to drill in a little bit more detail on what's the growth rate of the two separate businesses and on the overseas test prep what's the enrollment growth and ASP growth like?

I'm just trying to get a grasp on how fast is the overseas test prep enrollment growing?

Is ASP still driving the majority of the growth?

Thank you.

Yes, Q2 is a slow period for overseas test prep so enrollments were actually a negative 1% so they were for the quarter -- where's enrollments -- enrollments was 68,000 for the quarter so slightly down from last year.

But revenue was up 29% for overseas test prep.

It's also a slow quarter for overseas study consulting so revenue was up around 26%, 28% as well.

So that's why they're about the same growth rate.

The busy period for overseas study consulting is actually Q4.

So the May quarter is when you see a large revenue jump because we recognize revenue once the students get in to a school and they accept that, then we recognize that revenue.

So you'll see a huge jump in overseas study consulting revenue in Q4.

Q3 will be an overseas test prep quarter as well as Q1 and then the Q2, Q3 and Q4 are the K-12 after-school tutoring quarters.

Does that help you with the understanding of our business?

Yes, I'm just trying to see whether overseas -- the enrollment growth, would that be on a year-on-year basis picking up or would you still heavily relying on ASP growth?

Overseas test prep enrollment is up for the year to date but it was negative 1% for the last quarter.

It's dependent on ASP growth not as much as you think; it's actually more dependent on the shift towards smaller classes.

So a lot of students in the overseas test prep are taking one on one or small classes so that does -- the ASP growth is about 15% and the other portion is due -- and the enrollment growth is between 2% to 4% and the rest of it is due to small class shift.

Okay, thank you.

Thank you, Clara.

[Frank Fung], Deutsche Bank.

Thank you for taking my questions.

My first question is regarding the online education.

What is the number of online enrollments for last quarter and which segment do you consider will have the greatest impact from online competitors?

And will you perhaps consider partnership with other online platforms in terms of product execution?

Okay.

Yes, the number of paid users in the quarter was 61,000 which was up -- let me see what the growth rate was -- it was up 21% year over year so it was a good quarter for Koolearn Online.

Most of the classes will be in the K-12 sector and overseas test prep sections so just our K-to-college regular business.

We don't really see any real competitors in this K-to-college segment yet but it doesn't mean they aren't coming.

I know you've heard and you've heard all the hype from YY then they disappointed on their platform.

We don't really see anyone else; I think we're all kind of starting in this business and I think since we have the best brand name we believe that we have an advantage going into this business.

So we intend to pursue it aggressively.

Okay, thank you.

And I have another question.

Given the strong cash flow and operations for this fiscal year would you consider a dividend to shareholders?

Thank you.

Yes, we've paid dividends the last two years and we'll consider it again after Q4, the fiscal year has finished.

So the Board talks about it at most Board meetings and then we'll consider it again in the July Board meeting after Q4 earnings so we know how much cash we generated this year.

Our cash flow has been quite strong as you know, $189m versus $111m last year, so it's up almost 70% year over year.

And that's because we haven't opened very many learning centers and so the CapEx is quite low.

And so this year we'll generate probably $220m, $230m in free cash flow, much higher than our net income.

That shows you how efficient our business model is on a capital use basis.

Okay.

Thank you.

Vivian Hao, Deutsche Bank.

Hi.

Sorry, actually I think my team has (inaudible).

You were trying to have two questions, Vivian; I thought you were being clever.

Sorry.

I'm dialing in from overseas so the line is really bad and I apologize.

I am just joking.

Thank you, Vivian.

You can have a question if you like.

Yes, I think my question has just been answered.

Thank you.

Thank you, Vivian.

See you soon.

Charles Cartledge, Sloane Robinson.

Hi, Louis.

Congratulations on your results.

My question relates -- you've started to monitor capacity utilization in a way that you didn't do previously.

Perhaps you could share with us how that's changed because these results would seem to indicate lower learning centers and higher revenue as you highlighted that these numbers are going up?

And then could you share with us your thoughts on the longer term, maybe using -- maybe Beijing is too much of an aspiration because it's so mature but what's the medium-term outlook for capacity utilization and what might that mean for your operating margin two or three years out?

Thank you, Charles.

Our utilization for the quarter was up about 300 basis points so it's actually quite good.

It's probably between -- last year was about 13% to 14%; this year it was closer to 17%, 18% for the quarter.

So it's actually quite good.

I think long term we would be happy over the next two or three years with utilization numbers in the 20% to 22% range.

If that happens, our operating margin will go over 20% on a GAAP basis.

So it will be very healthy for our business and we will --

Now it sounds low but as many of you know we count every seat in every operating hour that the school is open so the number will -- ideally the best we can do in a learning center will be close to 30%, 30% or 35%.

So it is -- 20% is quite good and we're typically around 15% but that number is climbing.

So over the last 12 months it's been up two to three percentage points across the board almost every month.

So that's why you're seeing the improvement in operating margin.

And that's part of the effort we have undertaken to encourage more enrollment in large classes and small classes and to fill more the seats for each of the classes and then that's really helping with our utilization and our operating margin as well.

Thank you.

Thank you.

Kenny Lu, Flowering Tree.

Hello, Louis.

Congratulations on the strong result.

Thank you.

My first question is about -- in the past two or three quarters you had very tight grip on the learning center opening and then just now you mentioned that you're going to give more liberty to the local school heads if they can grow profit, they can maybe have more freedom in opening new learning centers.

Is there any shift in the thought on the management side?

Why is there such change?

Because the business is so good; the demand is quite strong, especially in the K-12 sector.

And so we went from one extreme to the other.

We went from opening learning centers that we incentivized the school heads based on revenue mostly and then we shifted this year to incentivizing them only based -- mostly based on profit.

I think now we are happy with the progress and the expense control in the operating margin.

We want to get growth because we want to capture more market share.

So I think as -- but this year meaning we're only halfway through the fiscal year, our school heads are incentivized on profit.

Many of them are already well in excess of their profit numbers.

So we want -- but we don't want to punish them for opening up learning centers that will benefit us in the long term and so we're going to set up a system where they don't get penalized for opening learning centers, especially the profitable ones.

And I think that won't hurt our operating margin long term, it will actually improve it as well as improving our top line and improving our market position in each city.

So we think it's the right approach.

We went from too fast a growth on revenue and low -- and declining margins to incredibly increasing margins and then slower revenue growth.

The balance for us is 20% to 25% revenue growth and then operating margin improvement every year of up to 100 basis points or so.

That's a nice steady state for us and that requires opening 60 to 80 learning centers.

I encouraged the school heads to open learning centers in Q2.

They actually -- we actually ended up with a net minus 2 even though we opened 11 new learning centers because we closed -- 7 of them were replacements and 6 underperforming learning centers were closed.

So we want to encourage them to open more learning centers by not penalizing them on the profit side.

So it won't hurt the margin; the margin will still be accretive.

Okay.

So what will be the mechanism in place to ensure the quality of the new school openings?

Well, the same process.

We look at every city and see which ones are profitable and the utilization rates in each learning center of every city.

And so some of the cities are performing really well and we're going into busy season for K-12, especially middle and high school.

So I want to encourage those cities to open up learning centers as soon as possible to capture the end of Q3 and Q4 which is the busy season for middle and high school, Zhongkao and Gaokao.

So we want to -- I would like ideally to open 20 to 25 learning centers between now and May.

And so the way to do that is not to penalize those school heads because they're already very profitable and exempt them on the basis of these expenses for the new learning centers.

And I think that will benefit New Oriental in the next fiscal year and accelerate our enrollment as well as our revenue growth.

Okay.

So if I understand correctly the new school opening process still needs to be centrally controlled by the finance department (multiple speakers)?

It will be controlled by my department, by finance.

Steven Yang and our team will control it.

Understood.

Okay.

If I can ask another question?

Sure.

It's on the management side.

So Mr. Chen Xiangdong has resigned for personal reasons so how does the Board or the management think about the future structure of the senior management?

Is there going to be an EPO going forward or Michael is going to play both Chairman and EPO?

I think we've anticipated this happening for a couple of quarters now so this is not a surprise to us internally.

The good thing in my view is that it makes Michael will have to work harder so good.

So I think it's a positive event meaning Michael will be even more engaged in the business than he already is.

Also we have a deep bench, Zhou Chenggang, (inaudible), Steven Yang, (inaudible).

We have a lot of people, Sha Yunlong who will also pick up the slack.

So we very much appreciate Chen Xiangdong's 15 years of devoted service to New Oriental; he's been a great asset to us.

But this really wasn't unexpected so we've been preparing for it for a little while now.

Okay, got it.

Thank you very much.

Thank you.

Charles Cartledge, Sloane Robinson.

Could you help us better understand with regard to your online offering whether it's a sort of nice to have, profitable in its own right, operation or do you think that it could be a whole new business line in scale for revenue and profit as large as those that you introduced in the last five years like K-12 for example?

I don't think it will be as large as K-12 or overseas test prep but I think it will be significant.

It's at $30m growing 30% to 50% a year so I would expect it to be a significant business in several years.

And it's highly profitable so it is scalable.

And the key thing is there are really strong synergies between the online and offline world.

The winners of the future in education will use the technology platform of online as well as the offline learning centers.

So we've seen in many countries and many businesses that online/offline integration is the best experience for the students.

So we need it, it's integral to our business, but it's not going to outpace K-12 offline revenue; it's not going to outpace overseas test prep revenue in the next five years.

But it will be significant and it's highly profitable, it's high margin business.

Thank you.

Thank you, Charles.

We are now approaching the end of this conference call.

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

Over to you, Mr. Hsieh.

Thank you, Operator.

We want to thank everyone for joining us today and we look forward to seeing you in future conferences and calls.

If you have any other questions please feel free to contact Sisi or any of our representatives at New Oriental.

Thank you and have a good day.

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

Thank you for your participation.

You may all now disconnect.