New Oriental Education & Technology Group Inc (EDU) 2016 Q3 法說會逐字稿

Ladies and gentlemen, good evening, and thank you for standing by for New Oriental's third fiscal quarter 2016 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's conference, Ms. Sisi Zhao, New Oriental's Investor Relations Director.

Ms. Zhao, please proceed.

Thank you.

Hello, everyone, and welcome to New Oriental's third fiscal quarter 2016 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 Stephen Yang, Chief Financial Officer.

After his prepared remarks, Stephen 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 Mr. Yang.

Stephen, please.

Thank you, Sisi.

Hello, everyone, and thank you for joining us on the call.

We are pleased to report another quarter with solid results.

The fiscal second half year is traditionally the peak season for our K-12 all subjects after-school children's business, as national exams for college, high school entrance and final exams for all grades are approaching.

During the third quarter, we did exceptionally well on the top line, with revenue up 20.6% year over year to $346.9m, and total enrollment up 25.2% to 755,100.

If not including the impact from the RMB depreciation, our revenue growth would have been 26.4%.

Our continuing and intensive efforts to introduce the new O2O Two-Way Interactive Education System proved to be a satisfactory investment of time, capital and resources.

We are pleased by the growth in our K-12 all subjects after-school tutoring business, which consistently have been delivering strong growth, with revenue up 35% and enrollment up 31% year over year in the third quarter.

At the end of the third quarter, our newly revamped POP Kids program experienced a revenue increase of 40% and new products reached 50 cities, up from 44 in the second quarter.

U-Can Visible Progress system that is being used in all 54 existing cities has been enjoying growing recognition from both parents and students.

To add to that, the current market conditions are favorable to us, as we are seeing Chinese parents are more inclined to invest in education, with the economy slowing down slightly.

With all of this, we have been able to bring in more new customers, and more customers are choosing to stay with New Oriental.

To further leverage the success achieved by the O2O system, we expanded the investment in integrated education further to other key business lines.

In March, we officially launched the IELTS Interactive Education System, which is the O2O solution for our overseas test prep business, in 3 major cities in China.

We're definitely committed to building out our O2O system going forward and to maximizing its profitability.

Turning to pricing, per program blended ASP slightly decreased by 1% year over year.

On an apple-to-apple basis, which is GAAP revenue divided by total teaching hours, hourly blended ASP increased by about 1%.

A breakdown of the hourly blended ASP, U-Can was flat.

POP Kids increased about 5%, and overseas test prep program increased about 4% year over year.

The slowdown of overall hourly blended ASP growth is mainly due to the shifting of revenue from overseas test prep business with higher ASPs to the U-Can and POP Kids classes.

Also, these growth rates were calculated in US dollar terms, so the RMB devaluation has negatively impacted our ASP growth by about 5%.

We are pleased with the expansion of the operating margin in the third quarter, which was achieved through constantly improving operational efficiency and stringent cost control.

During the third quarter, operating income increased by 32.6% year over year, and operating margin increased by 110 basis points to 12.2% from 11.1% a year ago.

To be sure, we will continue to drive efficiency and bring value to our customers, which will ultimately create sustainable long-term growth for our business.

Now, let me walk you through our performance across individual business lines.

Our K-12 all subjects after-school tutoring business achieved gross revenue growth of about 35% year over year for the third quarter, and enrollment growth of about 31%.

Breaking it down, the U-Can middle school, high school all subjects after-school tutoring business achieved a gross revenue increase of about 33% year over year.

Student enrollment grew approximately 31% year over year.

Our POP Kids program continued to generate real momentum, with gross revenue significantly up about 40% and enrollment up 31% year over year.

Our overseas test prep and consulting business achieved revenue growth of more than 7% year over year.

Finally, revenue for VIP personalized class business increased approximately 22% year over year.

Next, I will provide some updates on the ongoing execution for our Optimize the Market strategy that requires healthy balance between top-line and bottom-line growth, while investing heavily in the build-out of our O2O Integrated Educational System.

In the third quarter, we opened new school in the city of Zhuhai, a fast growing city on the southern coast of China.

We also added a net of 6 learning centers and expanded certain existing ones, adding approximately 10,000 square meters of classroom area.

For the rest of the fiscal year, we will continue with our expansion plan and add additional capacity in cities with the greatest potential for both growth and profitability.

We believe that we have sufficient capacity to support our business for the rest of the fiscal year, which as mentioned earlier is the peak season for New Oriental.

Turning to our online business, we invested $13m in refining our O2O system and pure online learning platform in the third quarter, most of which were reported under cost of goods sold and G&A expenses.

We are managing it well within the $50m investment plan for the fiscal year, which we previously indicated is our target this year.

The success of our O2O system is not only driving our revenue growth in K-12 business, but also proven to be effective in other business lines.

Customer retention rates increased and new customers are coming in due to excellent market feedback.

Before I go into the details about our online business, just to quickly recap three levels of our online platform.

The first level, also the core of our online system, is an O2O Two-Way Interactive Education System across all of our business lines.

The second level is our pure online learning platform, the supplementary online education products under the New Oriental brand.

The third level of our ecosystem is for New Oriental to take minority shareholdings in online education companies that complement our own online education offerings.

Let's start with O2O Two-Way Interactive Education System, which extends New Oriental's traditional offline classroom teaching offerings to online education services.

Solid progress was made on all fronts.

U-Can Visible Progress teaching system, our interactive education system, has been used in all 54 existing cities by the end of the quarter.

POP Kids program, including our new product, [Shuangyou] in Chinese pronunciation, had another strong quarter, with revenue up approximately 40%.

This is a record high since the revamp in 2014, and enrollment was up more than 31% year over year.

By the end of the third quarter, it has expanded its reach over 50 cities in China, and we expect the growth trend to continue for the rest of the year.

The O2O system for the domestic test prep program was being used in 5 cities by quarter end.

And since its launch in the second quarter, the O2O system for overseas test prep program has been introduced and is now being used in 3 cities.

For the second level of our online education ecosystem, we have seen healthy growth in our pure online learning platform and other supplementary online education products.

In the third quarter, Koolearn.com generates net revenue of $12.7m, up 24.7% year over year.

The number of paid users increased over 71% year over year.

The number of cumulative registered users has reached more than 12.8m.

To add to these great results, the operator of our Koolearn platform received the investment of $50m from affiliate of Tencent Holding Limited.

We made the announcement in February, and you may find more details there.

Koo.cn, our own online broadcast open platform for both New Oriental and third-party teachers, achieved over 756,300 registrations.

DONUT, a series game-based mobile learning apps for children, reported over 38.2m downloads.

Le Ci, an English language vocabulary training app for mobile phones and tablets app, reported about 3.8m users by quarter end.

For the third level of our online education ecosystem, we invest in select online education companies with a minority stake, and we keep looking for new opportunities that will not only complete our own offerings but also facilitate our own O2O integration.

Now, let me walk you through the other key financial details for the third quarter.

Operating costs and expenses for the quarter were $304.6m, a 19.1% increase year over year.

Non-GAAP operating costs and expenses for the quarter, which excludes share-based compensation expenses, were $300.2m, a 19.2% increase year over year.

Cost of revenues increased by 15.1% year over year to $145m, primarily due to increase in teachers' compensation for more teaching hours.

Selling and marketing expenses increased by 8% year over year to $45m, primarily due to increase in brand promotion expenses and selling and marketing staff's compensation.

General and administrative expenses for the quarter increased by 30% year over year to $114.6m.

Non-GAAP general and administrative expenses, which excludes share-based compensation expenses, were $110.1m, a 30.8% increase year over year, primarily due to increase in R&D expenses and human resources expenses related to the development of our O2O integration.

Total share-based compensation expenses, which were allocated to related operating costs and expenses, increased by 12.5% to $4.4m in the third fiscal quarter.

Operating income for the quarter was $42.3m, a 32.6% increase compared to $31.9m in the same period of prior fiscal year.

Non-GAAP income from operations for the quarter was $46.7m, a 30.4% increase compared to non-GAAP income from operations of $35.9m in the same period of prior fiscal year.

Operating margin for the quarter was 12.2%, compared to 11.1% in the same period of the prior fiscal year.

Non-GAAP operating margin, which excludes share-based compensation expenses for the quarter, was 13.5%, compared to 12.5% in the same period in the prior fiscal year.

Net income attributable to New Oriental for the quarter was $48.4m, representing a 16.8% increase from the same period of prior fiscal year.

Capital expenditures for the quarter were $19.4m, and this was primarily attributable to the opening of 20 new learning centers and the renovations at existing learning centers.

Turning to the balance sheet, deferred revenue balance, which is cash collected from digital students for courses and recognized proportionally as revenue as the instructions delivered, at the end of the third quarter were $585.3m, an increase of 37.8% as compared to $424.9m at the end of the third quarter of fiscal 2015.

Before we move into Q&A session, let me go through our expectations for the fourth fiscal quarter.

We expect total revenues to be in the range of $378.1m to $391.3m, representing year-over-year growth in the range of 15% to 19%.

If not including the impact from the recent RMB depreciation, the projected revenue growth rate will be in the range of 20% to 24% for the fourth quarter of fiscal year 2016.

Also, some of you may be aware that starting in May this year, China's tax reform of replacing business tax with a VAT, value-added tax, will expand to the customer service sector.

As a result, some business units of New Oriental may need to start paying 6% VAT for their gross revenues instead of 3% or 5% business tax, which is what we have been doing during past years.

For the fourth quarter of this fiscal year, the impact will be minimal, as it only affects one month.

We expect that the negative impact on our top line to be around 1% for the fourth quarter.

This was already factored in the revenue guidance I just shared.

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 open the call for this.

(Operator Instructions).

Julia Pan, Macquarie.

Hello, Stephen.

Hello, Sisi.

Thank you for taking my questions.

Congratulations for another strong quarter.

I have two questions.

The first one is we see an encouraging improvement in the margins in this quarter, with only 7 net increase of learning centers, and we do believe the margin's improvement to continue, but do you think you can expand your learning centers in a faster pace in this stage, given your market share in China?

And even in Beijing, it's still low at single digit.

My second question is that -- is about POP Kids.

POP Kids shows a really strong growth in this quarter of 40%.

Do you think the faster growth in POP Kids than U-Can section to continue, and what do you think the main driver behind this, other than the O2O injection?

Thank you.

Okay.

Thank you, Julia.

Your first question is about expansion plan.

You know we opened 7 new learning centers in Q3, and I think in the coming Q4, we plan to set up 10 to 15 new learning centers to prepare for the new fiscal year.

And yes, I think the K-12 market is huge, so in the next fiscal year, I think we plan to open 30, 40 new learning centers.

But compared to the 720 learning centers we have in hand, it accounts for only 3% to 5%, so it will not drag the margin.

And we will see the margin expansion continuously, because of the business leverage, and this is my answer for the first question.

Also, I also want to add one point.

Last fiscal year, we spent $39m of investment for O2O and pure online, and this year, we spent $50m.

So last year and this year are the peak for the investments.

Next year, I think we can cut some expenditures for the investment, so this is another level for the margin expansion.

And your second question for POP Kids, yes, we did a very strong quarter in Q3, and I think besides the O2O product, which is popular among the parents and students, I think the trend will continue.

So going forward, I just want to guide the POP Kids program grew by roughly 25% to 30% year-over-year growth.

And another reason is, as I mentioned earlier, the market for K-12 in China is huge.

It's very fragmented, and I think the big players, like New Oriental, will take more market share from smaller players.

That's my answer.

Is this clear?

Zoe Zhao, Credit Suisse.

Hi, management.

Congratulations on a strong quarter.

I have two questions.

One is, can you please provide an update on the upcoming summer promotion plan?

And the second one is, can you update us with the utilization rates, given that our gross product margin has been improving, but then it seems that our VIP revenue growth is also pretty strong this quarter.

Yes, that's my question.

Thank you.

Okay, the first question, about the price strategy, yes, as some of you have heard, we had some class with very low price in the market.

But I think we start to provide the lower-price summer math class for grade seven since several years ago in Beijing.

And the purpose of this is to attract more students to try our classes.

I think this strategy turns out to be successful.

I think this is one of the reasons why the Beijing K-12 business performed well in the past three or four years.

So we will continue to do that in Beijing this summer and spread other core cities.

Upon this, we expect to accelerate the market's consolidation, as the smaller players can't afford that.

And in terms of the impact for the margins in the coming Q1, I think the impact will be minimal, because the students enrollment for the low price accounts for only small part of the total enrollment, so the impact will be minimal.

And your second question, about the utilization rate, in the third quarter, our utilization rate continued to go up.

Now, we are at 20%.

Last year was about 18%, so that means 200 bps up.

And I think going forward, we will see the utilization rate going up, because lastly, about that, if we open the learning centers, new learning centers about 3% to 5% compared to the learning centers we have, it's not going to drag the margins.

So that means we will see more students within the current platforms.

So most of the growth going forwards will be the organic growth.

Yes, does it answer your question?

Tian Hou, T.H. Capital.

Hi, Sisi, Stephen.

The question is related to your upcoming plans for Xun Cheng to be listed in local markets.

Can you give a little bit color on this upcoming local listing and how your investor is going to benefit from such listing?

Thanks, Tian.

I think, yes, we've talked about Koolearn potential listing, as we mentioned in February's announcement.

But what I can say is we're still in the planning phase, so we still need more time to work with the other groups.

And so it's too early to say.

But in my opinion, if we put the Koolearn to be listed in China markets, it will give us the stronger brand name and we can raise some money, and I think more Chinese people will know Koolearn, so that's the benefit.

Okay.

Yes.

Fan Liu, Goldman Sachs.

Hi, Stephen.

Hi, Sisi.

Thank you for taking my questions.

So just two quick questions.

Number one is about your -- is that possible, would you mind sharing with us the utilization and also the margin profile for each segment, including overseas test preparation and also U-Can and POP Kids?

And also, the second question is about your revenue growth in Beijing and Shanghai this quarter.

Would you mind sharing with us as well?

Thank you.

Okay.

Thank you, Fan.

In terms of the operating margin of different business lines, the overseas test prep, the operating margin before the head office overhead is about 30%, and for the U-Can, the operating margin is about 25%, a little bit more than 25%.

And for POP Kids, now it's 13% to 14%, operating margin before the head office overhead, but it's at least 200 to 300 bps up compared to last year.

We're seeing higher utilization rate for POP Kids, and so this is the key, the operating margins for the different business lines.

And your second question is about Beijing, the revenue growth in Shanghai, Beijing.

Beijing's revenue growth is about 22% this quarter, 20%-plus, and Shanghai is around 14% to 15%.

Yes.

Okay.

Thank you, Fan.

Anne Shih, Brean Capital.

Alvin Jiang, Deutsche Bank.

Hi, Stephen, Sisi.

Congratulations on a strong quarter.

I had a quick question on the retention rate.

You mentioned that the retention rate improved a lot in this quarter.

Can you give us more color with the numbers on that?

Thank you.

Thanks, Alvin.

The retention rate in this quarter is about more than 70%, so I think somewhere between 70% to 75%.

And so compared to last year, the number was 60% to 65%, so it improved a lot.

And because I think the new O2O product, especially for the K-12 business, when the students start to use the new version products, I don't think they will go.

They will stick with us or the kids stay with us, so that's why we are seeing the higher retention rate compared to last year.

And going forward, you will see the retention rate go higher in the future.

Great, great.

Thank you.

Thank you.

Anne Shih, Brean Capital.

Hi, Stephen, Sisi.

Sorry about that earlier.

Thanks for taking my questions.

You mentioned that the O2O investments should decline in fiscal 2017.

Wondering if there is kind of a specific level that you're thinking of and what will it be focused on in terms of the spending?

I also have a follow-up question from earlier in the call on pricing.

I think this year, the strategy for K-12 was on gaining enrollments, but average pricing was kept more stable, with plans for I think pricing power to be flexed next year.

Is this still the target, and what's the likely growth we can probably see on average, even with a summer promotion in Q1?

Thank you.

Okay, in terms of the investment for the O2O and pure online, we spent $50m this year, and next year, I think we can cut some expenses for this, let's say the $45m or $40m.

I think mostly we'll keep almost all the IT stuff and content writers going forward.

But I think in the next year, we don't need the third-party services.

We bought a lot this year and last year, so next year, I think we can cut some of these expenses.

And in terms of your pricing question, this year, we used a different price strategy.

For example, for K-12 business, we only increased the price by no more than 5% year over year, not like several years ago, we increased the price by 8% to 10% several years ago.

But this year, as I said, we're still in the rolling out of the new products, so we only increased the price by only 5%.

Next year, I think our price strategy will be a little bit more aggressive compared to this year, so our target for the price increase will be 6% to 8% in the next year.

That's my answer.

Thank you.

Thank you.

Leon Chik, JPMorgan.

Hi, thanks for taking the question.

Just a simple one -- how did your GPM go down so much in 3Q?

Basically, cost of goods sold went up slower than sales, because we didn't see that in the second quarter, so we're just wondering if there's anything special in the third quarter.

Thanks.

Thanks, Leon.

It's a great question.

The Q3 and Q4 are the peak seasons for K-12 business, so I think the revenue growth in Q3 is better than we expected.

And yes, you will -- see the cost leverages here, especially for rental.

We just increased the new learning centers by 7. And for the current learning centers, the rental fee increased by only 5% year over year, so the rental increased by high single digit.

And also, we are seeing the higher utilization rates.

That means the one teacher is teaching more students within the same class, so that's why we are seeing the OP margin improvement.

I think going forward, the OP margin will still go up continually.

Yes.

So just basically normal operating stuff, no special stuff, right?

Just regular --

Yes, regular.

-- scale advantage.

Yes, yes.

Okay, thanks.

Okay, that's it.

Thanks, Leon.

Mariana Kou, CLSA.

Hi, management, congratulations again on a really strong set of results.

I just have a quick follow up I think on the question just now.

On the cost side, could you actually remind us what I guess the fixed and variable components for the teaching cost and what type of trends are you seeing in terms of cost increases for teachers?

Yes, the teacher's compensation is determined by two parts.

The first part, let's say the 60%, are the fixed ones.

It depends on the level of the different teachers.

And the second part, let's say the 40%, are the teachers' bonus, is relates to the retention rate, the utilization rate and the evaluations from students.

So that's the percentage of the teachers' compensation, so I don't know, is it clear to answer your question?

But are we seeing really -- what sort of salary increase are we talking about in recent quarters?

Are we seeing double-digit type of increases that's expected from teachers?

Yes, we increased the teachers' salary by 8% to 9% year over year.

So it's very stable.

Okay, great.

All right, thank you.

Yes.

Okay, thanks.

Claire Cao, Morgan Stanley.

Hi, management.

Thanks for taking my questions.

I have two questions.

The first one is related to the pricing strategy, as you mentioned that you may spread a low-price strategy to other cities, could you give us some more color on this?

What could be the potential P&L impact in the coming fiscal year when this low-price strategy is more widely rolled out?

And I have a follow up.

Thank you, Claire.

This is a good question.

Yes, as mentioned, we'll launch the low-price class, but only for grade seven and for math, for maybe some cities for Chinese.

But even though we launched these, I don't think it will have the negative impact for the margins for the next whole year.

Maybe it will have some negative impact for Q1, but very minimal.

For the next whole year, I think on the contrary, the margin will be higher by doing this, because we just give the one-time discount for this kind of students for one time.

So after one time, since the second time, I think more than 60%, 70% of the students will take another class with paying the normal price.

So, we'll still get the higher utilization rates.

For the next year, there's no margin dilution by this.

I think I would add that based on current retention rate for our K-12 business, and also, we have plenty of capacity for our K-12 business now, so basically, after Q1, most of the students who we attracted in Q1 will stay with the system for the rest of the year, like Q2, Q3, Q4's courses, and that will increase the utilization of our overall business, which will contribute a lot to margin expansion, actually.

Okay.

Okay, understood.

Thank you.

And my second question was I think Stephen mentioned we have seen increasing word-of-mouth referral in the quarter.

So just wondering, is it possible to share some data on this?

And what magnitude of operating leverage can we expect from sales and marketing line?

Thanks.

Sorry, we don't disclose the referral rates to the investors, but it doesn't mean it goes up.

And that's why, yes, you have seen the selling and marketing expense, it's increased only 8% in Q3, and in Q1, Q2, the selling and marketing expense growth rate was zero.

So going forward, I think the selling and marketing expense will increase below 10%.

Yes.

Got it.

That's very clear.

Thanks.

Okay, thank you.

Zoe Zhao, Credit Suisse.

Hi, management.

I have a follow-up question on the overseas business.

Can management break down the overseas test prep versus the overseas consulting business?

And also, I'm wondering, what is the margin, the operating margin, for the consulting business?

Thank you.

Okay, the overseas test prep business contributes 28% of our total revenue, and overseas consulting business contributes 8% to 9% of our total revenue.

And in terms of the margin of the overseas consulting business, it's about 20%, and I think the margin will go up a little bit higher next year, going forward in the next three to five years, because we will see more leverage there, 20% margin for overseas consulting.

That's my answer.

Thank you, Zoe.

Tian Hou, T.H. Capital.

Yes, Stephen, so the follow-up question is related to online education, so how fast can online education to grow in the next year or so?

So that's one.

Number two is the summer camp, so in the past two years, you [inaudible] had some issues with the summer camp, so what about this year?

Is this issue totally gone with the Company?

That's the two questions.

Okay.

I think the pure online company, Koolearn, I think going forward, the revenue growth will be, let's say, the 35% to 50% year over year.

It depends on the timing or different quarters, and so -- but in general, it will go up faster than the offline business.

And for the first half year, we had a very bad summer camp business numbers two years ago.

But last year, I think the summer camp business was okay, and this year, we won't have the bad numbers because the year before last year, there was the uncertainty of policy changes, but now, it's very, very clear for the Gaokao reform.

So there's no impact for the coming summer on summer classes.

Yes.

Okay.

Thank you, Stephen.

Okay, thank you, Tian.

Andrew Orchard, Nomura.

Hi, Mr. Yang and Sisi.

Thanks for taking my question.

Two questions, number one, on the VIP performance, it's still growing quite fast at 22%, but I guess with the whole business growing even faster, can you give us a sense of what the revenue proportion from VIP is this quarter versus the same quarter last year?

And then the other question is on the IELTS interactive system.

Given that you're just rolling this out, but in the longer term, are you also expecting that this interactive system will help you raise ASP for your IELTS classes?

Because I expect that IELTS retention rate is generally quite low, due to the nature of the courses.

So those are my two questions.

Thanks.

The VIP business.

The VIP business of this quarter, of Q3, contributes 29% of the total revenue, and last year, it was the same, 29%.

So as mentioned several quarters ago, the management just wants to cap the VIP business, the 30% of total revenue.

Our focus is on the class business.

So going forwards, I think the VIP contribution will still within the 30% of the total revenue.

And for the new IELTS product we launched in March, I think we used the same methodology for the O2O product we used in K-12 business.

More and more, what I mean is the high school students who are doing the high school, students are taking our IELTS class, so there still need to be online elements to help them to study more efficiently in the offline classes.

So I think it will help us to increase the price, because nobody else in the market has this kind of product.

So I think going forward, we'll still increase the price by 5% to 10% on apple-to-apple basis.

Thank you.

We are now approaching the end of the conference call.

I will now turn the call over to New Oriental CFO Mr. Stephen Yang 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.

Thank you.