Earnings Call Transcript - EDU Q2 2021

Operator, Operator

Good evening and thank you for standing by for New Oriental’s FY 2021 Second Quarter Results Earnings Conference Call. At this time all participants are in a listen-only mode. After the management's prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the meeting over to your host for today’s conference, Ms. Sisi Zhao. Thank you, please go ahead.

Sisi Zhao, Host

Thank you. Hello everyone, and welcome to New Oriental’s second fiscal quarter 2021 earnings conference call. Our financial results for the periods 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, Executive President and Chief Financial Officer. After his prepared remarks, Stephen and I will be available to answer your questions.

Stephen Yang, Executive President and CFO

Thank you, Sisi. Hello everyone, and thank you for joining us on the call. Although the impact of the pandemic continues to raise hurdles for business across the globe, we're pleased to announce a set of financial results in the second quarter of this year that are in line with our expectations. While reflecting strong signs of recovery in some of our business lines, as certain cities began their path to normalization. Total net revenue was $887.7 million, representing a 13.1% increase year-over-year, which is encouraging results despite the challenges. Our key revenue growth driver, K-12 after-school tutoring business, achieved year-over-year revenue growth of approximately 26%. Our U-Can middle school and high school all-subjects after-school tutoring business continued its momentum with a growth of approximately 27%, while our POP Kids program recorded a growth of approximately 24%. Our industry leading OMO system has been vital in the previous quarters to ensure our classes ran smoothly and it has once again proved to be instrumental in this quarter, as it provides our operation with strong flexibility to help the vast majority of our students migrate from OMO online class back to offline learning centers. We have gradually resumed service amid easing of the pandemic restriction measures. Encouraged by its effectiveness, we have been committed to expand the reach of our OMO system and are delighted to say that we are piloting OMO online courses in the vast majority of existing cities and trending new surrounding satellite cities in the autumn semester, attracting a promising number of new customers and students while the OMO system contributed single digits to the overall revenue in this quarter. With its ability to virtually reach both major and satellite cities across China, we have no doubt that it will grow rapidly in the coming quarters and become a major driver for our business growth in the future.

Sisi Zhao, Host

Okay. Operating cost and expenses for the quarter were $919.8 million, representing a 21% increase year-over-year. Non-GAAP operating costs and expenses for the quarter, which exclude share-based compensation expenses, were $901.4 million, representing a 20.4% increase year-over-year. Cost of revenue increased by 26.4% year-over-year to $453.7 million, primarily due to the increases in teachers' compensation for more teaching hours and higher rental costs for the increased number of schools and learning centers in operation. Selling and marketing expenses increased by 23.9% year-over-year to $133.6 million, primarily due to the addition of a number of customer service representatives and marketing staff aimed at capturing new market opportunities during the COVID-19 period, especially for our new initiatives in K-12 tutoring on our pure online education platform Koolearn.com. G&A expenses for the quarter increased by 13.5% year-over-year to $332.6 million. Non-GAAP general and administrative expenses, which exclude share-based compensation expenses, were $319.8 million, representing a 13.4% increase year-over-year. Total share-based compensation expenses which were allocated to related operating costs and expenses increased by 64.8% to $18.5 million in the second fiscal quarter of 2021. Operating loss for the quarter was $32.1 million compared to an increase of $25.3 million. Non-GAAP loss from operations for the quarter was $13.7 million, compared to an increased income of $36.5 million. Operating margin for the quarter was negative 3.6% compared to 3.2% in the same period of the prior fiscal year. Non-GAAP operating margin which excludes share-based compensations for the quarter were negative 1.5% compared to 4.7% in the same period of the prior fiscal year.

Stephen Yang, Executive President and CFO

Looking ahead into next quarter and the rest of fiscal year 2021, despite the continued challenges from the pandemic and the concerns surrounding the new wave of outbreaks emerging in China, we are more clear about the recovery trends of the company's near-term financial performance and the market opportunity over the long run. Our strategic focus and investment approach this year are aimed at improving product quality, increasing teacher salaries, and enhancing our industry leading system, which fully reflects our ethos of focusing on the essence of education. In view of market competition and the opportunity to take advantage of post-COVID market consolidation, we firmly maintain a stable and balanced investment strategy that would improve the quality of our education service, with the aim to achieve sustainable and long-term growth, as opposed to unhealthy short-term growth that often requires excessive investments and higher costs to acquire customers. As such, we will continue to focus on the following key areas. First, we will continue to expand our offline business. We aim to add around 20% to 25% capacity, including new learning centers and expanding classroom areas of some existing learning centers in the K-12 business this fiscal year. We believe our capacity expansion will prepare us to further take market share from other players post-COVID, as we believe some smaller players without strong financial positions in online class capability may struggle to sustain their businesses during this period. We expect the industry will undergo a wave of market consolidation once the pandemic phase subsides. The fact that we are a major player with a strong financial capacity and modern offline facilities enables us to further strengthen our market-leading position and penetration. Second, we will continue to leverage our investments into digital technologies and introduce our OMO system in more offline language training and test offerings, especially our K-12 tutoring and overseas test prep key business. The usage of online tools and content in our OMO system across all business lines will be enhanced. We believe the whole OMO teaching experience will benefit from our focus on developing the best teaching content and courseware as well as advancing training programs for our teachers. With all the aforementioned infrastructure in place, we will continue to pilot our OMO online initiatives in major cities with a high demand and higher operational efficiency and in surrounding satellite cities. We believe that our OMO initiatives will be one of the growth engines to increase our customer acquisition post-COVID since we can quickly replicate them in different parts of China, enabling us to capture market consolidation opportunities. This revamped new business model will also accelerate our margin recovery when the pandemic is over and further expand our long-term margin target. I must highlight that all of these OMO products are supported by our offline classes, which supplement each other in a hybrid format. All the teaching content and coursework materials, as well as the teachers, are developed and originate from our existing offline centers and resources. Furthermore, we will continue to invest in and implement new initiatives including productive content development, teacher recruitment and training, R&D, as well as marketing expenses in pure online K-12 after-school tutoring business on our Koolearn.com platform. Third, our top priority will remain as the focus on controlling costs and reducing expenditures across the organization to minimize the negative impact from the pandemic on the bottom line. We believe we will resume the expansion of overall non-GAAP operating margin year-over-year as COVID-19 gradually subsides. I would like to stress that we have great confidence in the fundamentals of our business, which we believe will continue to remain strong. Although we are facing various negative impacts from the pandemic, we have been increasing our investments in different strategies and remain optimistic about a brighter future for our business and believe our investments now will yield fruitful returns in the long run. Due to the concerns about a new wave of COVID-19 outbreaks emerging in North China, we have moved our offline classes to small-sized online broadcasting classes through the OMO system in over 10 cities, including major cities such as Beijing. Despite these challenges, our OMO system enables us to migrate classes between offline and online platforms swiftly and seamlessly. Therefore, the impact on our business will be cushioned should there be a significant outbreak. In the meantime, the unpredictability of the pandemic has also reminded us to plan ahead for the future as we continue to build new learning centers to ensure we will be ready to accommodate a large number of students when situations normalize. Looking ahead to the near term, our expectations for the next quarter are that we expect total revenue to be in the range of $1,098.6 million to $1,144.8 million, representing a year-over-year increase in the range of 19% to 24%. To provide a breakdown of the expected topline growth for key business units, K-12 after-school children business is expected to grow in the range of 27% to 32%. Overseas test prep program is expected to decline 25% to 20%. Overseas study, consulting, and study tour business is expected to decline 5% to 0%, and the growth of the Koolearn.com pure online education platform is expected to accelerate all year-over-year in dollar terms. Despite the fact that our overseas test prep and consulting service for the second quarter fared better than the first fiscal quarter, we still expect the overseas-related business to continue to experience challenges due to the pandemic around the globe, caused by the cancellation of overseas exams, suspension of overseas schools, and restrictions on travel. Next year, the impact on this overseas-related business will affect the entire educational industry in China, not just New Oriental, and may last over the coming one or two quarters. Thus, we are pleased to see that China has been controlling the pandemic situation relatively well, which sheds a more positive light on our domestic business. To conclude, we're now implementing all kinds of operational actions to boost enrollments and classroom utilization for the autumn semester and speed up the recovery of business after the resumption of schools and learning centers. We're confident that the demand for after-school tutoring will gradually pick up and trend toward normalized levels. I must mention that these expectations reflect our considerations of the latest pandemic situation as well as our current and preliminary view, which is subject to change. At this point, Sisi and I will take your questions. Operator, please open the call for questions. Thank you.

Operator, Operator

Thank you. Your first question comes from the line of Tian Hou of T.H. Capital. Please ask your question.

Tian Hou, Analyst

Sisi, Stephen, congratulations on the good quarter. So, in your opening remarks, you talk about OMO and it also shows the positive results in your last quarter's earnings and your offline enrollment growth, revenue growth is much higher than peers. So, I wonder, can you elaborate on how important the OMO strategy is for you in fiscal 2021, as well as the next couple of years? And by the end of this year, this fiscal year or next fiscal year, what proportion of OMO is going to be in your total enrollment or revenue? So basically, elaborate on your OMO strategy for the future?

Stephen Yang, Executive President and CFO

Thank you, Tian. This is a great question. On the market front, we are seeing a great business opportunity emerging, because more and more players have exited the market. We are putting more efforts into our offline business combined with the OMO model. We have piloted the market-leading OMO model in the vast majority of cities and set up the OMO business in 20 new satellite cities nearby the core city. Key metrics such as student retention rates and satisfaction from customers have exceeded our expectations this summer. The OMO contributed single digits to overall revenue this quarter. We believe the OMO model will grow rapidly moving forward and will become a major driver for our business growth. The OMO will help in the topline growth of our traditional offline business. Let me repeat some advantages of the OMO model. Firstly, it typically has a lower customer acquisition cost. This means we do not need to spend excessively on online channels. Secondly, we can easily replicate the OMO model in other provinces in China. Thirdly, the content of the OMO model is more localized compared to the typical large online broadcasting classes. I believe this advantage makes our OMO courses more appealing and results in higher student engagement. Lastly, the OMO model presents opportunities for cross-selling between our online courses and offline courses. I spent a lot of time on the OMO model, but I believe it is very important. Tian, is it clear?

Tian Hou, Analyst

Yes. Thank you so much Stephen.

Stephen Yang, Executive President and CFO

In the next fiscal year, the OMO will contribute more than it does this year. I believe we will see one or two more quarters to ultimately determine the revenue contribution, but I am confident that the revenue from the OMO model will be a meaningful number next year. Thank you.

Tian Hou, Analyst

Okay, great. Thank you so much.

Stephen Yang, Executive President and CFO

Thank you, Tian.

Operator, Operator

Your next question comes from the line of Mark Li of Citi. Please ask your question.

Mark Li, Analyst

Hi Stephen and Sisi, and thanks for the presentation. I want to ask at this point, could you give us some color for the FY22 guidance like in terms of revenue growth or capacity expansion or lower tier city penetration? Any color would be helpful? Thank you.

Stephen Yang, Executive President and CFO

Yes. I think we have done very well to run our business during the COVID-19 challenges. We expanded our capacity by 20% to 25%, and also raised the salary of the teachers during this hard time. I believe we’re ready for the New Year. For fiscal year 2022, I anticipate our revenue growth will be significant and our margins will expand. Firstly, we have a low base from this year, and I believe that China will control the pandemic relatively well. Most students will be able to return to our learning centers, and students from new lower-tier cities can also benefit from our OMO model. Yes, Mark?

Mark Li, Analyst

Sure. Thank you, Stephen.

Stephen Yang, Executive President and CFO

Thank you, Mark.

Operator, Operator

Your next question is from Felix Liu of UBS. Please ask your question.

Felix Liu, Analyst

Good evening management and congratulations on the results. My question is on COVID-19 impact. I know your guidance of 15% to 24% revenue growth for the next quarter has that reflected the current level of COVID-19 lockdown, or are we expecting potentially more cities to roll out similar measures? For this round of COVID-19, you mentioned that you're better prepared than last time. May I know if the new enrollment growth or the May quarter will be impacted, or are we okay with new enrollment growth at this time? Thank you.

Stephen Yang, Executive President and CFO

Felix, due to concerns of a new wave of the COVID-19 outbreak in North China, we have moved all offline classes to online in over 10 cities, including major cities such as Beijing and Xi'an, as well as regions in the northeast. Yes, there are negative impacts, but the key is how we handle these challenges. Our OMO system enables us to migrate classes between offline and online formats. We are better prepared to face this challenge compared to last year. One more point: Q3 will be impacted to some extent due to the late Chinese New Year holiday, which could lead to some schedule changes. However, I am optimistic about the business performance in Q4 and the next year despite these challenges.

Felix Liu, Analyst

Okay, thank you very much.

Operator, Operator

Next question comes from the line of Alex Xie of Credit Suisse. Please ask your question.

Alex Xie, Analyst

Hi management, thank you for taking my questions. My first question will be about OMO. Stephen, you’ve mentioned you covered 20 satellite cities; may I ask how many core cities and does that involve in covering the 20 satellite cities? What will be your plan to extend the OMO model in next fiscal year to cover more satellite cities and core cities? Secondly, congratulations Stephen on your new role as Executive President. Would you please share with us your responsibilities in this new role and your thoughts about the implication for corporate governance regarding this new role? Thank you.

Stephen Yang, Executive President and CFO

Okay, thank you first of all. I am happy to take the role of Executive President and CFO. I believe I will be spending more time in my current position. Fortunately, I have a very strong team; we have worked together for many years. My managers and staff, including Sisi, will support me more than before. Two years ago, I spent some time on the operations side. Some investors are aware of that. I enjoy working closely with the operational team, as it helps me become more familiar with the business and provide better instructions and guidance. As for the OMO portal, we are currently operating in seven provinces. We started from Hangzhou in Zhejiang province and have now expanded to Shandong, Shaanxi, Fujian, and some key provinces. So far, the progress in these provinces has exceeded our expectations, and I believe they will perform better going forward. We plan to continue to expand the OMO model to more provinces in the future. Thank you.

Alex Xie, Analyst

Got it, very helpful. Thank you.

Operator, Operator

Your next question comes from the line of Sheng Zhong of Morgan Stanley. Please ask your question.

Sheng Zhong, Analyst

Hi, good evening. Thank you for taking my question. Just one question about your offline price. You mentioned that it's increased very strongly. I am wondering the reasons for the price increase, especially as there is a lot of competition from online. Additionally, smaller institutions are also providing price discounts. Is it because you see the offline supply decrease post COVID-19 or are there any other reasons behind your pricing strategy? Thank you.

Stephen Yang, Executive President and CFO

Hi, Zhong. Our pricing strategy has been consistent and this quarter's hourly blended ASP was flat. We raised the price of the U-Can program by 8% and the U-Can VIP price increase was 5%, while we maintained the same price for other programs. I don't believe that competition from online platforms will impact our pricing strategy. Just so you know, we had a very successful summer promotion last year, during which we received over 1 million enrollments. We charged RMB 400, which is much more expensive than what online players typically provide; many offered free courses. Our retention rates remained over 60%. I believe that Chinese parents and students prioritize teaching quality and study results over price. Therefore, I expect our pricing strategy to remain consistent.

Sheng Zhong, Analyst

Thank you.

Stephen Yang, Executive President and CFO

Thank you.

Operator, Operator

Your next question comes from the line of Lucy Yu of Bank of America. Please ask your question.

Lucy Yu, Analyst

Hi Stephen. I just have a very quick question. You mentioned that in the third quarter there will be some negative impact from cost scheduling. Could you please quantify that for us, please?

Stephen Yang, Executive President and CFO

Yes, typically the delayed Chinese New Year impacts revenue by 5% to 6% in the K-12 business. Last year, the first of the two courses in the spring semester occurred in Q3, but we started all courses in March this year. So we sacrificed 5% to 6% of revenue from the POP Kids and U-Can programs this quarter; however, it's just a one-time impact based on timing differences.

Lucy Yu, Analyst

So, just to confirm, your guidance for the third quarter K-12 is 27% to 32%. If we account for the 5% to 6% back, it should be in the low 30s to high 30s, right?

Stephen Yang, Executive President and CFO

Yes.

Operator, Operator

Your next question comes from the line of Christine Cho of Goldman Sachs. Please ask your question.

Christine Cho, Analyst

Hi, thank you. Thank you, Stephen. I know that you are dual listing. Given this new status, could you give us some color on your capital allocation strategy going forward? Additionally, do you have any thoughts on your midterm guidance of 17% to 18% operating profit margin, any issues related to that? Thank you.

Stephen Yang, Executive President and CFO

Yes, Christine, regarding capital allocation: we raised money last year in November in the Hong Kong market due to the second listing. We prefer to allocate capital to investors. Historically, we've issued special dividends and conducted share buybacks several times. In terms of using the money, we prefer to make valuable investments, should we find potential synergies between the targeted company and ourselves worldwide; however, we will proceed very carefully. Secondly, we will focus on returning value to investors. Regarding your second question, we do not intend to change our near and long-term margin guidance. We still expect revenue growth recovery to take one to two quarters. We are seeing significant opportunities as smaller players have exited the market due to the pandemic. This presents a great opportunity for New Oriental going forward. That’s why we are committing to more investment now and expanding learning centers by 20% to 25% during difficult times. We are increasing teachers' salaries and hiring more marketing staff for ground promotions, which are more effective than online channels. We are allocating resources towards R&D on the OMO model as well. While these investments may impact margins temporarily, we are confident we will be able to deliver continued margin expansion after the pandemic phase.

Christine Cho, Analyst

Thank you so much.

Operator, Operator

Your next question comes from the line of Alex Liu of China Renaissance. Please ask your question.

Alex Liu, Analyst

Hi, yes thanks Yang, thanks Sisi. I think you kind of just answered my question, but my question was, in terms of margin, if you're looking at a non-GAAP operating margin, I think this quarter was still slightly declined year-over-year. Specifically, around what time should we expect the margin to bottom out in the next few quarters? Thank you.

Stephen Yang, Executive President and CFO

Yes, as I stated earlier, our revenue recovery still requires one to two quarters to normalize. There could be a small decline in the upcoming quarters. We are in an investing phase, focusing on hiring more staff and increasing expenditures for teacher compensation. The new wave of COVID in North China could also have slight impacts in Q3. However, I am optimistic about our performance in the coming quarters and throughout next year compared to Q2.

Alex Liu, Analyst

Okay. Thank you. I actually have a quick follow-up. Just regarding teacher compensation, I believe there has been a change to the compensation structure in the past fiscal year. I wonder how we should view the teacher compensation clause in the next few quarters. Is it fair to say that we might be past the period of high competition pressures on teacher compensation?

Stephen Yang, Executive President and CFO

Yes, that's an excellent question. The reason we raised teacher salaries was not due to competition from online players. The online players typically employ fewer teachers while we have a larger teaching staff. This decision was made internally by our management team that firmly believes in raising teacher salaries as a long-term strategic advantage. Even during challenging times, and when our topline growth was affected, we opted to increase teacher salaries, which we believe will result in higher utilization rates and student retention over the long run.

Alex Liu, Analyst

Thank you.

Stephen Yang, Executive President and CFO

Okay.

Operator, Operator

We are now approaching the end of the conference call. I will now turn the call over to New Oriental's Executive President and CFO, Stephen Yang for his closing remarks.

Stephen Yang, Executive President and CFO

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 here. Thank you very much.

Operator, Operator

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may now all disconnect.