Earnings Call Transcript - EDU Q3 2021

Operator, Operator

Good evening and thank you for standing by for New Oriental’s FY 2021 Third Quarter Results Earnings Conference Call. At this time, all participants are in a listen-only mode. After management's prepared remarks, there will be a question-and-answer session. Today’s conference is being recorded. If you have any 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

Okay, thank you. Hello everyone, and welcome to New Oriental’s third 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.

Stephen Yang, CEO

Thank you, Sisi. Hello everyone, and thank you for joining us on the call. With the pandemic largely controlled in China, albeit there is a small wave of outbreak in the northern part of the country, our business navigated the challenges and saw strong momentum in recovery. We are pleased to announce a set of financial results in the third quarter of this year that exceed our expectations. Total net revenue was $1,190 million, representing a 29% increase year-over-year, which is a very encouraging reflection affirming the business strategy that we have taken during the difficult period. Our key growth driver, the K-12 all-subjects after-school tutoring business, achieved year-over-year revenue growth of approximately 37%. Our U-Can middle school and high school all-subjects after-school tutoring business continued its momentum with a growth of approximately 35%, while our POP Kids program recorded a growth of approximately 40%. Our overseas related businesses, despite being under continued pressure due to the uncertainty of the pandemic situation and travel restrictions around the globe, showed strong resilience. Although the overseas test prep recorded a revenue decrease of about 12% for the quarter, this result is better than we expected, while the overseas consulting and study tour business recorded a revenue increase of about 11% year-over-year, which is a very positive result. Our industry-leading OMO system has been our core strategy since the start of the pandemic early last year, and it has once again proved to be instrumental in this quarter.

Sisi Zhao, CFO

Yes. Now, let me walk you through the key financial details for the third quarter. Operating costs and expenses for the quarter were US$1,089 million, representing a 35.1% increase year-over-year. Non-GAAP operating costs and expenses for the quarter, which exclude share-based compensation expenses, were $1,074.6 million, representing a 36.3% increase year-over-year. Cost of revenue increased by 35.3% year-over-year to US$539.5 million, primarily due to an increase in teachers' compensation for more teaching hours and higher rental costs for the increasing number of schools and learning centers in operation. The increase in teachers’ compensation would also put us in a better position to retain teaching talent, which are the most valuable assets in the education industry. Selling and marketing expenses increased by 32% year-over-year to US$156.1 million, primarily due to the addition of marketing staff with the aim of executing our OMO strategy to capture the new market opportunity post-COVID. General and administrative expenses for the quarter increased by 36.1% year-over-year to US$383.4 million. Non-GAAP G&A expenses, which exclude share-based compensation expenses, were US$383.3 million, representing a 40.3% increase year-over-year. Total share-based compensation expenses allocated to related operating costs and expenses decreased by 17.8% year-over-year to US$14.4 million. Operating income was US$101.5 million, representing a 13.5% decrease year-over-year. Non-GAAP operating income for the quarter was US$115.9 million, representing a 14% decrease year-over-year. Operating margin for the quarter was 8.5%, compared to 12.7% in the same period of the prior fiscal year. Non-GAAP operating margin, which excludes share-based compensation expenses for the quarter, was 9.7% compared to 14.6% in the same period of the prior fiscal year. Net income attributable to New Oriental for the quarter was US$151.3 million, representing a 9.9% increase from the same period of the prior fiscal year. Basic and diluted earnings per ADS attributable to New Oriental were $0.09 and $0.09 respectively. Non-GAAP net income attributable to New Oriental for the quarter was US$163.2 million, representing a 9.9% increase from the same period of the prior fiscal year. Non-GAAP basic and diluted earnings per ADS attributable to New Oriental were $0.10 and $0.10 respectively. Net operating cash flow for the third fiscal quarter of 2021 was approximately US$23.3 million. Capital expenditures for the quarter were US$105.8 million, primarily attributable to the opening of 142 facilities and renovations at existing learning centers.

Stephen Yang, CEO

Looking ahead into the next quarter of fiscal year 2021, we are clearer about the recovery trend of the company’s near-term financial performance and the market opportunity over the long run. Our strategic focus and investment approach this year aim at improving product quality, increasing teachers’ compensation, 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 the post-COVID market consolidation, we firmly maintain a stable and balanced investment strategy that will 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% capacity, including new learning centers, and expand the classroom area of some existing learning centers for the K-12 business in 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 a strong financial position and online class capability may not be able to sustain their business during this period. We expect the industry will undergo a wave of market consolidation as the pandemic phase ends. The fact that we are a major player with a strong financial capacity and new 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 for our K-12 tutoring business and overseas test prep key business. The usage of our online tools and content in our OMO system for all business lines throughout the whole network will be enhanced. It is our belief that with the whole OMO teaching experience, we will place more effort into developing the best teaching content and courseware, as well as developing more advanced training programs for our teachers. With all the above-mentioned infrastructure in place, we will continue to pilot our OMO online initiatives in major cities with high demand and higher operational efficiency, as well as in the surrounding satellite cities. We believe that our OMO initiatives will be one of the growth engines to increase customer acquisition post-COVID, as we can quickly replicate this in different parts of China, enabling us to capture the market consolidation opportunity. This revamped business model will also contribute to our margin recovery once the pandemic is over and help us further expand our long-term margin target. Here I have to highlight that these OMO products are supported by our offline classes. They supplement each other in a hybrid format. Third, during the peak of the pandemic, we recognized the necessity to ramp up spending in different areas of the business aimed at navigating the challenges posed by the pandemic. Now that the business is recovering to a normal level, we will closely manage the rise of capital expenditure across the company to improve overall operational efficiency. Here I would like to stress that we have great confidence in the fundamentals of our business, which we believe will continue to remain strong. We have been increasing our investments in different strategies, and we remain optimistic about the brighter prospects of our business, believing our investments now will bring recovery trends in the long run. Looking at our near-term expectations for the next quarter, we expect total revenue to be in the range of $1,101.9 million to $1,141.8 million, representing year-over-year increases in the range of 38% to 43%. To break down the expected top-line growth for key business lines, the K-12 business is expected to grow in the range of 45% to 50%. The overseas test prep program is expected to grow at around 30%. The overseas study, consulting, and study tour business is expected to be flat, and the growth of the Koolearn.com pure online education platform is expected to accelerate year-over-year in dollar terms. To conclude, we are taking all kinds of operational actions to boost enrollments and classroom utilization for the spring semester and speed up the recovery of the business after the resumption of the schools and learning centers. We are confident that the demand for after-school tutoring business is gradually picking up and trending toward a normalized level. I must mention that these expectations reflect our considerations of the latest pandemic situation and regulatory landscape, 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 this. Thank you.

Operator, Operator

Your first question comes from Felix Liu from UBS. Please go ahead.

Felix Liu, Analyst

Good evening, management. Thank you very much for taking my questions and congratulations on the strong quarter. My question is on regulation. I know during the past few months the regulator has made some relatively strict comments after instituting regulation. So, could you share some color about your take on potential regulation direction? Will there be any tightening in terms of the new learning center license ASP as well as after considering scheduling? Thank you very much.

Stephen Yang, CEO

Felix, it’s a good question. Actually, the government’s intention to tighten the after-school tutoring business policy is not a surprise to us. It has been discussed for a long time since 2018. We believe the regulatory efforts will foster a positive environment for the whole market to improve market standards and enhance the average teaching quality across the sector. We are aligned with government policy and are fully committed to work together with the government to build a better education market in China. I think the reform details are yet to be announced, so we cannot provide a full analysis on our business impacts. However, at this stage, we do not foresee any material impacts on the top line, although we believe some main costs may have a short-term impact to meet the new requirements. As the largest provider, New Oriental is well-positioned to comply with the potential policy reforms, and we expect China’s after-school tutoring market will further consolidate. We are prepared for this and are ready to take more market share from other players, Felix.

Operator, Operator

Thank you. Our next question comes from Mark Li from Citi. Please ask your question.

Mark Li, Analyst

Hi management, congratulations on the very strong results. May I ask for the upcoming summer promotion what’s our plan or any target? Especially, I see maybe with the rising synergy with our OMO model? Thank you.

Stephen Yang, CEO

Yes. We started our summer promotions four or five years ago, and last year we got over 1 million student enrollments from the summer promotion campaign, with a retention rate post-summer around 60%, which is a good number. This year, we plan to do the same and expect that summer promotion enrollments will boom, along with an anticipated higher retention rate after summer compared to last year. Simply put, we are looking to attract enrollments from the summer promotion temporarily, which is priced at around RMB400 to RMB500 per course. It’s not a free course, unlike some of our department courses. I believe the summer promotions will boost our overall year-round enrollment growth without negatively impacting margins for the full year, Mark.

Operator, Operator

Thank you. Our next question comes from Candis Chan from Daiwa. Please go ahead.

Candis Chan, Analyst

Hi, Sisi and Stephen. Thank you for taking my question and congratulations on this very strong set of results. My question is regarding the OMO. Can you share with us the revenue contribution of OMO currently? And also, what would be the percentage of OMO contribution in the long run as you expect? Additionally, what would be the long-term margin profile for OMO? Thank you.

Stephen Yang, CEO

While the OMO model only contributed single-digits to our other revenue this quarter, the potential to grow in China is promising. I think it will grow rapidly in the coming quarters and become a major driver of our business growth. We expect that the OMO will contribute around 10% of revenue next year, and regarding the margin profile, the OMO model should have a slightly higher margin compared to traditional offline classes. We initiated the OMO model last year, so we still need more time to refine it and solidify the margin profile. So far, progress is better than we expected, and we believe the OMO model will contribute increasingly more revenue going forward in the next fiscal year and over the next two to three years.

Operator, Operator

Thank you. Our next question comes from Tian Hou from T.H. Capital. Please ask your question.

Tian Hou, Analyst

Hi, Sisi, Stephen. Congratulations on the strong quarter. I see the overseas business recovering nicely, and some data shows that even though this year was a pandemic, the number of students applying to overseas schools was really high. So, what’s the outlook for the overseas testing and consulting part of the business? What do you see from today’s data? Thank you.

Stephen Yang, CEO

Thanks, Tian. I think the overseas test prep and overseas related businesses are recovering. The revenue decline of the overseas test prep this quarter was 12%. Last quarter, the decline was 29%, and two months ago it was a decline of 50% in dollar terms. Thus, we are seeing encouraging signs of recovery in the overseas test prep business. We expect that for Q4, the overseas test prep business will increase by around 30%. While knowing we have a low base last year, we are in the recovery phase for the overseas test prep business. In the consulting business, this quarter saw an increase of 11%, compared to our guidance for the consulting business last year, which was flat. Typically, Q4 is high season for overseas consulting business, and despite challenges, the performance of both the overseas test prep and consulting businesses has surpassed our expectations from several quarters ago.

Operator, Operator

Thank you. Our next question comes from Sheng Zhong from Morgan Stanley. Please ask your question.

Sheng Zhong, Analyst

Hi. Thank you for taking my question. Looking at Beijing, I think the learning centers are opening slightly slower. Could you provide any color on the government approval process? What are the key items during the inspection now? Based on this, what is your capacity expansion plan for next year that can be shared with us at this point? Thank you.

Stephen Yang, CEO

So far, we have opened almost all learning centers except for those in Beijing City. In Beijing, we currently have over 100 learning centers, but we are starting to open more larger centers now. This year, we plan to expand capacity by 20%, and after finishing our budget from last year with an expansion value of 17%, we will need to finalize our budget for next year before the next earnings call.

Sisi Zhao, CFO

Yes. Sheng Zhong, in addition to the situation in Beijing, I want to remind everyone that because we have the OMO system, we have been successfully conducting spring courses online even with the closure of offline learning centers. This has allowed all students to continue their classes online, and retention has remained stable. Overall, while Beijing’s situation is more challenging than in other cities and revenue declined, we are seeing improvements in reported Q3 and forecasted Q4 revenue trends for Beijing.

Operator, Operator

Thank you. Our next question comes from Alex Xie from Credit Suisse. Please ask your question.

Alex Xie, Analyst

Hi, management. Thank you for taking my questions and congratulations on a very strong set of results. Please comment on the margin trend in the next quarter and also for the next fiscal year. I believe we have a low base in the fourth quarter of last fiscal year. Thank you.

Stephen Yang, CEO

Yes. I think the revenue recovery is underway. On the market front, I believe we have business opportunities emerging. We have been making several investments since two quarters ago, increasing learning center expansion by 20% this year and raising teacher salaries twice. Additionally, we are increasing spending on R&D for the OMO, and we have hired more marketing team members to facilitate marketing activities. However, all of the aforementioned expenses will have a short-term impact on margins. That said, I still believe that margin declines for Q4 will narrow compared to this quarter. We are confident that we can achieve margin expansion after the pandemic is over, and we don't plan to change our long-term margin guidance. Thank you.

Operator, Operator

Great. Thank you. Our next question comes from DS Kim from J.P. Morgan. Please ask your question.

DS Kim, Analyst

Hi, good evening and congrats on the strong beat across the board. Can I follow up on your point regarding the margin decline that you mentioned was narrowing versus this quarter? Are you referring to last year or pre-COVID levels? Additionally, I have my own question regarding Koolearn. Some reports locally indicate some business adjustments; could you help us understand what the key changes in priorities are, plus potential margin impacts? For instance, Koolearn has been making about $40 million-plus operating losses every quarter in the past five or six quarters. Shall we expect the absolute size of the losses to narrow in fiscal year 2022, or should we only think about margin improvement and not the size of the losses? Thank you again.

Stephen Yang, CEO

DS Kim, I can’t disclose too many detailed numbers about Koolearn. However, I can share that Koolearn has been increasing its spending on R&D and marketing in the past quarter. We plan to exercise tighter control over marketing activities and spending moving forward. Our strategic focus is to invest in improving teaching quality and training teachers rather than heavily investing in marketing. We believe this is the essence of education. I believe that revenue from Koolearn will accelerate next quarter. The contribution to EDU margins from Koolearn will decrease going forward.

Operator, Operator

Thank you. Our next question comes from Lucy Yu from Bank of America Securities. Please ask your question.

Lucy Yu, Analyst

Thank you, Stephen. I have a follow-up question on the margins. In the fourth quarter, we have a relatively lower base, especially with the K-12 segment expected to grow 45% to 50%. Should we expect some improvement in that margin profile? What is actually driving the margin down compared to the same period last year? Thank you.

Stephen Yang, CEO

Yes. We believe we have leverage in our K-12 business because that segment is recovering very rapidly. However, as I mentioned, we are making investments for the future, including increasing teacher salaries, opening additional learning centers, and investing more in OMO. We have also hired a considerable number of marketing staff for ground promotions. As a result, you will need some time to see margin expansion, perhaps one more quarter. But I believe the margin profile in Q4 will be better than in Q3.

Operator, Operator

Thank you. Our next question comes from Jessie Xu from Nomura. Please ask your question.

Jessie Xu, Analyst

Good evening, management. Thank you for taking my question, and congratulations on a very strong quarter and an ambitious revenue target for Q4. My question is regarding offline normalization in Beijing. I want to understand what your best and worst-case scenarios are. If Beijing learning centers cannot open before summer, what would be the impact on our summer promotional campaign? Thanks.

Stephen Yang, CEO

So far, we have completed 17% of expansion in the first three quarters of this fiscal year. We still need 2% to 3% new capacity for Q4 to reach our 20% expansion target. We are prepared for the upcoming summer promotion. And don't forget that with our OMO model, we are much better positioned than last year. For the summer promotion, we plan to incorporate the OMO model, which means that the online elements will help us conduct the promotion differently than the traditional approach that was 100% offline.

Operator, Operator

Thank you. Our next question comes from Christine Cho from Goldman Sachs. Please ask your question.

Christine Cho, Analyst

Thank you so much. Congratulations on the solid results this quarter, Stephen and Sisi. It seems that the capacity growth this quarter of 70% looks a bit faster, and it seems that you are targeting around 20% growth, which seems to be kind of the low end of the 20% to 25% mid-term target. Is this temporary, or are there any lasting concerns, such as for example OMO expansion plans or any regulatory concerns? Thank you.

Stephen Yang, CEO

Yes, we aim for around 20% expansion for the full fiscal year 2021. Last year, we expanded by 26% with new learning centers. Typically, we ramp up additional learning centers from zero to 100% within three to four years. This means we have enough capacity to ramp up, and we have shifted some classrooms from overseas test prep to K-12 business to prepare for the growth of that sector due to the adverse impacts we suffered from the overseas test prep business.

Operator, Operator

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

Stephen Yang, CEO

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.

Operator, Operator

Great. Thank you. This concludes our conference for today. Thank you for participating. You may now all disconnect.