Apr 18, 2007
Operator
Good evening and thank you for standing by for New Oriental's third fiscal quarter 2007 earnings conference call. (Operator Instructions) I would now like to turn the meeting over to your host for today’s conference, Ms.
Sisi Zhao, New Oriental Investor Relations Manager. Please proceed.
Sisi Zhao
Hello, everyone, and welcome to New Oriental's third fiscal quarter 2007 earnings conference call. Our third fiscal quarter earnings results were released earlier today and are available on the company’s website, as well as on newswire services.
Today, you will hear from Michael Yu, our founder and Chairman and Chief Executive Officer, and Louis Hsieh, our Chief Financial Officer. After their prepared remarks, Michael and 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 provision of the U.S. 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 statements 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 http://investor.neworiental.org.
I will now turn the call over to New Oriental's CEO, Michael Yu. Michael.
Michael Yu
Thank you. Good evening and good morning, and happy to be here again to discuss our third quarter for 2007.
I am Michael Yu. Thank you for joining us today.
We delivered good results for the third fiscal quarter of 2007 as strong growth in our key business segment allowed us to exceed the high end of our revenue guidance by more than RMB43 million, or $5.5 million. In addition, the scalability of our business and the efficiency of our management systems were evident as we recorded net income of over $8 million, over 500% higher than the year-ago period.
Due to the winter school holiday, the third fiscal quarter is traditionally our second-strongest in terms of revenue, as many students enroll in winter classes to prepare for domestic and overseas tests. During this third fiscal quarter, student enrolment for our leading language training and test preparation courses grew from approximately 184,000 a year ago to over 199,000 in the third quarter.
In particular, our middle school and the POP Kids English training programs continue to show strong enrolment growth. Please note that the percentage growth of the student enrolment appears relatively low because the late Chinese New Year holiday pushed many students’ registration for the spring session from February into March.
Our content distribution and other business lines also delivered strong results, growing over 90% from the year-ago period. Although this area of our business is starting from a lower revenue base, we have high expectations about the potential growth.
Along with our distribution network of over 5,000 third party bookstores, we are consistently building our New Oriental bookstore, and we opened our 18th bookstore during the quarter. With tremendous demand for quality private education in China and a highly fragmented education environment, one of our key strategies is to rapidly extend our leading nationwide network.
In the third fiscal quarter, we opened new learning centers in six major cities. Our hub and spoke business model is designed so that each new learning center can leverage both teaching and administrative resources of nearby schools, and with widespread awareness of the New Oriental brand, we are able to ramp up enrolment relatively quickly.
In addition to expanding our physical network, we are also focused on building fruitful partnerships with international content providers to enhance our education offering and ensure that our students are receiving a quality education. We plan to roll out programs based on our initiative with Thomson Learning and Dynamic Education International later this year, and we are confident that they will be well-received by students.
Going forward, we will continue to explore strategic relationships with leading education providers to help us leverage our nationwide distribution channel and online space. Despite our achievements to date, the private education industry in China is still in its early stage.
In order to help capture the opportunities ahead of us, we are strongly committed to investing in our future growth. To this end, we expect to continue expanding our network of learning centers and schools to broaden our brand recognition through marketing initiatives and marketing activities, to invest in technology systems and of course to continue recruiting the best teaching talent in China, especially for the fourth quarter of this year.
We have to get prepared for the next year. Now, I will turn the call over to Louis Hsieh, our CFO, to take you through the financial numbers.
Louis.
Louis T. Hsieh
Thank you, Michael, and welcome to everybody on this call. As Michael just mentioned earlier, we had a strong quarter with strong top and bottom line growth and significant improvement in our operating margin.
Today, I will walk you through the contribution to our third fiscal quarter results and some financial highlights. Please note that certain figures I will talk about are non-GAAP, including all measures that are given excluding share-based compensation expenses.
You can find a reconciliation of these figures in the financial tables at the end of the press release. Our third fiscal quarter 2007 total revenues were RMB255.1 million, equivalent to $33.0 million, an increase of 51.3% from the third fiscal quarter of 2006.
Revenue from our education programming services comprising our language training and test preparation courses and primary and secondary education programs rose 49.3% year over year, driven by an increase in new student enrolment in language training and test preparation courses. This quarter’s results were especially strong because Chinese New Year holiday was later than usual in 2007, allowing Chinese students more time to attend supplemental education programs during their winter holiday and we also saw increased revenue from books and other education materials and services, which rose 93.4% to RMB14.8 million, equivalent to $1.9 million, from the year-ago period.
Overall operating expenses for the quarter were up 26.5% year over year. Of these, cost of revenues increased by 44.0% year over year, mainly due to the increased number of courses offered to a larger student base and the greater number of schools and learning centers in operation.
Selling and marketing expenses increased 37.7% year over year, mainly due to brand promotion expenses, as well as one month impact of an accounting reclassification of some human resource expenses in G&A to sales and marketing. General and administrative expenses increased 2.3% year over year to RMB64.8 million, the equivalent of $8.4 million.
Operating margins for the quarter was 21.2% compared to 5.8% in the corresponding period of the previous year. Excluding share-based compensation expenses, operating margins for the quarter was 23.4% compared to 6.4% in the corresponding period of 2006.
This increase was primarily due to the improved operating efficiency as revenue growth outpaced the growth in operating costs and expenses. Total share-based compensation expenses, which were allocated to related operating costs and expenses, increased to RMB5.6 million, the equivalent of $700,000 in the third quarter of 2007, from RMB1 million in the third quarter of fiscal year 2006.
Net operating cash flow for the quarter was RMB49.1 million, the equivalent of $6.3 million. Net income for the quarter was RMB65.3 million, the equivalent of $8.4 million, representing a 543.5% increase from the third fiscal quarter of 2006.
Net income attributable to holders of common shares excluding share-based compensation expenses increased to RMB70.9 million, the equivalent of $9.2 million. Basic and diluted earnings per ADS were RMB1.79, the equivalent of $0.23, and RMB1.72, the equivalent of $0.22 respectively.
Excluding share-based compensation expenses, or non-GAAP, basic and diluted earnings per ADS were RMB1.94, the equivalent of $0.25, and RMB1.86, the equivalent of $0.24, respectively. Each ADS represents four common shares.
Common shares used in calculating basic and diluted earnings per ADS increased in the third quarter of fiscal year 2007 due to 34.5 million new common shares issued and sold by the company in our initial public offering in September 2006 during the company’s second quarter, and approximately 2.4 million new common shares issued and sold by the company in our secondary offering in February 2007 during the third fiscal quarter. Moving to our balance sheet, our total cash and cash equivalents as of February 28, 2007, were RMB3.4326 billion, the equivalent of $443.4 million, an increase of 194.3% from November 31, 2006.
This jump was primarily due to the proceeds from the follow-on offering in the third fiscal quarter of 2007. In fact, approximately RMB2.0677 billion, the equivalent of $267.1 million, of total cash was paid to selling shareholders in early March of 2007, at the beginning of the company’s fourth fiscal quarter.
Before I give guidance, I would like to take a brief look at the comparison between the first nine months of fiscal year 2007 and the first nine months of fiscal year 2006. Student enrolment in language training and test prep grew 19.0% year over year to 754,300 students from 633,600 in the year-ago period.
Net revenues are up 37.1% year over year to RMB853.4 million, the equivalent of $110.2 million, from RMB622.6 million a year ago. Net income was up 185.2% year over year to RMB238.6 million, a U.S.
equivalent of $30.8 million, from RMB83.7 million in the year-ago period. Our operating margins went from 15.3% in the nine months ended February 28, 2006 up to 27.5% in the nine months ended February 28, 2007.
We are very pleased with these results. I will now read you New Oriental’s financial guidance for the fourth fiscal quarter of 2007.
Please note that the following outlook statements are based on our current expectations. These statements are forward-looking and actual results may differ materially.
Total net revenue in the fourth fiscal quarter of 2007 that runs from March 1, 2007 to May 31, 2007 is expected to be in the range of RMB177 million, U.S. equivalent $22.9 million, to RMB185 million, U.S.
equivalent $23.9 million, representing year-over-year growth in the range of 19.9% to 25.3%. Now, let me turn the call back to Michael for his closing remarks.
Michael Yu
Thank you, Louis. Once again, thank you for participating in our earnings call for the third fiscal quarter 2007.
Now, we would be happy to take your questions. Thank you.
Operator
(Operator Instructions) Your first question comes from the line of Brandon Dobell with Credit Suisse. Please proceed.
Brandon Dobell
Good morning. I wondered if you could walk through how we should think about what the timing impact of the Chinese New Year was on enrolments but also on revenue per student.
I think that came in a lot higher than we had looked for but enrolments came in lower than we had looked for. I am sure there is some connection with how that works from an accounting perspective or from a longer length of course perspective, but maybe, Louis, if you could walk us through how we reconcile those two numbers that would be great.
Louis T. Hsieh
That’s a great question and we are not surprised by it. What happened in this Q3 of ’07 was an atypical quarter because Chinese New Year occurred around the February 17th to 18th time period, so basically students had a longer period to study in Q3 of ’07.
So what happened was last year in Q3 of ’06, the amount of cash and student enrolments that were collected in that same quarter and actually recognized as revenue in Q3 of ’06 was about 38% of the total cash collection. So last year, the revenue in Q3 was RMB147 million, of which about RMB58 million of which was recognized in Q3 of ’06.
Now, when we switch to Q3 of ’07, that changed. We had RMB176 million in short-term language and test prep revenue, and this time 61% of that revenue this year was actually recognized in the same quarter.
That difference is already RMB38 million, which takes you from -- so that is one big factor. The second issue relates to your question on student enrolments was that because Chinese New Year was so late this year, around February 17th, what happened was when the students go back to school, they do not go back to school until February 26th or 27th, and then about a week later they start signing up for spring courses.
So normally, Chinese New Year is at the end of January. Those students would have started signing up for courses in February, end of February, middle to end of February.
This year, they did not start signing up for classes until March, so much of the student enrolment that would have occurred in Q3 has actually been pushed to Q4. Does that make sense, Brandon?
Brandon Dobell
Yes, it does make sense.
Louis T. Hsieh
The third factor was that of the RMB255 million in revenue in Q3 of this quarter, actually in the short-term learning side, which is about RMB220 million of that revenue, half of it was actually revenue collected from Q1 and Q2 student enrolments, so it is recognized in Q3. If you recall in Q1, our student growth rate was 25.9% increase year over year, and in Q2 of ’07, it was a 20.3% increase.
Those are unsustainable levels. They are too high.
So RMB110 million of that revenue from those students who paid in Q1 and Q2 is actually recognized in Q3.
Brandon Dobell
So it sounds like you have both a front-end impact, where you had some recognition from prior quarters because courses were longer, but you also have a back-end impact which pushed out enrolments by a week or two, which would have pushed people from Q3 into Q4.
Louis T. Hsieh
Exactly right, and so what the impact is, just so everybody is clear, that will actually slightly negatively impact our Q4 revenues because the first week or 10 days of March, there will not be much classroom activity, so the classes will not start until the middle of March this quarter. Because of that, Q4 revenue will be slightly down from what it would have been.
But because the macro economic trends are quite favorable, our growth, we are still comfortable with a 20% to 25% revenue increase year over year. That’s the same guidance we gave in Q3.
Brandon Dobell
I will be mindful of the one question. I will jump back in the queue.
Operator
Your next question comes from the line of [Tien Ho] with [inaudible]. Please proceed.
Tien Ho
Hi, Michael and Louis. I was not planning to ask a question on the call but since nobody jumped up, so I said I’ll give it a shot.
How many total schools or learning centers did you open in this quarter? Six?
Louis T. Hsieh
In this quarter, we did not open any new schools.
Tien Ho
But the centers?
Louis T. Hsieh
We did add nine new learning centers and we closed two, so we now have a total of 128 learning centers and schools and we added one bookstore.
Michael Yu
Because of the Chinese New Year, we really did not have the chance to register for new schools because the government offices closed for the New Year actually for the third quarter. We are opening new schools this fourth quarter and also we are opening more new learning centers to prepare for the summer quarter, the first quarter of next year.
Tien Ho
Do you have any plans -- in next quarter, how many schools do you want to open? How many learning centers do you want to open, or how many you want to --
Michael Yu
You mean Q4 of ’07?
Tien Ho
Yes.
Michael Yu
Until the end of May?
Tien Ho
Correct.
Michael Yu
I think we are going to open about 10 new learning centers all over China and maybe two or three new schools.
Tien Ho
The other question is did you increase your price in the last quarter?
Louis T. Hsieh
Our ASP increases year over year were around 10% or 11%.
Tien Ho
Did that happen in the last quarter?
Louis T. Hsieh
Yes, this is a year-over-year comparison, so this is for Q3 --
Michael Yu
Not a quarter by quarter, it is a year over year.
Tien Ho
I got it, so compared with last year, the increase -- okay, got it.
Louis T. Hsieh
But a caveat to that is that this course fee increase, a lot of it is attributable to the fact that we are actually offering smaller classes with nicer environments, so it is not necessarily an exact apples-to-apples comparison. In fact, the big classes, the fees are approximately the same.
It is because students are willing to pay more for a nicer environment and smaller classes that the ASPs are going up.
Michael Yu
Instead of the [inaudible] the price of [inaudible] rates because we put students in a different classroom environment to study but a different price.
Operator
Your next question comes from the line of Paul Keung with CIBC World Markets. Please proceed.
Paul Keung
I just want to confirm that despite the timing of the Chinese New Year that the enrolment goals is back to the mid-teens next quarter and then pricing is around 10%, 12% again, that pace is still on track.
Louis T. Hsieh
We have not disclosed forward pricing but it should be relatively comparable to Q3. We would expect student enrolment to be higher than 8% but probably lower than the 20% that we saw in Q2 and for sure lower than the 26% we saw in Q1.
So it is a good ballpark to be in the low teens.
Paul Keung
Okay, so pricing is on track. Then, a real quick question on the acquisitions.
I am just curious what the environment is like now, given you had mentioned in the past that a lot of the potential sellers and opportunities out there were looking for much higher prices. Has the environment changed at all?
I know it is only a quarter or so, but has it changed at all?
Louis T. Hsieh
Actually, it has not changed. The environment is still quite difficult for us to make an acquisition at this time but we still have a number of acquisitions in the pipeline.
So it does take longer than we would like and there is still a lot of private equity money that is pouring into this sector and still trying to create the next New Oriental.
Operator
Your next question comes from the line of Jason [Kotick] with NWB Investments. Please proceed.
Jason Kotick
My questions were mostly answered but I think on the deferred revenues on the balance sheet, was that the same impact as what happened within Roman’s and the Chinese New Year impact?
Louis T. Hsieh
That is exactly right. What happened was that last year at the end of Q3, we had RMB140.7 million in deferred revenue that went into Q4.
This year, in Q3 of ’07, we only had RMB135 million in deferred revenue. That is because of two factors.
One was because 61% of the revenues were actually already recognized in Q3 this year versus only 38% last year, there was less to defer. Second was what Michael mentioned earlier in his prepared remarks, which is that the Chinese New Year holiday was late this year, so students did not start enrolling for spring courses until March, so then you will see them directly in the fourth quarter.
Operator
Your next question comes from the line of Trace Urdan with Signal Hill Group. Please proceed.
Trace Urdan
I would just like to follow up on this theme a little bit more precisely. Can you review the definition of the enrolments that you report exactly?
Might I suggest that maybe it is not -- there is a disconnect here between how you define those enrolments and clearly how the revenue gets recognized. Maybe there needs to be a different measure that more closely reflects the number.
My understanding is we are talking about the number of student days in class versus just the raw number of students that were enrolled. Is that a fair characterization?
Louis T. Hsieh
That is a great question, Trace. The way we have -- we have two systems.
We report student enrolment to you folks on the line by the actual number of students who come in to our schools and learning centers that quarter and actually pay cash. That does not mean they complete their courses or even take their courses that quarter.
So they will get counted in that student enrolment because that is the way our systems were set up, is to take cash revenue as we get them from the students. So that is how our student enrolment count is calculated.
Now, because of U.S. GAAP, our revenues are pro-rated based on how long this class is.
So if the class is three months, we will recognize one-third of that cash revenue each month during the class, and classes will overlap into quarters. So because of that, there is a slight disconnect between the number of student enrolments and the actual revenue versus the actual collected student enrolment cash revenue.
That is why we have that deferred revenue number in our balance sheet, but our systems are not such that we can reconcile those easily. We have not -- because of the U.S.
GAAP and the pro-rated revenue recognition, we have to live with this slight disconnect.
Trace Urdan
If I could, sort of related to that, can you help me understand -- I understand the point of there being fewer revenue days in the coming quarter as a function of Chinese New Year, but the deceleration from the 37% year-to-date rate of growth and the 20% to 25% rate that you are talking about next quarter, it seems like a more significant drop than just a week of classes being deferred, but maybe not.
Louis T. Hsieh
But if you notice our past guidance, it is about that way. We guided Q3 in the 20% to 25% range and we ended up doing 51%.
I do not think we can do that for Q4, but I think we are comfortable with 20%, 25% in Q4, which is typically our second slowest quarter anyway. Q4 is really the set-up for the summer.
Trace Urdan
Fair enough, and then if I can sneak one more in, the tax rate looked especially low this quarter. Was there something that went into that?
Louis T. Hsieh
In Q1, we were extremely conservative so we took a large tax reserve on the advice of our accountant. We were comfortable that we would not need that tax reserve, so some of it is coming back in Q2 and Q3.
Trace Urdan
Okay, so when we look at a year-to-date number, is that more close to what we should think about modeling?
Louis T. Hsieh
It should be about 7.5%. It should go up in the years to come by 0.5% or 1% a year.
Operator
Your next question comes from the line of Mark Marostica with Piper Jaffray. Please proceed.
Mark M. Marostica
Good evening, everyone. My question relates to looking forward to the August quarter and to the degree that you have any sense of how the backlog is building, or course interest is building as you look into the all-important summer timeframe.
That would be helpful.
Michael Yu
The summer building up means the first quarter of next year? Q1 of next year, right, of our fiscal year?
Actually, Mark, we are trying our best to get prepared for the first quarter of next fiscal year. We are doing great marketing these days, and I personally am actually involved in it.
Also, we will open in the fourth quarter of this year and the first quarter of next year, we are going to open more learning centers. We are going to open maybe somehow 20 learning centers both in English and high-end Elite learning centers -- VIP learning centers, actually.
Also, we are trying to push up the New Oriental brand a little more quickly so that more people in China will recognize this brand and if they think about or want to study, they will come to New Oriental. I am sure that we are trying to get prepared for the summer.
Mark M. Marostica
How many schools will you have up and running in Q1 of ’08 versus Q1 of ’07?
Michael Yu
You mean how many new schools we are going to open?
Mark M. Marostica
No, not new schools but just how many total campuses, how many total schools will you have in Q1 versus --
Michael Yu
We have 34 schools, right? For the next two quarters, we are going to have another four to five new schools opening in provincial cities.
Mark M. Marostica
Right, so if you look back to Q1 of ’07, so August a year ago, how many schools did you have at that point?
Michael Yu
We had 20?
Louis T. Hsieh
At the end of May, which is our IPO filing, it was 25 schools, 111 learning centers. So if you look at August, I do not have the exact number for August but we had added seven new schools in Q1 so it was about 32, and I believe the number was about 115 or 116 learning centers.
So you can expect us probably, given Michael’s numbers, to be in the 140 to 150 total learning centers and about 38, 39 schools.
Michael Yu
Also, looking forward, now that we have gone to most of the major cities in China, so even if we open new schools, we will open these schools in the middle-sized cities. That means that while we are opening new schools, it is very important for us to open new learning centers in big cities with the schools.
That means we invest less but you can attract more students with an easy strategy and you can save money. Also, you can make more money.
Every time we open a new learning center, we can also generate revenue of up to RMB3 million to RMB5 million. But to open a new school, usually we have to do RMB5 million within almost three years in a middle-sized city.
So opening new learning centers is very important while we are still opening new schools all over China.
Mark M. Marostica
One last question and I will jump back into the queue, and that is the ASP you mentioned, Louis, was up 10% to 11% in February, you expected the same in May. Again, my question looking into the August quarter, would you expect ASPs to be up about the same in August as well?
Louis T. Hsieh
We will visit that question this quarter but traditionally we have increased prices between 6% and 8%. Given the fact that the product mix is changing and we are going to smaller class sizes, you can expect ASP overall to go up.
Operator
Your next question comes from the line of Brandon Dobell with Credit Suisse. Please proceed.
Brandon Dobell
Just a couple of quick follow-ups. I’m just back in the queue again here.
As you look out to the schools that you plan to open, or learning centers you plan to open in the next two or three quarters, are you comfortable with where those are in the approval process with the government in terms of finding sites, getting the licenses, getting the people set up? I’m just trying to gauge your comfort level or confidence level with the new school openings scheduled.
Michael Yu
We are comfortable with our new school opening schedule. We have good relations with the government and actually, the cities that we are going into actually we have connected with the government and have talked with the government.
Most of them are supporting us to go into their city as quickly as possible, actually.
Brandon Dobell
Is there any potential impact that you see next year from the Olympics, either in Beijing or just generally, in terms of how students are going to be enrolling or patterns in enrolment or what the government might be doing?
Michael Yu
Actually, we are not very sure at this time but the Beijing Government just gave out an announcement, and also the provincial government, that people from outside Beijing will not be stopped from coming to Beijing for the Olympics or for other purposes. About two months ago, people were -- there was a rumor that said the government will stop people from coming to Beijing for that one month and also will stop Beijing people from working for about two weeks.
But now, the government says everything will go as normal. People can come into Beijing any time they want, and also those people who are working in Beijing from other places can also stay in Beijing and continue their jobs or whatever.
My expectation is that the only thing affecting New Oriental during the Olympic game period is that the hotel fees will be very much higher, so we have to pay more for the hotel space. They come to study during the summertime.
Our strategy is that actually we are going to move some of our campuses down to some suburban areas, suburban campus areas of Beijing, so that we can avoid the congestion, actually.
Brandon Dobell
Final question; Louis, you talked about the class sizes getting a bit smaller. I would assume that that’s primarily in language training or are we going to see that happen in test preparation also?
Louis T. Hsieh
It is mostly in language training but test prep also it is happening, where students just want a better environment because they can afford to pay for it, so they would prefer class sizes instead of 400 maybe 50 to 100, or 30 to 50, because they are going to pay multiples of the large class fees. Language training is, the size is going down from 50 to 100 down to more 25 to 50’ish.
Michael Yu
Let me explain further for this classroom size. From this year on, we are going to divide our classroom size into three parts.
One is we call the big classroom size, from 50 students up to maybe 400 students. This is called the big classroom size.
We are not really going to raise the ASP in this sector very much because in this sector, students would like to pay reasonable money to study in a big environment. But we are going to do exactly from 20 students to 40 students, is what we call the small size classroom.
We are going to raise the prices in this sector much higher than the larger classroom size, because before we do not do this kind of definition. We are going to offer the small size classrooms a better environment, a better facility and even offer them drinks and food so that they enjoy the environment where they are studying.
But we are going to charge them more because in China, more and more parents of students would like to study in a better environment. Also, we are going to set up a VIP classroom, maybe around 10 students, maybe from five students to 15 students.
We are going to build up learning centers with this environment with very small classrooms but with better facilities and more tutors and more teaching guidance so that we can cater to the needs of the students, different needs of students on different levels in China.
Brandon Dobell
Do you think you have enough teachers to do that? If you take a 400 person class, divide it into eight 50 people classes?
Michael Yu
Actually, it is even easier to find teachers to teach the VIP classroom. Teachers which are most difficult to find are the big classroom teachers because they are not only teachers, they are speakers.
They are giving speeches. They should be charming and charismatic.
In a small size classroom teachers and for VIP classroom teachers, the only thing a teacher needs is their patience and their ways of teaching students in detailed ways. That is easier to find these teachers, actually.
Also, every day we get a lot of applications from teachers teaching in other institutes. I do not think teachers is a big problem where we divide a classroom into these three sizes.
Louis T. Hsieh
Brandon, to give you the statistics, as of May 31 last year, we had 1,744 teachers. As of February 28th, so nine months later, we had 2,291 teachers.
So we have added more than 500 teachers, including almost 200 in Q3 alone. So we are basically ramping up the teacher numbers.
Operator
Your next question comes from the line of David [DeGrath] with MSS. Please proceed.
David DeGrath
I had a question about the underlying G&A growth rate. When I adjust for the accounting change, it looks like the last couple of quarters it has been 3% to 4% growth year over year.
I am wondering if there is a change in the business model there, and if that rate is sustainable in Q4 and beyond.
Louis T. Hsieh
I think this time G&A was only up 2.3% because of the accounting change, there is only one month left in Q3, so it was only the December month. So that is why the G&A change was lower.
David DeGrath
How are you able to sustain that low of a growth rate, I guess, when enrolments are growing?
Louis T. Hsieh
Because of the systems -- we basically built up a lot in ’05-’06, all our systems. Our headquarters does not require that many more people as we grow, so that is the leverage in our business model.
Our content is scalable across the whole network. Actually, if I look at the headcount, G&A headcount for the quarter actually went down 108 people.
So for the quarter, we went down from 1,290 down to 1,182 between Q2 and Q3. So we are getting efficiencies in the G&A.
As Michael mentioned, we will actually increase our sales and marketing spend in preparation to make sure that we have a strong summer quarter, so even though G&A is being held steady you are going down relative to the revenue growth. Sales and marketing will probably make a big push in this Q4 and early Q1.
David DeGrath
My understanding was that the part-time teachers are in that line as well, which I would think would be growing --
Louis T. Hsieh
Yes, so I will give you the breakdown of part-time teachers. At the end of Q3, it is 1,309, and full-time teachers is 982, so more than half the teachers are part-time.
That is part of our strategy because we do not want to pay them full-time when the classes are empty part of the day.
David DeGrath
So that was the end of Q3. Do you have the numbers for the end of last fiscal year, or last year’s Q3?
Louis T. Hsieh
Yes, at the end of May 31 of ’06, so basically last fiscal year, was 837 part-time teachers and 907 full-time teachers, so the trend is definitely toward part-time teachers.
David DeGrath
Then, I was curious as to the two learning center closures this quarter. What was the reasoning behind that?
Louis T. Hsieh
The learning center closures, one was in Shanghai because we opened three new learning centers in Shanghai and closed one, so we just moved locations, so we actually had a net add of two in Shanghai. The other learning center closed was in [Jingzhou] and I do not know the exact reason why.
Michael Yu
Maybe the reason is the timing.
Louis T. Hsieh
Oh, probably the lease expired. Maybe it was a shorter term lease.
David DeGrath
Did you relocate that one?
Michael Yu
It’s a very small learning center. We are opening a new learning center in [Jingzhou] this year for English.
Louis T. Hsieh
Yes, so it is just going to be a change. There will be a timing difference where the learning center will close this quarter but will open in a different location, or be a larger one next quarter.
David DeGrath
Finally, I was wondering if you could talk about revenue growth in POP Kids, Elite English, and then how the professional certification business is going? I don’t know if it’s too early for that.
Louis T. Hsieh
The professional certification business is too early because the revenues will actually start this quarter. As far as the revenue growth from the key segments, overseas test prep grew 80% year over year in revenue but the student numbers did not increase that much.
It was only about 3.5% because of the enrolment difference, so 8% total enrolment growth because of the timing difference of the Chinese New Year. Revenue from high school grew 49% and kids grew 53% year over year.
David DeGrath
And Elite?
Louis T. Hsieh
Elite grew -- Elite didn’t grow -- it grew 3.9%. Elite is going through that transition of dynamic education, so we are in the process of that transition and adding learning centers in Elite.
Michael Yu
The transition will be for almost a whole year to change from our old teaching model to a dynamic education teaching model, so we are in that transition. But we are very comfortable with that because we know that later when we finish the transition, this is a good area for New Oriental to go into the high-end.
We can do that much better.
Operator
Your next question comes from the line of Alberto Bassetto with Jayhawk Capital. Please proceed.
Alberto Bassetto
I have a follow-up question on the number of students on the enrolment and the definition I understand is that you recognize students as a new student coming into the school for that specific quarter, and that this number for this quarter is 8% higher than the same quarter 2006, which is I would say lower than the year-over-year guideline. So the question is how confident are you that for the fourth quarter you will go back to the high teens?
Louis T. Hsieh
I don’t know about high teens but don’t forget we already have six weeks of data. It is the middle of April and we started the quarter March 1.
We get weekly numbers on cash revenue and students, so we are seeing -- starting in March, we are starting to see growth again.
Operator
Your next question comes from the line of Trace Urdan with Signal Hill Group. Please proceed.
Trace Urdan
Louis, I wanted to make sure that I really understood what is happening with the ASPs because I think I heard you ascribe all of the increase to this mix shift towards the more expensive classes and suggest that pricing wasn’t really a factor in the quarter but I was not sure that that was correct.
Louis T. Hsieh
The mix shift accounts for about RMB38 million. The 61% of the revenue collected in Q2 is actually recognized in Q3 versus 38% a year ago.
Then, 8% student growth and 11% ASP growth gets you to the growth differences.
Trace Urdan
Right, but within that 11%, what I am interested in is it seems like the driver of the growth in ASP is the migration towards more expensive, smaller classes versus simply an increase in rates on existing classes. Is that right?
Louis T. Hsieh
That’s correct although typically overseas test prep will still be increased year over year by quarter.
Trace Urdan
I presume that these sort of smaller higher-end classes, this takes the form of a different product offering. Is that right?
Louis T. Hsieh
It is pretty much the same course -- just creating a nicer environment where the student has more chance to interact with the teacher.
Trace Urdan
Right, no, I get it but when the student is signing up, they are saying do you want the regular or the super premium or -- how long have those higher-end options been available to the students? Is that something you have always done or is that something that you have introduced in the last year?
Michael Yu
Actually, we have done little by little over last year, but this year we have given all the schools clear definitions about our higher-end and middle-end and lower-end, or what we all big classroom size, small classroom size, and VIP classroom size.
Trace Urdan
Okay, what I am trying to get at is I heard you say that you are going to continue to offer even more premium classes, but what I am trying to understand is whether there is some kind of an anniversary that we are going to come up against with respect to this trend.
Louis T. Hsieh
This has been ongoing for a couple of years.
Trace Urdan
Okay, all right, that’s fair. Then, if I could ask one other question that I get asked and do not really have a good answer for and have not seen articulated by you guys, but I wonder if you could speak to what the average capacity is when you open up a new school and whether that has changed at all.
Are the schools larger or smaller as you go forward? And then, if you could, speak to the system-wide capacity that you are seeing right now -- capacity utilization, rather?
Louis T. Hsieh
We do not look at -- we have answered this before, that we do not look at capacity utilization as such because it is easy for us to add learning centers in a city. So if we get into any kind of capacity issue, we just open a learning center.
So capacity has never been an issue. Don’t forget our schools for nine months of the year are probably empty half of the day.
We are getting the school hour day. As far as capacity goes, don’t forget 19 of our schools have been open the last two years, so they have not even hit 50% capacity, let’s say.
It is never an issue because we just open learning centers. So Beijing, if we hit a capacity issue, we just open another learning center.
But the truth is we are putting capacity in the system, so it is a step function issue but it is not a problem for us, other than during the summer.
Trace Urdan
Is there some kind of minimum size? When you open up a new school, are the new schools that you open up sort of the same structures that they have always been?
Do they need to be a certain size in order to establish a brand presence in the market before you start opening up learning centers?
Louis T. Hsieh
I think our newer schools are smaller than the older schools because the cities are smaller.
Michael Yu
Another reason is actually we like to open more learning centers in a city because if you open a big school in one place, students have to travel a long time, especially considering these days Chinese cities with lots of traffic jam, so that is why we are opening smaller schools with more learning centers. The model has changed a little because we want students to have access to our schools more easily.
Louis T. Hsieh
But even a smaller school is still about 100,000 to 200,000 square feet. It will be basically a whole building.
Operator
Your next question comes from the line of Mark Marostica with Piper Jaffray. Please proceed.
Mark M. Marostica
Just a follow-up on your comments regarding ramping up marketing spend in advance of the summer again. To that point, I am curious as to whether or not you are drastically changing at all your branding and marketing techniques this year for the summer versus last year.
What is changing in your marketing mix in terms of how you try to generate interest?
Michael Yu
Actually, not very much has changed for the marketing strategy. Mostly we are doing lectures all over China’s cities.
Last year, we did maybe 50 cities but this year, we go up to more than 100 because I think more students actually want to know about New Oriental's teaching style before they decided to come into New Oriental to study. This year, from March until the end of June, we are going to give more than 2,000 lectures all over China with our famous teachers, including me personally speaking.
Also, we are also going to do some marketing with part of the working -- on the side of the road --
Louis T. Hsieh
Billboards, kiosks?
Michael Yu
Kiosks, yes, with the kiosks. Also, we are going to do some brand impression marketing, like maybe in the train stations or in the airport or on the campuses of universities, actually.
So that should be spending more money than last year but it should inject more people because some will get a little bit more clearly before they decide to come to New Oriental to study. They should push more student enrolments into New Oriental.
Mark M. Marostica
Just one last follow-up on the marketing, should we expect that line item to still, in terms of how you think about the spend on marketing, should we expect that line item to grow slower than revenue or should we expect it grow faster than revenue going forward?
Louis T. Hsieh
It was 11% this quarter versus 12% a year ago, so it was revenue -- revenue should outpace marketing spend as a percent of revenue. The total marketing dollars will go up.
Mark M. Marostica
So you expect that 11%, 12% to be a good number as we look into the out years? Okay.
Perfect.
Louis T. Hsieh
For Q1, it won’t even be --
Mark M. Marostica
Right, right. I’m thinking more on an annual basis.
Michael Yu
I think the percentage of marketing of total revenue will go up a little higher for the fourth quarter of this fiscal year because we are going to get prepared for the first quarter of next year. For the first quarter of next year, the marketing will be lower because the total revenues are higher.
Operator
Your next question comes from the line of Scott [Scheissler] with Tiger Global. Please proceed.
Scott Scheissler
Congratulations on a great quarter. Just one quick follow-up question; you mentioned that the headcount, the G&A headcount went down by I think it was like 60 or 70 or 80 or 100 people during the quarter.
I was just wondering if you could go through the nature of why those people or why headcount got reduced. That would be great.
Louis T. Hsieh
I think a lot of it has to do with people leaving. We just are not hiring as many people in G&A, so as people leave, you know --
Michael Yu
Actually, it is a result of a kind of an order in our system building, because at the beginning of this year, I ordered all the heads of the schools to try to employ, to use more efficient people, to not use more people. I asked them to use five people to do ten people’s job with eight people’s money, actually.
That is why the number of people is coming down. But I also at the same time asked them to employ more talented teachers.
That is why our teacher number is going up, actually. It is a kind of strategy for the whole year.
Scott Scheissler
Just to follow up, has it impacted -- obviously it has a significant impact on margins. Do you guys have any -- if you guys were to compare where you are at now versus where you were at a year ago, what do you think the implication that that has long term on the margins?
Louis T. Hsieh
It has obviously a very positive implication. If you look at the first three quarters, I don’t have the total number yet but G&A and sales and marketing together are significantly down from last year as a percent of revenue, so we are getting at least 600, 700 basis points difference.
So it is having a huge impact and you see that at the bottom line.
Scott Scheissler
Lastly, was there a portion of the increased margin this quarter that was non-recurring? You know, you essentially -- you didn’t recognize too much revenue but you recognized revenue in accordance with U.S.
GAAP. Were pro forma margins this quarter actually lower than reported margins, just because of the way the timing worked?
Louis T. Hsieh
Gross margins were up year over year from 57% to 58%, but they are down from Q1, which was like 67%. So that is normal, but there is nothing -- no odd one-time revenue recognition issue.
We do everything in accordance with U.S. GAAP.
Operator
Your next question comes from the line of Lin Shi with Lehman Brothers. Please proceed.
Lin Shi
Thank you for taking my questions. I just want to follow up on the student enrolment question.
I noticed in the first three quarters of this fiscal year, the year-over-year growth of student enrolment has been slowing down, from 26% in Q1, 20% in Q2, and 8% in Q3. I know there is some particular reason for Q3, but I still wonder for Q1 and Q2, how we should look at the number.
Also, whether you can give me some color regarding the capacity utilization status of your existing learning centers. Thank you.
Louis T. Hsieh
I think the student number at 26% Q1, is that sustainable, and 20% is still high and 8% is too low. We have always guided around 10% to 14% student growth is reasonable.
Like I said, in Q3 we actually recognized RMB17 million of revenue from Q1 enrolment and RMB94 million from Q2 enrolment. So it is basically a lot of students are enrolling early, one or two quarters in advance, more so than they did in the past.
So that is one issue, but I think -- we are still guiding around 10% to 14% student enrolment growth is comfortable for us. I do not think this 8% -- this 8% is lower this quarter because Chinese New Year was late, and so students did not go back to school to register for classes until March.
March, as you know, falls into our Q4. Last year, because the Chinese New Year was earlier, they were enrolling for classes in February, which falls into Q3.
Also, we are going to get caught at some point by the law of large numbers. So as our student base will top over 1 million students this fiscal year, it is getting harder and harder to grow 20%, 25% on those kinds of numbers on a student count basis.
That is why we are guiding 10% to 14%. As far as capacity utilization, we mentioned earlier we do not really have any constraint on capacity.
19 of our schools have been open the last two years, so they are not even close to being full. The ones that are half on sort of being relatively utilized, we just open learning centers.
So in Shanghai, we opened three new learning centers this quarter. Learning centers are quick to put up.
They do not cost very much and they make money within three months. It is just not a way we really look at the business because it has never been a problem, other than during the summer.
Operator
Your next question comes from the line of Art [Defcone] with Oppenheimer Capital. Please proceed.
Art Defcone
Can you just quickly talk about a couple of initiatives of yours -- the road show you were recently on, talking about your consulting services and what type of impact we want to think about for the P&L and timing? And then also, the potential impact from the computer-based TOEFL and what that might do for pricing?
Louis T. Hsieh
The consulting business is just part of our other business. It is very small, so it is overseas consulting.
It is growing but it is just a small part of our business. On the computer TOEFL --
Michael Yu
Actually, it is building impact on students, also the pricing because we are using computers to teach students, so the price goes up. High-end students think it is very reasonable.
Also, because we have good lab facilities. Also, we publish a lot of computer-based TOEFL books only by New Oriental, so actually this attracts more students to come to New Oriental to study.
Generally speaking, in computer-based TOEFL training, we kind of monopolize the market actually. There are not really many other institutes who are training students.
Also, one thing is they do not have the lab facilities and they do not have the book. If they are going to use the book, we have logos on the cover of the books, actually.
Otherwise they have to pirate the books being used in their classroom, so this is another reason that we currently publish all the TOEFL books in China. This kind of stops other institutes from opening various TOEFL projects actually.
So this area, I think we occupy more than 90% of the market.
Art Defcone
But both too small at this point to start to think about in terms of an impact to the P&L?
Louis T. Hsieh
Could you repeat the question, please?
Art Defcone
Both of them are too small at this point to think about them having an impact on the P&L?
Louis T. Hsieh
The TOEFL has a huge impact on the P&L, because TOEFL is a big part of our business on the overseas test prep.
Art Defcone
I should say the move to the computer-based, is that anything significant?
Louis T. Hsieh
Whenever there is a course change and a new test, it kind of helps us if the students don’t feel they can just buy books and do it because it is so new. They will come to New Oriental to get the latest in a transition time period.
The dynamic education, the computer-based learning, is for Elite English only and that is too early, but that model we are comfortable with will be very profitable, because it lets us use fewer teachers and more computer-based training.
Operator
You have a follow-up question from the line of Trace Urdan with Signal Hill. Please proceed.
Trace Urdan
I’m sorry to come back one more time and I don’t mean to put you on the spot, but I wanted to ask you, there is news on the tape this morning that Kaplan is partnering with ACE Education to enter a market for prepping students in China for entry into U.K. universities.
I wonder if you could just talk about what that -- do the U.K. universities use the same standardized tests that the American universities do to look at students?
Do you know how your student body breaks down in terms of students who are looking to enter U.S. universities versus U.K.
universities? If you could just give a little color on that specific market, that might be helpful.
Michael Yu
The test that U.K. universities use is different from the test that is used by American universities.
The U.K. universities use IELTS to evaluate students’ English ability.
American universities use TOEFL to evaluate students’ English ability. On the IELTS side, we are not dominant.
We occupy about 55% to 60% of the market. There are some other institutes who are also doing the IELTS.
They occupy like about 45%, around 45% of the market. That is why this year we are doing a great marketing on the IELTS side to attract the students to come to New Oriental system to study.
Also, what they are doing, they combine the teaching, studying with application together so that it is easier to apply for U.K. universities.
That is what exactly we are doing from actually three months ago, so I think we feel comfortable to occupy these market opportunities that combine students’ teaching, learning, teaching, application for universities and then for their [language services] also. Chinese students actually nowadays are looking more and more to go study in the United States and Canada universities, actually.
To my knowledge, more and more high school students actually are applying for United States universities instead of U.K. universities because of the America maybe [advocates] or the university recognizes that Chinese students really have money and that it is also -- since the year before last, it is easier for Chinese students to get a visa to study in the United States.
It is almost as easy as students can get a visa in U.K. universities.
The reason for students to go to the U.K. is that several years ago, the visa was easier to get from the U.K.
Also, the universities are easier to get for students. Nowadays, this transition has been happening in the United States, so that is why yesterday we got the news that an Asian student killed many American students.
We were so afraid and we were afraid that that was a Chinese student. The fact is that it is a South Korean student is a relief, actually.
Louis T. Hsieh
It was a South Korean student who had been in the U.S. since he was eight years old, so --
Michael Yu
So it is not a Chinese student problem.
Louis T. Hsieh
It was actually reported in China that it was a Chinese student.
Michael Yu
Yes, so everybody was scared, actually.
Operator
We are now approaching the end of the conference call. I will now turn the call back over to the New Oriental Chief Executive Office, Michael Yu, for his closing remarks.
Please proceed, sir.
Michael Yu
Thank you, everybody. You gave us a lot of good questions.
I do not know whether we have given you the answers, but anyway, we are going to do our best for the results, for revenue, for profit, and also for marketing for our future, for our common future since you have invested money into New Oriental. If you have any further questions, please do not hesitate to contact Louis, or any other of our investor relations representatives.
In case of emergencies, then contact me. Thank you.
Have a good night and a good morning. Bye-bye.
Operator
Thank you for your participation in today’s conference. This concludes the presentation.
You may now disconnect. Good day.