As the old saying goes, "You need to strike when the iron is hot." Management at New Oriental Education & Technology Group (EDU 3.06%), a provider of in-person and online after-school tutoring in China, knows that the business is red-hot right now; it is striking by leveraging its balance sheet and growing brand by pushing a massive expansion throughout the Middle Kingdom.

That context is important to keep in mind. While the company's earnings release this week might have shown income growth that left much to be desired, the top line remains very healthy -- and the company is aggressively investing in its future.

Three Asian elementary school children standing in front of chalkboard underneath chalk-drawn mortarboards

Image source: Getty Images.

New Oriental earnings: The raw numbers

Before we dive into the nuts and bolts of the company's earnings, let's take a look at the headline numbers.

Metric Fiscal Q3 2018 Fiscal Q3 2017 Year-Over-Year Growth
Revenue $618 million $438 million 41%
Non-GAAP EPS $0.57 $0.48 19%
Free cash flow $48 million $77 million (38%)

Data source: New Oriental Education. GAAP = generally accepted accounting principles.

As I alluded to earlier, it's important to keep the profit and free cash flow growth in perspective. Between February 2017 and February 2018, New Oriental increased its number of schools and learning centers by a whopping 25% to 1,000 -- and total square footage jumped 41%.

When such a build-out occurs, there's typically a lag. New Oriental has to pay for the buildings to be constructed or renovated, hire staff, and pay for local advertising. But students don't fill those learning centers to capacity for a while. We are right now in that lag.

That said, metrics continue to be impressive for the company. While total enrollment climbed just 7.7% during the quarter, this has more to do with the timing of winter/spring class sign-up than anything else. This year, that push fell in the second fiscal quarter. Taken together, the company showed robust enrollment growth of 30% spread across the past two quarters. Additionally, student registrations were up a whopping 65% during the first eight weeks of the fiscal fourth quarter.

Because students often pay for a full semester's worth of after-school tutoring, but that revenue is recognized over time, it's also crucial to track New Oriental's backlog of deferred revenue. On that front, there was again a strong showing: deferred revenue climbed 43% to $1.08 billion.

In the earnings release, CEO Chenggang Zhou said: "We are committed to sustaining a healthy balance between top line and bottom line growth as we execute our well-proven 'Optimize the Market' strategy. Following a strong track record in the previous three quarters, we continued to make great strides in our planned acceleration in capacity expansion across cities with superior growth potential and higher operating efficiency."

What else happened during the quarter?

  • The key growth driver -- K-12 after-school tutoring -- showed revenue growth of 51%.
  • POP kids program clocked in with 50% revenue growth.
  • The online-to-offline (O2O) program saw revenue grow 63%.
  • Starting off of a much smaller base, the online-only K-12 after-school tutoring program witnessed 176% revenue growth.

One of the reasons New Oriental saw such robust revenue growth was because it used heavy promotional activity a year ago to entice students and families to join the company's ecosystem. One year out, we are now seeing the fruits of those decisions.

Moving forward, New Oriental's brand remains paramount in attracting new students. The school has the scale to provide classes at competitive prices that smaller schools can't afford, and once in the ecosystem, parents and families also face mildly high switching costs. The move toward more online learning tools also offers the chance for higher-margin enrollments.

Looking ahead, New Oriental plans to continue pushing the expansion of its physical locations. It will reinvest heavily in research and development as it tests out new online-only versions of its programs, and expects revenue growth to come in at a healthy 36% to 40% clip in the fiscal fourth quarter of 2018.