More than a year ago, New Oriental Education & Technology Group (NYSE:EDU) signaled that it would be undertaking a massive expansion effort. The move made sense: The Chinese education market is largely fragmented, and the company's scale allows it to offer after-school and supplementary tutoring at slightly lower costs than smaller operations.
The move is largely paying off. While the company has yet to realize the full benefits of its additional scale, this week's earnings announcement for the second fiscal quarter of 2019 is an indication that students and their families are flocking to -- and, increasingly, staying with -- New Oriental's learning centers.
Before we dive into the details, let's take a look at the headline numbers.
|Metric||Q2 2019||Q2 2018||Year-Over-Year Change|
|Revenue||$597 million||$467 million||28%|
|Free cash flow||$82 million||$123 million||(33%)|
There are a couple of crucial caveats that go along with these results. On the negative side, GAAP earnings actually came in at a loss of $0.16 per share, versus a profit of $0.03 per share in the year-ago period. The difference was accounted for by (1) excluding share-based compensation and (2) a change in accounting rules which requires changes in the fair value of long-term investments to be recorded as a gain or loss. New Oriental's long-term investments realized a $35 million loss, which made up the lion's share of the GAAP shortfall.
On the positive side, revenue increases were even stronger than reported above when kept in constant currency (yuan). If reported as such, the company's sales would have grown by 34%.
The most important long-term indicator
But as important as those numbers are in the short term, enrollment numbers always have been -- and will be -- the real indicator of long-term health for education organizations. And on that metric, New Oriental continues to do exceptionally well.
|Metric||Q2 2019||Q2 2018||Year-Over-Year Change|
|Schools and centers||1,125||940||20%|
There are lots of ways you can parse this. On one hand, enrollment is growing faster than school and learning center expansion, which means that New Oriental is drawing more customers even in mature markets. A more pessimistic angle would be that while enrollment grew 24%, square meterage jumped 30% year over year.
But even that would come with the caveat that these newer, larger learning centers take time to fill. New Oriental can't set up shop and expect to be at full capacity on day one. That also helps explain why the company's free cash flow shrank (building new centers), and why operating expenses grew faster than sales; you have to pay for the buildings and teachers even before the tuition-paying students arrive.
In the earnings release, founder and Chairman Michael Yu said, "We are pleased to see our overall business continue its strong momentum in the second quarter of fiscal year 2019. ... This was driven largely by our key business unit, K-12 all-subjects after-school tutoring."
He broke down where all that growth came from:
- K-12 after-school all-subject tutoring saw sales increase 38% (44% in yuan).
- U-Can middle and high school tutoring revenue jumped 39% (46%).
- POP Kids program -- which focuses on younger students -- saw sales increase 35% (41%).
What else happened during the quarter?
There were several tidbits worthy of mention from the quarter, including:
- Deferred revenue jumped 10% to $1.14 billion. This figure is lower than investors are used to, but it was due largely to changes in how tuition is collected.
- A new three-year, $200 million term and revolving credit agreement was entered into. The money will be used on share repurchases and business operations.
- New Oriental ended the quarter with roughly $3 billion in cash and investments, and zero long-term debt.
But the most important piece of news for long-term investors came from CEO Chenggang Zhou (emphasis added):
Starting from the fiscal year 2019, we initiated a pilot program to standardize teaching content and methodology in the U-Can middle and high school tutoring business, which has started to bear fruit as we achieved a remarkable increase of customer retention. As we develop best practices gradually, we will begin to roll out the pilot program in our online and offline K-12 tutoring business to further improve teaching quality. We believe this will in turn boost our competitive advantages as we offer the best learning experience to our students.
Long-term investors know the key to a great investment is the strength of the moat protecting it. What Zhou highlighted is vitally important: By investing money in researching, developing, and teaching best practices, students were more likely to stay in the U-Can program.
It takes time and money to develop those programs, and New Oriental's war chest gives it the ability to invest in this crucial aspect -- something smaller players don't have. It increases positive outcomes for students and the company alike. Applying those same tactics to the K-12 program -- the most important division at New Oriental -- could bear significant fruit for investors.
For the third fiscal quarter of 2019, New Oriental expects revenue in the range of $770 million to $793 million. If it hits the midpoint of that target, it would represent an increase of 26.5%. If, however, that increase were realized in yuan, it would be even higher -- clocking in at 34%.