After Rapid Expansion, New Oriental Education Flexes Its Leverage Muscles

For-profit education may not have a great reputation in North America, but it's an entirely different story in China. Case in point: New Oriental Education (EDU 2.77%), a company that has pivoted from focusing on English-language, overseas test prep to K-12 after-school tutoring.

The company has used its scale to offer affordable options for parents looking to give their children an upper hand. Given the growth of the business, it appears to be resonating with Chinese families. The company's second-quarter earnings release, made public on Tuesday, further reinforces this narrative.

Image source: Getty Images.

New Oriental Education earnings: The raw numbers

Before we dive into the details for New Oriental, let's review how the company did on the headline numbers:

Data source: New Oriental Education. EPS* presented on non-GAAP (adjusted) basis per American depositary shares.

There are a lot of important moving parts here. First, no one likes to see earnings or free cash flow growing slower than sales. This can be a warning that a company doesn't have leverage -- and is spending far too much to chase after growth.

But this is where context matters: New Oriental is in the middle of a massive expansion into "lower tier" cities in China. It costs a lot to build, buy, or rent space to house learning centers and hire teachers. And these schools aren't immediately at full capacity -- meaning there's a lag between opening and full utilization.

So investors shouldn't be too worried about slower earnings growth. All things considered, the company showed impressive leverage. Its non-GAAP (adjusted) operating margin -- which factors out stock-based compensation -- improved 100 basis points year over year to 12.2%. This was helped by the fact that selling and marketing costs rose just 5% while general and administrative expenses rose just 19%.

Diving deeper into the company's leverage

The key for any for-profit education company is growth in enrollment. Over the past year, New Oriental expanded its total square footage by 24% -- highlighting the company's growth ambitions. By the end of the quarter, there were 1,233 learning centers and schools in China, a marked increase from 1,081 at the same time last year.

But enrollment during the second quarter rose at a much faster pace -- 34% total to 2.76 million students. That's an enormously positive sign for the company: Growth isn't only coming from opening new locations -- existing locations are adding students, too.

In essence, New Oriental's moat comes from two sources: scale creating lower prices, and the network effects of best practices. The larger New Oriental becomes, the better it is able to teach existing students. This is because costs can be spread out over more locations, making it possible for New Oriental to offer lower prices relative to the competition. The second form of network effects comes from the ability to correlate and compare best practices in-house -- building the faith that families put into the company in helping their children.

A great example of how this plays out comes from the company's recent summer promotion. It offers deals for rising seventh graders to lock them into the company's programs before they start secondary school. The idea is that these deals will pull students into New Oriental's ecosystem, and keep them there for the next six years.

New Oriental pulled in 765,400 students via this summer promotion. While that might seem impressive, that's only 4% more than last year. But there's a huge difference of note: Last year, the price was 200 yuan (roughly $30); this year, it was 400 yuan. The fact that enrollment was able to grow despite the prices doubling is impressive. It also makes it more likely that New Oriental will be able to retain the students it has, given these parents are willing to pay higher prices. And indeed, management stated in the conference call that the student retention rate was increasing.

What else happened during the quarter?

Here are other notes from New Oriental's second quarter:

• The company ended the quarter with $3.2 billion in cash and investments, versus just $96 million in long-term debt.
• The dual-model classroom -- which has a master teacher instructing via the internet with assistants in the physical rooms -- has continued expansion and will continue to be rolled out.
• Overall, K-12 after-school tutoring was the main driver of growth, with revenue jumping 29% (37% in local currencies).
• Within that category, the middle- and high-school program saw revenue growth of 27% (36% in yuan), while the POP program for younger students grew 31% (40% in yuan).

Looking ahead

At the end of his prepared remarks, CEO Chenggang Zhou said the company had a number of priorities for the upcoming year:

• Continuing expansion of off-line sites, with a square footage increase of 20% in the year ahead.
• Continuing the rollout of the dual-teacher model in lower-tier cities.
• A focus on online-to-offline integration.

But above all, the company is focused on optimizing utilization. Which means the company wants its schools -- especially the newer ones -- to have as many students as possible.

Management expects revenue in the coming fiscal year -- which began on June 1 -- to come in between $1.050 billion and $1.075 billion. If the company realizes that target, it would represent 24% growth at the midpoint in dollars, and 28% in yuan.