Chinese education company New Oriental Education (NYSE:EDU) this morning released earnings that show some progress in key areas, but also highlight the challenges the company will face in the coming quarters.
Wall Street appeared initially generally pleased with the fiscal second-quarter numbers, as shares popped as much as 6% on the market's opening, though shares dropped later in the day. Given that, we'll focus first on the good news for shareholders before diving deeper into the headwinds.
Enrollment picks up once again
When it comes to for-profit educators, no metric is more important for long-term investors to monitor than enrollment. In 2014, New Oriental stock lost almost one-third of its value, thanks in large part to slowing revenue growth and projections for meager enrollment growth.
As you can see in the chart below, before today, the prior three quarters had not offered much to get excited about -- with the last quarter in particular raising a red flag as enrollment dropped 3.4%.
However, the slowing growth in all the quarters except the third quarter weren't nearly as bad as they seemed. New Oriental has shifted its focus from rapid expansion of learning center locations to concentrating on making existing locations more popular destinations for students.
Therefore, even the though number of locations has actually shrunk, the fact that enrollment was still picking up -- and increased at a very nice clip in the last quarter -- is good news for investors.
Positive momentum in enrollment, however, does not mean New Oriental is free of challenges. Though revenue was up 13.4% for the just-reported quarter, expenses grew 20%, with the bulk of that increase coming in the form of raises in teacher salaries.
In general, if you're a for-profit educator looking to differentiate yourself from the competition, it's a good thing to pay your teachers well. However, such expense increases were only half the reason for shrinking profitability. The other half were significant discounts to students -- explained as a "customer loyalty program" -- especially those entering the seventh and 10th grades.
This fits into the company's larger shift occurring away from adult English language learners -- where, according to the company's conference call, enrollment fell 30% -- and focusing more on K-12 students and after-school programs. The loyalty program seems to be working for now, as enrollment at after-school tutoring programs jumped 40%.
What investors need to watch moving forward
Looking ahead, margins will be an important factor to watch. Management was clear that some of the slowing revenue growth came from increased competition. The more for-profit education becomes a commodity, the more New Oriental's margins could suffer.
After widening continuously throughout 2013, the company's net margin suffered last year, and investors should look for stabilization in this metric in the year to come.
The company is trading for roughly 16 times earnings and just 11 times free cash flow.
If the company's loyalty program can attract and lock in new students for the long haul, this could be a great buy price. If, on the other hand, competition continues to eat away at New Oriental's business -- or force it to offer steeper discounts -- it could be bad news for shareholders.
Brian Stoffel owns shares of Apple. The Motley Fool recommends Apple and New Oriental Education. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.