Article / 21 July 2015 at 23:31 GMT

Earnings Review: New Oriental passes the test but costs are high

China Watcher / Shanghai
China
  • Reaction to New Oriental's results was mooted despite beating expectations 
  • Its customer loyalty program aided results
  • The high enrolment figures for the quarter are slightly misleading
  • Operating expenses are growing due to higher R&D costs

By Neil Flynn

New Oriental Education released its fiscal fourth quarter and full-year earnings report on June 21, with the headline revenue and earnings beating expectations. Despite this, the reaction in the market was rather mooted, with the share price closing up 0.55% to $23.75. Here are three key points from the earnings release. 

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Enrolment numbers were high for the fourth quarter but the numbers were slightly distorted due to the timing of the Chinese New Year. Photo: iStock

Headline results beat

New Oriental posted revenue of $328.8 million, which beat management’s guidance midpoint of $327.8m and analysts’ consensus of $326.8m. This represented 14.3% sequential growth and 14.4% annual growth. 

This concludes a disappointing year for the firm, in which it posted its lowest annual growth rates over the past three years. The firm also posted earnings (Non-GAAP EPADS) of $0.26, which beat analysts’ consensus of $0.21. This is encouraging progress after the weak earnings performance in the first half of the fiscal year in which both revenue and earnings failed to beat consensus. 

The customer loyalty program that was implemented in the fiscal second quarter aided the revenue growth. When customers make a purchase, they receive points to the value of between 2% and 5% of the purchase price, which can then be spent on future tuition fees. This is to encourage customer retention, and the deferred revenue resulting from this contributed $5.3m to total revenue during the quarter.
New Oriental's revenue history
Source: New Oriental Education

The company announced revenue guidance of between $441.3m and $457m for the fiscal first quarter, which implies sequential growth of between 34.2% and 39%, and annual growth of between 12% and 16%. This suggests that investors will see a continuation of the slower revenue growth that dogged the fiscal year 2015.

Student enrolments appear to show big increase

The fiscal first quarter is typically when New Oriental experiences strong student enrolment growth, but the firm posted a 29.9% sequential increase to 783,400 during the fourth quarter. It should be noted that due to the late timing of the Chinese New Year, which concluded at the end of the fiscal third quarter in February, the firm didn’t record the post-New Year enrolment growth that it typically does. However, it was instead recorded in the fiscal fourth quarter, at the start of March, hence why New Oriental posted the notably high enrolment figures for the quarter.

As you can see, the fiscal third quarter is typically the second strongest of the year, compared to the weakest being in the fiscal second quarter. The average combined increase in student enrolment numbers in the third and fourth quarters over the second quarter is approximately 120,000 over the past three years, and 150,000 when the unusually low 2014 figure is excluded. 2015 saw a combined increase of 143,400, so the large enrolment number isn’t as impressive as it initially seems.
New Oriental's student enrollments
Source: New Oriental Education

Fiscal year 2016 should see a return to standard enrolment trends, and this should allow investors to see the true performance of the different business segments. The K-12 after-school tutoring business saw 57% enrolment growth during the quarter, and 21% revenue growth, but this growth was distorted by the enrolment growth during the quarter.

Growing operating expenses may be a concern


The firm has been focusing on building out its online and O2O services, but this has caused a notable increase in R&D costs. Operating income fell 26.9% annually to $22.49m. This is a disappointing result for the firm, as it had been increasing its operating income over the past three ears. 

The fourth-quarter operating margins between 2012 and 2014 were 8.6%, 11.8%, and 14.9% respectively, but 2015’s decline to 10.7% is concerning. Competition in the industry is growing, and the firm is understandably investing in R&D in order to maintain its market position. However, investors may have to accept growing operating expenses in 2016.
New Oriental's profit margins
Source: New Oriental Education. 
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I have long been bullish over New Oriental’s partnership with Tencent, which has seen the release of an English learning app called uDa, specifically for the Gaokao (Chinese university entrance exam). The intention is to launch a similar app for each Gaokao subject. 

However, over the past few months, rival apps have been spending heavily on advertising and marketing. I have previously discussed the launch of 51Talk, from 51Jobs, which is an English language-learning app that connects Chinese students with English speakers, for a very low price of between RMB 8 and RMB 15 for a 25-minute class. 

New Oriental could argue that for other subjects, the uDa app is the best on the market, but the 51Talk app format is the best way for students to learn English. The issue is that as operating expenses are growing due to higher R&D costs, I expect that we will see further expense growth as competition in the industry increases.

– Edited by Gayle Bryant

Neil Flynn is a portfolio manager at Alcuin Asset Management. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.

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