Ladies and gentlemen, good evening and thank you for standing by for New Oriental's fiscal quarter 2016 earnings conference call. At this time, all participants are in the listen only mode. After management's prepared remarks, there will be a question and answer session. Today's conference call is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the call over to your host for today's conference, Ms. Sisi Zhao, New Oriental's Investor Relations Director. Ms. Zhao, please proceed.
Thank you. Hello, everyone, and welcome to New Oriental's third fiscal quarter 2016 earnings conference call. Our financial results for the period were released earlier today and are available on the company's website, as well as on Newswire services. Today, you will hear from Stephen Yang, Chief Financial Officer. After his prepared remarks, Stephen will be available to answer your questions. Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involving higher risks and uncertainties. As such, our results may be materially different from the views expressed today. A number of potential risks and uncertainties are outlined in our public filings with the SEC. New Oriental does not undertake any obligation to update any forward-looking statements, except as required under applicable law.
As a reminder, this conference is being recorded. In addition, a webcast of this conference call will be available on New Oriental's investor relations website at investor.neworiental.org. I will now turn the call over to Mr. Yang. Stephen, please.
Thank you, Sisi. Hello, everyone, and thanks for joining us on the call. We're pleased to report another quarter with solid results. The fiscal second half year is traditionally the peak season for our K-12 all subjects after school tutoring business, as national exams for college, high school entrance, and final exams for all grades approaching. During the third quarter, we did exceptionally well on the top line, with revenue up 20.6% year-over-year to $346.9 million and total enrollment up 25.2% to 755,100. If not including the impact from the RMB depreciation, our revenue growth would have been 26.4%. Our continuing intensive efforts to introduce the new O2O two-way interactive education system proved to be a satisfactory investment of time, capital, and resources.
We are pleased about growth in our K-12 all subjects after-school tutoring business, which consistently has been delivering strong growth with revenue up 35% and enrollment up 31% year-over-year in the third quarter. At end of third quarter, our newly revamped POP Kids program experienced a revenue increase of 40%, and new product reached 50 cities, up from 44 in the second quarter. U-Can visible progress system that is being used in all 54 existing cities, has been enjoying growing recognition from both parents and students. To add to that, the current market conditions are favorable to us as we are seeing Chinese parents are more inclined to invest in education with the economy slowing down slightly. With all of this, we have been able to bring in more new customers, and more customers are choosing to stay with New Oriental.
To further leverage the success achieved by the O2O system, we expanded the investment in integrated education further to other key business lines. In March, we officially launched the IELTS interactive education system, which is the O2O solution for our overseas test prep business in three major cities in China. We are definitely committed to build out our O2O system going forward and to maximizing its profitability. Turning to pricing, per program blended ASP slightly decreased by 1% year-over-year. On an apple-to-apple basis, which is GAAP revenue divided by total teaching hours, hourly blended ASP increased by about 1%. A breakdown of the hourly blended ASP: U-Can was flat, POP Kids increased above 5%, and overseas test prep program increased about 4% over year-over-year.
The slowdown of overall hourly blended ASP growth is mainly due to the shifting of revenue from overseas test prep business with higher ASP to the U-Can POP Kids classes. This growth rate will calculate in U.S. dollar terms, so the RMB devaluation has negatively impacted our ASP growth by about 5%. We are pleased with the expansion of the operating margin in the third quarter, which was achieved through constantly improving operational efficiency and stringent cost control. During the third quarter, operating income increased by 32.6% year-over-year, and operating margin increased by 110 basis points to 12.2% from 11.1% a year ago. To be sure, we will continue to drive efficiency and bring value to our customers, which will ultimately create sustainable long-term growth for our business. Let me walk you through our performance across individual business lines.
Our K-12 all subjects after-school tutoring business achieved gross revenue growth of about 35% year-over-year for the third quarter, enrollment growth of about 31%. Breaking it down. The U-Can. middle school, high school, all subjects after-school tutoring business achieved a gross revenue increase of about 33% year-over-year. Student enrollment grew approximately 31% year-over-year. Our POP Kids program continued to generate real momentum with gross revenue significantly up, about 40%, enrollment up 31% year-over-year. Our overseas test prep and consulting business achieved revenue growth of more than 7% year-over-year. Revenue for VIP personalized class business increased approximately 22% year-over-year. I will provide some updates on ongoing execution for our optimized market strategy that requires healthy balance between top line and bottom line growth while investing heavily in the build-out of our O2O integrated education system.
In the third quarter, we opened a new school in the city of Zhuhai, the fastest growing city on the southern coast of China. We also added a net of six learning centers and expanded 13 existing ones, adding approximately 10,000 sq m of classroom area. For the rest of the fiscal year, we will continue with our expansion plan and add additional capacity in cities with the greatest potential for both growth and profitability. We believe that we have sufficient capacity to support our business for the rest of the fiscal year, which as mentioned earlier, is the peak season for New Oriental. Turning to our online business. We invested $13 million in refining our O2O system and pure online learning platform in the third quarter. Most of which were reported under cost of goods sold and G&A expenses.
We are managing it well within the $15 million investment plan for the fiscal year, which we previously indicated is our target this year. The success of our O2O system is not only driving our revenue growth in K-12 business, but also proven to be effective in other business lines. Customer retention rates increased and new customers are coming in due to excellent market feedback. Before I go into the details about our online business, just to quickly recap the 3 levels of our online platform. The first level, also the core of our online system, is an O2O two-way interactive education system across all of our business lines. The second level is our pure online learning platform, the supplementary online education products under the New Oriental brand.
The third level of our ecosystem is for New Oriental to take minority shareholdings in online education companies that complement our own online education offerings. Let's start with O2O two-way interactive education system, which extends New Oriental traditional offline classroom teaching offerings to online education services. Solid progress was made on all fronts. U-Can visible progress teaching system. Our interactive education system has been used in all 54 existing cities at the end of the quarter. POP Kids program, including our new product, Shuangyu in Chinese pronunciation, had another strong quarter with revenue up approximately 40%. This is a record high since the revamp in 2014. Enrollment was up more than 31% year-over-year. By end of third quarter, it has expanded its reach over 50 cities in China, and we expect the growth trend to continue for the rest of the year.
The O2O system for the domestic test prep program was being used in five cities by quarter end. Since its launch in the second quarter, the O2O system for overseas test prep program has been introduced and is now being used in three cities. For the second level of our online education ecosystem, we have seen healthy growth in our pure online learning platform and other supplementary online education products. In the third quarter, koolearn.com generates net revenue of $12.7 million, up 24.7% year-over-year. The number of paid users increased over 71% year-over-year. The number of cumulative registered users has reached more than 12.8 million. To add to this great result, the operator of our Koolearn platform received an investment of $50 million from affiliate of Tencent Holdings Limited.
You may find more details there. koolearn.com, our own online broadcast open platform for both New Oriental and third-party teachers, achieved over 756,300 registrations. Donut, the series game-based mobile learning apps for children, recorded over 38.2 million downloads. LeCi, English language vocabulary training app for mobile phones and tablets, reported about 3.8 million users by quarter end. For the 3rd level of our online education ecosystem, we invest in select online education companies with a minority stake, and we keep looking for new opportunities that will not only complete our own offerings, but also facilitate our own O2O integration. Let me walk you through the other key financial details for the third quarter. Operating costs and expenses for the quarter were $304.26 million, a 19.1% increase year-over-year.
Non-GAAP operating costs expenses for the quarter, which excludes share-based compensation expenses, were $300.2 million, a 19.2% increase year-over-year. Cost of revenues increased by 15.1% year-over-year to $145 million, primarily due to increase in teachers' compensation for more teaching hours. Selling and marketing expenses increased by 8% year-over-year to $45 million, primarily due to increase in brand promotion expenses and selling and marketing staff's compensation. General and administrative expenses for the quarter increased by 30% year-over-year to $114.6 million. Non-GAAP general and administrative expenses, which excludes share-based compensation expenses, were $110.1 million, a 30.8% increase year-over-year, primarily due to increase in R&D expenses and human resources expenses related to the development of our O2O integration. Total share-based compensation expenses, which we'll allocate related operating costs and expenses, increased by 12.5% to $4.4 million in the third fiscal quarter.
Operating income for the quarter was $42.3 million, a 32.6% increase compared to $31.9 million in the same period of the prior fiscal year. Non-GAAP income from operations for the quarter was $46.7 million, a 30.4% increase compared to non-GAAP income from operations of $35.9 million in the same period of the prior fiscal year. Operating margin for the quarter was 12.2% compared to 11.1% in the same period of the prior fiscal year. Non-GAAP operating margin, which excludes share-based compensation expenses for the quarter, was 13.5% compared to 12.5% in the same period in the prior fiscal year. Net income attributable to New Oriental for the quarter was $48.4 million, representing a 16.8% increase from the same period of prior fiscal year. Capital expenditures for the quarter was $19.4 million, this was primarily attributable to the opening of 20 new learning centers and the renovations at existing learning centers.
Turning to the balance sheet. Deferred revenue balance, which is cash collected from registered students for courses and recognized proportionally as revenue as the instructions are delivered, at the end of the third quarter, was $585.3 million, an increase of 37.8% as compared to $424.9 million at the end of the third quarter of fiscal 2015. Before we move into the Q&A session, let me go through our expectations for the fourth fiscal quarter. We expect total revenues to be in the range of $378.1 million to $391.3 million, representing year-over-year growth in the range of 15%-19%. If not including the impact from the recent RMB depreciation, the projected revenue growth rate will be in the range of 20%-24% for the fourth quarter of fiscal year 2016.
Some of you may be aware that starting in May this year, China's tax reform of replacing business tax with a VAT, value-added tax, will expand to the customer service sector. As a result, some business units of New Oriental may need to start paying 6% VAT for their gross revenues instead of 3% or 5% business tax, which is what we have been doing during past years. For the fourth quarter of this fiscal year, the impact will be minimal as it only affects one month. We expect that the negative impacts on our top line to be around 1% for the fourth quarter. This was already factored in the revenue guidance I just shared. This forecast reflects New Oriental's current and preliminary view, which is subject to change. At this point, I will take your questions. Operator, please open the call for this.
Thank you. The question and answer session of this conference call will start in a moment. In order to be fair to all callers who wish to ask questions, we will take one question at a time from each caller. If you have more than one question, please request to join the question queue again after your first question has been addressed. To ask a question now, please press star one on your telephone and wait for your name to be announced. If you wish to cancel your request, please press the pound or hash key. Your first question comes from the line of Julie Pan from Macquarie. Please go ahead.
Hello, Steve, and hello, Sisi. Thank you for taking my question. Congratulations for another strong quarter. I have two questions. First one is, we see an encouraging improvement in the margins in this quarter with only seven increase of learning centers. We do believe the margins improvement to continue, but do you think you can expand your learning centers in a faster pace in this stage, given your market share in China and even in Beijing is still low at single digits? My second question is about POP Kids. POP Kids shows a really strong growth in this quarter of 40%. Do you think the faster growth in POP Kids than U-Can session to continue? What do you think the main driver behind this other than the O2O injection? Thank you.
Thank you, Julie. Your first question is about expansion plan. We opened seven new learning centers in Q3, and I think in the coming Q4, we plan to set up 10 to 15 new learning centers to prepare for the new fiscal year. I think the K-12 market is huge. In next fiscal year, I think we plan to open 30, 40 new learning centers. But compared to the 720 learning centers we have in hand, it will count for only 3%-5%, it will not drag the margin. I think it will continue, we will see the market expansion continuously because of the business leverage. This is my answer for the first question. Also, I want to add one point. Last fiscal year, we spent $39 million on investment for O2O and pure online. This year, we spend $50 million.
Last year and this year are the peak for the investment. Next year, I think we can cut some expenditures for the investment. This is another driver for the margin expansion. Your second question is for POP Kids. Yes, we did a very strong quarter in Q3. I think besides the O2O product, which is popular among the parents and students, I think the trend will continue. Going forward, I just want to guide the POP Kids program grow by let's say 25%-30% year-over-year growth. Another reason is, as I mentioned earlier, the K-12 market in China is huge, it's very fragment. I think the big player like New Oriental will take more market share from small players. That's my answer. Is this clear?
Thank you. Our next question comes from the line of Zoe Zhao from Credit Suisse. Please go ahead.
Hi, management. Congratulations on a strong quarter. I have two questions. One is, can you please provide an update on the upcoming summer promotion plan? The second one is, can you update us with the utilization rate, given that our gross profit margin has been improving, it seems that our VIP revenue growth is also pretty strong this quarter. That's my question. Thank you.
The first question about the price strategy. As some of you have heard, the class with a very low price in the market. I think we start to provide the lower price summer math class for grade 7s since several years ago in Beijing. The purpose of this is to attract more students to try our classes. I think this strategy turns out to be successful. I think this is one of the reasons why the Beijing K-12 business performed well in the past three, four years. We will continue do that in Beijing this summer and spread other core cities. Upon this, we expect to accelerate the market consolidation. The small players can't afford that.
In terms of the impact for the margins in the coming Q1, I think the impact will minimal because the students enrollment for the low price, it accounts for only small parts of the total enrollment. The impact will be minimal. Your second question about the utilization rate. In the third quarter, our utilization rates continue to go up. Now we're 20%. Last year was about 18%, that means 200 basis points up. I think going forward, we will see the utilization rate going up. Because last thing about that, if we open the new learning centers about 3%-5% compared to the learning centers we have, it will not break the margin. That means we will see more students fit in the current classrooms. Most of the growth going forward will be the organic growth. Does it answer your question?
Thank you. Our next question comes from the line of Tian Hou from TH Capital. Please ask your question.
Hi, Sisi, Stephen. The question is related to your upcoming plans for the Koolearn to be listed in the local market. Can you give a little bit color on this upcoming local listing and how your investor is going to benefit from such listing?
Thanks. Yeah. I know I'm talking about Koolearn potential listing, as we mentioned in February's announcements. What I can say is we're still in the planning phase, we still need more time to work with the other groups. It's too early to say. In my opinion, I think if we put the Koolearn to be listed in China markets, it will give us the more strong brand name, we can raise some money. I think more Chinese people will know Koolearn. That's the benefit. Yeah.
Mm-hmm. Okay.
Yeah.
Thank you. Our next question comes from the line of Fan Liu from Goldman Sachs. Please go ahead.
Hi, Stephen. Hi, Sisi. Thank you for taking my questions. Just two quick questions. Number one is about your, if that is possible, would you mind sharing with us the utilization and also the margin profile for each segment? I mean, including overseas test preparation and also U-Can and the POP Kids. The second question is about your revenue growth in Beijing and Shanghai this quarter. Would you mind sharing with us as well? Thank you.
Okay. Thank you, Fan. In terms of the operating margin of different business lines, the overseas test prep, the operating margin before the head office overhead is about 30%. For the U-Can, the operating margin is about 25% or a little bit more than 25%. For POP Kids, now it is 13%, 14%, the operating margin before the head office overhead. It is at least 200, 300 basis points up compared to last year. We are seeing the higher utilization rates for POP Kids. This is the key operating margins for the different business lines. Your second question is about Beijing, the revenue growth in Shanghai.
Yeah. Beijing's revenue growth is about 22% this quarter, 20 plus, and Shanghai is around 14%-15%.
Yep.
Okay.
Thank you, Fan.
Thank you. Our next question comes from the line of Anne Shih from Brean Capital. Please ask your question. Anne Shih from Brean Capital, your line is open. Please ask your question. Thank you. We will move on to the next question. The line comes from Alvin Jiang from Deutsche Bank. Please go ahead.
Hi, Stephen, Sisi. Congratulations on the strong quarter. I have a quick question on the retention rate. You mentioned that the retention rate improved a lot in this quarter. Can you give us more color with the numbers on that? Thank you.
Okay. Thanks, Alvin. The retention rate in this quarter is about more than 70%. I think so somewhere between 70%-75%. Compared to last year, the number was 60%-65%. It's improved a lot. Because I think the new O2O product, especially for the K-12 business, when the students start to use the new version products, I don't think they will stick with us or the kids stay with us. That's why we're seeing the higher retention rates compared to last year. Going forward, you will see the retention rates go higher in the future.
Great.
Yeah.
Great. Thank you.
Thank you.
Thank you. Our next question comes from the line of Anne Shih from Brean Capital. Please go ahead.
Hi, Stephen, Sisi . Sorry about that earlier. Thanks for taking my questions. You mentioned that the O2O investments should decline in fiscal 2017. Wondering if there is a specific level that you're thinking of, and what will it be focused on in terms of the spending? I also have a follow-up question from earlier in the call on pricing. I think this year the strategy for K-12 was on gaining enrollments, but average pricing was kept more stable with plans for, I think, pricing power to be flexed next year. Is this still the target? What's the likely growth we can probably see on average, even with the summer promotions in Q1? Thank you.
Okay. In terms of the investment for the O2O and purely online, we spent $15 million this year. Next year, I think we can cut some expenses for this. Let's say the $45 million or $40 million, because I think mostly we'll keep almost all the IT staff and content writers going forward. I think in next year, we don't need the third-party services. We bought a lot this year and last year. Next year, I think we can cut some of these kind of the expenses. In terms of your pricing, the question, this year we used a different price strategy. For example, for K-12 business, we only increased the price by no more than 5% year-over-year. Not like several years ago. We increased the price by 8%-10% several years ago.
This year, as I said, we're still in the rolling out the new product. What I mean is, we only increased the price by only 5%. Next year, I think our price strategy will be a little bit more aggressive compared to this year. Our target for the price increase will be 6%-8% in next year. That's my answer. Thank you.
Thank you.
Thank you all. Next question comes from the line of Leon Chik from JP Morgan. Please ask your question.
Hey. Hi. Thanks for taking the question. Just simple one. How did your GPM go down so much in Q3? Basically, cost of goods sold went up slower than sales. I guess we didn't see that in second quarter, so we're just wondering if there's anything special in third quarter. Thanks.
Thanks, Leon. It's a great question. The Q3 and Q4 are the peak season for K-12 business. I think the revenue growth in Q3 is better than we expected. Yeah, I think you will see the cost leverage here, especially for rental. We just increased the new learning centers by seven. For the current learning centers, the rental fee increased about only 5% year-over-year. The rental increased by high single digits. Also, we are seeing the higher utilization rates. That means the one teacher are teaching more students within the same class. That's why we are seeing the Operating margin improvement. Yeah. I think going forward-
Okay.
The Operating margin will still go up continually. Yeah.
Just basically normal operating stuff. No special stuff, right?
Regular
scale advantage.
Yeah.
Okay. Thanks. Okay, that's it.
Thanks, Leon.
Thank you. Our next question comes from the line of Mariana Kou from CLSA. Please ask your question.
Hi, management. Congratulations again on the really strong set of results. I just have a quick follow-up, I think, on the question just now on the cost side. Could you actually remind us what the, I guess, the fixed and variable component for the teaching cost, and what type of trends are you seeing in terms of cost increases for teachers?
Yeah. The teacher's compensation divided by two parts. The first part, let's say the 60%, are the fixed ones, depends on the level of the different teachers. The second part, let's say the 40%, are the teacher's bonus as relates to the retention rate, the utilization rate, and the evaluation from students. That's the percentage of the teacher compensation. I don't know, is it clear to answer your question?
Yeah. Are we seeing really, what sort of salary increase? Are we seeing double-digit type of increases that's expected from teachers?
Yeah. We increased the teacher salary by 8%-9% year-over-year.
Okay, great.
stable. Yeah.
All right. Thank you. Yep.
Okay, thanks.
Thank you. Our next question comes from the line of Claire Cao from Morgan Stanley. Please go ahead.
Hi, management. Thanks for taking my question. I have two questions. The first one is related to the pricing strategy. As you mentioned that you may spread the low price strategy to other cities, could you give us some more color on this? What could be the potential P&L impact in the coming fiscal year when this low price strategy is more widely rolled out? I have a follow-up.
Okay. Thank you, Claire. It's great. Good question. As mentioned, we will launch the low price class only for grade 7 and for math, or maybe some cities for Chinese. Even though we launch this, I don't think we will have the negative impact for the margins for the next whole year. Maybe it will have some negative impact for Q1, but it's very minimal. For the next whole year, I think on the contrary, the margin will be higher by doing this. We just give the one-time discount for this kind of students for one time. After one time, since the second time, I think more than 60%-70% of the students will take the class with paying the normal price. We'll still get the higher utilization rate. For the next year, it's no margin dilution by this.
Yeah. Actually, I would add that actually based on current retention rate for our K-12 business, also we have plenty of capacity for K-12 business now. Basically, after Q1, most of the students who we attracted in Q1 will stay with the system for the rest of the year, like Q2, Q3, Q4's courses. That will increase the utilization of our overall business which will contribute a lot to margin expansion, actually.
Yeah.
Okay.
Okay. Understood. Thank you. My second question is, I think Stephen mentioned that we have seen increasing word-of-mouth referral in the quarter. Just wondering, is it possible to share some data on this? What magnitude of operating leverage can we expect from sales and marketing line? Thanks.
Sorry. We don't disclose the referral rates to the investors, definitely it goes up. That's why you have seen the sales and marketing expense increased only 8% in Q3, in Q1, Q2, the sales and marketing expense growth rates was zero. Going forward, I think the sales and marketing expense will increase below 10%. Yeah.
Got it. That's very clear. Thanks.
Okay. Thank you.
Thank you. Our next follow-up question comes from the line of Zoe Zhao from Credit Suisse. Please go ahead.
Hi, management. I have a follow-up question on the overseas business. Can management break down the overseas test prep versus the overseas consulting business? Also, I'm wondering, what's the operating margin for the consulting business? Thank you.
Okay. The overseas test prep business contributes 28% of our total revenue, and overseas consulting business contribute 8%-9% of our total revenue. In terms of the margin of the overseas consulting business, it's about 20%. I think the margin will go out a little bit higher next year, going forward next three, five years, because we will see more leverage there. 20% margin for overseas consulting. That's my answer. Thank you, Zoe.
Thank you. Our next follow-up question comes from the line of Tian Hou from TH Capital. Please go ahead.
Yeah, Stephen. The follow-up question is related to online education. How fast can online education grow in the next year or so? That's one. Number two is the summer camp. In the past two years, you guys did have some issues with the summer camp. What about this year? Is this issue totally gone with the company?
Okay.
That's the two questions.
Okay. I think our pure online company, Koolearn, I think going forward, the revenue growth will be, let's say the 35%-50% yearly year. It depends on the timing or the different others. In general, it will go up faster than the offline business. For the summer camp, yeah, we had a very bad summer camp business numbers two years ago. Last year, I think the summer camp business was okay. This year, I don't think we will have the bad numbers. Even before last year, there was the uncertainty of policy changes, but now it's very, very clear for the Gaokao reform. There's no impact for the coming summer, for summer classes. Yeah.
Okay. Thank you, Stephen.
Okay. Thank you, Tian.
Thank you. Our next question comes from the line of Andrew Orchard from Nomura. Please go ahead.
Hi, Stephen Yang and Sisi Zhao. Thanks for taking my question. Two questions. Number one on the VIP performance. It is still growing quite fast at 22%, but I guess with the whole business growing even faster, can you give us a sense of what the revenue proportion from VIP is this quarter versus same quarter last year? And then the other question is on the IELTS interactive system. Given that you are just rolling this out, but in the longer term, are you also expecting that this interactive system will help you raise ASP for your IELTS classes? Because I expect that IELTS retention rate is generally quite low due to the nature of the courses. Those are my two questions. Thanks.
The VIP business of this quarter, of Q3, contributes 29% of the total revenue. Last year was same, 29%. As mentioned several quarters ago, the management just wants to cap the VIP business, the 30% of total revenue. Our focus is on the class business. Going forward, I think the VIP contribution will still within the 30% of the total revenue. For the new IELTS product we launched in March, I think we used the same methodology for the O2O product we used in K-12 business. More and more young, what do you know, the high school students or junior high school students are taking our IELTS class. They still need to be online elements to help them to study more efficiency in the offline classes.
I think it will help us to increase the price because nobody else in the market has this kind of product. I think going forward, we'll still increase the price by 5%-10% on year-over-year basis.
Thank you. We are now approaching the end of the conference call. I will now turn the call over to New Oriental CFO, Mr. Stephen Yang, for his closing remarks.
Again, thank you for joining us today. If you have any further questions, please do not hesitate to contact me or any of our investor relations representatives. Thank you.