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New Oriental Education & Technology Group Inc. Continues to Build Impressive Moat Around Its Business

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The education space in China is quickly evolving. New Oriental Education (NYSE: EDU) was founded by Micheal Yu as an organization that could provide English-language test prep for students who were looking to go to college abroad. But he quickly discovered that the business didn't offer much of a moat: Given the one-off nature of such classes and increased competition, the company couldn't continue to thrive the way he wanted.

So he decided to pivot. While not dumping the English classes, Yu chose to focus instead on after-school tutoring for K-12 students. While competition could still encroach, the very nature of the business -- with students potentially attending for 14 consecutive years and forming mental and emotional bonds with their learning centers -- provides a much stronger business model.

Based on results from the company's second quarter, released earlier this week, that move has been a wise one.

Just the numbers

Here's how New Oriental fared on its key metrics.

 

Revenue

EPS

Total Enrollment

Tutoring Enrollment

Q2 2016

$395 million

$0.29

1,037,700

N/A

Growth

20%

12%

32.5%

39%

EPS represents non-GAAP earnings. Data source: New Oriental. 

It's important to note that revenue growth would have been even more impressive had it not been for such a strong dollar. In local currency (renminbi), revenue was up 23%. The company also recorded free cash flow of $158.1 million, up 27% from last year's $124.1 million.

Given these figures and a price of about $44.50 per share, New Oriental trades for 29 times earnings, and just 15 times free cash flow.

What management had to say

The company's strength in after-school tutoring is clearly the driver for growth going forward. Yu pointed out that both types of programs offered -- POP, for children, and U-Can, for high-school students -- have shown impressive enrollment and revenue growth.

K-12 after-school tutoring business achieved approximately 32% gross revenue growth and an over 39% enrollment growth. ... Our POP Kids program achieved gross revenue growth of more than 35% and enrollment growth of approximately 46% for the fiscal year 2016. Meanwhile, our U-Can business recorded gross revenue growth of more than 30% and enrollment growth of approximately 35% for the fiscal year.

But investors shouldn't forget about the company's significant online-to-offline (O2O) efforts. This is a way for New Oriental to recruit and engage students online, and eventually attract more students to the classroom. Yu said those investments are paying off: "The O2O system for the K-12 business is the driving force behind the robust revenue growth as it significantly improves customer retention rate and acquisition efficiency."

While the program might cost the company a pretty penny in the short run, it helps build the all-important moat around the company over the long run.

What else happened in the quarter?

  • New Oriental's pure-play online education portal, Koolearn.com, doubled its number of paid users and saw revenue growth of 29%.
  • The number of learning centers and schools opened came in at 748, up from 724 from the same time last year.
  • Operating margins increased by 110 basis points, to 13.4%.

Looking ahead

For the company's next quarter, management expects revenue to come in a range with a midpoint of $518 million, which represents 13% growth. It should be noted, however, that in constant currency, this equates to roughly 20% revenue growth.

While currency exchange rates might be holding down results in the short term, there's no denying the success the company has had in its pivot to tutoring.

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Brian Stoffel has no position in any stocks mentioned. The Motley Fool recommends New Oriental Education. 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.