New Oriental Education & Tech Grp (ADR) Holds the Naysayers at Bay

Back in December, a Reutersreport surfaced claiming that New Oriental Education (NYSE: EDU) had engaged in fraud by having teachers and tutors complete college application materials for students.The stock dipped 14% on the news. While the allegations are certainly alarming, most of it is just noise: Years ago, New Oriental pivoted from the test prep business for students who wanted to study abroad to the after-school tutoring business for K-12 students.

Keeping that crucial distinction in mind is important, because as far as what is now the "core" business goes, the company's earnings release this past week was glowing with good news.

Image source: Getty Images.

New Oriental results: The raw numbers

I'll dive into what made the quarter such a great one below, but first, let's look at the headline numbers the company reported

Metric

Q4 2016

Q4 2015

Year-Over-Year Change

Revenue

$341 million

$278 million

22.7%

Non-GAAP earnings per share

$0.08

$0.07

14.2%

Data source: New Oriental.

It's important to note that while the 23% bump in revenue was impressive, it would have been even better if not for currency headwinds. In local currencies, the company's sales were up 30.2%. Either way, this came in well ahead of expectations set by management last quarter -- as it predicted a top-end revenue figure of $335 million.

Digging into the numbers

But when it comes to education companies -- which I have been very wary of over the years I have been covering them for The Motley Fool -- nothing is more important than enrollment numbers. It is here where we can get a true feeling for where the company is headed and what kind of value it might be adding for its students.

And on this front, New Oriental is performing exceptionally well: Enrollment in the company's programs -- the controversial test prep and the core tutoring programs -- was up 56% from the same period in 2015. The full roster count ended at 1,312,300 students.

Let's put this in context: In one year's time, New Oriental grew its enrollments by adding over 470,000 new students.

It's worth looking at where that growth came from. The company had a total of 789 learning centers and schools throughout China at the end of the quarter, up from 720 the year before. Clearly, added capacity helped.

But that's not all. Enrollment in the company's after-school programs was up 78%, while revenue increased 45%. Some might be concerned about long-term discounting when revenue growth can't keep pace with enrollment growth. I, however, don't think it's anything to worry about. The company offers steep discounts to new students to get them entered into the system. After families test run New Oriental's schools, they have the choice of taking their children out or continuing to enroll them while paying full fees. I think that's a smart long-term strategy to win over students and their parents.

The moat continues to widen

Chairman and founder Michael Yu touted the results in the company's press release, saying,"We are experiencing increased student satisfaction as we bring together the best learning experiences to help students achieve more, which in turn boosts retention rate and new student enrollment and also contributes to strengthening our brand reputation."

He's basically hitting all the points that are helping the company build its sustainable competitive advantage. And that widening moat has many facets.

First, the company has the advantage of scale. As it grows ever larger, some of the overhead costs -- like teacher payment systems, software, and technology -- will eat up less and less of the revenue brought in.

Second, with each new location, the company is building a stronger brand. Admittedly, that brand is only as powerful as the instruction each local school provides. And this can work both ways. If evidence of fraud popped up in the tutoring programs, serious questions might be raised about the strength of the brand. But for the time being, this is an advantage for the company.

And finally, it has a very unique form of high switching costs. Students become accustomed to the physical locations, teachers, and classmates at these locations, and parents know that switching kids out of a tutoring program can create real headaches. Schools have a personal touch in that respect, and -- if executed with care -- this can provide an additional advantage for New Oriental.

What lies ahead?

Looking forward to the next quarter, management expects revenue to come in between $409 million and $422 million. That represents 18% to 22% growth in dollars and an even more impressive 25% to 29% growth in local currencies.

Even with positive business momentum, shares are trading hands for only 15 times trailing free cash flow.

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Brian Stoffel has no position in any stocks mentioned. The Motley Fool recommends New Oriental Education & Technology Group. The Motley Fool has a disclosure policy.