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Edited Transcript of ONE.N earnings conference call or presentation 13-Nov-19 1:00pm GMT

Q4 2019 OneSmart International Education Group Ltd Earnings Call

Nov 29, 2019 (Thomson StreetEvents) -- Edited Transcript of OneSmart International Education Group Ltd earnings conference call or presentation Wednesday, November 13, 2019 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Honggang Zuo

OneSmart International Education Group Limited - Chief Strategic Officer, CFO & Director

* Rebecca Shen

OneSmart International Education Group Limited - IR Director

* Xi Zhang

OneSmart International Education Group Limited - Founder, Chairman & CEO

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Conference Call Participants

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* Felix Liu

UBS Investment Bank, Research Division - Research Analyst

* Jiayuan Weng

Blue Lotus Research Institute - Analyst

* Yiran Sheng

Morgan Stanley, Research Division - Equity Analyst

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Presentation

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Operator [1]

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Good day, and welcome to OneSmart to report fourth quarter and fiscal year 2019 financial results on November 13, 2019. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Rebecca Shen, Director of Investor Relations. Please go ahead.

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Rebecca Shen, OneSmart International Education Group Limited - IR Director [2]

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Thank you, operator. Good morning and good evening, everyone, and thank you for joining OneSmart International Education Group Limited Fourth Quarter 2019 Earnings Conference Call. The company's earnings results as well as supplementary slide presentation were released earlier today and are available on the company's IR website at www.onesmart.investorroom.com. Joining me today are Mr. -- our CEO, Mr. Steve Zhang; Mr. Greg Zuo, our Director, Chief Financial Officer and Chief Strategic Officer. Following our prepared remarks, our management team will join the Q&A session as well.

I will remind you that this call may contain forward-looking statements made under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements are based on management's current expectations and current market and operating conditions and relate to events that involve known or unknown risks, uncertainties and other factors, all of which are difficult to predict and many of which are beyond the company's control, which may cause the company's actual results, performance or achievements to differ materially from those in the forward-looking statements. Further information regarding these and other risks, uncertainties and factors is included in the company's filings with the U.S. Securities and Exchange Commission. The company does not undertake any obligation to update any forward-looking statements as a result of new information, future events or otherwise, expect as required under the law.

With that, I will now turn the call over to Steve. Please go ahead.

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Xi Zhang, OneSmart International Education Group Limited - Founder, Chairman & CEO [3]

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Thank you, Rebecca, and hello, everyone. We are pleased to conclude fiscal year 2019 with robust top line growth and a solid financial and operational results, which demonstrated our strong execution despite the very challenging regulatory environment.

We further strengthened our position in the premium K-12 after-school training market. Strong market demand, our premium brand and service quality and outstanding operational strength in premium training market helped us continue to gain market shares. As we move forward to the new fiscal year starting September 2019, we will further upgrade our premium services to improve customer satisfaction, refine our incentive scheme to better motivate our staff, and optimize our operations to ensure profitable growth.

We are in the midst of a fast-growing and constantly changing industry with both opportunities and challenges lying ahead of us. Going forward, we will continue to invest in OneSmart Online and further enhance our premium services by integrating online-merge-offline, OMO, technologies. Fully integrated with our offline services, the recently launched OneSmart Online platform has delivered satisfactory initial operating results. Our new technologies have greatly improved students' learning interest and customer satisfaction. Our goal is to establish OneSmart Online as the largest online-based premium education services platform to better serve the high-end demand through both online and off-line channels. We believe that our online strategies will help us expand into lower-tier cities in the long run.

We are greatly inspired by the growing demand and opportunities to better motivate those who make outstanding contribution to the company's future development and success. I have decided to donate 1.2% of the company's total share base I own to establish a Superhero Fund. I sincerely hope that more people will be entitled to enjoy the benefit of the growth and success of the company.

I will now turn the call over to Greg, who will provide a presentation of our market position, strategy and operations.

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Honggang Zuo, OneSmart International Education Group Limited - Chief Strategic Officer, CFO & Director [4]

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Thanks, Steve. We are extremely thankful to your generosity for setting up the Superhero Fund by donating your money and shares. Hello, everyone. Thank you all for joining us today. We are very pleased to deliver another year of solid growth, and our revenue reached approximately RMB 4 billion, which almost doubled from RMB 2.1 billion of fiscal year 2017, just 2 years ago. We continue to see strong demand from the K-12 and young children after-school education services industry in China. We also benefit from the consolidation that the industry is experiencing. Our advantages in providing premium services, lean cost structure and the standardized system help us drive outstanding economics and create substantial entry barriers.

During the past fiscal year 2019, we experienced several external factors that had quite notable impact to our business. We had a year when the industry had the most tightened regulatory requirements. We had to relocate some of our learning centers, open larger new centers at lower floors with higher FICO standards.

We also had to spend extra time and cost to hire or prepare our teachers to be compliant with teachers license requirements. Although those added onetime cost expenses, we believe all of these efforts will make us a more competitive player in a better industry environment. In addition, 2019 is also a year when we saw rapid adoption of education technology by our students and parents. As a market leader in the premium sector, we believe that advanced online technologies, if integrated with extensive offline teaching experience and operations, can significantly improve learning experience and effectiveness. As such, while we decided to deploy a more balanced expansion strategy off-line, we will make reasonable investment to develop our online strategies.

Now turning to today's presentation that we uploaded into our website. We will first spend a fair amount of time to discuss the premium education services sector. We felt it is important to explain to our investors in more granularity how attractive that sector is, what advantages we have built to make us the #1 player in this sector, and why we are optimistic about the growth and profitability prospect of our business. If you turn to Page 5 of our earnings presentation slides, we would like to point out that we have a clearly differentiated position in the China education services market, where some of the largest players of our industry focus on the mass and mid- to high-end markets, we are focused on the premium sector with higher price point by providing more advanced premium services, thanks to the 1-on-1 personalized tutoring nature. According to a survey by Frost & Sullivan, OneSmart is the most recognized premium brand in China.

Page 6 gives a good overview of the premium market. Premium after-school tutoring sector is projected to grow much faster than the overall market and expected to reach nearly RMB 200 billion by 2022. We believe the fast growth is underpinned by the 3 secular trends of our industry: rising awareness and preferences for individualized learning; consumption upgrade by increasing number of middle class families in China; and rising willingness to pay for premium services. It is also notable that while OneSmart is the largest player in the premium sector by revenue, we only take about 2.4% market shares, indicating substantial room for growth.

We further elaborate on Page 7 how we built our distinguished position in providing industry-leading premium services, which we believe lies on the 3 key pillars: quality, services and innovation. Our premium 1-on-1 tutoring services is the most effective way to improve a student's score within a limited time frame, a much immediate help for our students to prepare for their highly selective entrance exams in China. This is our main demand and we expect the demand to remain very robust. Second is our touching services, which provides personalized care to our students and helps improve level of engagement. Third is innovation. We continuously pursue and upgrade new products and technologies to enhance the learning experience and effectiveness. We developed robust teaching system UPC, OMO tools and platforms, AI-powered OneSmart Online, et cetera.

We are very excited to announce that we are building our online strategies and aim to establish OneSmart Online as the largest online-based premium service platform. Our online strategies are based on our fundamental belief that online education helps better serve the needs of our customers, which include convenience, better communication and enhanced learning experience. We already launched middle of the week online classes for our students for 1-on-1, VIP, HappyMath, FasTrack students. We believe our years of experience will enable us to build OneSmart Online with improved algorithms powered by data collected from extensive off-line experience. It's also important to point out that our goal is to deliver profitable growth, which means we will not burn money for scale. We will focus on our existing student base in cross-selling this new services, which helps us to deliver a profitable business model. We plan to provide more details on OneSmart Online in our future earnings calls.

We would also like to refresh a few key points that we discussed in our previous earnings call. Page 9 explains why we could consistently achieve scalable profitability in the past few years. We believe these 3 core advantages in our business model will continue to drive growth and profitability as we scale up our learning centers portfolio on a national level. Page 9, we updated our ramp-up data to the latest Q4 quarter, which once again confirmed satisfactory result, both in Shanghai and the top 10 cities outside Shanghai. It is critical to understand our ramp-up performance, which essentially explains why we are having temporary downward margin trend as new learning centers consist of more than half of our entire portfolio. We maintain our outlook that we will return to a double-digit operating margin in fiscal year 2020. We will continue to disclose this ramp-up data in future earnings calls.

Page 11 is the 3-year strategy we discussed during last earnings call. As we move into fiscal year 2020, we will focus on these 3 core service lines and prioritize the top 20 cities to generate scale and economics. We plan to open much fewer learning centers in the new fiscal year as we carry out a more balanced capacity expansion plan and continue to focus on ramping up a large number of existing newly opened centers.

I would now like to turn the call over to Rebecca, who will go through details of our financial results during the fourth fiscal quarter of 2019. Please go ahead.

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Rebecca Shen, OneSmart International Education Group Limited - IR Director [5]

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Thank you, Greg. Let me first provide key financial highlights and discuss the performance in our core -- in our core business segments, and lastly, walk you through the key financials during the fourth fiscal year 2019.

Let me start with 2 strong growth metrics. New student enrollments increased by over 60% year-over-year. Our top line growth for the quarter has exceeded 40% turning into geographic revenue contribution as we continue to further scale up in cities outside Shanghai. Revenue of Shanghai accounted for 55% of the total revenue, down from 62% same quarter of 2018.

Now let me go through the key highlights during the fourth fiscal quarter of 2019 to provide you with the outlook on your -- on our business development for the fiscal year 2020. Now let me -- OneSmart VIP business, which is our premium K-12 1-on-1 training services, has seen strong average monthly enrollment growth exceeded 50% in the following cities, including Suzhou, Chengdu, Changsha, Zhengzhou, Chongqing, Taizhou, Wenzhou, Zhuhai, Ningbo, et cetera, despite one-off regulatory impact. The one-off regulatory impact already started to normalize.

Net revenues outside Shanghai grew by 53% year-over-year and its share of total revenue increased to 45%. Our newly launched VIP 1-on-1 training services, which is a premium version of our existing VIP programs and supported by OMO technologies, precisely target at super premium market, and further strengthen our premium brand image and has received positive feedback from the customers.

Our latest UPC 12, or proprietary teaching and service system, further improves our existing VIP services by upgrading curriculum database and better analyzing teaching and study effectiveness.

Revenue of International Education program, which is premium 1-on-1 training services for students attending international schools grew by 73% year-over-year while average monthly enrollments grew by 189% compared with the same period last year. We see this as an attractive sector with emerging demand and serve the needs from high-end customers. Operating margin, excluding headquarters' G&A expenses for the OneSmart VIP business reached 27.9% by Q4 compared with 27.7% for the same period last year.

HappyMath, which is the premium math education program has seen a robust growth in cities outside Shanghai of over 80%. Our geographic focus going into the new fiscal year for new capacity will be in cities including Hangzhou, Nanjing, Suzhou, Chengdu, Wuhan, et cetera. To adapt to the regulatory changes in the area of school admission practices, particularly in Shanghai, we have updated our programs to address the broader market demand for young children math education and increased presence in cities outside Shanghai.

Integrating IDT 8, our latest proprietary HappyMath education system with cutting-edge OMO technologies, artificial intelligence tools and smart devices, we successfully enhanced customers' satisfaction through more engaged learning experience.

We also introduced a new HappyMath VIP Program, which is built on our investments in R&D and OMO technologies and aims to advance math scores while teaching English at the same time to further improve students' learning outcomes.

FasTrack English, our premium English education brand, continues to record rapid growth driven by strong market demand will continue to grow in Yangtze River Delta to strengthen our advantage position. Leveraging OMO technologies, we have launched live broadcasting program during the workday to help the students prepare and review their courses. The PIER 5, our proprietary innovative English teaching methodology has integrated with cutting-edge technologies of AI and 3D foundation to enhance students' engagement and learning outcomes. And operating margin excluding regional and headquarters' G&A expenses has turned positive during the quarter despite heavy R&D investments and rapid capacity expansion and is expected to further improve in the new fiscal year.

Now let me walk you through the other key financial details for the fourth fiscal quarter of 2019. Net revenues were RMB 1,311.1 million, an increase of 40.4% from RMB 933.6 million during the same period last year. The increase was mainly attributable to the growth of average monthly enrollments as well as the consolidation of Tianjin Huaying business.

Average monthly enrollments increased by 29.5% year-over-year to almost 160,000. ASP of fiscal year 2019 for the company during the quarter -- ASP for fiscal year 2019 for the company was down by around 3% year-over-year, which is due to consolidation of Tianjin Huaying business, whose primary business is cross programs. ASP of OneSmart VIP increased by around 4% compared with fiscal year 2018.

Cost of revenues increased by 44.6% year-over-year to RMB 667.1 million. We increased teachers' compensation to attract more experienced teachers and added rental costs to support the relocation of some of our learning centers for regulatory compliance purpose. Selling and marketing expenses increased by 34.1% year-over-year to RMB 259.9 million. Non-GAAP selling and marketing expenses, which excludes share-based compensation expenses, were RMB 259.9 million, an increase of 40 -- an increase of 34.4% from RMB 193.5 million during the same period last year. The increase was as a result of sales and marketing activities to support new student enrollment growth and adoption of more effective sales and marketing channels as well as marketing activities associated with the newly launched OneSmart Online.

General and administrative expenses increased by 83.7% year-over-year to RMB 307.7 million. Non-GAAP general and administrative expenses, which excludes share-based compensation, were RMB 282.1 million, an increase of 100% from RMB 141.4 million (sic) [RMB 141.1 million] during the same period last year. The increase was primarily due to a rise in R&D developments of education technology, teaching systems and curriculum materials associated with both our premiums off-line business and newly launched online business. We also incurred fair amount of general and administrative expenses to comply with the new regulatory standards to support the openings of learning centers.

Now let me move on to cover some other key financial points for the fourth fiscal quarter of 2019. Capital expenditures for the fourth fiscal quarter of 2019 were RMB 76.2 million, an increase of RMB 11.2 million from RMB 65 million in the fourth fiscal quarter of 2018. The increase was mainly due to the payment of leasehold improvements.

As of August 31, 2019, the company had cash and cash equivalents of RMB 1,377.4 million and short-term investments of RMB 454.4 million.

OneSmart's prepayments from customer balance, which represents cash collected from enrolled students for courses and recognized proportionately as the training sessions are delivered, were RMB 2,161.9 million at the end of the fourth fiscal quarter of 2019, an increase of 8.4% (sic) [8.5%] from RMB 1,991.6 million at the end of the fourth fiscal quarter of 2018.

To -- turning to outlook for fiscal year 2020. Based on our current estimates, net revenues for fiscal year 2020 are expected to be between RMB 4,992.3 million and RMB 5,192 million, an increase of 25% to 30% from fiscal year 2019. This outlook represents OneSmart's current and preliminary view, which is subject to uncertainty.

This concludes our prepared remarks. I will now turn the call to the operator and open for Q&A. Operator, we're ready to take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question today comes from Elsie Sheng of Morgan Stanley.

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Yiran Sheng, Morgan Stanley, Research Division - Equity Analyst [2]

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I have 2 questions on behalf of Sheng Zhong. The first question is about your online strategy. You mentioned that you will focus on OneSmart Online and OMO strategy next year. Can you elaborate more on the online? And also, do you have any target in terms of revenue and margins for the online business? Second question is about your margin. You mentioned that your margin will start to recover in the coming year. Do you have any more details about -- like on starting from which quarter the margin will see a turnaround.

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Honggang Zuo, OneSmart International Education Group Limited - Chief Strategic Officer, CFO & Director [3]

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Thank you, Elsie, for your questions. Let me answer your first question regarding our online strategy and then followed by the second question on the margin expansion status. So regarding OneSmart Online as we just very pleased to have launched. We actually have been developing OneSmart Online for a couple of quarters now. We are developing this strategy because -- based on our fundamental belief that we think the online education will greatly help our children and parents in learning and also communications. So we first have launched in a small scale in the last 2 quarters that we provided middle of the week 1-on-1 tutoring services for our VIP students. In those programs, we have the same teacher who teach offline and the same students who learn through our standard curriculum. So we felt, in that way, combining online/offline to provide greater convenience, but also a better effectiveness in our teaching. Secondly, as I mentioned, it is online/offline integrated. As you know, we have a very robust internal teaching system called UPC for the VIP program, which has 12 million teaching notes and 10 million tests and questions. We have already basically digitized those materials. We are not a pure online player who just launched the services, we are launching the services based on our years of teaching experience. And thirdly, we want to emphasize that we won't burn money to build business in a very large scale in short time -- period of time. We will first target our existing student base to enhance their learning experience, which means we're going to cross-sell this product, which means the customer acquisition cost, which is a common challenge for the online education, will be much lower in our business model. And secondly, as we mentioned, we already digitized our teaching notes. And in addition, we incurred about RMB 80 million in R&D and related cost and expenses in the last quarter already. So that spend was primarily to integrate our digitized teaching content with the live broadcasting platform that we're building.

So regarding your question on the guidance on the top line margin for this OneSmart Online business, we are still in the middle of finalizing the plan. We just had a new senior management team on board to be in charge of this business. We'll finalize the plan. We would continue to disclose more details once we had a firm plan for the fiscal year 2020.

Now turning to your second question regarding the margin expansion status. We actually, for this past Q4, our margin already started to expand. If you take out the additional R&D spending of the RMB 80 million I just mentioned, which is roughly equivalent to 5.5% of Q4 revenue. That means our Q4 non-GAAP operating margin would have been 13.3%. That compared to 14.8% for the same period last year. That's a significant narrow down of the gap, which from the Q3, which had a gap of 7%, as you'll recall. So we are very pleased with the result.

Now we gave the outlook in the last call that our margin will recover in fiscal year 2020 started in September. We maintain that view. We think our margins will be back to double digits for the full year 2020. In terms of timing, we think the recovery will be less visible in the first 2 quarters of the new year than the last 2 quarters for a couple of reasons. One, it will take time to digest the large amount of newly opened centers. So it will take a couple of more quarters for the ramp-up due to the nature of our business. And two, we plan to open another 50 centers for the new fiscal year 2020. And we actually usually open center during the first quarter. So we will have another fair amount of new centers to be opened in Q1. That will dilute the ramp-up of those existing centers a little bit. And actually, one more reason, as you know, Q1 September to November is a thin quarter in terms of seasonality rather than Q3 and Q4.

So that effect will be less visible. So -- but we -- to conclude, we are very optimistic about our margin recovery as you can read from the ramp-up data we have been providing. We are very optimistic about the margin recovery for the years to come as well.

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Operator [4]

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Our next question today comes from Felix Liu of UBS.

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Felix Liu, UBS Investment Bank, Research Division - Research Analyst [5]

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Steve, Greg and Rebecca, congratulations on the robust results. My question is mostly on the top line. You mentioned that going into FY '20, you're going to have a more controlled capacity expansion. So may I know what will be the impact to top line? Will -- do -- I notice we expect a sort of a slowdown in top line growth. So how will that be distributed between the 4 quarters in next year?

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Honggang Zuo, OneSmart International Education Group Limited - Chief Strategic Officer, CFO & Director [6]

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Thank you, Felix. Question on the top line growth. We gave the guidance for the new year -- for year-over-year growth of 25% to 30% for a few reasons. One, after 2 years of expansion, we would like to have a more balanced and controlled growth for the new year, which means we're going to open much less centers, which right now we plan for 50 centers compared to 117 centers last year. So this will slow down our top line growth due to less opening of new centers. Secondly, the reason we just had a slowdown for this quarter, which I think is pretty understandable for our industry, after 2 years of rapid growth, it would take 1 year or 2 for us to slow down and enhance our operations. We need to further improve our premium services in a number of areas. We want to build our online strategy, which was announced. And we're making efforts on starting incentive plan, which will try to help our productivity as well. So thirdly, although we're saying the regulatory impact will be largely behind us, but we anticipate some of the impact will continue to spill over to fiscal year 2020. It's especially for our young children math program, HappyMath. As you know, our target market is mainly in Shanghai and Shanghai is experiencing a change in admission procedure or even some lottery plan in the primary school system, which we target at. So those 3 reasons are behind the rationale why we lowered our guidance for the new fiscal year, which we think is very reasonable and which will lay a foundation for a much faster growth in the years to come. We do anticipate accelerating growth between 30% to 40%, even 45% in the year or 2 after 2020.

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Felix Liu, UBS Investment Bank, Research Division - Research Analyst [7]

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And may I just follow up on the regulation? I think I'm very glad to see that you have adjusted your HappyMath courses to adapt to the regulation. And also, a follow-up question on that is, how is our compliance status on the learning center as well as teacher licensing so far? And any spillover impact on that into FY '20?

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Honggang Zuo, OneSmart International Education Group Limited - Chief Strategic Officer, CFO & Director [8]

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So regulatory is at a couple of fronts. As you mentioned, the first one is the registration license and permits for learning center operations. We have -- the regulations, in particular, is very stringent in a number of provinces we operate, such as Zhejiang and Jiangsu. We are very pleased to let you know that we have largely achieved or received most of the permits and license for those centers in the 2 provinces, which has a significant progress we made. We're actively applying for license and permits for the rest of the learning centers in other parts of China, which is less stringent in the enforcement status but had a much slower approval process. We are patiently waiting for their approval but in the meantime, we are improving our own standards. I think the second front on regulatory impact is what I mentioned for score admission procedures, particularly in Shanghai, which had an impact on (inaudible) business. As you know, we are changing our program curriculum to move away from primary school admission entrance interviews, but more on the broader demand for young children math education and training. So we have, as you know, revamped our teaching material, made a press release. It's a couple of months back. We are rapidly diversifying our business away from Shanghai. As you know, we -- our business outside Shanghai grew 80% in the last quarter. So those will help our -- us to mitigate that impact. But we do anticipate a couple more quarters of pressure on the growth rate on the (inaudible) business, which means our HappyMath business.

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Operator [9]

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(Operator Instructions) The next question comes from Terry Weng of Blue Lotus.

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Jiayuan Weng, Blue Lotus Research Institute - Analyst [10]

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I had one question here. What is the company's view on the online (inaudible) landscape, especially for the premium online education?

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Xi Zhang, OneSmart International Education Group Limited - Founder, Chairman & CEO [11]

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Yes. On this, we can actually see that the market demand for our online premium kind of teaching services is growing very fast because the whole China is kind of in the process of kind of consumption upgrade. So we can definitely see that right now in the first-tier and second-tier cities, the parents are not that price sensitive. They want the convenience. So that's why we say that the whole demand for the premium teaching services are increasing actually very fast right now in China. So we see that's a huge opportunity for OneSmart because we have the brands. We have a good teaching and service system. We also have kind of -- in the past kind of year, we also invested a lot in terms of technology, in terms of the products and services. So I think that in the coming several years, the online part will also be one of our major growth drivers. (inaudible) can elaborate more on this.

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Honggang Zuo, OneSmart International Education Group Limited - Chief Strategic Officer, CFO & Director [12]

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Yes. Thanks, Steve. Just to add 2 more points to your answer. I think, Terry, we -- the first point we'll emphasize is that as very experienced operator of young children education, we -- regardless the format, online or offline, we want to emphasize that the teaching quality and training effectiveness is the key long-term success factor for the business. So in general, we believe we are very well positioned to play the sector as we accumulated millions of teaching notes and questions and answers in sort of off-line experience. So we're very well positioned to play in this sector, especially as Steve mentioned, the premium 1-on-1 online sector.

The second point I want to mention is that -- as we all know that the unit economics or economic model of a pure online player is not sustainable. The reason behind is the very high customer acquisition costs, which we believe will continue for a couple of years at least, and also their own development of teaching material and IT development. All of those areas actually are our advantage as we have a pretty large student base that we can cross-sell, but also that we are -- have accumulated existing very large base of digitized material, which will cost us much less in research and development of those online platforms and teaching systems.

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Operator [13]

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(Operator Instructions) As there are no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to Rebecca Shen for any closing remarks.

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Rebecca Shen, OneSmart International Education Group Limited - IR Director [14]

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Thank you, operator. In closing, on behalf of the entire management team, we would like to thank you again for your participation in today's call. If you have any further inquiries in the future, please feel free to contact us. Thank you.

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Operator [15]

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The conference has now concluded. Thank you for attending today's presentation, you may now disconnect.