Capacity expansion and online initiative on track. TAL Education has beensuccessfully expanding its foot print by: 1) fast-learning center capacity expansion, and2) online education initiatives. From February to August 2017 (1HFY18), TAL added 2knew classrooms, compared to the full-year high-end guidance of 4k additions. Thecompany guides that capacity expansion in the next 2 to 3 years will still be 30-50% y-o-y,which should support top-line growth in the long run. Investment in online educationcontinues to bear fruit. In 2QFY18, the online course enrolment accounted for 30% of totalenrolment and grew 200% y-o-y. The initiatives, although likely to drag down margins andASP in the short run, should fuel growth in the long term.    Revenue beat but miss in margin. TAL’s revenue came in at USD456m in 2QFY18(ended August 2017), up 68% y-o-y, 4% higher than our expectation and consensusestimate. Quarterly student enrolments were up over 100% y-o-y to 2.2m, driven primarilyby summer promotions in small classes and online courses. Gross margin declined 5pptsy-o-y, of which 1) 2ppts was due to capacity expansion, 2) 1-1.5ppts due to onlinepromotions and summer promotions, and 3) 1.5-2.0ppts due to incremental loss from theacquired Shunshun Bita (overseas consulting business). Sales and marketing expensesincreased 35% q-o-q due to increasing headcount as well as more marketing andpromotion activities. As a result, non-GAAP operating margin declined 4.5ppts y-o-y to17.5% in 2Q. We expect the margin to decline 1.5-2.0ppts in 3Q primarily dragged by lossfrom Shunshun. No promotions will take place in the coming quarters. We estimateFY18e non-GAAP operating margin to decline 1.4ppts y-o-y, followed by a 1.9pptrecovery in FY19e as Shunshun should enter the mature stage. The company guides thatthe utilisation rate will likely improve from early 2018. Deferred revenue grew 57% y-o-y,of which deferred revenue from small classes grew by 60-70% y-o-y. 2Q non-GAAP netprofit came in at USD71, 4% lower than consensus. TAL’s mid-range revenue guidancefor 4QFY18 is USD414m, implying 59% y-o-y growth, largely in line with consensusestimate. Some seasonal factors have impacted the 3Q guidance as only 67.5% of thefirst semester’s revenue would be recorded in 3QFY18e (Sep-Nov 2017), versus 70.2%in 3QFY17.    Maintain Buy with a new TP of USD35 (from USD28.33). We lower our FY18/19eEPS estimates by 13%/3%, but increase FY20e EPS by 8% as we fine-tune ourrevenue and margin assumptions for FY18-20e. Our DCF-based TP is raised toUSD35, primarily due to the change in earnings estimates. Our new TP implies a 42xFY19e ex-cash PE against a 62% three-year EPS CAGR in 2017-20e. Downsiderisks include a slower-than-expected capacity expansion.

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