51Talk Online Education Group Q1 FY2020 Earnings Call

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's First Quarter 2020 Earnings Conference Call. At this time, all participants are in listen-only mode. After management's prepared remarks, there will be a question-and-answer session. Today's conference call is being recorded. I will now turn the call over to your host, Ms. Judy Piao, Investor Relations for the company. Please go ahead, Judy.

Thank you. Hello, everyone, and welcome to the first quarter 2020 earnings conference call of China Online Education Group, also known as 51Talk. The company's results were issued via newswire services earlier today and are posted online. You can download the earnings press release and sign up for the company's distribution list by visiting the IR section of its website at ir.51talk.com. Mr. Jack Huang, our CEO; and Mr. Min Xu, our CFO, will begin with some prepared remarks. Following the prepared remarks, Mr. Liming Zhang, our COO, will also join the call for our Q&A session. Before we continue, please note that today's discussion 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 involve inherent risks and uncertainties. As such, the company's results may be materially different from the views expressed today. Further information regarding these and other risks and uncertainties is included in the company's Form 20-F and other public filings as filed with the U.S. Securities and Exchange Commission. The company does not assume any obligation to update any forward-looking statements except as required under the applicable law. Please also note that 51Talk's earnings press release and this conference call include discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial measures. 51Talk's press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures. I will now turn the call over to our CEO, Jack Huang. Please go ahead.

Hello, everyone. Thank you very much for joining our earnings call today. We started 2020 with strong, 52.2%, year-over-year growth in net revenues, 10 percentage points higher than the growth rate implied by the high end of our guidance. In particular, K-12 one-on-one mass market net revenues increased 77% year-over-year to RMB404 million. This performance was driven by our continued strategic focus and successful execution of our K-12 one-on-one mass market offerings in non-tier-one cities, students taking more lessons at home during the COVID-19 outbreak, and increasing awareness of both our brand and online education. Benefiting from these factors, our gross billings grew sequentially to RMB597 million. This growth was even more impressive in that it came versus our fourth quarter peak season. Our K-12 one-on-one mass market gross billings increased 45% year-over-year to RMB564 million, reaching 94% of our total gross billings. Our first quarter active students increased to 286,000 from 257,000 for the last quarter, an increase of 11% sequentially. During the virus outbreak, aside from giving out free online classes and one-on-one English lessons to K-12 students in Wuhan and other impacted regions in China, we also provided medical supplies to the Philippines as part of our pandemic recovery efforts. I am very proud of our employees who have made extraordinary efforts to help students maintain their study continuity through the outbreak. With these efforts, we were able to largely preserve productivity and operational efficiencies during the lockdown period. We worked closely with our Filipino teachers to ensure they could conduct classes effectively at home to meet the rising demands of our students, promoting further integration of the educational resources of China and the Philippines. These unprecedented times have further highlighted and reinforced both the value and the natural progression of online education in China. We have seen increasing penetration of online education in non-tier-one cities due to the COVID-19 outbreak. This, together with our strong performance in the first quarter, provides us with even further confidence in our chosen pathway to sustained top-line growth and profitability, especially as we further fine-tune our products and services and continue to enhance our core business focus on K-12 one-on-one mass market offerings in non-tier-one cities. With that, I will now turn the call over to Min Xu.

Thank you, Jack. Hello, everyone. Solid first quarter financial and operating performance helped us begin 2020 on a positive note. In addition to robust growth in net revenues and gross billings, we reported another profitable quarter with non-GAAP net income of RMB57 million. Excluding the RMB16.9 million favorable impact from the coronavirus relief policies, our non-GAAP net margin would have been 8.2% compared with a non-GAAP net margin of negative 19.5% for the same period last year. The improvement was due to higher lesson consumption and operational efficiency gains during the quarter. Additionally, we achieved record high operating cash flow of RMB172.7 million. To keep the company on track for sustainable growth and profitability, we have been proactively adapting our operational strategy. This has allowed us to minimize the potential business impact caused by the COVID-19 outbreak and maintain high efficiency at all levels, ultimately elevating our brand recognition as a leading and dependable online education platform in China. Now let me walk you through our first quarter financial details. Net revenues for the first quarter were RMB487.1 million, a 52.2% increase from RMB320.1 million for the same quarter last year. The increase was attributed to an increase in the number of active students as well as an increase in average revenue per active student. The number of active students in the first quarter was 287,000, a 26% increase from 227,000 for the same quarter last year. The average revenue per active student in the quarter increased by 20.7% year-over-year. Gross profit for the first quarter was RMB343.1 million, a 60% increase from RMB214.3 million for the same quarter last year. Gross margin for the first quarter was 70.4% compared with 67% for the same quarter last year. One-on-one offerings gross margin for the first quarter was 71.2% compared with 69% for the same quarter last year. The margin expansion was mainly attributable to price increases. 51Talk’s small class offering gross margin for the first quarter was 54% compared with 45.7% for the first quarter of 2019. Total operating expenses for the first quarter were RMB314.9 million, a 13.2% increase from RMB278.1 million for the same quarter last year. Sales and marketing expenses for the first quarter were RMB228.4 million, a 22.6% increase from RMB186.3 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the first quarter were RMB226.1 million, a 21.5% increase from RMB186 million for the same quarter last year. Non-GAAP sales and marketing expenses, excluding branding expenses, were 32.3% of the gross billings for the first quarter compared with 34% for the same quarter last year. Product development expenses for the first quarter were RMB35.9 million, an 11.9% decrease from RMB40.7 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP product development expenses for the first quarter were RMB36 million, a 10.4% decrease from RMB40.1 million for the same quarter last year. G&A expenses for the first quarter were RMB50.7 million, a 0.9% decrease from RMB51.2 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP G&A expenses for the first quarter were RMB46.7 million, a 3.0% decrease from RMB48.1 million for the same quarter last year. In this quarter’s income statement, we added an other income line above the operating income. Other income for the first quarter was RMB16.8 million, which included RMB10.3 million VAT exemption and RMB6.5 million super deduction. Operating income for the first quarter was RMB44.9 million compared with operating loss of RMB63.8 million for the same quarter last year. Non-GAAP operating income for the first quarter was RMB51.1 million compared with non-GAAP operating loss of RMB59.9 million for the same quarter last year. Excluding RMB16.9 million positive impact from the coronavirus-related relief policies, non-GAAP operating income for the quarter would have been RMB34.2 million, representing a 7.0% non-GAAP operating margin. Net income for the first quarter was RMB50.8 million compared with a net loss of RMB66.2 million for the same quarter last year. Non-GAAP net income for the first quarter was RMB57 million compared with a non-GAAP net loss of RMB62.4 million for the same quarter last year. Excluding the favorable impact of RMB16.9 million from the coronavirus-related relief policies, non-GAAP net income for the first quarter would have been RMB40.1 million representing an 8.2% net margin. Diluted EPS for the first quarter was RMB2.26 compared with EPS of negative RMB3.25 for the same quarter last year. Each of our ADS represents 15 Class A ordinary shares. Non-GAAP diluted EPS for the first quarter was RMB2.54 compared with EPS of negative RMB3.06 for the same quarter last year. As of March 31, 2020, the company had total cash, cash equivalents, time deposits, and short-term investments of RMB1.21 billion compared with RMB1.05 billion as of December 31, 2019. The company had advances from students of RMB2.26 billion as of March 31, 2020 compared with RMB2.19 billion as of December 31, 2019. Now let's talk about outlook. We cannot predict whether the coronavirus-related impact we are experiencing in the first quarter will continue or to what extent during the remainder of 2020. However, based on the latest information available, we currently expect Q2 net revenues to be between RMB460 million to RMB470 million, which would represent 30.5% to 33.3% year-over-year growth from RMB352.6 million for the same quarter last year. The above outlook is based on current market conditions and reflects the company’s current and preliminary estimates of marketing and operating conditions and customer demand, which are all subject to change. This concludes our prepared remarks. We will now open the call to questions. Operator, please go ahead.

Yes. Thank you. We will now begin the question-and-answer session. For the benefit of all participants on today’s call, if you wish to ask your question to management in Chinese, please immediately repeat your question in English. The first question comes from Vincent Yu with Needham & Company.

Thank you, management. Thank you for taking my question. My first question is, have we seen any changes in class-taking behavior, especially for these new students we gained in the first quarter as more schools have reopened and the students have to not only go to school but also take classes after the normal class time on the weekends? My second question is what kind of initiatives or methods we are going to take to maximize the students we gained in our first quarter on our platform going forward? Thank you.

Thank you for the question. Let’s briefly talk about the general trends of student engagement we see in April and May. So, number one, the lesson consumption per active student in Q2 obviously will be lower than Q1, but still much higher than in previous quarters. And we are also very confident that new students we acquired in Q1 will be as active as any new students acquired in previous quarters. We track one very important metric, which is the lessons taken by our quarterly active students, and what we see is that this number in the previous quarter, actually in Q4, has grown year-over-year by 8%. In Q1, that growth surged to 30%. So obviously in the future quarters, it’s the growth of that metric will not be as high as 30%, but it will be above the previous mentioned 8% level. The reason why we believe it is very important to improve lesson consumption of our students is that we believe the key to studying a language is actually the frequency you practice that language, and that’s why we put a lot of emphasis on encouraging our students to take more lessons and to practice more. We believe that the lesson consumption of all of our students is actually double the lesson consumption of our peers who are mainly focused on using North American teachers. Vincent, can you repeat your second question?

Okay. My second question is actually similar to something you have already mentioned, basically asking how can we maintain these students on our platform? I think you mentioned some frequency.

In addition to what we have mentioned about improving the engagement of our students, over the past year, we have actually done a lot of projects aimed at enhancing the students’ learning experience on our platform. For example, we’re trying to improve the ratings that students are giving our teachers and improving the QA system for both the teachers and our service personnel who are trying to find ways to further improve our services. We are also updating our dynamic courses that are very interactive, H5 based, which can really attract a lot of our younger students. We’re doing all of this to improve their learning experience and increase our customers' satisfaction.

Okay. Thank you.

Thank you, Vincent.

Thank you. And the next question comes from Fawne Jiang with Benchmark.

Hi, Jack. Good afternoon. Congrats on a very strong quarter. My questions are regarding your sales and marketing efficiency. Jack, you mentioned that the strong performance in the first quarter was largely driven by a combination of lower tier penetration and strength in branding. Just wonder—given the current strong user traffic profile, whether there’s any strategic shift in terms of where you spend your margin dollar when it’s on further on new user acquisition or incrementally more to retain the current user that’s going to your platform. How should we think about efficiency down the road, whether for the rest of the year or long term? And any commentary around your strong profitability in the first quarter; how should we look at the profitability profile for the rest of the year?

For your first question, this quarter the new students we acquired from non-tier-one cities actually reached a very high level, close to 75%. In the past two to three years, we have consistently focused on the non-tier-one cities. One of the key reasons we focus on that market is that the customer acquisition costs are actually relatively low, and the customers in that market have a strong intention to refer new students or their friends to our platform, and they also have better retention. So that’s why we continue to focus on non-tier-one cities, and that is one of the crucial factors that leads to higher sales and marketing efficiencies. In terms of our customer acquisition channel, the referral percentage of our new students is close to 65%, which is due to better student engagement and our focus on non-tier-one cities, so people are more willing to refer their friends to our platform. Q1 and Q3 are typical quarters when we will spend more on branding. We’re seeing more students coming to our platform because of our TV ads and other advertisements. Q1 is our second profitable quarter, and it’s also the third profitable quarter for our one-on-one business. This is the first quarter we achieved more than 10 million profit. We’re confident that we will continue to be profitable for the rest of 2020. In addition to net income, we also achieved impressive operating cash flow of RMB173 million, following a strong operating cash flow of close to RMB400 million in 2019. Looking forward to 2020, we should see significant growth compared to that 2019 number. I also want to take this opportunity to share our strategy and our view on the balance between profitability and growth. Our company’s strategy is to maintain a small profit, and we will reinvest excess profit back into product development, G&A, and sales and marketing to drive further growth and attract more new students to our platform. It’s important for us to maintain a strong operating cash flow. The coronavirus lockdown has actually improved online education penetration in the non-tier-one cities, and we take this as an opportunity to expand our market share. Our focus will be increasing the number of students. Looking at our one-on-one business, new paying students grew 41% year-over-year and 21% quarter-over-quarter in Q1. Diving deeper into our core business of K-12 one-on-one mass market new paying students, that number grew 49% year-over-year and 30% quarter-over-quarter in Q1. This is very strong growth in terms of new paying student numbers, and we hope this trend will continue as we look forward to attracting more students to our platform and gaining more market share. Thank you.

Thanks, Jack.

Thank you. And the next question comes from Bo Pei with Oppenheimer.

Hello. So I’m going to translate myself. So my first question is about some of the regions in China that have already announced the summer break will be delayed for this year. What is our projection on the impact to our business? My second question is about after this COVID-19 impact, are we going to focus on gaining market share with relatively more aggressive sales and marketing spending or will we take this advantage to improve our profitability? Thanks.

Many regions have announced that they’re going to start summer break around mid-July, and some regions announced they will start summer at the end of July. This is already better than our previous expectations. We understand this means that the summer of 2020 will be softer than previous years. However, we are different from other large class size or more test-focused education companies. Our lesson consumption is not much different. As mentioned before, we already have better engagement from our students. We believe even though the summer break could be shortened leading to softer demand, our strong new paying student number as well as the improved student engagement will more than compensate for the potential negative impact. Regarding your second question, we prioritize gaining market share. We mentioned earlier that online education penetration in non-tier-one cities is likely to accelerate in the coming quarters and years. The leaders in this space have the best opportunity to benefit from this trend. With nine years of operating history, we have established one of the best brands in the space. We will allocate all our resources to take advantage of this opportunity to gain more market share. Regarding profitability, we’re confident that we can achieve profitability while aggressively investing in sales and marketing. Our cash flow is strong, with operating cash flow in Q4 reaching RMB173 million despite Q1 being a typically soft season. Our ability to make money is also reflected in the gross billing contribution we mentioned earlier where we achieved a gross billing contribution margin close to 20%. Although there is currently a gap between the GAAP net margin and the gross billing contribution margin, we believe we have the capacity to reach a comparable operating margin in the future. As you can see, as soon as there is an increase in lesson consumption, we immediately see a considerable profit, indicating our capability to generate more profit in the future.

Got it. Thank you.

Thank you.

Thank you. And the next question comes from Roger Parodi with Silverhorn.

Hello, Jack. Hello, Min Xu. Can you hear me?

Yes.

Yes.

Congratulations on the outstanding quarter. You already answered some of the questions that I have, so let me add one. You mentioned that the Wuhan team is a big part of your sales team, and obviously they were in adverse circumstances during their lockdown. When you would assume that all of your sales team would have been fully operational, how much additional impact could you have had? What is the negative impact that you had given that a big part of your sales team actually had to work under adverse circumstances? That’s the first question. The second question is, when you now invest in more growth, whom do you mainly compete against? Is it other online education companies or do you primarily try to get students from offline companies and convert them online?

During the COVID-19 outbreak, we faced significant operational challenges. Demand was quite high in February and March, with free trial lesson demand being 30% to 50% higher than our capacity. At the same time, 100% of our Wuhan team was working from home, which led to lower efficiencies. Starting in April, things have gotten back to normal. A lot of our offices have reopened, and by May, our Wuhan office was operating normally, resulting in increased operational efficiencies in Q2. Despite a decline in recognized revenue due to fewer lesson consumption, our gross billing is expected to grow sequentially, partially attributing it to improved sales and marketing. Regarding the competitive landscape, it can be split into three parts. First, the online peers; in non-tier-one cities, we believe we have a stronger brand compared to most competitors and more competitive products that are suitable for the mass market. Second, many offline schools in non-tier-one cities are fragmented. As mentioned earlier, the trend is that online education penetration is accelerating, which is beneficial for us. Lastly, we see incremental demand from students or parents who haven’t sent their kids to offline or online schools. Many young parents born in 1980 or later have a strong desire to send their kids to learn English to improve their opportunities for the future.

Excellent. Thank you.

Thank you, Roger.

Thank you. As there are no further questions now, I would like to turn the call back over to the company for closing remarks.

Thank you once again for joining us today. If you have further questions, please feel free to contact 51Talk’s Investor Relations through the contact information provided on our website.

This concludes this conference call. You may now disconnect your line. Thank you.

Thank you.

Thank you.