51Talk Online Education Group Q2 FY2020 Earnings Call

Hello ladies and gentlemen. Thank you for standing by for China Online Education Group’s Second 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.

Hello, everyone and welcome to the second 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 Chief Executive Officer, and Mr. Min Xu, our CFO, will begin with some prepared remarks. Following the prepared remarks, Mr. Liming Zhang, our Chief Operating Officer, 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 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 for joining our conference call today. We extended our outstanding performance by registering another quarter of robust results across the board in the second quarter. These results were fueled by the continued optimization of our K-12 one-on-one mass market strategy in non-tier-one cities as well as the overall growing market awareness and acceptance of online education brought about by the effects of the COVID-19 pandemic. Financial highlights of the second quarter include our net revenues increasing 40% year-over-year to reach RMB493.5 million, a figure 5.0% above the high end of our guidance. Net revenues from our core business K-12 one-on-one mass market offerings increased 61.0% year-over-year to reach RMB417.9 million. Furthermore, our gross billings reached RMB676.4 million, growing 35.7% year-over-year, and recording the highest growth rate since the first quarter of 2018. Our K-12 one-on-one mass market gross billings grew 46.4% year-over-year to RMB612.5 million, accounting for 90.6% of our total gross billings. Operationally, our teams continued to execute well and capture market opportunities. We grew our number of active students by 27.8% year-over-year in the second quarter. To augment our K-12 offerings, we recently launched brand new Level-K courses for kindergarten students aged 3 to 5 years old, aiming to broaden our student base and build good study habits from a young age through our platform. We also held tournaments for our flagship China Youth Talk speech contest between April and August. This high-profile event attracted more than 500,000 K-12 aged contestants from across the country and showcased the achievements among some of the most talented youth. In the second quarter, we embarked on a brand uplift effort in the Philippines to further enhance our already strong appeal among existing and potential instructors. A highlight of this campaign is the appointment of Ms. Pia Wurtzbach as our brand ambassador in the Philippines. She is a former Miss Universe with strong popularity among our target instructor demographic. With her appointment and our continuous promotion efforts, we further strengthened our leadership position in online education and effectively promoted teaching careers at 51Talk for Filipinos with high English proficiency, passion for teaching, and familiarity with Chinese culture. Additionally, on September 2nd, at the K-12 Online Education Service and Evaluation Standard conference, we presented the first enterprise standards for the K-12 Online Education Industry which we believe is an important step forward in the maturity of our industry and the standardization of the service scope and requirements for K-12 online education enterprises. In summary, we are proud of our second quarter achievements both financially and operationally. The firm’s organizational foundation built over the years, coupled with our focus in the K-12 one-on-one mass market in non-tier-one cities, has helped us emerge today in a stronger, better position. As we move into the second half of 2020, I look forward to continuing to execute on our mission, bringing our strong value proposition to the market and long-term benefits to all our stakeholders. With that, I will turn the call over to our CFO, Xu Min.

Thank you, Jack. Hello, everyone. I’m pleased to report another strong quarter marked by both continued top-line growth and robust profitability driven by our strategy to pursue healthy growth while keeping a close eye on operational efficiencies. During the second quarter, we achieved non-GAAP net income of RMB39.6 million, as our net revenues and gross billings continued to expand. Excluding the RMB17.9 million favorable impact of government-related COVID-19 relief benefits received in the second quarter, our non-GAAP net profit margin would have been 4.4%, compared with a non-GAAP net margin of negative 7.8% for the second quarter of 2019. In addition, we are pleased to record operating cash inflow, a key metric of our financial health, of RMB172.1 million. I should also highlight our successful follow-on public offering during the quarter, which further strengthened our balance sheet and stimulated investor interest. I am confident that the company is on the right track for continued growth and profitability. Now let me walk you through our second quarter financial details. Net revenues for the second quarter were RMB493.5 million, a 40.0% increase from RMB352.6 million for the same quarter last year. This increase was primarily attributed to an increase in the number of active students as well as an increase in the average revenue per active student. The number of active students in the second quarter was 298,200, a 27.8% increase from 233,400 for the same quarter last year. The average revenue per active student in the quarter increased by 9.5% year-over-year. Excluding the positive impact of the coronavirus related exemption of employer obligations on social security contributions, gross profit for the second quarter was RMB349.9 million, a 42.8% increase from RMB245.0 million for the same quarter last year. Gross margin for the second quarter was 70.9%, compared with 69.5% for the same quarter last year. One-on-one offerings gross margin for the second quarter was 71.6%, compared with 71.1% for the same quarter last year. The margin expansion was mainly attributable to a favorable mix of higher margin products. 51Talk’s small class offering gross margin for the second quarter was 58.9%, compared with 54.5% for the second quarter of 2019. The increase was primarily due to a favorable mix of higher margin products. Total operating expenses for the second quarter were RMB332.4 million, an 18.7% increase from RMB280.1 million for the same quarter last year. Sales and marketing expenses for the second quarter were RMB239.9 million, a 27.4% increase from RMB188.4 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the second quarter were RMB237.4 million, a 26.8% increase from RMB187.3 million for the same quarter last year. Non-GAAP sales and marketing expenses, excluding branding expenses, were 30.7% of the gross billings for the second quarter, compared with 32.6% for the same quarter last year. Product development expenses for the second quarter were RMB38.6 million, a 6.6% decrease from RMB41.4 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP product development expenses for the second quarter were RMB37.0 million, a 7.0% decrease from RMB39.7 million for the same quarter last year. G&A expenses for the second quarter were RMB53.9 million, a 7.0% increase from RMB50.4 million for the same quarter last year. This increase was primarily due to the higher professional services fees in connection with the follow-on public offering. Excluding share-based compensation expenses, non-GAAP G&A expenses for the second quarter were RMB51.1 million, a 7.7% increase from RMB47.5 million for the same quarter last year. Since the first quarter of this year, we added another income line above the operating income in our income statement. Other income for the second quarter was RMB9.6 million, which included RMB7.0 million VAT exemption and RMB2.6 million super deduction. Operating income for the second quarter was RMB27.1 million, compared with an operating loss of RMB35.1 million for the same quarter last year. Non-GAAP operating income for the second quarter was RMB34.0 million, compared with non-GAAP operating loss of RMB29.4 million for the same quarter last year. The total favorable impact of coronavirus relief policies was RMB17.9 million in the second quarter, which comprised the impact of exemption of employer obligations on social security contributions on operating income of RMB10.9 million, in addition to the coronavirus policy-related VAT exemption of RMB7.0 million. Excluding the favorable impact, non-GAAP operating income for the quarter would have been RMB16.1 million, representing a 3.3% non-GAAP operating margin. Net income for the second quarter was RMB32.8 million, compared with a net loss of RMB33.2 million for the same quarter last year. Non-GAAP net income for the second quarter was RMB39.6 million, compared with a non-GAAP net loss of RMB27.6 million for the same quarter last year. Excluding the favorable impact of coronavirus relief policies of RMB17.9 million in the second quarter, non-GAAP net income for the second quarter would have been RMB21.7 million, representing a 4.4% net margin. Diluted EPS for the second quarter was RMB1.44, compared with EPS of negative RMB1.62 for the same quarter last year. Each of our ADS represents 15 Class A ordinary shares. Non-GAAP diluted EPS for the second quarter was RMB1.75, compared with EPS of negative RMB1.34 for the same quarter last year. As of June 30, 2020, the Company had total cash, cash equivalents, time deposits and short-term investments of RMB1.43 billion, compared with RMB1.05 billion as of December 31, 2019. The Company had advances from students of RMB2.41 billion as of June 30, 2020, compared with RMB2.19 billion as of December 31, 2019. Now let’s talk about outlook. While there are still uncertainties related to the coronavirus pandemic during the remainder of 2020, based on information currently available, we currently expect Q3 net revenues to be between RMB525 million to RMB532 million, which would represent a 28.5% to 30.2% year-over-year increase from RMB408.7 million for the same quarter last year. The above outlook is based on the current market conditions and reflects the Company’s current and preliminary estimates of market and operating conditions and customer demand, which are all subject to change. This concludes our prepared remarks. We will now open the line for questions. Operator, please go ahead.

Thank you. [Operator Instructions] The first question today comes from Vincent Yu of Needham & Company. Please go ahead.

Thank you management for taking my question and congrats on the great quarter. I have three questions. The first question is, can you guys elaborate on the reintroduced Level-K courses, for example, the course pricing compared to the K-12 offering? And will we also focus on targeting lower-tier cities as well? The second question is, we are noticing more marketing efforts made by us as well as competitors. How should we think about the sales and marketing expenses for the second half of 2020? The third question is, as we are seeing a great quarter for both active students and gross billings. Has the reopening of schools had any impact on our operation or should we expect to see steady growth for both metrics in the second half of 2020 and going forward? Thank you.

So, Jack already answered question one, and I will answer question two and question three. So what we developed this new Level-K course, because we’re seeing there is a lot of demand from the students aged 3 to 6 years old. And a lot of times the level-zero courses we have already are actually too difficult for them. So that is why we invest heavily to develop this Level-K course. In order to make the courses more suitable for the younger kids, we added a lot of games and components, and we included a lot of animation. We increased a lot of the interaction between the teachers and the students. We also retrained our teachers so that they understand how to teach younger aged kids. Right now, the majority of our students, actually more than 70% of those are in the non-tier-one cities. So, naturally, we believe our new Level-K lesson will attract many of the younger kids in the lower-tier cities to be able to start early in English training, and we believe this will help us further penetrate the lower-tier cities. So, talking about question two, you mentioned that you’re noticing more marketing efforts made by 51Talk as well as our competitors, how should we think about the sales and marketing expenses for the second half? First of all, I want to stress that we're not directly competitors to either AI players or large class players, who are actually the major players elevating their effort on sales and marketing. We focus mostly on Spoken English, which is kind of capability development instead of test preparation. Our product is actually relatively high-priced compared to the low-priced AI lessons or large class lessons. We’re targeting different demands, even though they may come from the same customer group. Because they represent different demands, it’s not exclusive. It’s not like someone bought an AI lesson or large class lesson, most likely, they still will buy our courses. This is why we can maintain our current CAC level, and keep our sales and marketing quite efficient. That being said, we're still going to increase our investment in sales and marketing because we're seeing a lot of opportunities and demand is there. We’re trying to invest in sales and marketing to meet our customer demands. As we said before, we're investing excess profit back into marketing and branding. Our second half non-GAAP sales and marketing expenses as a percentage of gross billing is likely to be higher than the Q2 level, which is around 35%. That percentage will be closer to the Q1 level. In Q1, our non-GAAP sales and marketing expenses was roughly 37.9% of the gross billing. Hopefully, that can give you some color. For the third question, you asked about our strong growth in both active students and gross billings, and the impact of school reopening on our operations and the growth trend in the second half. With the reopening of schools, our students' lesson consumption is starting to get back to normal. Both in Q1 and Q2, the coronavirus lockdown really helped to increase lesson consumption for the students. It was growing in double digits. But we expect lesson consumption growth to be in low single digits in the second half instead of the double-digit growth seen in the first half. This is not a concern because we do expect our net revenue growth will mainly come from the growth of our active students. The demand remains solid and our gross billing year-over-year growth will likely be in the high 20s percentage, while the number of paying students is expected to grow over 40%. So we're not worried about any demand. We're actually very excited about the opportunities in the second half.

Got it. Very clear. Thank you.

Thanks, Vince.

The next question comes from Fawne Jiang of Benchmark. Please go ahead.

Yes. Thanks for taking my questions. Congrats on a very solid quarter. Jack, I just want to understand how you think about the long-term sustainable growth for the company. Clearly, 2020 will benefit from the lockdown. I just wonder what your observation on the user behavior you acquired during the lockdown is. Are they different from your past new users and heading into 2021 or beyond what would be a reasonable growth outlook we could assume for the company?

In 2020, we see very strong growth in new paying users, which actually has been the highest in recent years. Not only is the user increase strong, but we also see a very high level of student engagement. We believe student engagement is very crucial in getting good training results. We are seeing that in the summer months and in July and August, the lessons per active student is above 15 lessons per month, which we believe is the highest level for the industry. Not only this, we do expect -- we're seeing the year-over-year growth close to 5%. We expect the trend to continue. We also anticipate that the high number of new paying users will bring in more referrals and elevate brand awareness, creating a very strong momentum for the company.

Understood. That's very helpful. My second question is regarding your geographic penetration. As you point out, your non-tier-one students account for 70% of your total active students. In terms of your geographic strategy, are you targeting more tier-two cities or do you think you have a better opportunity in much lower tier 3 or even lower? How are you allocating your resources based on different tiers of cities?

In terms of growth rate, the Tier 3 and lower cities have the highest growth rate. However, in terms of the size of gross billing, right now tier-two cities have the largest share of our gross billing. If you look at the market, the Tier 2 market is much more mature than the Tier 3 or lower-tier cities. So right now, we will probably put more effort in the Tier 3 and lower-tier cities, but we will still allocate a very significant chunk of resources to tier-2 cities too.

Understood. Thank you very much. I'll go back to the queue.

Thank you, Fawne.

[Operator Instructions] The next question comes from Roger Parodi of Silverhorn. Please go ahead.

Hi, Jack. Hi, Xu. Congratulations on an outstanding quarter.

Hey, Roger.

I have two questions. The first one, we have seen your active student year-on-year growth rate steadily accelerate in the past few quarters. Now it's at 28%. One year ago, it was below 20%, or around 19%. What is driving this growth in active student numbers? The second one, you already touched on in the first question, but maybe you can give a bit more color regarding this Level-K English that you now started and how you compete with the existing players who obviously spend a lot of money on this, like the Banma AI, Guagua Long, and so on. Does this affect your lead cost? And has this had an impact on your conversion rate?

In 2020, we actually put a lot of emphasis on growing the user numbers. We believed the increase of new paying students is more important than other financial metrics. This is why we focused on operations to increase our market share and elevate brand awareness. We believe that as long as we continue to invest in user acquisition, this growth acceleration trend will continue. Also, we have put a lot of focus on our core product. With that focus, we have significantly increased our efficiencies. We concentrate on conversion rate, renewal rate, and all the basics, which has helped improve our service quality and improved student engagement, driving a lot of inactive students back into action and increasing the growth of active students. Regarding the pre-K English market, we just launched our Level-K product to address this market. In this space, there are many players offering AI products. We believe we offer very different solutions. For the AI products, kids watch videos and do a lot of self-study. Our solution, however, utilizes live teachers to help them improve their English through conversation. These are completely different products. We do believe this market will grow and will experience very fast growth in the next few years. Although AI products are not expensive, leading many parents and students to start with these offerings, we do not view that as a threat; rather, it is an opportunity. Many AI products help educate the market and stimulate interest from students and parents. However, at a certain stage, the self-study offered by AI products will not meet the demands of parents and students, leading them to look for 51Talk's product. When there's a need to improve their understanding and conversation skills in English, they will find that live online lessons are the best option. We believe this is a great opportunity for us.

Right. Got that. Thanks a lot. Thanks, Xu Min.

Thank you, Roger.

As there are no further questions, now I’d like to turn the call back over to the Company for any 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 at ir.51talk.com, or The Piacente Group Investor Relations. This concludes this conference call. You may now disconnect your line. Thank you.