51Talk Online Education Group Q3 FY2020 Earnings Call

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group’s Third 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 third 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. Mr. Jack Huang, our Chief Executive Officer; and Mr. Min Xu, our CFO, will begin with some prepared remarks. Following the prepared remarks, 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 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.

Okay. Hello, everyone. Thank you very much for joining our earnings conference call. We are pleased to report another robust quarter of solid financial and operating results. Our third quarter performance proves the merits of our strategy focused on the K-12 one-on-one mass market offerings in non-Tier-one cities and showcases our ability to execute our initiatives. Highlights of the quarter included net revenues reaching RMB538.5 million, up 31.8% year-over-year, surpassing the top end of our guidance with contributions from our K-12 one-on-one mass market offerings growing by 46% year over year to hit RMB471.8 million. Moreover, the number of active students on our platform in the third quarter grew to 338,000, up 30.9% compared to the third quarter in 2019. In the third quarter, our gross billings reached RMB728.4 million and grew 33.1% year-over-year, of which our K-12 one-on-one mass market gross billings grew 37.2% to RMB692.2 million. Clearly families across China are gaining greater familiarity and comfort with online learning channels and recognizing the strong value we provide. As they do, they are sharing their positive experiences with their friends and our high-quality brand reputation is spreading. In October, we were honored to be invited as the only online education enterprise to join the 2020 China Annual Conference for International Education and provide key inputs for future guidelines and requirements for online foreign teachers in China. At the conference, we signed a framework agreement with the China Education Association for International Exchange to jointly create recruiting and training standards for online foreign teachers. These standards will become part of China Ministry of Education’s policies regulating online foreign teachers. We are excited to be part of this national level working group. We look forward to sharing our experience working with thousands of online foreign teachers and helping shape the future of our industry. Also in October, we hosted our 2020 Sino-Philippines Educational Exchanges Seminar attended by education and government leaders, including the ambassadors from China and the Philippines. Through live streaming, we engaged over 5,000 people from China and the Philippines to celebrate the 45th anniversary of the establishment of diplomatic relations between the two countries, showing mutual cooperation and our positive role in cross-border relations. This video received the Guinness World Records award for the largest online video album of people waving. In conclusion, our K-12 one-on-one mass market non-tier-one city strategy is working, our teams are executing and the groundwork we’ve laid is allowing us to take advantage of more and more market opportunities. With these pieces in place, we will continue to contribute sustained long-term growth and maintain balanced bottom-line achievements.

Thank you, Jack. We continued our growth momentum in Q3 achieving solid topline increment, coupled with another quarter of profitability, our fourth consecutive profitable quarter. As the demand for online education continues to accelerate, our strategy to pursue balanced growth is delivering as planned. For example, during the quarter, we increased non-GAAP sales and marketing expenses by 31% year-over-year to capture certain market opportunities and increased non-GAAP product development expenses by 13% year-over-year to further improve our technology platform and curriculum. Despite the increase in expense, we still recorded profitability this quarter, with non-GAAP net income coming at RMB38.5 million. Excluding the RMB15 million favorable impacts of Coronavirus relief policies in the third quarter, our non-GAAP net profit margin would have been 4.4%. Additionally, our operating cash flow reached RMB186.1 million. Looking ahead, we will continue on our pathway of sustained growth and executing our strategies that bring to students in this rapidly developing market our strong value proposition for learning English. Now let me walk you through our third quarter financial details. Net revenues for the third quarter were RMB538.5 million, a 31.8% year-over-year growth. This increase was primarily attributable to the increases in the number of active students. Our number of active students in the third quarter was 338,000, a 30.9% year-over-year growth. Gross profit for the third quarter was RMB391.8 million, a 33.9% year-over-year growth. Gross margin for the third quarter was 72.8%, compared with 71.6% for the same quarter last year. One-on-one offering gross margin for the third quarter was 73.2%, compared with 72.7% for the same quarter last year. The margin increase was mainly attributable to the improvement of efficiency of American Academy lessons. Gross margin for 51Talk’s small class offering for the third quarter was 63.6%, compared with 56% for the third quarter of 2019. The increase was mainly due to a favorable mix of higher margin products. Total operating expenses for the third quarter were RMB379.6 million, a 26.8% year-over-year increase. Sales and marketing expenses for the third quarter were RMB282.8 million, a 31.3% year-over-year increase. Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the third quarter were RMB280.6 million, a 30.6% year-over-year increase. Non-GAAP sales and marketing expenses, excluding branding expenses were 31.8% of the gross billings for the third quarter, compared with 32.6% for the same quarter last year. Product development expenses for the third quarter were RMB43.8 million, a 14% year-over-year increase. Excluding share-based compensation expenses, non-GAAP product development expenses for the third quarter were RMB42.1 million, a 12.8% year-over-year increase. G&A expenses for the third quarter were RMB53 million, a 16.2% year-over-year increase. Excluding share-based compensation, non-GAAP G&A expenses for the third quarter were RMB50 million, a 14.2% year-over-year increase. Since the first quarter of this year, we added other income line above the operating income in our income statement. Other income for the third quarter was RMB9.3 million, which included RMB7.6 million VAT exemption and RMB1.7 million super deduction. Operating income for the third quarter was RMB21.4 million, compared with a loss from operations of RMB6.7 million for the same quarter last year. Non-GAAP operating income for the third quarter was RMB28.3 million, compared with a non-GAAP loss from operations of RMB3.3 million for the same quarter last year. The total favorable impact of Coronavirus relief policies was RMB15 million in the third quarter. Excluding this impact, non-GAAP operating income for the third quarter would have been RMB13.3 million, representing a 2.5% non-GAAP operating margin. Net income for the third quarter was RMB31.6 million, compared with a net loss of RMB5.8 million for the same quarter last year. Non-GAAP net income for the third quarter was RMB38.5 million, compared with a non-GAAP loss of RMB2.3 million for the same quarter last year. Excluding the favorable impact of Coronavirus relief policies of RMB15 million in the third quarter, non-GAAP net income for the third quarter would have been RMB23.5 million, representing a net margin of 4.4%. Diluted EPS for the third quarter was RMB1.38, compared with an EPS of negative RMB0.28 for the same quarter last year. Each ADS represents 15 Class A ordinary shares, non-GAAP diluted EPS for the third quarter was RMB1.68, compared with EPS negative RMB0.11 for the same quarter last year. As of September 30, 2020, the company had total cash, cash equivalents, time deposits and short-term investments of RMB1.6 billion, compared with RMB1.1 billion as of December 31, 2019. The company has advances from students of RMB2.6 billion as of September 30, 2020, compared with RMB2.2 billion as of December 31, 2019. Now let’s talk about the outlook. While there are still uncertainties related to the Coronavirus pandemic during the remainder of 2020, based on the latest information available, we currently expect Q4 net revenues to be between RMB525 million to RMB530 million, which would represent a 32.2% to 33.4% year-over-year increase from RMB397.2 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 the market and operating conditions and customer demand, which are all subject to change. On September 8, 2020, 51Talk announced that its Board of Directors has authorized a share repurchase program of up to US$20 million between September 2020 and September 2021. As of November 19, the company has repurchased close to 70,000 ADS for approximately US$1.7 million under this program. This concludes our prepared remarks. We will now open the call to questions.

Thank you. [Operator Instructions] Our first question is from Vincent Yu from Needham & Company. Please go ahead.

Thank you. Thank you for -- thank you management for taking my question. My first question is, how should we think about the active student trends and the gross billing trends in the fourth quarter and the first quarter, such as tough comp and the potential year-over-year decrease? Second question is the student behavior areas in terms of user timestamp, the number of classes taken per student compared to last year during the summer break? Third question is as we approach 2021, can we share some color on what will likely drive 51Talk’s growth in the next year? Thank you.

Okay. Thank you, Vincent. Yeah. What I said [Foreign Language] Okay. So Jack will talk about the -- some trends and I will fill in some details. So number one, we’re doing quite well in Q3 and Q4. We’re -- 51Talk as a company is well established and we have a very good brand and have a very good reputation among our students and parents. And in Q3, we started to take some measures, actually we mentioned this before we started to cut our course package size in order to lower the total price to drive user growth. So this is very important for us. For example, in Q3, the new paying students for our K-12 business increased more than 68% year-over-year. So this is a very significant growth. In Q4, we plan to continue to execute on this strategy. We will continue to cut our course package size in order to target our customers in tier-two and tier-three cities. If you look at 2021 growth, we have confidence in our student retention. We will continue to execute our strategy to decrease the package size and to drive user growth. As you know, in this quarter, 68% of our new users are from referrals. The bigger our user base is, the more students we’re going to get from referrals. We believe this is a great strategy for us. That concludes Jack’s comments. Now I’ll give you some comments on the active students, as well as the gross billing trend in Q4 and maybe in Q1. Basically, our active students will continue to have very healthy growth in Q4 and Q1, and we believe that the trend will continue. Even in Q1, we believe our student engagement will really help us improve their retention. Additionally, we’re driving user growth, so there are more and more new users coming onto our platform, leading to new active students. We believe with our strategy to continue user growth, our active students’ growth will continue to be very healthy. In terms of gross billing, as I mentioned earlier, we are actually looking to decrease our average package size. So you’re likely going to see that our average order size will decline maybe 20% year-over-year in Q4, which is a pretty steep decline. However, our number of net paying students is likely going to grow more than 45% year-over-year. Despite seeing slower growth, we believe this is a small price we can afford to drive user growth because we have healthy cash flow and a significant amount of deferred revenue. So it actually helps us to slow down the gross billing growth while increasing our user base is more important for us. Regarding user behavior, life in China has mostly gone back to normal this summer, and the user behavior is quite similar to past summer. The average revenue per user remains flat. We’re predicting that lesson consumption will likely decline in double digits; however, that will be more than compensated by the increase in active students. We do not expect to see a year-over-year decline. We’re still going to see year-over-year growth, but it will be much lower than current Q1’s year-over-year increase of 52%. It's more than likely going to be below the usual 30% year-over-year growth we normally see in a regular quarter. I hope this answers your question.

Yes. Very helpful. Thank you, Jack. Thank you, Min.

Yeah. No problem. Thank you, Vince.

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

Jack, Min, hello. [Foreign Language] Just quickly translate my questions. Still regarding your active student growth, it was very impressive growth in past quarters. Just wondering what’s the user profile for your newly acquired active users and particularly your strategy in terms of how you continue to drive the growth of new users as well as the retention of the new users?

Okay. [Foreign Language] All right. So regarding the student profile for the new students, there’s no big difference compared to last year. It’s very similar. We’re still seeing more than 70% of students coming from non-tier-one cities. However, there is one obvious change where we’re seeing a nice user growth acceleration in tier-one markets. We believe it’s for two reasons. First, there are fewer customers looking for good value in tier-one cities. Secondly, it takes some time for the tier-one city customers to find out that other products cannot deliver as good results as our leading product. This is why we believe this tier-one user growth acceleration will continue as we continue to improve our product and service quality. In terms of what we’re doing in our sales to really drive the acceleration, we’re placing a higher priority on user growth rather than gross billing growth. In terms of KPI, we give user growth a higher weight than gross billing, which naturally drives our sales to focus on user growth. For user retention, we are starting an initiative to improve the service quality of our student success team. This team will work closely with parents and students to enhance their learning experience and ensure good results, which we expect will lead to good renewal rates and referral rates. As we continue to cut the size of our first order, our renewal order size should increase, along with the renewal rate. Consequently, our students' lifetime value should increase as well. However, we are facing the challenge of ensuring our student success team has the capacity to service a much larger user base, so we are working hard to enhance their efficiency and add headcount to maintain a high standard of service quality to our students. This is a challenge we plan to tackle in the coming two quarters.

It is clear. Thanks for the color. Congrats on a strong quarter.

Thanks, Fawne.

As there are no further questions now, I’d 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 our website or the Piacente Group Investor Relations. Thank you.

This concludes this conference call and you may now disconnect your lines. Thank you.