Earnings Call Transcript - COE Q4 2021

Operator, Operator

Hello, ladies and gentlemen. Thank you for joining China Online Education Group's Fourth Quarter 2021 Earnings Conference Call. This call is being recorded. I will now hand it over to your host, Mrs. Investor Relations for the company. Please proceed, Ni.

Jiajia Huang, Unknown Executive

Hello, everyone, and welcome to the Fourth Quarter 2021 Earnings Conference Call of China Online Education Group, also known as 51Talk. The company's results were issued by our newswire services earlier today and are posted online. You can download the earnings press release and standards for the company's distribution list by visiting the IR section of our website at ir.51talk.com. Mr. Jack Huang, our Chief Executive Officer; and Mr. Min Xu, our Chief Financial Officer; 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 this 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 discussion 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. Thank you. Hello, everyone. Thank you for joining our conference call. In response to the changes in the government regulations related to after-school tutoring, we have taken measures to restructure our business so that the company's 2022 strategy will keenly focus on overseas business. In the fourth quarter, overseas business net gross billings have reached USD 2.9 million, more than triple Q3 net gross billings. As the overseas business momentum continues to build, we have extended our product offerings to students in more than 50 countries and regions outside Mainland China. We have been able to leverage our strengths for high-quality teacher resources, interactive curriculum, and advanced technology platforms to quickly establish our presence in the new markets. We will stick with our proven business model, which balances growth with profitability and was proven in the Mainland China market. We are excited about exploring opportunities in overseas markets, which allow our Filipino teachers to help more students in the world to be able to talk to the world. In order to comply with applicable laws and regulations and allow our listing company to focus on the overseas business, I have sent a proposal to our Board to acquire the company's Mainland China business. Meanwhile, I will continue to lead our listing company as the Chairman of the Board and the CEO to drive the growth from the overseas markets, and the Board has formed a special committee to evaluate my proposal.

Min Xu, CFO

Thank you, Jack. Hello, everyone. We concluded 2021 with RMB 2.2 billion revenue, a 5.5% increase from last year. Non-GAAP net income for 2021 was RMB 133 million, representing a non-GAAP net margin of 6.1%. We have streamlined our operations to meet our smaller scale. As a result, the fourth quarter operating expenses were RMB 321 million, representing a 30% decrease from the second quarter. Net revenues for Q3 and Q4 of 2021 were RMB 574 million and RMB 413 million, respectively, representing a sequential decline of 1% and 28%. The number of active students who attended lesson consumption in Q4 was 299,000, a 20% sequential decline from 376,000 for Q3. Gross margin for Q3 and Q4 was 73.5% and 78.6%, respectively. Total non-GAAP operating expenses as a percentage of net revenue was 63% in Q3 and 77% in Q4. Non-GAAP sales and marketing expenses for Q3 were RMB 191 million, down 39% sequentially. Non-GAAP sales and marketing expenses for Q4 were RMB 235 million, among which RMB 124 million was due to deferred sales and marketing expenses write-off. Excluding the write-off, Q4 non-GAAP sales and marketing expenses would have been RMB 111 million, down 42% sequentially. Non-GAAP product development expenses for Q3 were RMB 39 million, down 38% sequentially. Non-GAAP product development expenses for Q4 were RMB 16 million, down 60% sequentially. Non-GAAP G&A expenses for Q3 were RMB 101 million, among which RMB 51 million was restructuring costs. Excluding restructuring costs, Q3 G&A expenses would have been RMB 50 million, down 34% sequentially. Non-GAAP G&A expenses for Q4 were RMB 67 million, among which RMB 22 million was restructuring costs. Excluding the restructuring costs, Q4 G&A expenses would have been RMB 45 million, down 10% sequentially. Q3 impairment loss of RMB 31.8 million was due to goodwill and intangible asset write-off related to acquisitions. Other income for Q3 was due to RMB 6.0 million super deduction credit. Q4 impairment loss of RMB 0.4 million was due to intangible asset write-off related to the employee performance evaluation system. Other income for Q4 was due to RMB 0.6 million super deduction credit. Non-GAAP operating income was RMB 64 million in Q3 and RMB 7 million in Q4, representing 11% and 2% operating margin, respectively. Interest income for the third quarter of 2021 was negative RMB 7 million due to RMB 15 million reversal of interest income accrual from the time deposits early withdrawal, partially offset by interest income of RMB 8 million. Other income for Q4 was RMB 8 million, mainly due to government subsidy. Non-GAAP net income was RMB 79 million in Q3 and RMB 55 million in Q4, representing 14% and 13% net margin, respectively. Non-GAAP diluted EPS was RMB 0.23 in Q3 and RMB 0.16 in Q4. The company's total cash, cash equivalents, time deposits, and short-term investments were RMB 1.3 billion at the end of Q3, and there was no restricted cash. The company's total cash, cash equivalents, time deposits, short-term investments, and restricted cash were RMB 0.99 billion at the end of Q4, among which RMB 50.6 million were restricted cash, which was advances from students under government supervision. Advances from students were RMB 2.3 billion at the end of Q3 and RMB 1.8 billion at the end of Q4. The gap between advances from students and the cash balance has decreased from RMB 1,052 million in Q2 to RMB 997 million in Q3 and then to RMB 775 million in Q4. For more of our 2021 full year and Q3, Q4 results, please refer to our earnings press release. Looking forward to the first quarter of 2022, we currently expect the net gross billing of overseas business to be between $4.4 million and $4.6 million, representing sequential growth between 52% to 59%. The above outlook is based on our current market conditions and reflects the company's current and preliminary estimate of market 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.

Operator, Operator

And we will take the first question from Long Lin from The Benchmark Company.

Min Xu, CFO

Hello, Long. We cannot hear you. You might be muted.

Long Lin, Analyst

Sorry. Can you hear me now?

Unknown Executive, Unknown

Yes.

Long Lin, Analyst

So my question is about your overseas business. Just want to get a sense of the growth potential for the overseas expansion. And where do you see your key markets and how conducive are these markets for your services?

Min Xu, CFO

So I'll take this question. Jack, do you want to take this question?

Jiajia Huang, CEO

Hello, Long. We cannot hear you. You might be muted. Sorry. Can you hear me now? Yes. So my question is about your overseas business. Just want to get a sense of the growth potential for the overseas expansion. And where do you see your key markets and how conducive are these markets for your services? So I'll take this question. Jack, do you want to take this question?

Min Xu, CFO

Okay. Yes. Thank you for the question. We are very positive about the potential of our overseas market. We've done a lot of work, and we see this market size is huge. Additionally, the overseas market is very similar to the Chinese market, and looking at the global market for 2022, our focus will be in Southeast Asia. These countries are quite similar to China in terms of demand for English education, especially K-12 English education. Another important fact is that COVID-19 has continued to drive the demand for online education in Southeast Asia, much like what occurred in China in 2020. We observed a dramatic increase in the penetration of online education. We started our overseas business in the third quarter of 2021 and were able to achieve USD 2.9 million in gross billing in the fourth quarter, which more than tripled the gross billing in the third quarter. We also provided guidance for the first quarter, indicating a more than 50% sequential increase. We see online English education as probably the largest segment within our online language learning, and we perceive very limited competition in these target markets in Southeast Asia. This gives us a lot of confidence that we can quickly expand our overseas market. Our business model has been well validated in the Chinese market over the past few years, allowing us to achieve balanced sustainable growth. With that expertise and know-how, we believe we can apply our knowledge to the overseas market and become one of the leading brands in online English education. Yes, I hope this answers your question.

Long Lin, Analyst

Okay. So just a follow-up. For your key markets, what are the competition and regulatory risks like in those markets? Also, how do you build your brand in those markets?

Min Xu, CFO

So I'll take the first question. I'll let Jack tackle the second part. So far, we have not yet identified any regulatory risk in the markets where we're active. We currently have paying students from more than 50 countries and regions outside Mainland China. This geographic diversification helps to mitigate the impact from any potential regulatory risk in any specific region. So Jack, can you talk about the brand building?

Jiajia Huang, CEO

So I'll take the first question. We have not identified any regulatory risk in the markets where we're active. We currently have paying students from more than 50 countries and regions outside Mainland China. This geographic diversification helps to mitigate the impact from any potential regulatory risk in any specific region. Jack, can you talk about the brand building?

Min Xu, CFO

Yes, when it comes to branding, we believe that the combination of a quality product and excellent service is crucial for establishing a strong reputation. Fortunately, we have spent the last ten years testing our product and service in the Chinese market. Our curriculum is highly interactive and tailored to meet the needs of our customers. It is also aligned with the European standard, the CFR. With our advanced technology platform, engaging curriculum, and top-notch service, we have experienced significant success in China over the past decade. We see that the demand for English as a second language in Southeast Asia is quite similar to that in China. As we enhance our product and service, we will be well-positioned in those markets. Another key aspect of building our brand is localization, and we recognize the necessity of executing effective localization in our primary markets. We are dedicating resources to strengthen our branding efforts in these initial markets.

Long Lin, Analyst

Okay. So my second question is about the cost structure for the difference between the international business compared with the China business. Can management also provide an outlook for the company's gross profitability this year? You just mentioned about localization, which is a key part of your overseas business. How will that impact your costs going forward?

Min Xu, CFO

Sure. I'll take the question. If you look at the business model, the steady-state cost structure of the overseas business is very similar to our current business in Mainland China. We believe the gross margins are both above 70%. The target ratio as a percentage of gross billing is also 50% for sales and marketing and below 10% for G&A and R&D. Obviously, we need to reach a certain scale to achieve that kind of cost structure target. If we can grow at a moderate pace, we are likely to achieve positive cash flow in 2023 and positive gross contribution by 2024. Localization presents challenges, as many Chinese companies are expanding overseas. The good news for us is that we do not need major localization work on our core product, which is teaching English; we do not require major work on our curriculum or technology platform. The only localization work we need to do is in the sales and marketing part. For any customer interfaces related to sales and marketing, we need to address that. Regarding core product curriculum and technology, some localization work is needed, but it is very light. Therefore, we do not expect this to change our targets for the research and development expense ratio.

Jiajia Huang, CEO

Our core product, which focuses on teaching English, does not require significant changes to our curriculum or technology platform. The only localization necessary pertains to sales and marketing. We need to address customer interfaces in these areas. While some minor localization is required for the core product's curriculum and technology, it is minimal. As a result, we do not anticipate any impact on our targets for the research and development expense ratio.

Min Xu, CFO

Yes. I want to add one more point: English learning is our core product. We have a significant advantage with more than 30,000 Filipino teachers. The Filipino teachers enhance the learning experience for students and help us achieve very good margins. Due to our advantages in teacher resources and the international composition of our teachers, we are making good progress in transitioning our strategy and focus from the domestic business to the overseas market.

Operator, Operator

We will now take the next question from Boris Suvorov from Bova.

Unknown Analyst, Analyst

My question is about the distribution of assets and liabilities between Mainland China and non-Mainland China students. As per the last report, it shows about 151 million in current assets in U.S. dollars. What percentage of those current assets are for Mainland China?

Min Xu, CFO

I'll take this question. Currently, there is no clear-cut division of liability and assets between the Mainland China part and the overseas market part. Once the Board has evaluated, in terms of the value of both businesses, we still need to split the overhead. However, one principle we will look at in splitting these two areas is that we will always ensure the overseas business has positive net equities, which means, in principle, we will keep more cash than the gross billings or deferred revenues from overseas students. Regarding domestic business, as I mentioned earlier, there has always been a significant gap between the advances from students versus the cash. After the split, we believe that our domestic business will maintain that trend. Yet, going forward, we expect that all these advances from students will be utilized and turned into profit. This is why we are confident that splitting domestic and overseas businesses will allow a very clean balance sheet for the overseas business, permitting it to grow on its own trajectory. Simultaneously, for the domestic business, we can focus on our students to ensure all lesson credits are used, and that our students will learn and improve.

Unknown Analyst, Analyst

As a follow-up, a similar question: If the company will split into non-Mainland China and Mainland China, what about product development expense and general and administrative? In terms of staffing, do you foresee any cost deductions arising from the splits between the two companies or do most engineers and general admin staff remain with the non-Mainland China company?

Min Xu, CFO

Yes, we will split our staff for G&A and R&D. Clearly, anything related to a public company will stay with the public company. Most of the patents and IP will belong to the public company. We currently have a very small G&A and R&D team, so roughly, it will be probably 50-50. Half of the staff will stay with the domestic business, and half will remain with the public company, focusing on the overseas market.

Operator, Operator

There are no further questions at the moment. And we have a follow-up question from Long Lin from The Benchmark Company.

Long Lin, Analyst

Yes, I have a follow-up on your overseas business. I just wanted to know if the company needs any additional capital to fund the overseas expansion.

Min Xu, CFO

I'll take this question. Currently, we do not need additional capital to fund overseas business growth. The cash balance in our overseas bank accounts is sufficient to drive our growth until we turn cash flow positive, which we believe could happen in 2023.

Operator, Operator

We have no further questions, so I would like to turn the call back to the company for closing remarks. Mrs. please go ahead.

Unknown Executive, Unknown

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.

Min Xu, CFO

Thank you, everyone.

Operator, Operator

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