Earnings Call Transcript - GOTU Q3 2020

Operator, Operator

Ladies and gentlemen, thank you for joining us for the GSX Techedu Inc. Third Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity for questions. Please note that this event is being recorded on November 20, 2020. I would now like to introduce your first speaker today, Ms. Sandy Qin, IR Senior Manager of GSX. Thank you. Please go ahead.

Sandy Qin, IR Senior Manager

Thank you, operator. Hello everyone and thank you for joining us today. GSX earnings release was distributed earlier today and is available on the company's Investor Relations website. On the call with me today are Mr. Larry Chen, GSX Founder, Chairman and Chief Executive Officer; and Ms. Shannon Shen, Chief Financial Officer. Larry will give a general overview and then Shannon will discuss the financials. Following the prepared remarks, Larry and Shannon will be available to answer your questions. Before we begin, I would like to remind you that this conference call contains forward-looking statements as defined in the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements are based upon management's current expectations and current market and operating conditions and relate to events that involve known or unknown risks, uncertainties and other factors, all of which are difficult to predict and many of which are beyond the company's control and may cause the company's actual results, performance or achievements to differ materially. Further information regarding these and other risks, uncertainties or factors is included in the company's filings with the SEC. The company does not undertake any obligation to update any forward-looking statements, except as required in applicable law. As a reminder, this conference is being recorded. In addition, a live and archived webcast of this conference call will be available on GSX Investor Relations website. You are also welcomed to subscribe to our quarterly investor newsletters through the same website. It is now my pleasure to introduce Larry. Larry, please go ahead.

Larry Chen, CEO

Thank you, Sandy. Good evening, and good morning to you all. Thank you for joining us today on this earnings call. We have achieved another robust quarter with net revenues hitting an all-time high of RMB 1.97 billion, which is 3.5 times that of the same quarter of last year. We are also pleased to report that our student structure has grown healthier with net revenue from our primary school becoming the largest contributor. These outstanding results speak to our continuous focus of providing the highest quality services to students and parents, our consistent training to frontline employees, and our unwavering efforts to improve operational efficiencies and organizational capabilities. In the face of increasingly fierce competition and ever-driving customer acquisition costs, we remain committed to pursuing effective traffic acquisition through high ROI channels, sticking to efficient sales and marketing spending, and executing an effective growth strategy based on customer lifetime value. This summer, we achieved the highest operating efficiency in the sector, and we believe we will continue to achieve this on a full-year basis in 2020. In the meantime, we continue to invest extensively in our teaching staff, product design, content development, and technology innovation, raising overall compensation for our tutors to attract more top-tier talents. While it puts pressure on our gross profit and net income over the short term, we view all of this spending as an important investment in our long-term future. Online education is a labor-intensive and talent-intensive industry, and the leading companies must manage and serve a large number of employees. Excellent organizational capabilities will be the key driver for a player to achieve long-term success. In terms of our business model, we chose to focus on the online live classroom format in the past, and we will continue to focus on it in the future. We recently integrated our key trial business and our Gaotu Ketang brand. Gaotu Ketang integrates and streamlines our instructors and tutor teams, service standards, products, and technologies. Our goal is to deliver a large class quality, the learning experience of a small class, and the feeling and educational results of one-on-one tutoring. We believe this integration further demonstrates our dedication to our focused strategy and better positions us to capture the enormous opportunities during the fast consolidation period of the online education industry. So far, the integration has exceeded our expectations. The class completion rates and the conversion rates are showing significant improvements. Our Genshuixue brand will focus on providing post-secondary education training classes such as CET graduate school automation exams and various professional qualification exams. Some investors may wonder about our view on AI interaction courses. From our observation, the application of artificial intelligence in online education is still in its early stages. The application of AI in the preschool market and the synergies between the pre-K and K-12 markets are still in need of further observation and discussion. Of course, with the advancement of technology, we can solve some of the basic needs of students through systems and AI, while various other requirements and personalized demands will be better matched by technology. Hence, we have been constantly increasing our investment in research and technology, with the third quarter's R&D expenses totaling RMB 200 million. However, no matter how technology and AI develop, the ultimate key to genuinely earning the trust of clients and bringing meaningful learning results to students is to always strive to win over their hearts and ignite their interest in learning, helping them cultivate great learning habits and shape their personalities through our sincere and distinguished services. Regardless of the current intense competition, we still see vast potential in the online education industry and are fully prepared to explore all possibilities based on the solid foundation we have built over the years. We look forward to generating more value for our shareholders and sharing the future of online education with you. Now I will pass the call to our CFO, Shannon, to walk you through our financial and operational details.

Shannon Shen, CFO

Thanks, Larry, and thank you everyone for joining the call. Now, I will walk you through our operating and financial results and provide guidance for the next quarter. Please be reminded that all the financial data I mention will be in RMB terms, unless otherwise noted. For the third quarter of 2020, we continued to deliver solid results. Net revenues increased by 253% year-over-year to RMB 1,970 million. For the first time, our revenue reached just shy of RMB 2 billion in one quarter. This helps us rank as one of the top players in the online live large class industry. This is our eighth consecutive quarter with year-over-year net revenue growth of more than 250%. Net revenues from our online K-12 business grew by 283% year-over-year, which is the 11th consecutive quarter that we have been above 250%. We recorded RMB 2,100 million in gross billings, up by 137% year-over-year. The growth in gross billings was mainly due to our solid recruitment of new students, despite the tough competition. Because of the pandemic, both college and high school entrance exams were delayed, and the timing of the summer holidays in different provinces and cities varied. As a result, the summer vacation in 2020 was shorter than in prior years, which affected us by reducing one term of our curriculum. Even though the situation was quite challenging, we attracted a satisfactory number of new paid course enrollments. At present, we have set up regional operation centers in 15 cities outside of Beijing. We increased our recruitment and training of high-quality tutors to meet enrollment demand during the summer vacation. We are committed to constantly providing a better and more customized learning experience for parents and students. In the third quarter, we recorded paid course enrollments of 1,260,000, which was up by 134% year-over-year. The number of student enrollments in both regular priced courses and promotional courses continues to set new records, which adds to a significant increase in our brand awareness. The increase in first-time users was primarily driven by our effective investments in sales and marketing efforts. Now let's break down our operations and financials by business line. Net revenues from our K-12 courses increased by 283% year-over-year to RMB 1,800 million and accounted for 89% of net revenues. We expect the proportion of K-12 revenue will continue to expand as our main source of revenues. Going forward, all K-12-related services will be solely provided by the Gaotu Ketang brand. Within the K-12 business, our Primary School segment continues to grow rapidly, making it the largest contributor in terms of net revenues. This achievement validates our strategy of prioritizing the primary school market and demonstrates the effective and consistent execution of our corporate strategy. Gross billings contributed by K-12 courses rose by 141% year-over-year to RMB 1,800 million. Paid course enrollments for our K-12 courses increased by 141% year-over-year to 1,150,000. The average selling price for K-12 paid course enrollment was around RMB 1,600, compared with around RMB 1,500 in the last quarter and around RMB 1,600 in the same quarter last year. The quarter-over-quarter increase in the average selling price for K-12 paid course enrollment was mainly due to seasonal factors. The year-over-year average selling price remains stable, which is what we promised at the beginning of the year because we wanted to provide fair access to high-quality education resources across the country. We have always tried to hire the best instructors and tutors in the industry so that our students receive the highest quality instruction. Average enrollments per class rose to 2,800 compared with 2,000 in the second quarter of 2020 and 1,400 in the same period of 2019. The significant year-over-year and quarter-over-quarter improvements demonstrate the rapid increase in our enrollment sizes during the summer vacation. Throughout this summer, our student structure has grown sustainably, with the number of non-graduate grade students significantly increasing, laying a solid foundation for our future retention. Net revenues from our foreign language, professional, and interest courses offered under our Genshuixue brand increased by 125% year-over-year to RMB 200 million, accounting for 10% of net revenues. Gross billings contributed by foreign language, professional, and interest courses rose by 135% year-over-year to RMB 300 million. Paid course enrollments for our foreign language, professional, and interest courses increased by 79% year-over-year to 1,010,000. The gross profit margin increased by around 260 basis points year-over-year to 74%. Non-GAAP gross profit margin, which excludes share-based compensation, increased by around 260 basis points year-over-year to 75%. Selling expenses increased to RMB 2,100 million in the third quarter of 2020. Within that, expenses for traffic acquisition were approximately RMB 1.5 billion. Expenses for branding activities were approximately RMB 58 million, and the remaining expenses cover labor, servers, bandwidth, etc. There was a certain timing mismatch between our gross billings and the traffic acquisition expense due to our front-loaded traffic acquisition. In the third quarter, we strategically front-loaded investments of around RMB 200 million in traffic acquisition for the promotional courses recruitment for the fourth quarter, which generated no gross billings in the third quarter. This spending offset by another round of RMB 200 million that we front-loaded in the second quarter, as mentioned in our prior earnings call, resulted in a better change in the actual traffic acquisition cost for this quarter. Excluding the cost of brand promotion, our return on investment for pure first-time user acquisition was around 1.3. From various channels' feedback, our ROI was still ahead of the industry. We have greatly improved our student structure on several dimensions. Firstly, paid enrollments from lower-tier cities increased to 57% in this quarter, signaling our penetration into lower-tier cities further improved due to the successful execution of our customer acquisition strategy in those regions. Lower-tier cities present a large and explosive market, and our higher growth of paid enrollments in lower-tier cities proves our potential. Secondly, back in the spring semester, a proportion of those enrollments were from short-term or graduate grade courses. Throughout this summer, we significantly increased the size of non-graduate grade students. This structure will benefit our future retention and greatly help propel our subsequent overall growth. Going forward, we will take advantage of our strength in operational efficiency and continue to invest in traffic acquisition. Research and development expenses increased by 286% year-over-year to RMB 200 million. This rise was primarily due to an increase in the number of content professionals and technology development personnel, as well as an increase in compensation for such staff. Our constant investments in research and development are important for our ability to further drive operational efficiency in the future. General and administrative expenses increased to RMB 200 million from RMB 24 million in the third quarter of 2019. The increase in general and administrative expenses was mainly due to an increase in the number of general and administrative personnel, an increase in compensation paid to general and administrative staff, and an increase in fees for the ongoing investigation. Interest income and realized gains from investments this quarter from cash, cash equivalents, short-term and long-term investments increased by 264% to RMB 18 million from RMB 5 million in the third quarter of 2019. This increase was primarily due to an increase in cash and short-term wealth management investments, as well as the realization of gains generated from short-term and long-term investments during the quarter. As of September 30, 2020, we had cash and cash equivalents, short-term investments, and long-term investments of RMB 2,100 million in aggregate compared with a total of RMB 2,700 million of cash and cash equivalents, short-term investments, and long-term investments as of December 31, 2019. Net operating cash outflow for the third quarter of 2020 was RMB 608 million. The outflow was primarily due to higher marketing expenses paid to improve our market share and brand awareness, an increase in compensation for fast-growing staff, and an increase in service and expenses to support our rapid growth of students and daily operational activities. Furthermore, RMB 24 million was paid for our Zhengzhou property purchase, and we also had RMB 99 million in capital expenditures during the period. With that, I will now provide our business outlook. Our net revenues for the fourth quarter are projected to be between RMB 2,076 million and RMB 2,116 million, representing an increase of 122% to 126% on a year-over-year basis. These estimates reflect our current expectations, which are subject to change. Thanks, operator. We are now able to take questions.

Operator, Operator

Thank you. We will now start the question-and-answer session. The first question today comes from Gregory Zhao of Barclays. Please go ahead.

Gregory Zhao, Analyst

Hi, Chen, Shen, Sandy, thanks for taking my question. So my question is still about the market as a competitive landscape, right? So we noticed some private companies have raised a lot of money in the past six months, and a lot of the investment has been spent on marketing and user acquisition. So I just want to understand GSX's plans and strategy in response to the competition? And how long do you think this kind of competition will last? And also, how should we think about the market competition, the impact on your student enrollments in the September quarter, and we saw the sequential trend of the enrollments is a bit different from the past years? Thank you.

Larry Chen, CEO

Thank you, Greg. When discussing online education, we refer to the leading core companies. There have been significant changes in the market over the past few months, with some private companies securing substantial funding. Looking at the data from the third quarter, we see that in the online live classes sector, we are ranked among the top four players in terms of revenue. We recognize that summer is a crucial time for new enrollment recruitment throughout the year, which led us to strategically increase our investments. This summer, our sales and marketing expenditures grew considerably compared to last year, but we remain mindful of market fluctuations. According to third-party data, some competitors' summer spending on sales and marketing surpassed RMB 4.5 billion. In terms of return on investment, we likely maintain the highest ratio. Based on current market conditions and the performance of various players, we anticipate that competition will intensify in 2021, and we believe peer competition may reach a pivotal point by 2022. Our strategy continues to prioritize our customers, enhance efficiency, and improve key metrics. We are confident that as we achieve the highest operating efficiency, we will attract capital consistently.

Shannon Shen, CFO

Thanks, Greg. Adding to Larry's point, in the short-term, the fierce competition seems to bring pressure to companies. However, if we look at the long-term, the industry position will become clearer after the competition, and companies with low operational efficiency will accelerate their cash-burning speed. Only companies with higher operating efficiency will emerge as the final leaders. The route has never changed when we look at each sector in the TMT business. However, we have received many questions about how to evaluate which company has the highest operating efficiency. From our perspective, we think there are a couple of aspects to testify this. First, financial results are always the most straightforward way to look at a company’s operating efficiency. Since 2017, we have faced significant losses but gained a fast growth speed across the sector. Although we have had single quarters of net loss, looking at the whole year, we still have confidence in our competitive operating margin. We will likely be one of the very few companies that have a high probability of achieving positive operating cash flow when viewed annually. Secondly, the team and organizational capability are critical. We have built and solidified an exceptional and scalable management team. This team is diversified, young, and has a strong sense of corporate identity. Despite the challenges we faced this year, we retained our core management team. When a company grows rapidly, a team willing to contribute their energies and careers becomes the most valuable asset. We have emphasized that online education has a long-service trend, and we need to improve across our entire value chain. As we scale, we realize the importance of this perception. For example, some companies may excel at serving students long-term but struggle with new student recruitment, and vice versa. We remain focused on improving our organizational capabilities, striving for 3% to 5% better on each segment of the long value chain. That is our approach to facing competition, and we believe that when we do the right things, results will turn in our favor.

Gregory Zhao, Analyst

Okay, thank you very much.

Shannon Shen, CFO

Thanks, Greg.

Operator, Operator

The next question comes from Mark Li of Citi. Please go ahead.

Mark Li, Analyst

Hi management. Thank you for taking my questions. I want to ask about this quarter's gross margin. I think we have a two to four-point decline quarter-on-quarter, which seems to be a bit softer compared to Q2 and the last year trend. But our ASP and scale are doing well. So I mean, what is the reason for the gross margin? And also, how should we think about the trend going forward? Thank you.

Shannon Shen, CFO

Okay, thanks Mark. Our gross margin last quarter, if we look at it on a year-over-year basis, is in an increasing trend, but there was a slight decrease quarter-over-quarter. The reason is mainly due to seasonality. As our student base expands, seasonal effects will become apparent. In the third quarter, we provided a large number of promotional classes with limited revenue contribution. However, it still incurs costs such as infrastructures, networks, and fixed labor costs, especially to provide better learning experiences and services to our promotional classes. We recruit tutors up front for a month to provide training and ensure they perform well. This caused our salary paid to tutors to increase. Additionally, the timing of the entrance exams led to a concentration of learning materials costs, contributing to the gross margin decline. We do see our gross margin recovering in Q4 due to a full season of courses and more even distribution of learning materials costs.

Mark Li, Analyst

Okay. Thank you.

Operator, Operator

The next question comes from Maggie Zheng of Haitong International. Please go ahead.

Maggie Zheng, Analyst

Thank you for taking my question. I notice that there is a quarter-on-quarter decline in K-12 paid enrollments, even though we increased our sales and marketing efforts. Can you explain that? Is it because of the conversion rates or is it because some of the student base shrank in this quarter?

Shannon Shen, CFO

Thanks, Maggie. This is also due to seasonality. Student enrollment and gross billings for K-12 business show distinct seasonality. Typically, most retentions happen in Q2 and Q4, while most new student recruitments happen in Q1 and Q3. During the third quarter, the majority of paid enrollments are first-time users; we spent sales and marketing expenses to attract them. This contrasts with Q2, when most paid enrollments come from retention, leading to lower additional costs. As seen in previous trends, we expect paid enrollments to increase in Q4.

Maggie Zheng, Analyst

Thank you.

Operator, Operator

The next question comes from Felix Liu of UBS. Please go ahead.

Felix Liu, Analyst

Good evening, management, and thank you for taking my question. I agree with what you mentioned during the earnings release that you will focus on an LTV-based approach towards selling and marketing. Could you elaborate on this? Also, I'm curious about how long a student typically stays with your platform, and what is the lifetime value of an average student? My second question is on ROI. I understand you're outperforming the industry peers, but compared to previous periods, your ROI is declining. Are you implementing any strategies to improve the ROI moving forward?

Shannon Shen, CFO

Thanks, Felix. The market for primary school is still the largest in the K-12 sector, and we need to put a lot of energy into this market. The best strategy is to serve parents and students to their satisfaction, allowing them to stay on the platform longer and improving lifetime value. We have enhanced our Primary School segment in several ways. First, we continue to focus on recruiting and developing teaching talent. Recently, top-tier teachers, favored by parents, have joined us as instructors. We have also upgraded our primary school curriculum to provide a learning capability-oriented and results-driven course system. Second, we emphasize the training of tutors in educational psychology to enable them to better serve our students and communicate effectively with parents. Third, we constantly upgrade our live streaming technology to ensure a smooth learning experience. As a result of these enhancements, we see significant improvement in our primary school's retention rate, which is now leading all segments. This strategy will help improve our ROI. Though the primary school sector may have a lower ROI than middle and high schools, the potential for LTV in this segment justifies this focus. If we can help students stay longer, we can absorb a slightly lower upfront ROI.

Felix Liu, Analyst

Thank you very much.

Operator, Operator

The next question comes from D. S. Kim of JPMorgan. Please go ahead.

D. S. Kim, Analyst

Hi, good evening. Hi Mr. Chen, hi Shannon. Thanks a lot for taking my questions. I have two. First about just a follow-up on your earlier point: may I confirm if we can still generate unit economics on the newly acquired students, excluding retained and existing students? If so, what's the lifetime – the length of the student you assume in that scenario? That's my first question. My second question, if I may, is regarding high-level strategy for Mr. Chen. Would you consider developing ways to grow organic traffic over the medium term, say, through homework help, similar to some of our top-tier groups? Or some kind of platform as we did in the past, just to prepare for an unlikely scenario wherein third-party channels become prohibitively expensive? Would you consider that in the medium term? I also noticed we have acquired an online business recently; could you elaborate on the rationale?

Shannon Shen, CFO

Thanks, Mr. Kim. Your first question is important. There's much discussion in the sector regarding whether new students can generate positive unit economics, as many companies report lower retention rates for newly acquired students compared to existing ones. This summer, we maintained a strategy to recruit students and keep them through both the summer and subsequent semesters because we believe longer retention correlates with better outcomes. We’ve witnessed our strategy leading to greater loyalty and retention for students who progressed through both sessions. As for the second question regarding organic traffic through homework assistance, I will defer to Larry.

Larry Chen, CEO

I want to add that for lifetime value, three elements are critical: customer acquisition cost, which refers to the expense incurred to recruit a student; gross profit margin, which closely relates to selling prices and operating efficiency; and retention rates, an essential metric for defining depth. All three combined create a leverage effect, contributing to our long-term competitive advantages. Regarding organic traffic, many players are exploring similar avenues, and the specifics of these initiatives depend heavily on stage alignment, organizational characteristics, and operational efficiency. We are still exploring this avenue.

D. S. Kim, Analyst

Thank you very much for the insights.

Shannon Shen, CFO

Thanks. Regarding the acquisition you mentioned—if we did acquire another online education arm, we would announce it publicly once finalized. Noting that the management team of that business has a deep education industry experience and innovative student acquisition methods is crucial. However, we currently don't have a clear plan related to your inquiry; if significant developments occur, we will provide an announcement.

Operator, Operator

The next question comes from Tian Hou of T.H. Capital. Please go ahead.

Tian Hou, Analyst

Hi Larry, Shannon, and Sandy. Two basic questions: one is for your elementary, middle school, and high school, what is the enrollment composition as well as the revenue composition? That's number one. Number two, what is the average size of the class in Q3? Those are the two questions. Thank you.

Shannon Shen, CFO

Thanks. For your first question, primary schools are the biggest revenue contributors this quarter, and since the ASP in primary school is lower than junior and high school, even more enrollments have contributed relative to those segments. For your second question, the average size of a class in the third quarter has reached 2,800 students. Hope that answers your question. Thanks.

Tian Hou, Analyst

Yes, Shannon. Thank you.

Operator, Operator

Your next question comes from Alex Xie of Credit Suisse. Please go ahead.

Alex Xie, Analyst

Hi, thank you for taking my questions. My first question is about organizational capabilities. You mentioned that this will be your main advantage and challenge ahead. Could you elaborate on the aspects of your organizational capabilities and changes after upgrading your organizational structure? My second question is about your view on future product and service changes. For instance, with intensified customer service, will the product portfolio become more diversified?

Larry Chen, CEO

Thank you, Alex. GSX is focused solely on online education as an independent company. We provide detailed operational and financial metrics that offer insights into the online education market. Our organizational capabilities are a significant competitive edge. In our first three years, we encountered numerous challenges, which led to rigorous standards and self-review practices within our team. The GSX staff is highly aspirational; they are curious, serious, and committed to excellence, which we integrate into our daily work. Since September, we have merged Genshuixue and Gaotu Ketang under the Gaotu Ketang brand, enhancing our resources and improving our technology, product quality, instructor effectiveness, and management practices. Over time, we expect this will lead to a more competitive and efficient Gaotu Ketang. Education extends beyond teaching to include talent cultivation. We continuously seek top-quality tutors and have brought on nearly 15,000, ensuring the quality of our education moving forward. Enhancing engagement with students is also vital. As their motivation increases, they develop a desire to change. Our aim is to provide courses that combine the quality of large classes, the experience of small classes, and the impact of one-on-one tutoring. Finally, we are working on our future product mix to satisfy customer demand, including the development of programming courses that align with our capabilities.

Alex Xie, Analyst

Got it. Very helpful. Thank you very much.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Sandy Qin for any closing remarks.

Sandy Qin, IR Senior Manager

Okay, thank you, operator. And thank you everyone for joining the call today. If you have any further questions, please don't hesitate to contact us or the company directly. Please feel free to subscribe to our news alerts on the company IR website. Thank you very much.

Operator, Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.