Earnings Call Transcript - RLX Q1 2023

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for the RLX Technology Incorporated First Quarter 2023 Earnings Conference Call. At this time, all participants are in listen-only mode. After management's remarks, there will be a question-and-answer session. Today's conference call is being recorded and is expected to last for about 40 minutes. I will now turn the call over to your host, Mr. Sam Tsang, Head of Capital Markets for the company. Please go ahead, Sam.

Sam Tsang, Head of Capital Markets

Thank you very much. Hello, everyone, and welcome to RLX Technology's first-quarter 2023 earnings conference call. The company's financial and operational results were released through PR Newswire services earlier today and have been made available online. You can also view the earnings press release by visiting the IR section of our website at ir.relxtech.com. Participants on today's call will include our CEO, Ms. Kate Wang; our CFO, Mr. Chao Lu; and myself. 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. These statements typically contain words such as may, will, expect, targets, estimates, intend, believe, potential, continue, or other similar expressions. Forward-looking statements involve inherent risks and uncertainties. The accuracy of these statements may be impacted by a number of business risks and uncertainties that could cause actual results to differ materially from those projected or anticipated, many of which factors are beyond our control. The company, its affiliates, advisors, and representatives do not undertake any obligation to update these forward-looking statements, except as required under the applicable law. Please note that RLX Technology’s earnings press release and this conference call include discussions of unaudited GAAP financial measures as well as unaudited non-GAAP financial measures. RLX press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited GAAP measures. I will now turn the call over to Ms. Kate Wang. Please go ahead.

Kate Wang, CEO

Thank you, Sam, and thanks, everyone, for making time to join our earnings conference call today. During the first quarter, we continued optimizing our compliant GB product offerings under the new regulatory framework and made steady progress, thanks to our effective product strategy and constant efforts to enhance our R&D capabilities. However, as we strive to develop improved products to meet our users' diverse demands, the prevalence of illegal products continues to pose near-term challenges to our business in the broader industry. First, let me provide some color on recent market conditions affected by illegal products. The biggest obstacle we faced in the first quarter of 2023 was competition from illegal products. These include flavored products manufactured by companies that haven't yet obtained licenses, some flavored products manufactured for export that are illegally sold in the domestic market, and counterfeit products. The existence of these illegal products not only impacts our sales, but also disrupts the recovery pace of the entire industry by slowing consumers' conversion to products that meet national standards. But on the bright side, the government has increased its efforts to crack down on illegal products, recently conducting special operations to focus on two major offenders: manufacturing companies that continue to illegally produce flavored products and retail participants that use the Internet as a distribution channel. The results of these government endeavors are encouraging thus far. We have noticed more and more unlicensed manufacturing companies deleting illegal products from their business scopes. Also, a number of retailers distributing illegal flavored products have been fined. Our sales have gradually recovered following the execution of these special actions. Our CFO will elaborate on this a bit later. We believe the government's crackdown on illegal products is still ongoing, and we are hopeful that it will effectively support the creation of fair and orderly market conditions, prompting a return to sustainable growth for law-abiding companies such as RLX. However, we remain vigilant on any potential rebound of these illegal activities. Amid the first quarter's external challenges, we remain focused on strengthening our core competitiveness and pursuing high-quality development. Enhancing our product development and scientific research capabilities has always been a key element of our strategy. We partnered with Shenzhen Bay Laboratory in the first quarter to establish the new optimization technology research and development platform. Together, we will explore and develop new peptide drugs based on electronic atomization technology, leveraging our DP clearance and industry-leading atomization technology to improve absorption efficiency and enhance user experience. Furthermore, we continue to execute our prudent product strategy in reaching and optimizing our product portfolio to meet the needs of different user groups. As of now, we have received approvals for 20 cartridge SKUs and 22 device SKUs. Encouragingly, we have received some positive feedback and constructive suggestions from users who have switched to our new products. We'll continue collecting user feedback and developing products accordingly, seeking superior performance and quality while helping adult smokers transition to GB products. We remain dedicated to our social responsibility alongside our efforts to offer high-quality compliant products for adult smokers. An outstanding example is our Pods Reborn program, one of our key sustainability initiatives to help reduce plastic waste. The program has grown by leaps and bounds since its inception in 2021. As of the first quarter of 2023, we have cumulatively collected over 3 million cartridges from over 80,000 users across 297 cities nationwide. Moreover, users can now use our official accounts to find recycling locations near them or book a pickup appointment online. The used pods are recycled into cement and then used to construct roads, bridges, and other infrastructure projects. As of today, we have invested RMB20 million in the first phase of our low-carbonization project, providing better infrastructure for rural villagers while conserving precious resources. To sum up, the first quarter was a mixed bag. While we made solid progress in improving our GB product offerings, we also experienced significant headwinds from illegal products. However, we firmly believe that as our users gradually adapt to GB products and the government's effort to protect market order and fairness takes effect, illegal products will eventually be pushed out to the mainstream market. And the worst seems to have been behind us. As a trusted e-vapor brand for adult smokers, we remain confident in our core competitiveness. We will deepen our commitment to providing compliant premium products that meet our users' needs as we explore growth opportunities in this evolving industry. With that, I will now turn the call over to our CFO, Chao Lu. He will elaborate further on some of our latest quarter's initiatives and go over our operational and financial results in more detail.

Chao Lu, CFO

Thank you, Kate, and hello, everyone. I will now provide an overview of our operational and financial results for the first quarter of 2023. Given the severe impact of illegal flavored products, we experienced an incredibly challenging first quarter, especially in January and February. These enticing flavored but unsafe and illegal products caused users to shift more slowly than expected to our GB products, driving a significant decrease in our net revenue to RMB189 million in the first quarter. However, our sales have recently shown clear signs of recovery, partly thanks to the government's large-scale operations to combat illegal products. Specifically, our monthly sales experienced sequential improvement, especially after the government's special actions in March. In fact, monthly sales almost doubled in March compared to January. However, the negative impact of illegal products is still lingering, as it will take some time for the market to digest inventories, much like in the fourth quarter of last year when it took a couple of months for users to consume our older products. The near-term challenges from illegal products will gradually ease and become more manageable, and users will gradually adapt to GB products. Now turning to gross margin, the first quarter of 2023 was our first full quarter under the new excise tax policy on e-vapor products, which came into effect in November 2022. As a result, our gross margin fell to 24.2% in the first quarter of 2023 from 38.3% in the same period last year. If we exclude the impact of excise tax, on an adjusted basis, using net revenues which deducts excise tax we paid from the reported net revenues as the denominator, our adjusted gross margin fell only by 1.6 percentage points. This result reflects our continued efforts to improve our supply chain efficiency and product design to mitigate the deleveraging effect of reduced sales. Additionally, fixed costs, including the rent we paid for exclusive manufacturing plants and depreciation we booked for PP&E, dragged on our gross margin by a low single-digit percentage in the first quarter. Our gross margin will gradually improve along with our top line recovery in the coming quarters as the deleveraging effect, I just mentioned, will shrink. Alongside these cost optimization efforts, we continue to focus on improving operational efficiency. As a result, excluding share-based compensation, our non-GAAP operating expenses were down by 50.1% year-over-year in the first quarter of 2023. However, due to our reduced sales, we recorded a non-GAAP operating loss of RMB133 million in the first quarter. Furthermore, we recorded a net loss of RMB56.3 million in the first quarter of 2023. Excluding share-based compensation, our non-GAAP net income was RMB184 million in the first quarter of 2023. Non-GAAP basic and diluted net income per ADS were RMB0.139 and RMB0.136, respectively, in the first quarter of 2023. Our cash position remains solid. As of March 31, 2023, we had cash and cash equivalents, restricted cash, short-term bank deposits, short-term investments, long-term bank deposits, and net long-term investment securities totaling RMB15,369 million. Since the second half of 2022, we have been working to maximize the interest and investment income on our solid RMB15.4 billion cash position. Our strategic efforts are now paying off, and we generated RMB170 million in interest and investment income in the first quarter of 2023, implying an annualized interest rate above 4%, a significant improvement from less than 2% a year ago. Before I conclude, I'd like to provide an update on our share repurchase program. Our Board of Directors approved a share repurchase plan on December 8, 2021, under which we may repurchase up to US$500 million of our shares until December 31, 2023. As of December 31, 2022, we have repurchased about US$100 million of our shares under this program. Looking ahead, we will continue investing in our core capabilities and improving overall efficiency. We believe our sales and profitability will gradually pick up as the industry regains momentum. Our resilient business model and solid cash position will support us as we navigate the market dynamics, enabling us to deliver sustainable value to our shareholders and stakeholders in the long term. We will now open the call to questions. Operator, please go ahead.

Operator, Operator

Thank you. Our first question comes from Lydia Ling from Citi. Please proceed.

Lydia Ling, Analyst

Thank you. Hi management, this is Lydia from Citi. So thanks for the presentation. I have two questions. First, glad to hear that monthly sales have some sequential recovery just mentioned by CFO. So, could you share some more color on the sales recovery trend in the second quarter to-date, like how the monthly sales in April recovered so far? And also based on current recovery trend, how do you see the full year trend? Are you turning more positive or negative? And also want to know about your retailers' profitability recovery so far? And this is my first question. And the second question is on new products. How many are your new products currently in the pipeline and plan to further rollout this year? And also, what's your view on your competitive edge over your peers regarding those new products? And how about the channel inventory after the regulators crack down? Is the level already significantly declining? Thank you.

Chao Lu, CFO

Thanks very much, Lydia. So regarding your first question, it's about the second quarter trend. As we prepared in our opening remarks, we know that there is sequential improvement in our monthly sales. This trend has actually continued starting from last November until now, i.e., April or May, due to the natural conversion of users from the old generation of products to GB products, thanks to the regulator's great action in cracking down on illegal products and the product launches of various SKUs. We made price adjustments on April 17 and lowered our factory price of selected cartridges by mid-teens to provide better margins for retailers, and we do witness a restocking from our distributors since then. For the full year outlook, we are confident in the overall trends as the numbers have been growing every month, but there are also uncertainties as the overall user sentiment hasn't fully recovered yet, and retailers with retail licenses will have to decide whether or not to renew their retail licenses in the coming months. We are confident in the trend and maintain our internal operational targets. Regarding our retailers' profitability, the trend of their sales of GB products has been going upwards, especially after the regulators' special action in March/April. Of course, some retailers selling illegal products may have their sales affected by the special action as well, so it's difficult to estimate their profitability quantitatively as each has different fixed cost structures. Regarding the product pipeline, we have already launched 20 cartridge SKUs approved in April compared with 15 in February, meaning we have five increments in just two months. We will gradually launch these new products on a provincial basis, and we have a number of products submitted or in the progress of application in addition to the 20, and we will provide an update once we have obtained the approvals. We have a significant edge over other brands as we possess industry-leading R&D capabilities to innovate our distinct and appealing tobacco flavors for adult smokers. Unlike most of our peers, who heavily rely on their suppliers, we have our own exclusive production plants and e-liquid factory, which guarantees our product quality and allows us to adhere to our strict product control protocol. Lastly, we have the most diversified product portfolio and will continue to diversify it to meet the needs of various user groups. Regarding illegal products, it is challenging to estimate their level of inventory given that it's a flat market. As I mentioned earlier, we believe the negative impact of illegal products is still lingering, and it could take some time for the market to digest the inventories similar to the fourth quarter of last year, which took a couple of months for users to consume our old products. Thank you for your questions.

Lydia Ling, Analyst

Thank you.

Operator, Operator

The next question comes from Peihang Lyu from CICC. Please go ahead.

Unidentified Analyst, Analyst

Hi management, this is Peihang Lyu at CICC and thank you for your time and presentation. I have three questions for you. My first question is about the sales structure of your latest cartridge device across four product lines. Additionally, what is the current ratio of cartridges to devices? My second question pertains to flavors; what differentiates the various GB standard flavors like syn? Lastly, I would like to ask about district supervision and enforcement against illegal products. What is the current market proportion of legal GB products, and what will be the focus moving forward in terms of supervision and law enforcement? Thank you.

Sam Tsang, Head of Capital Markets

Thank you very much, Peihang. So I think the first question is about the price ranges and proportions. In March/April, we are still gradually launching various SKUs to markets, province-by-province. The mix across each product series largely depends on the pace of new product launches. We recognize our revenue upon delivery to our distributor warehouse. If we launch a new SKU, like what we did in March/April, for a particular series in that month, the self-contribution of that series will be higher than usual. Meanwhile, the users of our old Phantom device can still continue to use their devices to consume our new real Phantom cartridges, which is why our Phantom user base still constitutes the majority of our four product series. Internally, we do not have a specific target regarding the proportion of each series. We believe the proportion across each series will depend on user demand in the medium term. Regarding the second question about R&D and how we try to differentiate our flavors, we have four different series for our cartridges with varying flavor features: the Ciem, which offers a mild tobacco flavor; Chanhao, a more balanced tobacco flavor; Yanko, a strong tobacco flavor; and Puyen, which resembles the overseas style with a strong tobacco flavor. These four different cartridge series offer a wide range of options for our users, assisting them in selecting their desired cartridge. For example, a user with a long history of smoking might consider using Yanko for its strong kick, while a user preferring a lighter tobacco experience may prefer Ciem. Regarding the third question, after the crackdown on illegal products, it is difficult to estimate the level of GB product sales as well. However, we see that after the special action launched in March and April, it has been very effective. It is now more challenging for users to seek illegal flavored products compared to before, and our monthly sales of GB products have been growing. In the long run, we believe that regulators will continue to monitor our markets and crack down on illegal products regularly as these could lead to significant tax losses, product safety issues, and minor protection issues. As a compliant e-vapor brand, we have paid a 36% excise tax and maintain a rigorous quality control mechanism, fully supporting minor protection initiatives. We expect that regulators will closely monitor unlicensed manufacturers who have applied but failed to secure a license as well as licensed manufacturers who produce safer products for export but may illegally redirect them to the domestic market. Thank you.

Unidentified Analyst, Analyst

Thank you.

Operator, Operator

The next question comes from Charlie Chen from China Renaissance. Please go ahead.

Charlie Chen, Analyst

Good evening management, thanks for taking my questions. I got two questions here. The first one is about gross margin. Mr. Lu commented in the presentation that the GB margin is likely to improve with operating leverage continuing. But previously, you also mentioned that you have done some supply chain optimization as well as some product mix changes. Can you provide more color on the driving factors of those three aspects: operating leverage, supply chain optimization, and product mix change? How do those three factors drive your gross margin going forward, and by what magnitude if possible? My second question is regarding the margins of your new products as well as your newly launched accessories such as chewing gums and other products. How do those products contribute to your margins as well as how do the margins of selling those products by your retailers? Thank you.

Sam Tsang, Head of Capital Markets

Thank you, Charlie. As we shared in our opening remarks, the implementation of the excise tax pressured our gross profit margin (GPM). This was the first quarter that the excise tax came into effect, and we also experienced some deleveraging effects from depreciation and amortization. For future GPM trends, the recovery pace of our sales would be the most important factor. If sales recover faster than we expect, the GPM would also recover more quickly. Additionally, the second factor would be the cost of products calculated on a weighted basis. We believe the benefits of our continued efforts to improve supply chain efficiency will continue gradually. Regarding the new initiatives, there are still some pilot programs at this stage with minimal revenue contribution. We will definitely share more color with you once they can contribute meaningfully to our finances. Currently, the overall merchandise gross margin of our new initiatives is higher than that of our core e-vapor business as they are not subject to the excise tax. Thank you for your question.

Charlie Chen, Analyst

Thank you.

Operator, Operator

Due to time constraints, I would now like to turn the call back over to the company for closing remarks.

Sam Tsang, Head of Capital Markets

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

Operator, Operator

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