Earnings Call Transcript - RLX Q3 2021

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for RLX Technology Inc's Third Quarter 2021 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 45 minutes. I will now turn the call over to your host, Mr. Sam Tsang, Head of Investor Relations of the Company. Please go ahead, Sam.

Sam Tsang, Head of Investor Relations

Thank you very much. Hello, everyone, and welcome to RLX Technologies Third Quarter 2021 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 Co-Founder, Chairperson of the Board of Directors, and Chief Executive Officer, Ms. Kate Wang, Chief Financial Officer, Mr. Chao Lu, and myself, Sam Tsang, Head of Investor Relations. Before we continue, please note that today's discussions 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, target, estimate, intend, belief, potential, continue, or other similar expressions. Forward-looking statements involve inherent risks and uncertainties. The accuracy of these statements will 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, representatives, and underwriters do not undertake any obligations to update this forward-looking information, except as required under applicable law. Please note that RLX Technologies earnings press release, and this conference call, include discussions of unaudited GAAP financial measures, as well as unaudited non-GAAP financial measures. RLX's 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 conference call today. Since the second half of the third quarter, there have been proactive regulatory developments through the global e-vapor space, including in China. Last Friday, November 26th, 2021, the State Council announced its decision to amend the detailed invitation regulations of the Tobacco Monopoly Law of the People's Republic of China, by adding new 65s, which states that implementation rules for next generation tobacco products, including e-cigarettes, shall refer to relevant tools concerning the implementation regulation of the Tobacco Monopoly Law. On Tuesday, November 30, 2021, the State Tobacco Monopoly Administration released a consultation paper entitled 'Electronic Cigarettes: A National Public Service Initiative for Standards Information' under the state's administration for market regulation, seeking public comment regarding national electronic-cigarette product standards. Yesterday, December 2nd, 2021, the State Tobacco Monopoly Administration released a consultation paper entitled 'Administrative Measures for Electronic Cigarettes,' seeking public comments regarding administrative regulations, electronic cigarettes, covering various aspects, including production, distribution, retail sales, import and export, and inspections. We firmly support this amendment to the detailed implementation regulations and have begun making the required changes to fully comply with the new regulations and administrative measures. We believe the amendment will pave the way for long-term and sustainable growth in this sector. We are also aware of meaningful worldwide regulatory developments, which reflect similar trends globally. In the U.S., the FDA has made substantial progress, reviewing PMTA applications and granting its first e-vapor product authorization in October, demonstrating its recognition of certain e-vapor products' harm reduction effect. We are hopeful to follow global regulatory developments and align with e-vapor product regulations as the global trend. In view of growth, as countries worldwide recognize the universal products' harm reduction benefits for adult smokers. With these regulatory developments, especially in China, we believe the sector will enter a new era of development, marked by enhanced productivity and quality, social responsibilities, and improved intellectual property protection. As some of you may be aware, the third quarter was challenging on the commercial front for the entire industry value chain, which has been reflected in our key value chain partners' financial results, previously. Misinformation from temporary negative publicity regarding the e-vapor sector, and the Walgreens Co. in our teen restrictions, in response to outbreaks in China, which we discussed during last quarter's earnings call, had a significant adverse impact on the retail sales and product procurement at our branded stores since the latter half of the second quarter. As a result, we recorded a 34% quarter-over-quarter decline in our net revenue. However, we believe this revenue decline to be temporary and have a clear plan to achieve long-term healthy growth, which Chao will explain in detail later. Despite these industry challenges, we continued to focus on building a solid foundation for sustainable success. In the third quarter, we increased our scientific research efforts and continued to attract and recruit top talent to strengthen our sales, supply chain, and R&D capabilities. We are committed to providing adult smokers with innovative harm reduction products of the highest quality. Additionally, at RLX, we plan and act for the long term. Corporate social responsibilities have been an integral part of our values since day one. In the third quarter, we unveiled our 2020 to 2021 corporate social responsibility report. In it, we shared our progress regarding our CSR initiatives, including our industry-leading age verification system, Sunflower System 3.0, featuring robust technology to prevent usage among under-18s. Our RLX Care community service program promotes revitalization and common prosperity. These accomplishments are a testament to our dedication to fulfilling our social responsibilities. We strive to positively impact our users, employees, and the communities in which we live. With that, I will now turn the call over to our CFO, Chao Lu. He will elaborate further on some of our last quarter's initiatives and go over our operational and financial results in more detail. Chao, please go ahead.

Chao Lu, CFO

Thank you, Kate. And hello, everyone. I will start by sharing some of this quarter's major initiatives and developments, then walk you through our key financial metrics. We believe that offering the right products to the right user segments through the optimal route-to-market will be key to our sustainable, high-quality growth. To this end, we continue to expand our product offerings to meet the needs of diverse user segments and optimize our distribution and retail networks to ensure quality growth. With respect to our product, we are focused on offering better and more tailored vaping products for various user groups to help engage new users with the right products. This quarter, we introduced an E-cigarette brand targeting adult smokers with a long history of smoking. Our goal is to recreate an authentic smoking experience for adult smokers by launching eight tobacco-flavored cartridges in our initial stage. At the same time, we further upgraded our accessible product line, which caters to price-sensitive users' needs. We also recently re-launched Stellar or other premium device lines in China, offering upscale style options, including leather, lace, and other fashionable materials. We will continue to monitor user experiences closely and launch innovative, targeted products at the right time. We also made several advancements in user retention and engagement this quarter. We successfully upgraded our membership system, enabling members to enjoy more benefits as they accumulate reward points. A growing number of users are scanning the QR codes on their cartridges to collect ruble points, empowering users with instant product authentication. Separately, we have established more effective communication channels to provide unbiased, fact-based, scientific e-vapor product information to our users and the community. Finally, we are concentrating on distribution and retail channel optimization. Instead of engaging more distributors and expanding the number of our RELX branded stores, this quarter, we prioritized enhancing our existing distributors' organizational structures. We encourage our distributors to hire exceptional talent and refine their team structures within each department. We optimize existing RELX branded partners' stores by identifying areas with high retail sales potential and encouraging store owners to adjust their operations in accordance. In addition, we provided online and offline training for store owners and sales personnel to enhance their communication skills and enrich their product knowledge, countering the diverse effects from misinformation resulting from periodic negative publicity. We have also upgraded our digitalization system for branded partner stores, providing improved functionality and additional user portals to assist store owners and sales personnel in their daily operations. For our other retail outlets, our focus in the third quarter was to identify prime outlets for expansion through trials in various channels. These trials resulted in several initial successes, including strong momentum in lifestyle channels and other key accounts. In addition to our efforts on high-quality growth, we are deeply committed to fulfilling our corporate social responsibilities. We believe the healthy relationship between our products, users, shareholders, and the community, has been essential to the growth we have achieved over RELX's four-year history. With this in mind, we will work tirelessly to introduce new technologies to address industry challenges. For example, minor protection is one of RELX's highest priorities. We are putting all our efforts into our minor protection initiative, from product labels to trade channels and technology innovation. In June 2021, we began upgrading Sunflower System, our technology-driven minor protection system, to version 3.0, and have equipped all of our branded stores with the upgraded software. On the Sunflower System 3.0, all users are required to complete a name, ID number, and face recognition three-step verification before purchasing. After the amendment to China's national standards becomes effective, we will strictly adhere to any upgraded product requirements. For example, we are prepared to incorporate minor protection features such as child safety locks, similar to the features we integrated into our RELX ICE product lines back in 2019. As a Company that values long-term, high-quality growth, our commitment to corporate social responsibility is at the core of our daily operations. Echoing what Kate pointed out previously, our sector has entered the second half of the game with the State Council's decision to amend the detailed implementation regulations of the Tobacco Monopoly Law and the subsequent release of consultation papers regarding National Electronic Cigarette Product Standards by the State Tobacco Monopoly Administration. Unlike the first half of the game that lacked clear regulatory guidelines, this second half is marked by enhanced product safety and quality, authentic social responsibility, and improved intellectual property protection. The investments we made in products, talents, research, and compliance in the third quarter and beyond will place us in an advantageous position under the new regulatory paradigms. We expect these investments to ensure steady and sustainable growth, rewarding us and our shareholders in the long term. Turning to our financial results for the third quarter of 2021, net revenues decreased by 34% to RMB 1.68 billion, equivalent to $260.2 million, in the third quarter of 2021, down from RMB 2.54 billion in the second quarter of 2021. This decrease was the result of volatile market conditions, including negative e-vapor industry publicity since the latter half of the second quarter, the fact that the draft new rules announced on March 22nd, 2021 had not been formally confirmed, and no new implementation details were revealed during the quarter. Additionally, evolving restrictions in response to COVID-19 outbreaks in China had an adverse impact on our sales and channel inventory management. Gross profit decreased by 42.8% to RMB 656.0 million (US$101.8 million) in the third quarter of 2021, down from RMB 1.15 billion in the second quarter of 2021. Gross margin was 39.1% in the third quarter of 2021 compared to 45.1% in the second quarter of 2021. This decrease was primarily due to an increase in direct costs related to promotional activities and an increase in inventory provisions. Operating expenses were RMB 241.3 million equivalent to $37.5 million in the third quarter of 2021, representing a decrease of 244.4% from RMB 167.2 million in the second quarter of 2021. This significant decrease in operating expenses was primarily due to a recognition of share-based compensation expenses of RMB 523.7 million equivalent to $81.3 million, consisting of: share-based compensation expenses of RMB 90.8 million equivalent to $14.1 million recognized as selling expenses; share-based compensation expenses of RMB 320.1 million equivalent to $49.7 million recognized in general and administrative expenses; and share-based compensation expenses of RMB 112.8 million, equivalent to $17.5 million, recognized in research and development expenses. The significant fluctuations in share-based compensation expenses were primarily due to the changes in fair value of the share incentive awards granted to employees, affected by significant fluctuations in the Company's share price. Selling expenses decreased by 55.1% to RMB 56.5 million, equivalent to $8.8 million, in the third quarter of 2021, down from RMB 126 million in the second quarter of 2021. The decrease was primarily driven by fluctuations in share-based compensation expenses and a decrease in salaries and welfare benefits, partially offset by an increase in branding material expenses. General and administrative expenses decreased by 649.8% to RMB 253.2 million, equivalent to $39.3 million in the third quarter of 2021, down from RMB 46.1 million in the second quarter of 2021. The decrease was primarily driven by fluctuations in share-based compensation expenses and a decrease in salaries and welfare benefits. Research and Development expenses decreased by 808.3% to RMB 44.6 million, equivalent to $6.9 million in the third quarter of 2021, up from RMB 4.9 million in the second quarter of 2021. This decrease was primarily driven by fluctuations in share-based compensation expenses and a decrease in salaries and welfare benefits, partially offset by an increase in software and technical expenses, and an increase in consulting expenses. Income from operations was RMB 897.3 million, equivalent to $139.3 million, in the third quarter of 2021, compared with RMB 979.3 million in the second quarter of 2021. Income tax expenses were RMB 121.4 million, equivalent to $8.8 million, in the third quarter of 2021, compared to RMB 204.2 million in the second quarter of 2021. This decrease was primarily due to a decrease in taxable income. U.S. GAAP net income was RMB 976.4 million, equivalent to $151.5 million, in the third quarter of 2021, compared to RMB 824.3 million in the second quarter of 2021. Non-GAAP net income was RMB 452.7 million equivalent to $70.3 million in the third quarter of 2021, representing a decrease of 30.5% from RMB 651.8 million in the second quarter of 2021. U.S. GAAP basic and diluted net income per ADS were RMB 0.724 equivalent to $0.112 and RMB 0.717 which was equivalent to $0.111, respectively, in the third quarter of 2021. Compared to U.S. GAAP basic and diluted net income per ADS of RMB 0.595 and RMB 0.591, respectively, in the second quarter of 2021.

Operator, Operator

Thank you. We will now begin the question-and-answer session. For the benefit of all participants on today's call, if you wish to ask your question to management in Chinese, please immediately repeat your question in English. Today's first question comes from Lydia Ling at Citi. Please go ahead.

Lydia Ling, Analyst

Hi everyone. Hi Management. And thanks for the presentation, and this is Lydia Ling from Citi. I have two questions. My first question is, given the recent regulation update developments, would you like to share with us how your product portfolio will evolve going forward, and what changes can we expect to see in your existing product portfolio? And then my second question is, we saw further slowdown in the third quarter. Could you actually share more color on your fourth quarter to date operations trends and also your outlook for next year given the current regulation update and the COVID situation? Thank you.

Sam Tsang, Head of Investor Relations

Thanks very much, Lydia. So, regarding your first question about our product portfolio, we have already clarified our current development strategy. As mentioned in the opening remarks, we aim to offer device products to the right user segments through the optimal route-to-market channel. We are aware of the press conference held by the State Tobacco Monopoly Administration yesterday and the announced product consultation on National Electronic Cigarettes. During the transition period of the new requirements becoming effective, we will comply with the regulatory guidelines. Regarding the changes to our current product offerings, we anticipate that we may need to modify some of our current offerings when the draft National Electronic Cigarettes regulations become effective. However, we are confident that such changes will not be overly complicated for our Company, technically. We will continue to promote our products as harm reduction alternatives. As for your second question about our Q4 outlook and 2022, we do not currently have any guidance for the quarter and next year. We hope to share more when we have better clarity.

Charlie Chen, Analyst

Thank you, management, for taking my questions. I have two questions. The first is could you please share your observations on the current competitive landscape for this industry? Are there any changes compared to the first half of this year? And also, what are your thoughts on the retail pricing in the current environment? My second question is regarding single-store sales. What are the current single-store sales levels for your branded partner stores, and what do you consider to be a healthy level of single-store sales? Thank you very much.

Sam Tsang, Head of Investor Relations

Thanks very much, Charlie. I will address your two questions. One pertains to the competitive landscape and the other one regarding our RLX branded stores. To address the first question, as mentioned before, during the latter half of the second quarter, we noted that the industry did not progress as expected. This trend has continued into the third quarter, where we observe external factors affecting the entire industry, including our Company and our peers to varying degrees. Regarding the competitive landscape, we have observed significant consolidation compared to the first half of 2021. Regarding retail pricing, we have increased our promotional efforts in the third quarter to drive retail sales and alleviate inventory pressure within our value chain. We have also observed that given the decline in general consumer spending in China, many other companies have similarly adjusted their sales incentives. Overall, the magnitude of our subsidies and promotional efforts is relatively insignificant compared to other consumer goods companies in China, and we have already started to reduce them further. Moving forward, we will continue to monitor our inventory levels in conjunction with user demand to adjust our promotional efforts accordingly to maintain reasonable retail prices for our end users. Regarding your second question about single-store sales and what we consider healthy, single-store sales along with profitability and operational metrics have been a crucial focus in our day-to-day operations. We note the industry-wide decline in retail sales starting in the second half of 2021, however, we are seeing a recovery for many of our stores in recent months. Our stores operate in diverse locations, from shopping malls to streets with unique working environments. This variation means that each individual store's situation is very distinctive. Therefore, it's challenging to define a healthy parameter for single-store sales without looking at each store individually. As an e-vapor brand company, we are devoted to providing resources and tools to support store owners and sales personnel in their operations, including providing branding materials, POSM, training resources, digitalization tools, and enhanced site selection assistance. For this quarter, we launched several new products and upgraded our membership system to better drive user engagement and retention. With these initiatives, we believe we can, and will, continue to drive single-store sales.

Louise Lee, Analyst

Hi, management. Thank you for taking my questions. My question is regarding the Q4 outlook. I understand that you don't have guidance, but you just mentioned that you have seen some recovery during the past months. Could you share with us more details on the recovery in terms of single-store sales? Additionally, what is the current store count, and what is your target for year-end? Lastly, what are the drivers for the reported return in Q3?

Sam Tsang, Head of Investor Relations

Thank you very much, Louise. Based on our preliminary data, we see sequential improvements in retail sales and channel inventory management. Regarding our RLX brand stores, to date, we have been focusing on increasing single-store sales through the initiatives mentioned earlier, and we have observed initial success. For our retail segment, we see strong growth momentum in store counts across multiple channels, making it more diversified compared to previous periods. Of course, we are also keenly aware of the recent regulatory developments, especially the press release from the State Tobacco Monopoly Administration.

Jung Hao, Analyst

Hi, good management. This is Jung with XCICC. I have one question: what is the outlook for the regulatory developments regarding the nicotine limit of 2%?

Sam Tsang, Head of Investor Relations

Thank you very much, Jung Hao. I believe you are referring to the nicotine limit in the current cigarette product standards. As a U.S. registered China Company, we have long been aware of product requirements globally, including those in the European Union and the initial draft of National product standards. Looking at the well-developed markets' penetration, we believe lowering nicotine concentration will affect user satisfaction. However, most users can still be satisfied with specific nicotine content limits in the long run. From a product development and technology advancement perspective, we have introduced processes to ensure low nicotine concentrations provide better satisfaction since 2019. Currently, most of our cartridge nicotine concentrations are at 3%. If such national standards become effective, we will fully comply with the requirements listed in the National Product Standards, including those on nicotine content. Thank you very much.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to the Company for final remarks.

Sam Tsang, Head of Investor Relations

Thank you once again for joining us today. If you have further questions, please feel free to contact RLX Technologies Investor Relations team for the contact information provided on our website Ir.relxtech.com.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes today's conference call. You may now disconnect your lines. Have a wonderful day.