Earnings Call Transcript - RLX Q2 2021

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for RLX Technology Inc.'s Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After management's remarks, there will be a question-and-answer session. Today's conference 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 Investor Relations of the Company. Please go ahead, Sam.

Sam Tsang, Head of Investor Relations

Thanks very much. Hello, everyone, and welcome to RLX Technology's Second Quarter 2021 Earnings Conference Call. The Company's financial and operational results were released through a press release earlier today and have been made available online. You can also view the earnings press release by visiting the IR section of our website. 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 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 or guess, estimate, depend on belief, 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 these factors are beyond our control. The Company and its advisors, representatives, and underwriters do not undertake any obligation to update this forward-looking information, except as required under the applicable law. Please note that the RLX Technology earnings press release and this conference call include discussions of unaudited GAAP financial measures, as well as unaudited non-GAAP financial measures. Our RLX Technologies 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. Hello, everyone. Thank you for joining our earnings conference call today. As most of you are aware, two major regulatory developments took place around the second quarter of 2021. The first was on March 22nd when the authorities made an announcement, speaking public comments on a proposal to revise relevant regulations to strengthen the supervision of e-cigarettes and address quality and safety risks, enforce advertising problems, among others. We believe that such a regulatory framework is both necessary and beneficial for the long-term healthy development of the industry. It has served to eliminate the risks associated with uncertainties regarding the legitimacy of this product category. It can also help mitigate incidents and setbacks that have occurred in some other overseas markets and ensure the long-term vitality of the industry in China. As of today, no details under the regulatory framework have been released yet, and we will closely monitor and follow up on any further announcements. The second development took place in May and June when the Chinese National Health Commission published the China report on health hazards of smoking, 2020, mentioning vaping products. The media and public, along with some adult smokers and adult users of vaping products, were confused by certain context, historical information in the report about the harm reduction benefits of using vaping products. Next, the public has sustained confusion since the report's release. We have been working closely on relevant scientific research and consumer communication to provide better information and unbiased knowledge on related topics. RELX was founded to serve adult smokers with state-of-the-art products and an unwavering pursuit of scientific advances to deliver harm reduction benefits to our users. In the second quarter, we continued devoting resources to key operational areas, including scientific research and development, product innovation, quality assurance and control, and brand building. Moreover, as a public company, we have further strengthened our operational and financial internal controls to better protect our shareholders' value. In the second quarter, we maintained our momentum in attracting and developing higher-caliber talent and grew our workforce by 27%. These highly skilled individuals joined us from leading companies in the FMCG, technology, and pharmaceutical industries. We are pleased to see like-minded talents joining our course, and together, we have achieved satisfactory net revenue growth of 6%, from 2.4 billion RMB in the first quarter to 2.54 billion RMB in the second quarter. With that, I will now turn the call over to our CFO, Lu Chao. He will elaborate further on some initiatives taken during the last quarter and go over our operational and financial results in more detail. Chao, please go ahead.

Chao Lu, CFO

Thank you, Kate, and hello, everyone. It has been my pleasure and privilege to have worked at RLX for over a quarter by now. To quote Steve Jobs, the only way to be truly satisfied is to do what you believe is great work. At RLX, we're doing great work by providing products of the highest quality and safety standards to adult smokers for harm reduction for themselves and for their loved ones around them. I'm glad that I have joined this call. Now, let me share some specifics regarding the initiative we have taken in the second quarter. Following that, I will walk you through our financial results. In the past quarter, we continued the expansion of our offline distribution network and retail channels. While we saw some weakness in product procurement by branded stores in the second half of the quarter, most likely due to negative publicity in the e-vapor industry and the absence of clarity on the regulatory front, we firmly believe that the steady expansion of our distribution network and retail channels is key to our long-term growth and competitiveness. We hope that with the passing of time and fading out of publicity effects, the first procurement of branded stores will soon regain momentum. On the product front, we have focused on both device and flavor innovation. We are working on a rich pipeline of product offerings to cater to distinct user groups with differentiated preferences and price sensitivity. We expect these product offerings to be launched in stages to further drive penetration and enhance user retention. We also take pride in our reputation, consistently delivering high-quality products and investing heavily to improve quality control measures as we seek to further elevate user experience and inspire deeper user loyalty. We conduct rigorous quality assurance and control throughout our entire production cycles, and have established three production plans to further strengthen our QA and QC capability. Our QA and QC systems consist of five laboratories with 197 quality control checks to ensure that every intake of our aerosol represents the safest and finest of the vaping experience. Currently, we have over 110 professionals managing our entire quality control process, which includes raw materials, production, and finished products. In terms of scientific research, on July 3rd, 2021, we jointly published a research paper in The XCI Journal of Nicotoxicology and Environmental Safety with Sung Yunghse University, titled 'Comparison of Biological and Transcriptomic Effects of Conventional Cigarette and Electronic Cigarette Smoke Exposure at Toxicological Dose in BEAS-2B Cells.' The research paper revealed that based on equivalent nicotine content and acute exposure in cigarette smoke condensates, e-cigarette smoke contents have a significantly larger impact on cell defect and gene expression profile compared to conventional cigarette smoke, further demonstrating the harm reduction effects of e-vapor products versus cigarettes. On August 4th, 2021, our e-vapor clinical trial was successfully registered with the China Clinical Trial Registration Center and the WHO International Clinical Trial Registration Platform. Our trial is the first e-vapor clinical research project in China to have passed both ethical and expert reviews and to be approved for implementation, filling the void in domestic e-vapor clinical research. It is also a pioneering scientific study in the Chinese e-vapor industry. Looking forward, we will keep investing in in-house lab research related to product quality and safety, physiochemistry, pathological and clinical elements, and the evaluation of long-term use of e-vapor products. In keeping with our commitment to corporate responsibility, we remained dedicated to building and strengthening our trusted brand by consistently adhering to our strong ethical principles. On June 1st, immediately after the enactment of the law on the protection of minors, RLX was the first among all our peers to call on all industry participants to thoroughly study the regulations and strictly abide by all of them. In July, several provinces in China were affected by extreme weather and natural disasters, resulting in hundreds of casualties. We once again acted swiftly by donating millions to the China Foundation for Poverty Alleviation for emergency aid. In addition, we were also deeply concerned about our partners' losses and decided to set up the RELX Stores Relief Fund to help them recover their businesses. Now, turning to financial performance. Our top-line quarter-on-quarter growth slowed down in Q2 due to external factors as mentioned by Kate previously. The impact of these factors is difficult to predict and may linger after the second quarter as well. However, we remain devoted to continuing to drive user penetration among adult smokers as we firmly believe that the science and the benefits of harm reduction will prevail over misconception and false information. I will now provide a summary overview of our financial results for the second quarter of 2021. Net revenues increased by 6% to RMB 2.54 billion in the second quarter of 2021 from RMB 2.4 billion in the first quarter of 2021. The increase was primarily due to an increase in net revenue from sales to offline distributors, which was mainly attributable to the expansion of the Company's distribution and retail network. Gross profit increased by 3.8% to RMB 1.15 billion in the second quarter of 2021, from RMB 1.1 billion in the first quarter of 2021. The gross margin was stable at 45.1% in the second quarter of 2021 compared to 46% in the first quarter of 2021. Operating expenses were RMB 167.2 million in the second quarter of 2021, representing a decrease of 86.3% from RMB 1.22 billion in the first quarter of 2021. The significant decrease in operating expenses was primarily due to the recognition of share-based compensation expenses. Selling expenses decreased by 66.8% to RMB 126 million in the second quarter of 2021 from RMB 291.5 million in the first quarter of 2021, primarily driven by variations in share-based compensation expenses and a decrease in salaries and welfare benefits. General and administrative expenses decreased by 93.5% to 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 to positive RMB 4.9 million in the second quarter of 2021 from RMB 211.6 million in the first quarter of 2021, primarily due to fluctuations in share-based compensation expenses. Income from operations was RMB 979.3 million in the second quarter of 2021, compared with a loss from operations of RMB 111.9 million in the first quarter of 2021. Income tax expense was RMB 204.2 million in the second quarter of 2021 compared with RMB 176.3 million in the first quarter of 2021. U.S. GAAP net income was RMB 824.3 million in the second quarter of 2021 compared with a U.S. GAAP net loss of RMB 267 million in the first quarter of 2021. Non-GAAP net income was RMB 651.8 million in the second quarter of 2021, representing an increase of 6.8% from RMB 610.5 million in the first quarter of 2021. U.S. GAAP basic and diluted net income per American Depositary Share were RMB 0.595 and RMB 0.591 respectively, in the second quarter of 2021. As of June 30th, 2021, the Company had cash and cash equivalents, restricted cash, short-term bank deposits, short-term investments, and long-term bank deposits of RMB 14.88 billion compared to RMB 14.44 billion as of March 31st, 2021. This concludes our prepared remarks today. We will now open the call to questions.

Operator, Operator

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. The first question comes from Lydia Ling with Citi. Please go ahead.

Lydia Ling, Analyst

Hi management, this is Lydia from Citi, and thanks for the presentation and taking my questions. I have two questions. The first one is, given the slowdown in the Second Quarter, could you elaborate more on the Third Quarter to date trends and also your outlook on the Second Half, given currently the frequent negative publicity and also the regulatory environment? And my second question is on the expansion. Could you actually tell us about how many stores you opened in the Second Quarter and also what's your opening plan in the Second Half given current market conditions? And also, how is your distributor sentiment on the new openings? Thank you.

Chao Lu, CFO

Sure. Thanks very much, Lydia. So regarding the first question, it's mainly regarding the first-quarter trend and also the second-half outlook. As of the moment, e-vapor products remain under-penetrated among adult smokers in China. Though our Company believes that harm reduction products, including e-vapor products, are better alternatives for adult smokers in China. We remain committed to the trend of adult smokers converting from cigarettes to e-vapor products, and we are confident in the medium and long-term prospects of the industry, as well as our future performance. To directly answer your question regarding our third quarter to date trends, specifically, we have seen the decrystallization of operating and financial metrics in recent weeks as we continue to engage and retain our users. So we are very confident about the future outlook of the Company. Regarding your second question, it’s mainly about store numbers, opening plans, distributor sentiments, etc. Our overall store opening logic is very sound. Our model depends on where there are enough users using our products in order to support a brand upon a store in the given area or district. For our newly opened stores, we monitor and evaluate store productivity in combination with other macro and micro factors. If the store productivity after nearly opening stores is better than the expected productivity curve, we will allow more new stores to be opened and vice versa. We do have various color label packs in different districts based on existing store productivity to micro-manage and observe any cannibalization between existing and new stores. We indeed closely monitor the single-store economic model of our current brand department stores. Thanks very much for your question.

Operator, Operator

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

Charlie Chen, Analyst

Thank you, management, for taking my question. I have two questions here. First of all, I want to ask about the performance of your products in different categories, like the premium products versus the mainstream products which were launched about a quarter ago. So how's that developed so far? And my second question is regarding the retail price. As we observed, some competition in certain areas has been quite intense. So do you see any retail price softness, or volatility in some of the markets? And also, is there any special situation where distributors may do parallel trading, which means they're selling their products at a lower price outside of their authorized areas? Does that situation happen in your market? Thank you.

Chao Lu, CFO

Sure. Thank you very much, Charlie. Regarding the first question about product performance, we have been providing a diversified product portfolio with various price points. We do see that more and more smokers have different user groups trying to use our products as their harm reduction alternatives. We have received positive feedback and contribution from both our users and retailers regarding our new products. We will continue to cautiously monitor user behavior and trends, trying to optimize our product mix while further launching new product lines. The second question is on pricing. We have been closely monitoring the pricing across the value chain, especially the actual selling price and discounts from retailers’ point of view. We initiated a program to monitor the actual selling price of each layer of our value chain in the second quarter of 2021, and we do see that most of our retailers have been following the suggested retail selling price in the actual sales to adult smokers. Regarding unauthorized sales or distribution to unauthorized areas, we have been implementing effective measures using technology and control. We have a unique QR code system for each of our product lines. If we find any of our distributors or retailers report unauthorized products, we can reveal the identity of distributors selling such products and resolve the issue accordingly. Thanks very much for your questions.

Operator, Operator

The next question comes from Stephanie Lam with Haitong International. Please go ahead.

Stephanie Lam, Analyst

Hi, management. Thank you for taking my questions. I have two questions from my end. My first question is regarding store opening subsidies. We noticed that some of our peers have offered more store opening subsidies in the past couple of months. May we know what is the management's views on that, as well as your approaches to store opening subsidies? The second question is regarding raw material cost pressures and gross margin. Given the cost hike of raw materials, may we know if we have split up the wholesale prices to franchisees and distributors in order to pass the cost on? And how should we estimate the trend of the margin going forward? Thank you.

Chao Lu, CFO

Sure. Thanks very much, Stephanie. The first question is on subsidies. Given our competitive landscape, we have seen that our store opening subsidies have remained consistent and now have decreased consistently since we introduced our branded partner stores model back in early 2019. We have been assessing store subsidies largely based on the macro environment and the single-store economics of our branded partner stores. For the past two years, peers have offered more subsidies to potential store owners driven by their intention to penetrate the market and make a presence. However, these larger subsidies frequently do not translate into market share growth for their brands. Given the current developments of the industry, we have recently seen our peers start to decrease their subsidies to potential brands. In the medium and long term, we believe that store subsidies will be more rational and will become more dependent on the single-store economics of each brand. Regarding the second question is on the increase of raw material and whether it increased our pricing and margins. The prices of raw materials, such as chips and batteries, have been on an upward trend since the beginning of the year. As a result, some of our suppliers have experienced an increase in procurement costs throughout the supply chain. However, we have not experienced a significant increase in unit costs due to raw material prices so far. Therefore, we have not increased the wholesale price of our products sold to our distributors. We will closely monitor the latest supply chain developments as well as our suppliers' operating issues and believe that long-term cost optimization is achievable. Thanks very much for your question.

Operator, Operator

The next question comes from Jung Hao with CICC. Please go ahead.

Jung Hao, Analyst

Hi. Thanks, management for taking my question. I also have two questions. The first one is, we know that there are more e-cigarettes in the market. How would the management estimate their future competitive landscape among Chinese e-cigarette brands? And my second question is, since many similar vapes are eyeing the market, what actions would management take to solve this problem? That's my two questions. Thank you.

Chao Lu, CFO

Frankly speaking, the competitive landscape of the markets will be increasingly complex, requiring each brand or market participant to put more effort and further innovate in various aspects such as commercial strategy, product innovation, and scientific research efforts. We believe that with our leading position, strong brand equity, expansive retail network, and product innovation capabilities, we can maintain or expand our market leadership in the Chinese markets. Regarding the second question, unauthorized compatible parts pose a greater risk to e-vapor users' health, as the product quality and safety may not be guaranteed. These compatible parts are largely sold via illegal retail channels that may be accessible to underage users. As a brand, we have been collaborating with various partners to prohibit illegal sales of unauthorized compatible parts and have filed patent claims and lawsuits against brands using our patents without our permission. We also have expanded our product portfolio to cater to the diversifying needs of e-vapor users in various aspects, including flavor availability and product functionality. We still believe that these strategies will continue to be effective in combating unauthorized compatible products in the market. Thank you very much for your questions.

Operator, Operator

The next question comes from Louise Lee with Bank of America Securities. Please go ahead.

Louise Lee, Analyst

Hi. Thank you, management, for taking my question. I have two questions here. Firstly, I know that we actually set up our electronic cigarette clinical trial several weeks ago. So what is the major benefit of this? And secondly, about the regulation on the potential impact. What will happen if the whole industry is regulated under China tobacco? Thank you.

Sam Tsang, Head of Investor Relations

Sure. Thank you very much, Louise. For your first question on our clinical trial, our trial is the first e-vapor clinical trial project in China for e-vapor products that have passed both ethical and expert reviews and have been approved for implementation. We believe that this research can showcase our capabilities in scientific research and clinical trials. As a company, we believe that facts speak louder than words, and we hope that more clinical trials on e-vapor products will be carried out in upcoming years, with increasing fact-based communication across various parties. More adult smokers can use e-vapor products as their harm reduction tobacco alternatives. Regarding the second point on regulation, on March 22, the MIIT released the draft rules regarding e-vapor products. We have submitted our feedback regarding the proposed revision of the implementation plan. Currently, there are no new implementation details available. These regulatory measures aim to tackle potential product safety issues and regulate operating activities of the e-vapor industry. Thanks very much for the questions.

Operator, Operator

As there are no further questions now, I would like to turn the call back over to the Company for closing remarks.

Sam Tsang, Head of Investor Relations

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

Operator, Operator

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