TAL Education Group Q2 FY2021 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to the Second Quarter Fiscal Year 2021 TAL Education Group Earnings Conference Call. Please be advised that today’s conference is being recorded. I would now like to hand the call over to your first speaker today, Ms. Echo Yan, IR Director of TAL. Thank you. Please go ahead.

Thanks, operator. Thank you all for joining us today for TAL Education Group’s second fiscal quarter 2021 earnings conference call. The earnings release was distributed earlier today, and you may find a copy on the company’s IR website or through the newswires. During this call, you will hear from Chief Financial Officer, Mr. Rong Luo; Linda Huo, Vice President of Finance; and myself, IR of TAL. Following the prepared remarks, Mr. Luo and Ms. Huo will be available to answer your questions. Before we continue, please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. Potential risks and uncertainties include, but are not limited to, those outlined in the public filings with the SEC. For more information about these risks and uncertainties, please refer to our filings with the SEC. Also, our earnings release in this call includes discussions of certain non-GAAP financial measures. Please refer to our earnings release, which contains a reconciliation of the non-GAAP measures to the most directly comparable GAAP measures. I would like now to turn the call over to Mr. Rong Luo. Rong, please?

Thank you, Echo. Good evening and good morning to you all. Thank you for joining us today on this earnings call. We continue to see a positive recovery in China’s public health situation and economy in the second fiscal quarter. In the education sector, schools were able to reopen and start the school year on September 1 following the gradual resumption of offline teaching and tutoring during the summer months. At TAL, during the second fiscal quarter, we continued to execute our online and offline strategy, which remains on track. More and more of our offline learning centers could reopen. And currently, all of our learning centers in China are back in business at a certain level. The second fiscal quarter financial results reflect the extended impact of the earlier COVID-19 outbreak. Net revenue growth in the second quarter was 20.8% year-over-year in U.S. dollar terms to $1,103.3 million and 21.6% in RMB terms. Total normal-priced long-term course student enrollments increased by 65% year-over-year, mostly driven by online enrollments as well as Xueersi Peiyou small class. GAAP loss from operations was $49.1 million compared to income from operations of $60.8 million in the second quarter last fiscal year. Non-GAAP loss from operations was $11.8 million compared to non-GAAP income from operations of $89.7 million in the same period of the prior year. I will now turn the call over to Linda Huo, our Vice President of Finance. She will give you an update on our operational progress in the second fiscal quarter. Next, Echo Yan, our IR Director, will review the second quarter financials. After that, I will update you on our business outlook and on our business strategy and discuss our business outlook. Linda, please.

Thanks, Rong. I will review the various revenue streams of our tutoring business for the second quarter. Let me start with small class and other business, which consists of Xueersi Peiyou small class, Firstleap, Mobby, and some other education programs and services. These accounted for 67% of total net revenue compared to 75% in the second quarter last fiscal year. The revenue growth rate was 8% in both U.S. dollar and RMB terms. Xueersi Peiyou small class, which remains our stable core business, represented 57% of total net revenue in the second quarter compared to 65% in the same year-ago period. The lower revenue contribution from Xueersi Peiyou was mostly due to the faster growth of xueersi.com online courses, which accounted for 26% of total revenue in the quarter compared to 17% in the same period last year. Net revenue from Xueersi Peiyou small class was up by 7% in both U.S. dollar and RMB terms, where our normal-priced long-term course enrollments increased by 31% year-over-year. In the second quarter, normal-priced long-term Xueersi Peiyou small class ASP decreased by 19% in U.S. dollar terms and 18% in RMB terms year-over-year. The decline was mainly due to the mix change of Peiyou online and offline business propulsion as well as regular promotions. Our second quarter performance in the various tiers of cities reflects the relatively larger impact from COVID-19 on the top-tier cities versus the lower-tier cities in our geographic network. Xueersi Peiyou small class revenue from the top 5 cities, which are Beijing, Shanghai, Guangzhou, Shenzhen, and Nanjing, increased by 3% year-over-year in U.S. dollar terms and accounted for 52% of Xueersi Peiyou small class business. Revenue generated from cities other than the top 5 grew by 11% in U.S. dollar terms. The other cities accounted for 48% of the Xueersi Peiyou small class business. Next, I would like to discuss our Zhikang one-on-one business. This business sector achieved year-over-year revenue growth of 6% in both U.S. dollar terms and RMB terms. Zhikang one-on-one accounted for approximately 7% of total revenue in the second quarter of fiscal year 2021 compared to 8% in the same year-ago period. In this quarter, normal-priced long-term Zhikang one-on-one course ASP increased by 4% in both RMB and U.S. dollar terms year-over-year. Now, let me update you on our current capacity expansion strategy. Following our entry into 20 new cities in the first quarter, we added 1 more city, Hengyang, in the second quarter. Year-to-date, we are well on track with the planned offline capacity expansion speed. In line with our long-standing approach, we will continue to pursue healthy and sustainable learning center network expansion by following government guidelines and market demand. In Q2, on a net basis, the number of learning centers was unchanged from Q1 at a total of 936. We opened 22 new Peiyou small class learning centers and closed 19 Peiyou small class learning centers. We also closed a net of 3 Zhikang one-on-one learning centers. During the quarter, we added 25 Peiyou small class classrooms. In all, by the end of August 2020, we had 936 learning centers in 91 cities, of which 90 cities in China and 1 Xueersi Peiyou learning center in the United States. Among the total 936 learning centers, 716 were Peiyou small class and international education centers, 91 were the merged Firstleap and Mobby small class, and 129 were Zhikang one-on-one. As for Q3 of fiscal year 2021 until now, we have conditionally rented 14 Peiyou small class learning centers. As always, we expect to add a few more and close down some learning centers based on standard operations. We will continue to closely monitor the development with regards to COVID-19. These estimates reflect our current expectations, which is subject to change. Turning now to our online business, second quarter revenue from xueersi.com grew by 87% in U.S. dollar terms year-over-year and 88% in RMB terms, where normal-priced long-term course enrollment grew by 116% year-over-year to over $2.9 million. Online contributed 26% of total revenue and 52% of total normal-priced long-term enrollments this quarter compared to 17% of total revenue and 40% of total normal-priced long-term course enrollments in the same year-ago period respectively. The growth in online business was supported by the structural growth trends in online education as well as sales and marketing efforts and retentions of the previous quarters. In addition, in Q2, normal-priced long-term online course ASP decreased by 1% in both U.S. dollar and RMB terms year-over-year. With that, I will now turn the call over to Echo Yan for the update on second fiscal quarter financial results. Echo, please.

Thanks, Linda. Let me now go through some key financial points for the second quarter of fiscal year 2021. Gross profit increased by 14.3% to $581.2 million from $508.7 million in the same year-ago period. Gross margin for the second quarter decreased to 52.7% as compared to 55.7% for the same period of last year. Selling and marketing expenses increased by 44.3% to $379.8 million from $263.3 million in the second quarter of fiscal year 2020. Non-GAAP selling and marketing expenses, which excluded share-based compensation expenses, increased by 43% to $370.3 million from $258.9 million in the same year-ago period. The year-on-year increase of selling and marketing expenses in the second quarter of fiscal year 2021 was primarily a result of more marketing promotion activities to strengthen our customer base and the brand, as well as the higher compensation to sales and marketing staff to support more programs and service offerings. Other income was $45.3 million for the second quarter of fiscal year 2021 and was primarily due to the value-added tax and the social security expenses exemption offered by the government during the COVID-19 outbreak. Other expenses was $55.6 million in the second quarter of fiscal year 2020, mainly related to the loss from the fair value change of an equity security with readily determinable fair value. Impairment loss on long-term investments was $4.6 million for the second quarter of fiscal year 2021 compared to $54.2 million for the second quarter of fiscal year 2020 and was mainly due to declines in the value of long-term investments in several investees. Income tax expenses were $2.4 million in the second quarter of fiscal year 2021 compared to $8.1 million of income tax benefit in the second quarter of fiscal year 2020. Net income attributable to TAL was $15 million in the second quarter of fiscal year 2021 compared to a net loss attributable to TAL of $23.5 million in the second quarter of fiscal year 2020. Non-GAAP net income attributable to TAL, which excluded share-based compensation expenses, was $52.3 million compared to non-GAAP net income attributable to TAL of $5.3 million in the second quarter of fiscal year 2020. From the balance sheet, as of August 31, 2020, the company had $2,206.1 million of cash and cash equivalents and $580.8 million of short-term investments compared to $1,873.9 million of cash and cash equivalents and $345.4 million of short-term investments as of February 29, 2020. As of August 31, 2020, the company’s deferred revenue balance was $1,172.5 million compared to $497.6 million as of August 31, 2019, representing a year-over-year increase of 135.6%, which was mainly contributed by the tuition collected in advance for part of the fall semester of Xueersi Peiyou small class and online courses through our website. Now I will hand the call back to Mr. Luo to briefly update you on our strategy execution and provide the business outlook for the next quarter. Rong, please.

Thank you, Echo. Our business has worked through the unprecedented pressures of COVID-19 operating in the first half of this fiscal year and delivered a 30% revenue growth in RMB terms. We demonstrated our ability to provide quality education services to our customers even in this unexpected circumstance. This underscores the resilience of our long-term vision and strategy, our comprehensive and competitive product portfolio, as well as our capacities and capabilities in technology and operations. Today, along with the encouraging progress in China’s resumption of activities and liveliness in our works of life, our offline business is already in the process of gradual recovery. We will continue to pursue our offline development strategy to further expand our capacity at pace. We will cover more low-tier cities and further intensify our coverage in existing cities based on demand. Meanwhile, we will keep following all relevant government policies and regulations regarding national public health and remain well prepared to deal with any public health contingencies in the coming period, as always. As for online, under the current competitive landscape, we made no fundamental changes to TAL’s current execution and long-term strategies. We will keep working on enlarging our online market share by continued investment in technology, teacher supply chain, and marketing, and consistent hard work of building all-around online services with superior customer experiences. We firmly believe that as an education player, our path to success is defined by the quality of our products, services, and technology. Let me turn finally to our business outlook. Based on the current estimates, total net revenue for the third quarter of fiscal year 2021 is expected to be between $1,061.1 million and $1,094.3 million, representing an increase of 28% to 32% on a year-over-year basis. These estimates reflect the company’s current expectations, which are subject to change. That concludes my prepared remarks. Operator, we are now ready to take questions, please.

Thank you. The first question comes from Alex Xie of Credit Suisse. Please go ahead.

Hi, management. Thank you for taking my questions. So I’d like to ask about your thoughts on the growth expectations and strategies. In offline, we have seen that in last quarter, you didn’t really spend much. So what’s your plan for CapEx expansion in the future? And in online, since the competitive landscape has worsened due to more financing for private players, what will be your strategy going forward? Thank you.

Thank you, Alex. I think it’s a very good question. Right before we talk about some specific numbers in this quarter or next quarter, we would like to take this opportunity to walk through our business logic and strategies as a whole to give you some information about what we are doing and why we are doing it. I think if you can remember, six years ago, we were a traditional offline tutoring company. We had high-quality teachers and numerous learning centers. We operated our classrooms, we enrolled students in, and we performed a lot of activities like that. Under that operational model, in the past years, for example, between 2014 to 2018, we have expanded into 42 cities. This traditional model is very common in offline tutoring markets. However, coming to 2018, we were among the first in this industry to invent or develop online education models. We introduced the online live platform into our products and built a dual-teacher online model. I think that was the first time in this industry that we could separate the learning and practice roles, whereby master teachers could teach a lot of students simultaneously while assistant teachers could assist them in the online environment. This dual-teacher online class model has grown rapidly. Three years ago, we had only tens of thousands of enrollments; however, in the last quarter, we reached 2.9 million enrollments. The revenue contribution from this model two years ago was only around 8%. Today, it has risen to 26%. If I include Peiyou online as part of the online business, last quarter, we achieved almost 40% of revenue coming from online models—around 70%. This model has numerous advantages, and it has given us the capability to consolidate this market. If we had stayed with traditional offline models amidst many competitors, we still have low market share. But now, with the online model, we see consolidation opportunities like never before in this industry. So definitely, we will continue investing in technology, teacher supply chain, and marketing to maintain our leading position. However, this model is not perfect for resolving all problems. Education is not simply a marketing game; we need to focus on providing high-quality service to students. We need to attract students first. We need to take both the effectiveness and efficiency of marketing seriously. Currently, while the online model allows master teachers to instruct many students, it is difficult for students to ask questions. Hence, this model may work better for basic topics or individual levels. One challenging aspect today is that we face increasing customer acquisition costs, primarily driven by funding raised by competitors. We believe that online remains a revolutionary product compared to traditional offline. We are confident it will help us gain more market share than we previously anticipated. We need to be realistic about these models' limitations. We will leverage our branding, the content we have developed, and other advantages to reduce online operational costs. In various markets, the largest players will capture the most revenue and profits. We must ensure to be one of those key players. The pandemic has presented unforeseen opportunities for us. We've found that students who had to transition to online learning can also benefit from offline offerings. For context, last summer in Shanghai, we saw 200,000 Peiyou online enrollments compared to 120,000 offline enrollments. This data illustrates new opportunities to develop and invest more in localized online class models. Local content and localized teachers, along with tailored services, will form our strategy moving forward. To summarize, we will maintain our investments in technology and expand our Peiyou small class learning centers into more cities in the coming quarters. We have already rented 14 new learning centers with over 50 more in the pipeline. Growth from Q3 is expected to be better than Q2, following our expectations that we will not face significant public health crises. Thank you, Alex.

Thank you for the questions. The next question comes from the line of DS Kim of JPMorgan. Please go ahead.

Hello, sir. Good evening, and thank you so much for the insights you’ve shared. It’s really, really helpful. I have one question, actually two questions. First, as a housekeeping matter, could you check the segment performances and currency assumptions you have baked into the November quarter guidance? My real question, a more important one, is regarding customer acquisition costs. Some suggest it may be as high as RMB 4,000 to acquire one paying student. Can you share what you see regarding the unit economics and LTV of a student today, and how this compares to pre-COVID levels? How long might it take to break even against the current customer acquisition costs? Lastly, how many semesters can we expect to retain students on average amidst this intensified competition? Thank you.

Thank you, D. S. That’s quite the lengthy question. Let's unpack it a bit. Firstly, the expansion of online provider opportunities will consolidate to top players, which will facilitate the retention of a larger market share compared to traditional offline models. Currently, we see that new customer acquisition costs are climbing, especially for customers acquired through open market platforms. Conversely, we still have branding channels where students automatically come to us. Our brand recognition is growing, leading to increased traffic from these channels, putting us at a competitive advantage. As for new customer acquisition, it’s becoming pricier in competitive environments. However, it remains vital to evaluate how effectively we can convert new students into our mainstream programs while enhancing retention rates. Transitioning from low-cost entry offers to standard priced classes is also a key objective, along with improving retention and cross-selling or up-selling other products to them effectively. We continue to see progress in these areas as well. Regarding Peiyou online, we have a different cost structure since we don’t invest significantly in marketing there. Peiyou online margins are much healthier than other offerings. We saw over 130% growth in this segment. We plan to sustain this trend in the future while balancing different drivers to ensure our industry-leading position in this market. Thank you.

Thank you for the questions. The next question comes from Sheng Zhong from Morgan Stanley. Please go ahead.

Thank you for taking my questions. I have a question about the competition in the online space. As you mentioned, some private firms are receiving significant funding. Given that we are in a post-COVID scenario, how do you perceive the competition going forward? Also, considering your strategy to maintain leadership, what level of investment do you expect?

Yes. We might underestimate the complexity of online education. Some oversimplify competition to mere customer acquisition costs. However, the online education landscape is nuanced and requires navigating many challenges. In Q3 and Q4, we are prepared for any competitive funding announcements. We will uphold our investment strategies while also emphasizing internal improvements, such as technology enhancements and a strong teacher supply chain. Competition exists throughout operational life cycles, not just at the customer acquisition front. We intend to expand both our online and offline presence and improve efficiencies. We have seen exceptional growth rates and aim to maintain this trajectory for both Xueersi online school and Peiyou online. While we prepare for competition, our commitment to strategy remains unwavering. Thank you.

Thank you for the questions. Our next question comes from Felix Liu of UBS. Please go ahead.

Good evening, gentlemen. Thank you for taking my question. My inquiry pertains to the relationship or synergy between Peiyou and xueersi.com. It seems Peiyou online is making remarkable progress with minimal sales and marketing costs. Is there a possibility to leverage Peiyou online’s success to boost xueersi.com? Furthermore, what potential synergies could be realized between the offline network and xueersi.com operations? Thank you.

That’s a very insightful question. As the online market continues to grow rapidly, we have abundant opportunities to capture additional market share. Our strategy involves Xueersi online executing a breadth strategy to expand geographically while Peiyou online focuses on strong local connections and highlight individualized service offerings. We maintain marketing investments for Xueersi online to attain market share, even if this incurs operational losses. Conversely, Peiyou online will further deepen connections within local markets while sustaining substantial growth. There is synergy between our brands, technology, and operational leverage due to brand consistency across both platforms. However, we view Xueersi online and Peiyou online as separate strategies within our overarching mission to capture market share effectively.

Thank you for the questions. Next question comes from the line of Mark Li of Citi. Please go ahead.

Thank you for your time. I want to inquire about the offline operations as we’ve observed several promotions impacting the ASP. How is the promotion strategy developing heading into the upcoming quarter, and what are our offline growth targets for the next few quarters? How much recovery should we expect for offline segments? Any insights would be appreciated. Thank you.

The promotions you mentioned in Q2 stem from transitioning offline offers to online amid the pandemic, resulting in certain coupons for students redeemable in Q2 and partially in Q3. Currently, promotions are a significant part of our ramp-up strategy. As we enter Q3 and next year, we anticipate promotions to remain vital. Our focus will center around integrating online and offline models more effectively. For example, we need to optimize marketing efforts around our centers and ensure a seamless connection between students engaging with offerings in proximity. While we are currently executing city-level strategies, we aim to enhance efficiencies at deeper operational levels for our centers. Innovation in business models through product development remains essential.

Thank you for the questions. Next question comes from Lucy Yu of Bank of America Securities. Please go ahead.

Thank you, Rong, for taking my question. My inquiry pertains to the promotions in Peiyou Xueersi's offline market, particularly regarding discounts and their effect on GP margin or OP margin in your Peiyou offline segment. I seek to understand whether the margin is relatively stable, declining, or improving.

Indeed, in Q2, the margins within the Peiyou offline business declined, largely due to impact from the pandemic, which skews comparisons. However, we expect recovery in Q3 and Q4 as conditions normalize. Second half performance should rebound compared to Q2.

Thank you, Rong Luo. Would you mind providing a breakdown of Q3 results by business?

We do not disclose detailed information for competitive reasons. However, we can share that growth in our Xueersi online school will mirror trends from Q2, plus/minus some variations, while we also expect recovery in Peiyou's small class business.

Thank you for the questions. The next question comes from Alex Liu of China Renaissance. Please go ahead.

Thanks for taking my question. Two inquiries: Can you share TAL’s strategy concerning AI online classes? Given competitors like PAMA are aggressive in this space, what’s our plan? Additionally, do you anticipate AI classes will eventually equal existing online model revenues?

That’s an insightful question. I recommended reading the book 'On Intelligence' by Jeff Hawkins in past earnings calls. AI is a promising term, but we have not fully reached that level. Our online model is expanding, but we must gather more data as we develop personalized products. Our intention is to invest in these areas continually. We believe future products will arrive, but maturation may take time. While we pursue competitive advantages, developing intelligent self-learning models remains pivotal to our strategy moving forward.</s> Thank you. Let me address the gross margin decline. The decline is influenced by continued expansions of learning centers and an increase in teacher compensation costs. We expect that as we stabilize, growth investments will impact margins. Our commitment to our teachers and growth centers aligns with our long-term strategy, despite the current fluctuations.

With that, ladies and gentlemen, that concludes our conference for today.