U.S. Markets open in 1 hr 45 mins

Edited Transcript of COE earnings conference call or presentation 9-Dec-19 1:00pm GMT

Q3 2019 China Online Education Group Earnings Call

BEIJING Jan 16, 2020 (Thomson StreetEvents) -- Edited Transcript of China Online Education Group earnings conference call or presentation Monday, December 9, 2019 at 1:00:00pm GMT

TEXT version of Transcript

================================================================================

Corporate Participants

================================================================================

* Jack Huang

China Online Education Group - Founder, Chairman & CEO

* Judy Piao

China Online Education Group - Head of IR

* Min Xu

China Online Education Group - CFO

================================================================================

Conference Call Participants

================================================================================

* Long Lin

The Benchmark Company, LLC, Research Division - Research Analyst

* Roger Parodi

Silverhorn - Managing Partner

================================================================================

Presentation

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's Third Quarter 2019 Earnings Conference Call. (Operator Instructions) Today's conference call is being recorded.

I will now turn the call over to your host, Ms. Judy Piao, Investor Relations for the company. Please go ahead, Judy.

--------------------------------------------------------------------------------

Judy Piao, China Online Education Group - Head of IR [2]

--------------------------------------------------------------------------------

Thank you. Hello, everyone, and welcome to the third quarter earnings conference call of China Online Education Group, also known as 51Talk. The company's results were issued via Newswire services earlier today and are posted online. You can download the earnings press release and sign up for the company's distribution list by visiting the IR Section of its website at ir. 51talk.com.

Mr. Jack Huang, our Chief Executive Officer; and Mr. Min Xu, our CFO, will begin with some prepared remarks. Following the prepared remarks, Mr. Liming Zhang, our Chief Operating Officer, will also join the call for our Q&A session.

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 and Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the company's results may be materially different from the views expressed today. Further information regarding this and other risks and uncertainties is included in the company's Form 20-F and other public filings as filed with the U.S. Securities and Exchange Commission. The company does not assume any obligation to update any forward-looking statements except as required under the applicable law.

Please also note that 51Talk's earnings press release and this conference call include discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial measures. 51Talk's press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures.

I will now turn the call over to our CEO, Jack Huang. Please go ahead.

--------------------------------------------------------------------------------

Jack Huang, China Online Education Group - Founder, Chairman & CEO [3]

--------------------------------------------------------------------------------

Hello, everyone. Thank you very much for joining our conference call. The third quarter is a seasonally strong quarter for us, and our results for Q3 reflected consistent execution of our focused strategy.

Our net revenues and gross billings results exceeded the high end of our guidance ranges by 2.3% and 5.7%, respectively. We also recorded robust active student growth in the quarter up 23% year-over-year.

Unquestionably, our primary growth driver remains our K-12 mass-market one-on-one offering in non-Tier 1 cities. K-12 mass-market one-on-one gross billings grew 52% year-over-year to reach RMB 504.6 million and represented 92.2% of our total gross billings. The improvement in our fundamentals reflected our consistent strategy of focusing on K-12 mass-market in non-Tier 1 cities.

In the third quarter, we launched our mobile-friendly interactive curriculum for levels from 0 to 2 for our flagship course, Classic English Junior. The enhanced curriculum improves learning effectiveness and that leads to a better learning outcome through several new features, including interactive games, virtual teaching aids, improved facial emotional recognition and engaging role-play scenarios. As with all our curriculum, the goal is to maximize enjoyment and engagement through capturing the interest of our students and inspiring them to continue learning.

We also improved our proprietary Magic Mirror System by incorporating advanced elements of big data and analytics. Drawing our best data sets from our large student space, we use these analytics to generate deeper insights into our students' learning behavior, tailor individual learning path and suggest more effective study techniques that will allow our students to make more efficient progress.

On a separate note, I'm very proud to share that 2 of our students were selected from a national pool of applicants to represent Chinese youth and present speeches in English on the topic of environmental protection at the recent United Nations Climate Change Conference held in Madrid, Spain, on December 5. Our emphasis at 51Talk has always been the improvement of English communication skills, and we are proud to have been instrumental through our teachers, curriculum and program in enabling 2 of our students to participate in such a noteworthy event.

I am also happy that we successfully provided over 100 million one-on-one online English lessons from our inception in 2011 through the end of November this year. This is a nice milestone to mark as we work toward our vision to empower everyone to talk to the world.

As 51Talk continues to grow, we are confident that our balanced growth strategy and operational focus on non-Tier 1 cities will continue to yield solid value for our stakeholders.

With that, I will now turn the call to our CFO, Xu Min.

--------------------------------------------------------------------------------

Min Xu, China Online Education Group - CFO [4]

--------------------------------------------------------------------------------

Thank you, Jack. Our momentum from the first half continued into the third quarter as we achieved record high top line gross billings, gross margins as well as the smallest non-GAAP net loss in our history at RMB 1.8 million. Non-GAAP net margin improved to negative 0.4% from negative 7.6% in the previous quarter. Q3 operating cash flow was also historical high at RMB 123.2 million. These results reflected the wide market appeal of our offerings and our ongoing effort to improve operation efficiencies.

Now I would like to walk through our third quarter financial details. Net revenues for the third quarter were RMB 409.2 million, a 35% increase from RMB 303.2 million for the same quarter last year. The increase was primarily attributed to an increase in the number of active students and, to a lesser extent, an increase in average revenue per active students. The number of active students in the third quarter was 258,000, a 23% increase from 210,000 for the same quarter last year.

Net revenues from one-on-one offerings for the third quarter were RMB 383.4 million, a 37.6% increase from RMB 278.6 million for the same quarter last year. Net revenues from small class offering for the third quarter were RMB 25.8 million, a 4.9% increase from RMB 24.6 million for the same quarter last year.

Cost of revenues for the third quarter was RMB 116 million, a 5.8% increase from RMB 109.6 million for the same quarter last year. Cost of revenues for one-on-one offerings for the third quarter was RMB 104.6 million, representing a 12.6% year-over-year increase. Cost of revenues of small class offering for the third quarter was RMB 11.4 million, representing a 32% year-over-year decrease.

Gross profit for the third quarter was RMB 293.2 million, a 51.5% increase from RMB 193.5 million for the same quarter last year. Gross margin for the third quarter was 71.7% compared with 63.8% for the same quarter last year.

One-on-one offerings gross margin for the third quarter was 72.7% compared with 66.6% for the same quarter last year. The increase was mainly attributable to price increases and inclusion of the company's audio picture book in course packages, which carries a higher margin and is recognized as revenues at the time of delivery.

51Talk's small class offering gross margin for the third quarter was 56% compared with 32% for the third quarter of 2018. The increase was mainly due to optimization of product structure for small class offerings by reducing the lower-margin product offerings.

Total operating expenses for the third quarter were RMB 299.4 million, a 6.1% increase from RMB 282.2 million for the same quarter last year. The increase was mainly the result of an increase in sales and marketing expenses, partially offset by decreases of product development and general and administrative expenses.

Sales and marketing expenses for the third quarter were RMB 215.4 million, a 16.9% increase from RMB 184.2 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the third quarter were RMB 214.8 million, a 17.5% increase from RMB 182.7 million for the same quarter last year.

For our one-on-one businesses, non-GAAP sales and marketing expenses, excluding branding expenses, were 32.4% (sic) [32.6%]of the gross billings for the third quarter compared with 36.8% (sic) [36.5%]for the same quarter last year.

Product development expenses for the third quarter were RMB 38.4 million, a 15.8% decrease from RMB 45.6 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP product development expenses for the third quarter were RMB 37.3 million, a 13.9% decrease from RMB 43.4 million for the same quarter last year.

G&A expenses for the third quarter were RMB 45.6 million, a 12.9% decrease from RMB 52.3 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP G&A expenses for the third quarter were RMB 43.8 million, a 10.5% decrease from RMB 48.9 million for the same quarter last year.

Loss from operations for the third quarter was RMB 6.2 million compared with a loss of RMB 88.6 million for the same quarter last year. Non-GAAP loss from operations for the third quarter was RMB 2.8 million compared with a loss of RMB 81.5 million for the same quarter last year.

Net loss for the third quarter was RMB 5.3 million compared with a loss of RMB 90.4 million for the same quarter last year. Non-GAAP net loss for the third quarter was RMB 1.8 million compared with a loss of RMB 83.3 million for the same quarter last year.

Basic and diluted net loss per ADS for the third quarter was RMB 0.26 compared with RMB 4.5 for the same quarter last year. Each ADS represents 15 Class A ordinary shares. Non-GAAP basic and diluted net loss per ADS for the third quarter was RMB 0.09 compared with RMB 4.05 for the same quarter last year.

As of September 30, 2019, the company had total cash, cash equivalents, time deposits and short-term investments of RMB 906.4 million compared with RMB 785.6 million in Q2 and RMB 712.1 million in Q4 2018.

The company had deferred revenue of RMB 2.0 billion as of September 30 compared with RMB 1.9 billion in Q2 and RMB 1.7 billion in Q4 2018.

For the fourth quarter of 2019, the company currently expects net revenues to be between RMB 385 million to RMB 390 million, which would represent an increase of approximately 29.2% to 30.8% from RMB 298.1 million for the same quarter last year. The above outlook is based on the current market conditions and reflects the company's current and preliminary estimates of market and operating conditions and customer demand, which are all subject to change.

This concludes our prepared remarks. We will now open the call to questions. Operator, please go ahead.

================================================================================

Questions and Answers

--------------------------------------------------------------------------------

Operator [1]

--------------------------------------------------------------------------------

(Operator Instructions) The first question today comes from Long Lin with Benchmark Company.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [2]

--------------------------------------------------------------------------------

Congratulations on your first one-on-one business non-GAAP breakeven. Can management give us some color on the drivers behind it?

--------------------------------------------------------------------------------

Min Xu, China Online Education Group - CFO [3]

--------------------------------------------------------------------------------

Yes, sure. Thank you, Long, for the question. Yes, our one-on-one business non-GAAP net margin did improve to -- we did improve to a positive 0.7% from negative 7.3% earlier. So basically, there are -- from financial point of view, there are 3 key drivers: one is revenue scalability really contributed about 5 percentage points improvement; and the gross margin improvement actually contributed 1.6 percentage point improvement; and also, the sales and marketing efficiency improvement contributed about 1 percentage point. So -- however, we do want to remind everybody that due to the seasonality, the non-GAAP net margins for our one-on-one business for the next 2 quarters are likely to be negative.

--------------------------------------------------------------------------------

Jack Huang, China Online Education Group - Founder, Chairman & CEO [4]

--------------------------------------------------------------------------------

(Interpreted) So since 2018, we have been focusing on our Filipino teachers and also the K-12 market. And what we found out that after 2 years of great execution, our product's really gaining a lot of traction in the lower-tier cities. And as I mentioned earlier, we -- the core business has been growing at 52% year-over-year. And so not only our business growing fast, and it also has a profitable economic model. So we're glad that we can do a sustainable and profitable growth.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [5]

--------------------------------------------------------------------------------

That's very helpful. My second question is regarding your guidance. So you did not provide -- management did not provide gross billing guidance for Q4. Can management give us -- can you give us some reason behind that?

--------------------------------------------------------------------------------

Min Xu, China Online Education Group - CFO [6]

--------------------------------------------------------------------------------

Yes. Sure. So the reason that we did not provide gross billing number is because that it is really complicated to forecast the gross billing number, which is the main reason that leads to relatively late earnings report date. So without gross billing guidance, hopefully, we can report our quarterly results earlier, which will allow more time to attend conferences and communicate with investors.

So I just want to add more color. So -- number one, we still expect a very solid Q4 gross billing. And we do expect the sequential growth should be in the low single-digit percentage. And the second is that we will continue to provide gross billing numbers in our earnings releases.

And so -- and I also want to point out that we haven't seen -- although we've done a lot of things to be compliant to the current government regulations, which people might think it could impact the gross billing, but we haven't seen any impact on our gross billing numbers.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [7]

--------------------------------------------------------------------------------

Great. My third question is regarding the overall outlook. Can management talk about the overall outlook and the key trends for online education in 2020? Do you see any changing like industry dynamics in -- like in regulation, environment and competitive landscape, especially for the competition in lower-tier cities? How would that impact the COE? And what is management's outlook on the company's revenue growth and margin trend in year 2020, particularly for the lower-tier cities?

--------------------------------------------------------------------------------

Jack Huang, China Online Education Group - Founder, Chairman & CEO [8]

--------------------------------------------------------------------------------

Okay. (Interpreted) So for 2020, we believe the online education market after a few years fast development is becoming a more mature market. And we see that the competitive environment is kind of stable and should be very similar to 2019.

So in 2018 and 2019, 51Talk has been focusing on developing the market in lower-tier cities, and we're glad to see that our products provide good value and good results for our students and it's quite competitive. So we are very confident that we can continue to do well in 2020.

So we've also being focusing on our operational efficiencies. And for -- with our business continue to grow and we continue to increase our scale, we see our financials continue to improve and it's getting more healthy and we're also seeing that our operating cash flow continue to grow and reached RMB 123 million this quarter, and we believe this trend will continue.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [9]

--------------------------------------------------------------------------------

That's very helpful. So just follow up, you have been talking about like improving operational efficiency. Just wondering, what are some of the, like, key measures you have been taking to improve the operating efficiency?

--------------------------------------------------------------------------------

Jack Huang, China Online Education Group - Founder, Chairman & CEO [10]

--------------------------------------------------------------------------------

(Interpreted) So let's talk about in several different aspects. Number one is the gross margin. You can see that we achieved record high gross margin. And one of the reason is that some of the lower-margin business is having smaller percentage in the quarter.

And also, for -- the sales and marketing is the largest portion of our expenses. And you can see that in the first 3 quarters this year, our sales and marketing expenses as a percentage of our gross billing continued to decline.

And our G&A and R&D expenses have been relatively flat. And as we continue to expand our revenue, the percentage of G&A, R&D expenses as a percentage of our revenue continued to decline. Okay.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [11]

--------------------------------------------------------------------------------

So on the gross margin part, your gross margin improved nicely. Just wondering -- so you're saying it's like because of the reduction of lower-margin products. Just wondering, is it more because of the -- also, I think you mentioned in your earnings report that it's also because -- contributable to the price increase. Just wondering, is it more because of your price increase? Or is it because more of the reduction of your lower-margin products? And what's your pricing strategy going forward?

--------------------------------------------------------------------------------

Min Xu, China Online Education Group - CFO [12]

--------------------------------------------------------------------------------

Yes. I'll take the question. So if you look at the year-over-year margin improvement, it was roughly 780 bps. So 70% of this improvement came from one-on-one business, and the rest is from -- actually from the small class business. So for one-on-one business, our margin improved from 66.6% to 72.7%, that was due to -- mostly due to a price increase, and so to a lesser extent due to more efficient teacher operations. And for the small class business side, we actually improved our margin from 32% to 56%. This was mostly due to kind of fewer low-margin trial lessons and better margin for regular lessons, too.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [13]

--------------------------------------------------------------------------------

That's very helpful. So do you planning to further increase your price going forward? What's your pricing strategy?

--------------------------------------------------------------------------------

Min Xu, China Online Education Group - CFO [14]

--------------------------------------------------------------------------------

So our price will probably -- it's hard to say what we're going to do in 2020. But in the past few years, we typically hike our price once every year, but we haven't decided what to do in 2020 yet.

--------------------------------------------------------------------------------

Long Lin, The Benchmark Company, LLC, Research Division - Research Analyst [15]

--------------------------------------------------------------------------------

Okay. Good. So my last question is regarding your lower-tier city penetration strategy. Actually, I was trying to ask if management can share some operating metrics in lower-tier cities, such as retention rate and some of the user acquisition strategy and key marketing channels, and what does the management see the user acquisition cost trend going forward? Also, the contribution -- the revenue contribution from lower-tier cities? That's my last question.

--------------------------------------------------------------------------------

Jack Huang, China Online Education Group - Founder, Chairman & CEO [16]

--------------------------------------------------------------------------------

Okay. (Interpreted) So the growth in the non-Tier 1 city is actually the key driver of our growth. And so for our core business, the gross billing from the non-Tier 1 city is getting close to 75% of our total core business gross billing.

So we do expect this percentage to continue to grow. And we see a lot of potential in the lower-tier cities. That's why we're quite confident that we've got a lot of room for future growth.

So when we look at the customer acquisition in the lower-tier cities, we find out that people there believing more their close friends and referrals. So that's why we are seeing that the referral rate, namely the referral gross bidding as a percentage of total new user number is going to be more than 60%.

So in order to target lower-tier city customers, we're actually making a lot of changes and adjustments to our product and services. Just for one example, we believe the lower-tier city parents and students not only want good spoken English, they also want to have good grades in the school. So what we're doing in our services that we're providing a Chinese teacher reviewing session for the students. And so that not only they can have good spoken English, they can -- through the Chinese teacher tutoring, they can get good grades in the school.

--------------------------------------------------------------------------------

Operator [17]

--------------------------------------------------------------------------------

(Operator Instructions) The next question comes from Roger Parodi with Silverhorn.

--------------------------------------------------------------------------------

Roger Parodi, Silverhorn - Managing Partner [18]

--------------------------------------------------------------------------------

I have one question. First of all, congratulations to the very good results, quite impressive. Then one question. You generate substantial positive operating cash flow. At the same time -- I mean, it's a lot, right? When you extrapolate that to 12 months, you really generate a lot of cash, right? At the same time, you are still slightly, but it's still a small GAAP profit negative. How does this -- how do these 2 numbers fit together, there's not much CapEx? How is the relationship between that? I would expect with this cash-generating capability to be much more profitable. That is one question.

The other question I have is regarding -- I would like to follow up on the previous question, actually on the previous caller as well as on the pricing strategy (inaudible) new strategies coming up that probably they might even offer classes at a lower price than you have, and they as well -- they target as well lower-tier cities. How do you different yourself from competitors that mainly compete on price?

--------------------------------------------------------------------------------

Min Xu, China Online Education Group - CFO [19]

--------------------------------------------------------------------------------

All right. So I'll take the first question first. So -- yes, so we did have very strong operating cash flow. And so -- however, our total company's non-GAAP income is still negative. So I'll explain a little bit. So number one, the operating cash flow is actually very closely linked to our gross billing P&L contribution. So namely, our gross billing is same as cash revenue in some other companies' terms. So let me define the gross billing P&L contribution first. So basically, it is -- the gross billing times the gross margin and minus all the non-GAAP operating expenses.

So this number really reflects the lifetime profit for this period's gross billing. So for example, if you calculate using this formula, you will find out this quarter, our gross billing P&L contribution margin is 17.6%. And it's roughly like RMB 100 million, which is very close to the RMB 123 million operating cash flow. And if you compare this to a year ago in Q3 2018, the gross billing P&L contribution margin was negative 1%. And a year ago, the operating cash flow for Q3 2018 was only RMB 1.7 million. So you can see that they are very closely related.

And the reason why the GAAP profitability lagging gross billing P&L is also quite straightforward. The main reason is that the customer acquisition cost is realized in the current period, right? However, the lessons will be taken in the future periods. Thus, the recognized revenue and the profits all coming in future periods. Just because of this mismatch, when the company is growing, the GAAP probably will naturally lag gross billing -- the gross billing profit. So that's kind of a long-winded explanation of why there's a big difference. And I know it's complicated, and I'll be happy to discuss this with any investors, if anyone is interesting to find out more.

--------------------------------------------------------------------------------

Jack Huang, China Online Education Group - Founder, Chairman & CEO [20]

--------------------------------------------------------------------------------

(Interpreted) So in terms of competing with some of the low-priced competitors, we always believe we are an education company. The essence of education is actually a -- we provide better teacher and better learning experience, better effectiveness and good results, and then in turn, good reputation and good brand. So we will not compete with anyone in pricing. And because we do not want to sacrifice the product quality and the service quality. And we believe, in the long run, only those education companies provide the best learning experience and the best result can survive and can have a good brand.

--------------------------------------------------------------------------------

Operator [21]

--------------------------------------------------------------------------------

As there are no further questions, I'd like to turn the call back over to the company for closing remarks.

--------------------------------------------------------------------------------

Judy Piao, China Online Education Group - Head of IR [22]

--------------------------------------------------------------------------------

Thank you once again for joining us today. If you have further questions, please feel free to contact 51Talk's Investor Relations through the contact information provided on our website at ir. 51talk.com or the Piacente Group's Investor Relations. This concludes today's conference call. You may now disconnect your line. Thank you.

--------------------------------------------------------------------------------

Operator [23]

--------------------------------------------------------------------------------

This conference has concluded. You may now disconnect your line. Thank you for attending.

(Portions of this transcript that are marked (Interpreted) were spoken by an interpreter present on the live call.)