51Talk Online Education Group (COE) 2018 Q2 法說會逐字稿

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's 2018 Second Quarter Earnings Conference Call. (Operator Instructions) Today's conference call is being recorded. (Operator Instructions)

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

Hello, everyone, and welcome to the 2018 Second 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 our website at ir. 51talk.com. Mr. Jack Huang, our CEO; and Mr. Jimmy Lai, our CFO, will begin with some prepared remarks. Following the prepared remarks, Mr. Min Xu, our co- CFO, will also join for the 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 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 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.

Hello, everyone, and thank you for joining us for our quarterly earnings conference call. Leverage the success we achieved in the first quarter of 2018, we continue to expand our business in the second quarter, exceeding the top end of our net revenues and gross billing guidance. We also expanded our margins and reduced our operating expenses to support RMB 61.3 million year-over-year reduction in net operating loss.

Our growth reflects the success of our strategic initiatives, which are clearly focused on expanding our K-12 mass market one-on-one program. During the second quarter, we continue to broaden our reach with this offering, which accounted for 66.2% of total gross billings compared with 63.2% and 52% in the previous quarter and the prior year period, respectively.

In particular, we are seeing excellent results from our efforts to grow our student population in non-tier 1 places, which accounted for 55.4% of our K-12 mass market one-on-one gross billings in the second quarter of 2018. Traction with our Hawo small class offering is also gaining momentum. This best-in-class program generated gross billings of RMB 43.5 million in the second quarter, a 17.6% increase from the previous quarter.

Additionally, our adult program had stabilized with favorable results from our initiatives to attract more new students during the quarter.

Our pathway to growth is clear, and we are confident in the growth potential of our core segments, which, as I mentioned, are centered around our K-12 mass market one-on-one offering. In line with this focus, we are becoming more efficient at allocating resources and improving our margin profile. As such, our operational and financial accomplishments in the first half of the year provide the cornerstones for our future growth.

The market opportunity for our high-quality programs is substantial, especially in non- first-tier places, where we are aligning our efforts to meet increasing demand and create additional value for all of our students, partners and investors.

With that, I will now turn the call over to Jimmy, who will talk about our key operating metrics and financial results.

Thank you, Jack, and hello, everyone. For the second quarter of 2018, we continue to grow our revenue and improve our operating results, both quarter-over-quarter and year-over-year. As a result, our first half revenue increased 55%, and we narrowed our net loss by RMB 93 million for the first half of the year compared to the same period in 2017. These improvements are primarily due to optimization in sales and marketing efficiencies, this including implementing sales and marketing efficiencies, streaming line our research and development investment and overall margin expansion.

By aligning our resources on our lucrative and growing one-on-one offering and our fast-growing small class offering, we are able to more efficiently leveraging our expenses and our operating capabilities, including reducing costs associated with our new student acquisition channel.

With these 2 businesses accounting for the majority of our revenue, starting from this quarter, we are pleased to offer our investor additional transparencies into our business by breaking our additional metrics surrounding one-on-one program and our Hawo small class offering. In addition to gross billing, we will now be providing additional information for our K-12 mass market one-on-one program and Hawo small class offering, including net revenue all the way to operating results.

I would now like to walk through our second quarter 2018 financial highlights. Net revenue were RMB 281.7 million, a 46.9% increase from RMB 191.8 million for the same quarter last year. The increase was primarily attributed to an increase in a number of active students and, to a lesser extent, an increase in the average revenue per active students. The number of active students in the second quarter of 2018 was 195.5000 (sic) [195,000], a 28.4% increase from 152.3000 (sic) [152,300] for the same quarter last year.

Net revenue from our one-on-one offering were RMB 254.2 million, a 32.6% increase from RMB 198 point million (sic) [RMB 191.8 million] for the same quarter last year. Net revenue from our small class offering for the second quarter of 2018 were RMB 27.5 million. There were no revenue for the company's small class offering during the second quarter in 2018 as we introduced this offering in July of 2017.

Cost of revenue was RMB 96.5 million, a 35.7% increase from RMB 71.2 million for the same quarter last year. The increase was primarily driven by an increase in total service fees paid to teachers, mainly due to the delivery of an increasing number of paid lessons.

Cost of revenue from our one-on-one offering increased by 12.3% to RMB 79.8 million from RMB 71.2 million for the same quarter last year. Cost of revenue from our small class offering was RMB 16.7 million.

Gross profit was RMB 185.2 million, a 53.6% increase from RMB 120.6 million for the same quarter last year. Gross margin was 65.7% compared with 62.9% for the same quarter last year. Gross margin for our one-on-one offering were 68.6% compared with 62.9% for the same quarter last year. The increase was mainly attributable to a lower revenue mix from our American Academy program, which has a lower gross profit margin. Small class offering gross margin for the second quarter of 2018 was 39.4%.

Total operating expenses were RMB 261.7 million, a 1.3% increase from RMB 258 point million (sic) [RMB 258.4 million] for the same quarter last year. The increase was mainly the result of an increase in sales and marketing expenses, partially offset by decrease in product development and general and administrative expenses.

As a reminder, our non-GAAP financial measure excludes share-based compensation expenses. Total share-based compensation expenses were RMB 6.6 million for the second quarter of 2018. This compared with RMB 6.1 million in the same year ago period. Non-GAAP sales and marketing expenses was RMB 161.9 million, a 6% increase from RMB 152.8 million for the same quarter last year. The increase was primarily due to the higher branding and marketing expenses, partially offset by the RMB 17.6 million net effect of certain sales personnel expenses and the marketing expenses, capitalization and amortization under the new accounting standard adopted on January 1, 2018, as discussed in our press release.

Non-GAAP product development expenses were RMB 42.8 million, a 17.5% decrease from RMB 51.9 million for the same quarter last year. The decrease was primarily due to lower expenses related to decrease in the number of personnel. Non-GAAP general and administrative expenses were RMB 50.4 million, a 5.8% increase from RMB 47.6 million for the same quarter last year. Loss from operation was RMB 76.5 million compared with RMB 137.8 million for the same quarter last year. Non-GAAP loss from operation was RMB 69.9 million compared with RMB 131.7 million for the same quarter last year. Because of the foregoing, our net loss was RMB 73.7 million compared with RMB 139.3 million for the same quarter last year. Our non-GAAP net loss was RMB 67.1 million compared with RMB 133.2 million for the same quarter last year.

Basic and diluted net loss per ADS attributable to ordinary shareholder was RMB 3.6 compared with RMB 6.9 for the same quarter last year. Each ADS represent 15 Class A ordinary shares. Non-GAAP basic and diluted net loss per ADS attributable to the ordinary shareholders was RMB 3.3 compared with RMB 6.6 for the same quarter last year.

As of June 30, 2018, the company had total cash, cash equivalents, time deposits and short-term investment of RMB 601.5 million compared with RMB 623.4 million as of December 31, 2017. The company had current and noncurrent deferred revenue of RMB 1.4 billion as of June 30, 2018 compared with RMB 1.2 billion as of December 1, 2018.

For the third quarter of 2018, we now currently expect net revenue to be between RMB 295 million and RMB 300 million, which would represent an increase of approximately 24.9% to 27.1% from RMB 236.1 million for the same quarter last year. And we are also projecting gross billing to be between RMB 410 million to RMB 420 million, which will represent an increase of approximately 16% to 18.8% from RMB 353.4 million for the same quarter last year.

Gross billing for our one-on-one business to be between RMB 395 million to RMB 405 million, which would represent an increase of approximately 14% to 16.9% from RMB 346.5 million for the same quarter last year. Gross billing for our small class business is expected to be approximately RMB 15 million, which would represent an increase of approximately 117.4% from RMB 6.9 million for the same quarter last year.

The above outlook is based on the current market condition and reflect our preliminary estimate of market and operating condition 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.

(Operator Instructions) The first question comes from Nicky Ge of China Renaissance.

I have several questions here. My first question is about our profitability. Actually, you have seen very nice margin expansion this quarter and also you have seen the loss largely decreased both from Q-on-Q and year-on-year. Just wondering what is the profitability trend going forward. And my second question is about our revenue guidance for the full year. By looking at our gross billing growth, I think it's actually lower than our revenue growth this quarter and our guidance from last quarter. What is the impact around the growth for the full year? And my last question is about the competition. We have seen on the large educational agencies developing their online business very aggressively, but also we have seen some innovative machine learning platforms driving in the market also. So could management comment on the competitive landscape of online English study?

Okay. (foreign language)

So thank you for the question, Nicky. So first of all, we believe that from the management point of view, we manage the gross billing P&L, and we will talk about that later. And obviously, through our operation and we reduced our Q2 operating loss by RMB 61.3 million year-over-year, as we mentioned earlier.

(foreign language)

So similar to other education companies, we get prepayments from students and then recognize revenue as students take the classes. So there is a difference between gross billing and recognized revenue. So what we -- so we want to talk about a little bit more on the gross billing P&L. What we do is that we take the current quarter gross billing times the current quarter gross margin, then subtract sales and marketing, R&D and G&A expenses to arrive at gross billing P&L, which represented how much money we make from our operation during the quarter. So gross billing P&L for our one-on-one business was RMB 26 million or 7% of our one-on-one gross billing in Q2 because gross billing represented our business fundamentals, so achieving one-on-one business gross billing P&L breakeven is a big milestone for us and it's the first time in the company's history.

(foreign language)

So come back to the GAAP P&L breakeven, although we cannot provide any time line at this point, we're -- with the achievement of gross billing P&L breakeven, we're very confident and we see a clear pathway to the GAAP profitability.

(foreign language)

So when we talk about the company growth, let's focus on our core business, which is K-12 one-on-one mass market business. So this part of our business is actually growing faster than the rest of the company. During Q2, it was growing at more than 50%, and we believe it will be growing at faster pace at around 60% year-over-year growth. As a result, our K-12 one-on-one mass market, as a percentage of total gross billing, will increase from 66% in Q2 to more than 75% in Q3. So as a fast-growing business, our K-12 one-on-one mass market is increasing its percentage and it's growing faster. We expect this trend to continue in Q4.

(foreign language)

So talking about our Hawo small class business, this is a new business. It's kind of a startup business. And in terms of its decline, Q-over-Q decline is due to its seasonality. Our customer acquisition right now is depending on our school program, which there is a dip during summer break. So we expect Q4 will be our strongest quarter ever for Hawo small class business.

(foreign language)

So we believe in terms of English training, time is very important for our parents. So they want to see results for their kids, and so we believe we have the best product out there offering like one-on-one classes. And for many machine-learning products, they are good product, they are good supplement to live classes, but we don't believe they can replace the live classes. And we believe at the end of day, the quality of the product is important to our customers.

(foreign language)

(Operator Instructions) The next question comes from Zhonghai Yu of CICC.

(foreign language)

(foreign language)

So for -- our Hawo small class is still at very early stage, so the margin could be very volatile. And so this is why -- and as small class increased scale, we can see its margin improve quickly. So right now, our margin is at 40%. And for a one-on-four class, our mid-term target for our margins is roughly 60%.

(foreign language)

So the format of Hawo small class is that we have -- every weekend, we have 3 classes, 2 foreign teacher class and 1 Chinese teacher class. The Chinese teacher is full-time employee. So the cost for the -- of Chinese teacher per class depends on how many students they can support. So the more -- as the number of students they support increases, we can reduce the cost very quickly.

(foreign language)

So one of the key reasons we improved our one-on-one business profitability is because we're exiting our American Academy program because of the low margin. As the percentage of our American Academy decreases, our margin continue to increase and our loss will continue to reduce.

(foreign language)

So actually the core of our business, the K-12 one-on-one mass market business has a very healthy and sustainable business model. And if we look at our cost structure, there -- probably 31% of our cost is the cost of our sales, the cost of our product and then 43% is our sales and marketing. And these I'm talking about as a percentage of gross billing, and roughly 19% are our R&D and G&A. So we have a 7% gross billing contribution left. So because of this model, it's possible that we can grow at a very profitable pace, and we can really make money for our investors.

(foreign language)

So the third reason is that we have been strategically focusing on our core target market, which we believe are the non-tier 1 city market. And our product provides the best value out there for the non-tier 1 city parents and students. And also, there's an increasing demand for online English education, especially in the K-12 sector. So in the K-12 sector, the percentage for non-tier 1 city gross billing has been 65% for this quarter, and we believe, in Q3, it could increase to be more than 70%.

(foreign language)

And in non-tier 1 city market, our customers are happy with our product, and they are more likely to refer our product to their friends. As a result, our -- in the non-tier 1 city, our referral rate has reached 65%.

(foreign language)

So putting all this together, these are all the reasons for the big decrease in terms of operating loss for us. And this gave us a lot of confidence that as we continue to execute our strategy and that we will be able to further reduce our operating loss and target our profitability in future.

(foreign language)

So number one, we believe that new policies and regulations are targeting more offline schools. And second, we believe they are being more kind of exam preparation-oriented training institutions. And what we're doing, we are an online education company focusing on improving the real capability of the students, and government actually is encouraging this kind of education. And they were likely to welcome more companies like this.

(foreign language)

So we believe any kind of regulation will increase the barrier of entrance and is actually beneficial for incumbents. And at the same time, we're working with different branches of government, and we are looking for ways to improve the business environment.

(foreign language)

Regarding the last question you raised, the increase in prepaid balance -- in our balance sheet, this is primarily a result of the adoption of ASC 606, which was effective January 1, 2018. And certain sales and marketing direct and incremental expenses are capitalized and amortizing in the future period. So this increase represent that portion.

(foreign language)

(foreign language)

So first we want to clarify the 42.5% is not only branding, it's actually -- it's kind of general sales and marketing, which, including branding expenses, marketing expenses, which is same as customer acquisition. It also includes the -- our sales, service and even Chinese teacher service and compensation.

(foreign language)

So in long term, we believe that percentage shift continue to decrease. However, in the near term, as we continue to invest in non-tier 1 city markets, it can be volatile or even increase a little bit.

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

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, which is ir. 51talk.com or The Piacente Group's Investor Relations. This concludes the conference call. You may now disconnect your line. Thank you.

Once again, this concludes this conference call. You may now disconnect your line. Thank you.