China Distance Education CEO Discusses F3Q2010 Results - Earnings Call Transcript

Executives

Zhengdong Zhu – Chairman and CEO

Ping Wei – CFO

Analysts

Alicia Yap – Citigroup

Mark Marostica – Piper Jaffray

Bella [ph] – Oppenheimer

China Distance Education Holdings Limited (DL) F3Q2010 Earnings Call Transcript August 19, 2010 8:00 AM ET

Operator

Good evening and thank you for standing by for the China Distance Education Holdings Limited third quarter fiscal 2010 earnings conference call. Today, you will hear from Mr. Zhu, Chairman and CEO of the company; and Ms. Ping Wei, the CFO. During the prepared remarks, all participants will be in listen-only mode. After that, the company management will be available to answer your questions.

Before we start, we would like to remind listeners that this conference contains forward-looking statements. These statements are made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Among other things, the outlook for the fourth quarter of fiscal year 2010 and oral statements from management on this call, as well as the company's strategic and operational plans, contain forward-looking statements.

Forward-looking statements involve inherent risks and uncertainties. A number of factors could cause actual results to differ materially from those contained in any forward-looking statements. Further information regarding these and other risks is included in the company's annual report on Form 20-F and other documents of the company as filed with the Securities and Exchange Commission. The company does not undertake any obligation to update any forward-looking statements, except as required under applicable law.

As a reminder, this conference call is being recorded. A summarized presentation can be downloaded from the company's IR website and which we will be referring during the course of the call. In addition, a webcast of this conference call is available on the company's Investor Relations website at ir.cdeledu.com.

I will now turn the call over to Mr. Zhu to discuss the operational highlights. Mr. Zhu, please go ahead.

Zhengdong Zhu

[Interpreted] Thank you everyone for joining us on our third quarter fiscal 2010 results conference call. Our operating results were released earlier and available on the company’s Website as well as on newswire services.

As you would have seen from our earnings release, we delivered a good standoff results, with revenue growing 25% and non-GAAP net income increasing 80.6% as compared to the same quarter of last year, in line with our guidance. This result is driven by the continued enrollment growth in our healthcare and construction engineering verticals and a steady performance from our core accounting process, including accounting continuous education.

In addition, we continue to make progress on some of our newer initiatives. Our self-taught higher education vertical continued to expand in the quarter as the program increasingly gains acceptance among both students and government bodies. And we recorded $1.1 million in revenue in the quarter from our courseware production contracts for the National Primary and Secondary Educational Resources Sharing Coalition Project.

As you will recall from last quarter, we see the government-sponsored project providing access with others to courses taught by leading teachers and students and throughout the country. We won the official date to undertake the platform development and courseware production part of this project in April and look forward participating in the important initiative moving forward.

Let me now walk you through our operational development for the quarter in more detail. Starting on slide 5, revenue for the quarter increased 25% year-over-year to $10.3 million. Total course enrollments were 242,000, an increase of 13% year-over-year. In total, online course revenue increased 16.6% year-over-year to $6.3 million.

Slide 7 shows some operational update on our key service areas. We experienced steady enrollment growth in most of our core accounting courses. Our accounting continuous education, with a 42% increase in enrollment compared to the third quarter of 2009. CPA enrollment increased a modest 7%, while APQE or Accounting Professional Qualification Exam enrollment decreased slightly.

In general, we are seeing slight softness in participations for the professional accounting test preparation courses. We think that changes made to the test registration process had made it more difficult for test preparation training course providers such as DL to promote the courses to the test takers at the point of registration, which had been one of our promotional methods up to this point.

In addition, ASP for most of our accounting test preparation courses remains stable as compared to the same period of last year. Even though with lowered prices for continuous education courses in order to extend market reach of this program. Also despite these changes and uncertainties, based on our preliminary market surveys, we believe we continue to maintain our product leadership position and our strong market share.

In addition, we are happy to report that yet again our students this year achieved superior results for our entry level and intermediate level APQE exams, the results of which came out recently. As a result, we saw increased interest and heightening enrollment trends in those two exams.

Moving on to slide 8, our self-taught higher education courses, the self-taught vertical continue to pick up momentum, with enrollments for self-taught higher education reaching about 11,300 in the quarter, a 37% increase from the same period of last year. In particular, we have registered a steady and meaningful increase in enrollments for the study process monitoring program in Tianjin. This quarter, we enrolled about 4,200 students in Tianjin in this particular program. Based on the feedbacks from our partner in Tianjin, this number we will continue to raise steadily going forward.

As this is always how enrollment suggests that our pilot program in Tianjin at about a year-and-a-half of investments have taken hold. Hence we are now fully confident that our study process monitoring program once brought out in more recently added provinces and particularly in the larger provinces such as Jiangsu will generate significant and a steady revenue stream for the company. And while our program is starting to take hold in Tianjin, we also continued aggressively sign up near provinces so that we would cover a larger portion of the market.

On that front, we are pleased to announce that we have recently signed a contract to extend our self-taught education program to yet another province, Hunan Province, which provides us access to at least another 600,000 additional students. This brings the total number of provinces where we have signed self-taught study process monitoring program contracts to seven for a total potential market size of over 3.5 million self-taught higher education examination takers.

We are very pleased with the progress we have made to date on this initiative and believe that the segment will continue to grow at an accelerated pace as we begin to develop critical mass in the existing provinces and continue to negotiate and work with near provinces to further promote the program.

Let’s turn to slide 9 about other non-accounting course offering. As I mentioned, our healthcare courses performed well in the quarter, registering a year-over-year enrollment growth of 10%, supported by the launch of additional course offerings and our growing brand name recognition in healthcare field. In addition, our ASP for healthcare vertical increased by 10%. Construction and engineering courses also continued to see strong momentum with a 138% enrollment growth year-over-year, driven by the continuous education contract. Cash ASP decreased by 23% as compared to the same quarter of last year, and we saw a larger portion of enrollments coming in from lower ASP continuous education courses in the vertical.

Moving on to slide 10, we have made promising progress with our business that have training programs as well. As we have discussed, we worked diligently to restructure Yucai to streamline the operational controls on program delivery, funding application as well as the collections process. In addition, we have also spent a lot of effort in creating a more effective platform to drive long-term growth.

To date, we have been successful on all of those fronts. As part of our efforts, we have a new management team in place, have successfully signed a number of new cooperation contracts, and have obtained official endorsement from both the Ministry of Labor and Social Security and city level offices. In addition, we have finally started to collect payments on the training we have provided in 2009, although most likely on a smaller number of students than were initially provided by the progress management team.

We have taken a conservative approach to our accounting for Yucai, a larger portion of the 2009 training revenue was never recorded in either 2009 or in 2010. As a result, we do not believe that the reduction in the confirmed numbers will have a significant impact on our revenue for 2010. In addition, in this quarter, we wrote off about $920,000 of accounts receivable from Yucai’s book as G&A expense, and about $700,000 of the $920,000 had reached over 360 days in aging. And we also determined that the other $220,000 generated under the previous management team is no longer collectible.

Finally, as most of the restructuring occurred during spring, a critical season for the pre and summer enrollments, we are running [ph] a small training program for the quarter, and as a result, we will report minimal revenue in this fiscal year. However, on the (inaudible) contract we have signed and we will confirm, we have been requested to restart training courses as soon as both for university starts, which will be sometime in September.

Simultaneously, we continue to tightly control the operating costs, which helped to improve our non-GAAP gross margin for the quarter. Going forward, we will continue to focus our efforts on collecting the 2009 training revenues, expanding the program reach as well as building a solid online and offline combined training approach to adjust this need with higher promising markets.

This completes my update on business operations. Let me now turn the call over to Wei Ping, our CFO, to walk you through our third quarter of fiscal 2010 financials.

Ping Wei

Thank you Chairman Zhu. We maintained our strict focus on cost control in the quarter, including a decrease in selling expenses, which helped to contribute to our margin improvement in the quarter. In addition, as we continue to grow the business, we are benefitting from increasing operational leverage, which also contributed to our positive margin performance.

Let me now recap our key financial metrics for the quarter on slide 12. Total net revenues for the third quarter of fiscal 2010 were $10.3 million, representing a year-over-year increase of 25% from $8.3 million in the third quarter of fiscal 2009. Online education services net revenues for the third quarter of fiscal 2010 were $6.3 million, an increase of 16.6% from the third quarter of fiscal 2009. The increase was a result of increasing enrollment in accounting, healthcare and construction and engineering courses.

Revenue from books and reference materials increased by 22.3% to $1.3 million for the third quarter of fiscal 2010 due to the improvement in cash payment from customers. Other revenues, primarily comprised of courseware production services, magazine content production services, offline information technology courses and related services, professional training for accounting firms, and revenue from Gaokao retake courses offered by our Xinlixiang, increased 52.3% year-over-year to $2.7 million for the fiscal third quarter of 2010 from $1.8 million in the corresponding period of last year.

Cost of sales for the quarter was $4.3 million, a 2.3% decrease over the third quarter of 2009. Excluding share-based compensation, the non-GAAP cost of sales for the third quarter was $3.9 million, an increase of 0.8% over the same period last year. The year-over-year increase in cost of sales was mainly due to the increased direct operating costs for the new Gaokao retake courses offered by Xinlixiang. Such increase was mainly offset by the decrease in cost of our book and references materials and Yucai.

This quarter, the margin for our books increased nicely, as we started to sell our books directly to retail users online this year. Such direct sales are of much higher margins as compared to distribution by third parties.

Gross profit for the third quarter of fiscal 2010 was $6 million, a 56% increase from $3.8 million in the same period last year. Excluding share-based compensation, non-GAAP gross profit was $6.4 million, an increase of 46.5% year-over-year. Gross margin for the quarter was 58%, compared to 46.3% in the third quarter of fiscal 2009. Excluding share-based compensation, the non-GAAP gross margin for the third quarter of fiscal 2010 was 62.1%, as compared to 53% in the same period of 2009. The increase in non-GAAP gross margin was primarily a result of a decrease in costs incurred by Yucai and a decrease in production costs associated with our books, partially offset by increases in staff and rental costs associated with the new Gaokao retake courses offered by Xinlixiang.

Total operating expenses for the quarter were $4.9 million, an increase of 26.6% year-over-year and an increase of 32% over the second quarter of fiscal 2010. Excluding share-based compensation, non-GAAP operating expenses were $4.3 million, a year-over-year increase of 32% and a sequential increase of 32.6%.

Selling expenses were $2 million, a 1% decrease year-over-year and a 17.5% increase sequentially. Excluding share-based compensation, selling expenses were $1.9 million, a 0.5% decrease from the same period last year and a 16.6% increase sequentially as we continue to exercise stringent cost controls on advertising and promotional activities, although commissions to our agents increased due to the increase in sales.

General and administrative expenses were $2.9 million, representing a 56.2% year-over-year increase and a 44.1% sequential increase. Excluding share-based compensation charge, G&A expenses were $2.4 million, a 76.8% increase year-over-year and an increase of 48.2% sequentially. Bad debt provisions of about $920,000 by Yucai due to the reasons mentioned by Zhengdong earlier were the biggest reason for the increase in G&A in the quarter. Higher staff costs due to (inaudible) and higher professional fees also contributed to the increase.

This quarter, we recorded an income tax expense of $0.3 million, as compared with an income tax expense of $0.05 million in the same quarter last year. Net income was $1.3 million compared to net income of $0.1 million in the same period of 2009. Excluding share-based compensation, non-GAAP net income for the third quarter of fiscal 2010 was $2.4 million, a 80.6% increase as compared to net income of $1.3 million in the corresponding quarter in 2009.

Net operating cash inflow for the third quarter of fiscal 2010 was $1.8 million, compared to a net operating cash outflow of $0.6 million in the same period last year, primarily due to contribution of net income, the decrease in prepayment and deferred cost and the increase in refundable fees, partially offset by the decrease in deferred revenue. As of June 30^th, 2010, deferred revenue and refundable fees balance was $10.3 million, a decrease of 16.6% from the balance of $12.4 million for the second quarter of fiscal 2010, an 18.4% increase from the third quarter of fiscal 2009.

Cash and cash equivalents, term deposits and restricted cash as of June 30th, 2010 increased to $58 million from $57 million as of March 31, 2010 as we continue to generate cash flow from operations, primarily offset by the repurchase of shares as part of our share repurchase program.

This completes the financial overview. Now, I will turn the call back to Mr. Zhu for the final remarks on our strategy and business update as well as financial guidance for the fourth quarter of fiscal 2010.

Zhengdong Zhu

[Interpreted] Thank you Ping. In conclusion, we are pleased with our results for the quarter and with the progress we have made on our numerous initiative including our self-taught higher education program. Our core business remain robust and our long-term growth outlook is becoming more positive, as we continue to extend our course offering enter new verticals and further develop our brand name.

Nonetheless, we expect that the fourth quarter will be a transitional period for the company. Firstly, revenue for Yucai will come in later as we went through adjustments in spring enrollment season, and we have to raise few students back to school in September to spend our enrollment. Therefore, revenue expectation for the fourth quarter will be minimal, that will be recorded about $800,000 of revenue in Yucai in the fourth quarter of 2009.

Secondly, while we will continue to focus on our core online businesses, which remain solid, we expect to cease some of our initiatives under ITAT cooperation contracts, which include our sponsorship of the ITAT contest and provision of related online and offline training courses, after conducting a cost benefit analysis.

This will have an impact on our revenue in the fourth quarter, however, it will allow us to remain focused on our core businesses that provide higher margins and exhibit stronger long-term growth potential.

As such, we expect our revenue for the fourth quarter to come in between $10.2 million to $11.2 million as compared to net revenues of $10.2 million in the fourth quarter of fiscal 2009. This represents the company’s current and preliminary view which is subject to change.

Thank you for your time. We would now be happy to take your questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from the line of Alicia Yap from Citigroup.

Alicia Yap – Citigroup

Hi, good evening. Thanks for taking my questions. My first question is regarding the termination of ITAT cooperation contracts, just wondering when did you decide that you need to make that decision, and how will the lower revenues impact your margins in the fourth quarter?

Zhengdong Zhu

We decided to discontinue this business in Q3.

Ping Wei

Alicia, in terms of the financial impact of ceasing the ITAT, part of the ITAT cooperation, which actually includes an ITAT contest that was run usually every year in September and also a project called ITAT Pro, which is actually a long-term on-ground training project in partnership with our same partner. The total impact or total revenue contribution that would have been expected from that project for Q4 of this year would have been about $1 million, give or take a few hundred thousand maximum. So, that basically in short term would affect our revenue expectations especially for Q4 2010 by about $1 million.

Having said that though, that doesn’t mean we have stopped working with our partner on the ITAT training related area, that’s one thing I want to clarify. It’s just that we are working with our partner for new business models, because the old model was not generating meaningful profit for either us or our partner.

Now, at the same time, I also want to clarify one thing that is even though it sounds like a big amount for Q4 of fiscal 2010, because ITAT contest is just a once-a-year and it usually occurs in September, so the impact is actually most and obvious in September. In other quarters, revenue contribution is actually relatively small as well. So, it just don’t happen that and, you know, Q4 is the unlucky one.

Alicia Yap – Citigroup

I see, got it. Thank you for the very detailed explanation. Second question is that in terms of looking into longer term, if you can share like what are some of the areas that you think you can expand into?

Zhengdong Zhu

For all the effort we have put in and where we have continued to put in, we believe that our business will continue to grow in longer term. In our mature business, such as in accounting, with our consistent investment, we will achieve longer-term growth in this area. After series of investments and operations in healthcare and construction vertical, we believe that those two verticals will grow at an accelerated pace going forward. Therefore, self-taught program after a year-and-a-half investment in Tianjin, and we have the program expanded into seven provinces, we expect to see strong enrollment growth in next quarter on that fiscal year. While for Yucai, the restructuring of Yucai is complete, and we will see strong enrollment growth in September (inaudible) is coming, Yucai’s business will have a good potential ahead of us. We are looking into longer-term for our primary and secondary tutor market, we believe that the combined online and offline model will have a great opportunity reach into this market. All in all, we see that our accounting vertical will grow steadily and other verticals namely healthcare, construction and engineering, self-taught, Yucai, and primary and secondary tutoring business will grow faster in the longer term. Thank you.

Ping Wei

Okay. Alicia, in terms of new areas that we are looking to, right now all those existing verticals including the key growth focus such as self-taught and business start-up training, and the K-12 [ph] after-school tutoring are already keeping us very busy. We will probably look at the new opportunities and assess whether we have the bandwidth to further expand into newer verticals aside from what Zhengdong talked about. So, really that’s what we have on hand are keeping us already very busy for the next few years.

Alicia Yap – Citigroup

I see. Yes, sure, I understand. Just lastly, can you comment on the accounting business? There were or has been some weakness in terms of the user demand, and when do you expect the demand or interest to pick up again?

Ping Wei

The softness in accounting, Zhengdong mentioned, you know, probably partially due to the change of registration method making test preparation providers a bit unprepared for a different market approach, which is sort of the test prep market issues, but this thing for DL was actually, we already started alternatives. Last year, you probably remember that last year, we already started promoting our accounting courses in our programs and the brand name of Chinaacp.com [ph] in university and college campus, and we have continued to do that this year and going forward as sort of a replacement approach for the own site promotion.

We are happy we started that early even though the result of that promotion takes time to sort of the potentials of that and activities would take time to sort of realize, but that was good investment we made. And also, that’s part of the reason for the softness. Another reason I think Zhengdong did not mention, which is sort of kind of speculation as sort of temporary uncertainty in the macro environment in general, but we believe that reason should be fairly short-lived as time is growing very fast and as the China government is emphasizing more and more on enhancing internal controls, enhancing the transparencies and corporate governance by the companies listed not only overseas but also or actually primarily companies listed in capital markets in China. So, in that kind of environment, demand for professional accounting especially CPAs for sure will pick up, even though this year from what I saw, what we saw, I think the number of test takers actually came down slightly. I hope I answered the questions.

Alicia Yap – Citigroup

Yes, thank you so much. Thank you.

Ping Wei

Thank you Alicia

Operator

Your next question comes from the line of Mark Marostica from Piper Jaffray.