China Online Education Group (COE) CEO Jack Jiajia Huang On Q4 2019 Results - Earnings Call Transcript

China Online Education Group (NYSE:COE) Q4 2019 Earnings Conference Call March 9, 2020 8:00 AM ET

Company Participants

Jack Jiajia Huang - Founder, Chairman and CEO

Min Xu - CFO

Judy Piao - IR

Conference Call Participants

Fawne Jiang - Benchmark

Vincent Yu - Needham & Company

Bo Pei - Oppenheimer

Maggie Zheng - Haitong International

Roger Parodi - Silverhorn

[Transcript Provided by the Company]

Operator

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's Fourth Quarter and Full year 2019 Earnings Conference Call. At this time, all participants are in listen-only mode. After management's prepared remarks, there will be a question-and-answer session. 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.

Judy Piao

Hello, everyone, and welcome to the fourth quarter and full year 2019 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 Web site 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 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 these 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 Jiajia Huang

Okay. Hello, everyone. Thank you for joining our conference call. We concluded our 2019 with outstanding fourth quarter, marked with multiple financial and operational achievements. On the financial side, net revenues exceeded at the top end of our guidance range by 2% with total active students increased 20.2% year-over-year. Even more notable, we achieved our very first consolidated breakeven quarter in our company’s history.

As we continued to optimize execution on our strategically focused K-12 one-on-one mass-market offerings in non-tier-one cities, our K-12 mass-market one-on-one gross billings increased 37.2% year-over-year to RMB501.7 million, representing 86.2% of our total gross billings. Our gross billings from non-tier-one cities accounted for 74.2% of our K-12 mass-market one-on-one offerings, illustrating our successful penetration in non-tier-one cities.

Over the past two months, Chinese people have shown tremendous courage and resilience while facing the numerous challenges presented by the coronavirus epidemic. From an educational standpoint, as school campuses have remained closed, hundreds of millions of students and teachers have turned to online in an effort to maintain the educational continuity.

We believe that an even more profound and long-lasting awareness of the power of online education has emerged, and therefore anticipate online education penetration continued to increase especially in lower-tier cities. We are confident we can leverage our powerful online platform and our expertise in English language learning to make the high quality education resources available to more people.

More recently in February, as part of our efforts to support our offline education partners and others in need through the coronavirus epidemic, we opened access to our online classroom, the Air Class, free of charge until the end of April. The Air Class, which was established over a five-year period has offered more than 100 million classes since its inception.

The system which features hundreds of network nodes around the world and international subsea lines allows for smooth, reliable and high quality communications and real-time interactions between students and the teachers. With this strong technology platform and the support of our 23,000 foreign teachers, we were able to effectively offer free online one-on-one English lessons worth roughly RMB20 million to the students in Hubei province, the most effective province by the coronavirus epidemic.

We did this not only as a way to maintain educational continuity for students whose schools are closed, but also an important step towards building a win-win online merge offline ecosystem with many educational institutions.

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

Min Xu

Thanks, Jack. In the fourth quarter, we continued to establish new historical highs in net income, gross margin, and operating cash flow. Most significantly, we celebrated our first profitable quarter with non-GAAP net income of RMB5.3 million driven by a robust top line coupled with improvements in operating efficiencies. We also achieved record high operating cash flow of RMB167.1 million.

Additionally, our cash position increased 47.9% year-over-year and exceeded RMB1 billion for the first time. Looking into 2020, we have confidence that our profitable growth strategy and sharp focus on operational efficiencies, along with new market opportunities due to developing trends, presents a continued path to future growth.

Now let me walk you through our fourth quarter financial highlights. Net revenues for the fourth quarter were RMB397.9 million, a 33.5% increase from RMB298.1 million for the fourth 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 the average revenue per active student. The number of active students in the fourth quarter was 257,200, a 20.2% increase from 213,900 for the same quarter last year.

Net revenues from one-on-one offerings for the fourth quarter were RMB371.5 million, a 39.4% increase from RMB266.5 million for the same quarter last year. Net revenues from small class offering for fourth quarter were RMB26.4 million, a 16.5% decrease from RMB31.6 million for the same quarter last year.

Cost of revenues for the fourth quarter was RMB110.6 million, a 1.0% decrease from RMB111.8 million for the same quarter last year. The decrease was primarily driven by a decrease in service fees paid to European and American teachers.

Gross profit for the fourth quarter was RMB287.2 million, a 54.2% increase from RMB186.3 million for the same quarter last year. Gross margin for the fourth quarter was 72.2% compared with 62.5% for the same quarter last year.

One-on-one offerings gross margin for the fourth quarter was 73.6% compared with 66.6% for the same quarter last year. The increase was mainly attributable to one, price increases; and second, the 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 fourth quarter was 52.7% compared with 27.9% for the fourth quarter of 2018. Total operating expenses for the fourth quarter were RMB288.4 million, an 8.5% decrease from RMB315.2 million for the same quarter last year.

Sales and marketing expenses for the fourth quarter were RMB202.5 million, a 4.5% decrease from RMB212.2 million for the same quarter last year. The decrease was mainly due to lower branding expenses.

Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the fourth quarter were RMB201.6 million, a 4.3% decrease from RMB210.6 million for the same quarter last year. Non-GAAP sales and marketing expenses, excluding branding expenses, were 30.4% of the gross billings for the fourth quarter compared with 35.0% for the same quarter last year.

Product development expenses for the fourth quarter were RMB37.0 million, a 13.0% decrease from RMB42.6 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP product development expenses for the fourth quarter were RMB36.8 million, a 9.6% decrease from RMB40.7 million for the same quarter last year.

G&A expenses for the fourth quarter were RMB48.9 million, a 19.2% decrease from RMB60.5 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP G&A expenses for the fourth quarter were RMB46.3 million, a 17.8% decrease from RMB56.4 million for the same quarter last year.

Operating loss for the fourth quarter was RMB1.2 million compared with operating loss of RMB129.0 million for the same quarter last year. Non-GAAP operating income for the fourth quarter was RMB2.5 million compared with operations loss of RMB121.4 million for the same quarter last year. Our GAAP and non-GAAP bottom lines turned positive for the first time in our company history.

Net income for the fourth quarter was RMB1.5 million compared with net loss of RMB140.0 million for the same quarter last year. Non-GAAP net income for the fourth quarter was RMB5.3 million compared with non-GAAP loss of RMB132.4 million for the same quarter last year.

Basic and diluted net income per ADS for the fourth quarter was RMB0.07 compared with net loss per ADS of RMB6.90 for the same quarter last year. Each ADS represents 15 Class A ordinary shares.

Non-GAAP basic net income per ADS for the fourth quarter was RMB0.25 compared with net loss per ADS of RMB6.45 for the same quarter last year. Non-GAAP diluted net income per ADS for the fourth quarter was RMB0.23 compared with diluted net loss per ADS of RMB6.45 for the same quarter last year.

As of December 31, 2019, the company had total cash, cash equivalents, time deposits and short-term investments of RMB1.05 billion compared with RMB712.1 million as of December 31, 2018.

As of Q4, we changed deferred revenues account name to advances from students. The company had advances from students of RMB2.2 billion as of December 31, 2019 compared with RMB1.7 billion as of December 31, 2018. For more of our 2019 full year financial results, please refer to our earnings press release for further details.

Looking forward to the first quarter of 2020, the company currently expects net revenues to be between RMB450 million to RMB455 million, which would represent a year-over-year growth rate between 39.3% to 40.9%.

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.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from Fawne Jiang of Benchmark. Please go ahead.

Fawne Jiang

Hi, Jack, Min. This is Fawne Jiang. Congrats on a very solid quarter. My first question is actually on your first quarter guidance. As Jack mentioned on the call, online education in general and your firm specifically seem to benefit from the current virus disruption. Your guidance suggested accelerated growth trend. So just wondering if you can give us additional color in terms of what you have observed on the ground, including the user traffic demand? And particularly on the user side, for the new user you are recruiting right now, is the profile similar or different from your previous group and your strategy to retain and convert these users going forward?

Jack Jiajia Huang

Okay. So thank you for your questions. So number one, we do see a very positive impact due to the recent events. So near term, we see that because students now have more time, they are more willing to try the online education platforms. And because of that it did bring some change to Q1. Q1 used to be a soft season. And as you can see that the guidance we gave between RMB450 million to RMB455 million represents roughly 40% year-over-year growth. So it’s quite strong compared to normal Q1.

Okay. So in terms of the new user point of view, we are seeing strong interest starting from Chinese New Year until now and we’re seeing a lot of growth in trial lessons and incoming calls, etc. And for the students coming in, we’re seeing more students are based in non-tier-one cities which is our targeting audience. However, we do face a shortage of personnel and a lot of our course consultants are based in Wuhan and they are forced to work from home because the office do not open. So I would say that do impact the productivity and efficiency. So it is hard to turn a lot of the interested students into paying students immediately. However, we believe the improvement in awareness of online education and willingness to try online education do have a long-term positive impact on the future adoption of online education.

So after the Chinese New Year, we are putting a lot of efforts and resources in recruiting more course consultants and students success personnel. We are seeing very strong future growth in the lower-city markets and we’re very happy that we can participate in helping getting the students in the lower-tier city markets more superior education resources. And as the leading player in this market, we believe we will play a very important role. Thanks.

Fawne Jiang

Thanks, Jack. Second question is really regarding your strategic adaption of changes with the big opportunity ahead, particularly in regards to your course designs and teacher recruitment. And on your Air Class platform, what are you aiming to position that as a sustainable open platform potentially benefitting from the revenue growth down the road?

Jack Jiajia Huang

Okay. So in terms of curriculum and right after the Chinese New Year, we started to offer free open classes to elementary students to help those students to get familiar with the key study content for the coming semester. And also in terms of developing new courses, we are preparing Pre-K courses targeting younger students and we’re also developing more H5-based course contents to make the study more interactive and more interesting for our students. In terms of teacher operations, we are putting more resources in recruiting more teachers and also putting more resources in training our teachers to prepare to meet the higher demand from our students.

So in terms of the technology platform, our Air Class platform, we’re very proud that we’re one of the very few companies in the industry who owns our own technology platform. And this platform has already delivered more than 100 million lessons and it can meet more than 140,000 students’ demand in one day. So, we are happy to open this platform to help our offline partners. And right now it’s for free and for the future, if we have the resource to further develop this platform to be more third-party friendly, then we might open this to more partners and it could be a future revenue resource. Thanks.

Fawne Jiang

Thanks. A very impressive quarter. I’ll go back to the queue.

Min Xu

Thank you.

Operator

The next question comes from Vincent Yu of Needham & Company. Please go ahead.

Vincent Yu

Hi, management. Can you hear me?

Min Xu

Yes.

Vincent Yu

Sure. Thank you. So my first question is on the regulations. So when any new updates on the regulation form, should we expect to see like more regulations or less regulations in 2020, like in your estimation based on your assessment or understanding with the policy making? And the second question will be around the free classes. We had priced free classes in Hubei which is about 20 million worth of free classes. So are they going to be included in the first quarter sales and marketing expenses?

Jack Jiajia Huang

So we have taken measures to be complying to the current government regulations and these regulations mostly focus on the selling packages, lesson time and teacher qualification. So we did a lot of work. Right now, most of our teachers have TEFL certificates. And our students’ class – for K-12 students, the class will have to finish before 9 PM. And for the selling packages, they are also in compliance with the government regulation. And so we’re very confident that these regulations will help make our industry healthier by driving weaker competitors and kind of a restored order and it’s actually beneficial to the incumbence. Also, I want to add that we do not see more regulations coming out. And the government will spend more time enforcing the existing regulation instead of making changes regularly.

Min Xu

Okay. So we announced that we’ll donate some of the one-on-one lessons to students in Hubei province. So number one, this will happen over probably a quarter or two. The number you’re quoting is kind of the value of the lesson if it is sold at the market price. And as you see, our margin is above 70%. So the real cost will be less than 30% of that number. And also the numbers of one-on-one lessons taken will probably be a much smaller number happening in Q1. So we do not expect this will significantly impact our operating expenses.

Vincent Yu

Got it. Thank you.

Operator

The next question comes from Bo Pei of Oppenheimer. Please go ahead.

BoPei

Hi, Jack, Min and Judy. Good evening. As we can see in China under the coronavirus impact, many students going to use third party platforms to get their education from schools like Alibaba’s DingTalk, Tencent’s WeChat, etc. So my question is about how our classes interact with these channels, these kind of courses? And then my second question is on sales and marketing. So apart from the free classes that we are giving out, what is the overall sales and marketing strategy right now? And then, how does that impact next couple of quarters’ sales and marketing costs this?

Jack Jiajia Huang

Okay. To answer your first question, our target customers are mostly elementary students aged between 5 and 12. And for their parents, like the school study and spoken English, they are totally two different things. So when they get online to follow their school schedule to study their English maybe vocabulary, maybe grammar, it’s very different from the spoken English training they are getting at 51Talk. And the lessons they are taking at 51Talk is very supplemental. So you can see, also in terms of time, we’re totally at different time. When the students are taking the required online lessons for school study content, at the same time they cannot take 51Talk lessons. So again, both in terms of their goal and their time, it’s totally two different markets and we’re meeting two very different demands. So this is why you can see that a typical Q1 soft season is now turning a very strong season with people willing to spend time to take more lessons on our platform.

Okay. So in terms of our sales and branding strategy, so we mentioned in some other occasions that for our branding expenses, we typically spend more in Q1 and Q3 when the school starts. That’s when we do more advertisement. However, for Q1, because of the coronavirus, some of the TV programs we previous decided to put in branding expenses now are cancelled. So we were able to move some of these expenses into direct marketing and we’re seeing very good efficiencies from those channels, and we’re getting new users better than our expectations.

Bo Pei

Got it. Thank you. Congrats on the reassuring guidance again. Thanks.

Operator

The next question comes from Maggie Zheng of Haitong International. Please go ahead.

Maggie Zheng

Hello. Can you hear me?

Jack Jiajia Huang

Hi, Maggie. How are you doing?

Maggie Zheng

Fine. Thank you. Congratulations on your impressive results. My first question is about your user acquisition costs. Can you please share with us the user acquisition costs before and post the outbreak of the coronavirus? And I would also like to know how many of your enrollments are coming from referrals and how many of them are coming from new users? Thank you.

Jack Jiajia Huang

So among our new users, more than 60% of them are from referrals. And since 2018, we have been focusing on non-tier-one city users and they are more likely to refer their friends. And so we believe this is a very strong driver for our strong referral rate. So for customer acquisition costs, it has been quite stable recently and it’s been around RMB3,000 to RMB4,000 per new user.

Maggie Zheng

Thank you. And my second question is: since you are making profit for the first quarter, would you expect this profitability to continue and what’s the normalized profit margin you expect in long term?

Jack Jiajia Huang

Okay. So I guess you’re talking about what do we believe could be the future profitable margin? So we would like to take time to explain the gross billing P&L and the GAAP P&L. So you can see that our gross billing in this quarter is actually much higher than our net revenue. Our gross billing is 582 million and our net revenue is 398 million. So typically when we calculate the gross billing P&L contribution, we will take the gross billing times of the current margin, then subtract non-GAAP expenses including S&M, R&D and G&A, and roughly for this quarter we can get: for one-on-one business we can achieve 24.8% gross billing P&L contribution margin. And for the consolidated company, we can achieve 23.3% gross billing contribution margin. So if you look at that, that’s potentially a long-term operating margin, if you can see this. But now let’s get back to our current business. And if you look at net margin in the near term, we mentioned earlier that we’re targeting a profitable growth, which means we’re trying to maintain our breakeven. And once we can break even, then we will put the gross billing growth at a higher priority, which means we will try to keep our net margin a small positive value and then we will reinvest the profit we get into sales and marketing to expand our market to increase the number of users. And we believe that’s where the future profit will be coming from. So again, just to repeat, when we talked about the profitable growth, we’re talking about maintaining our net margin at breakeven line and trying to achieve as much growth as possible.

So just to add one point that our goal is not to maximize the net margin. Our goal is trying to improve our operating cash flow. As you can see in Q4, we achieved historical high operating cash flow of 167 million. And for the full year 2019, our operating cash flow is close to RMB400 million. And so this operating cash flow is very close to free cash flow since our CAPEX is a very small number. And so we believe that we’re one of the very few companies that can achieve very high operating cash flow. I just point out that our focus will be to continue to improve the operating cash flow for our investors.

Maggie Zheng

Thank you. That’s very clear. My last question is regarding impact from rescheduling of the new semester. As the new semester has postponed and it’s likely that weekends will become only one day and the summer holidays will be shortened. How much would you expect that will impact to your second quarter results?

Jack Jiajia Huang

So we’re not clear that when the school will start, so it is hard to evaluate how many weekends or how much summer time will it take. But it’s very likely it will take some of those time. So it is a negative impact on Q2 and Q3 revenue recognition. However, we do see, as we mentioned, we do see stronger interest and more willingness and improved awareness of the online education, so we believe that all these positive impacts will at least partially offset the negative. So it is hard to see what the impact will be on Q2 and Q3, but we are very confident that as long as we offer a very good product and good service, we should see students coming to our platform to study.

Maggie Zheng

Okay. Thank you. Congratulations again on your good results. Thank you.

Jack Jiajia Huang

Thanks, Maggie.

Operator

The next question comes from Roger Parodi of Silverhorn. Please go ahead.

Roger Parodi

Hi, Jack. Hi, Min Xu. Thank you for taking my questions. First of all, congratulations for the very good results, congratulations for the strong cash flow generation, as you had explained before, that’s outstanding. My question is regarding the impact of the coronavirus in regards to the conversion rate and is it more difficult or is it easier now for your sales staff to convert the interest students into paying students, can you see the impact on that? And you already explained to us that you’re not running at full capacity in terms of your sales team, but is there any change in the dynamics of kind of sales kind of people who work on it, can they sell better? And the other question, can you give us some guidance in terms of gross billings? I know you don’t announce it officially anymore, but can you give us some guidance in regards to gross billings?

Jack Jiajia Huang

Okay. So the first question is about the conversion rate. So if we break down into different steps, for those steps do not need to involve people. For example, going from registration to trial lesson, those steps you are seeing a better conversion rate. And however, for those steps which needs customer service, needs help from our course consultant and ,as we mentioned earlier, because of the lack of personnel and stronger demand, the conversion rate is actually lower. So if you combine these two, our conversion rate stays roughly the same. And however, because more students are trying to register and trying to take the free trial lesson and in general we are better off.

So in terms of gross billings, because of seasonality, the Q4 is a strong season for gross billing and Q1 is a slow season for gross billing. And also, we can see that for small class business, it is typically much stronger in Q2 and Q4 because most of the renewals happens in those two quarters. So the Q1 gross billing for small class business will be much lower than in Q4. So combine those two, we can expect our Q1 gross billing will still be lower than Q4 gross billing. However, the Q-over-Q decline will be better than normal seasonality.

Roger Parodi

Thanks. That makes it clear. Thank you.

Jack Jiajia Huang

Thank you, Roger.

Operator

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

Judy Piao

Thank you once again for joining us today. If you have further questions, please feel free to contact 51Talk Investor Relations through the contact information provided on our Web site or The Piacente Group investor relations. This concludes the conference call. You may now disconnect your lines. Thank you.