COE 51Talk

Operator

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's 2018 First Quarter Earnings Conference Call. At this time, all participants are in a 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. Hanyu Liu, Investor Relations Manager for the company. Please go ahead, Hanyu.

Hanyu Liu

Hello, everyone, and welcome to the 2018 first 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 Web site at ir.51talk.com. Mr. Jack Huang, our Chief Executive Officer; and Mr. Jimmy Lai, our Chief Financial Officer, will start with the prepared remarks. Our Chief Operating Officer, Mr. Liming Zhang, will also join for the Q&A session later. Before we continue, please note that today's discussion will contain forward-looking statements made under the Safe Harbor provision 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 on 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

Hello, everyone, and thank you for joining our quarterly earnings conference call. 2018 is off to a good start as we exceeded the top-end of our guidance in both net revenues and gross billings. Our first quarter results reflect the successful implementation of our strategic initiatives to focus our company on the thriving K-12 market, which represented 84% of our Q1 gross billings. We see a clear pathway to leverage our core competencies and grow our company. The cornerstone of our successful strategy is our K-12 mass market one-on-one program, which represented 63% of total gross billings in the first quarter and continues to grow. Our Hawo small class offering is also attracting an increasing number of students and this early-stage program is gaining traction. The advances we have made in each of our programs are designed to emphasize higher quality and improve our margin profile, as we continue to wind down our American Academy one-on-one offering. With our strategic initiatives squarely aligned in the K-12 market, we are able to more readily reach our target market not only in tier-one cities, but also in lower-tier cities where we see tremendous growth opportunity. Our model and strategy are resonating well within this segment of the market with steadily increasing gross billings from non-tier-one cities. For our K-12 mass market one-on-one program, gross billings from non-tier-one cities accounted for 63% in the first quarter of 2018 versus 52% a year ago. In summary, our top priority for the remainder of 2018 will be K-12 mass market one-on-one program which will lead our penetration in non-tier-one cities. We will also expand Hawo small class program, utilizing resources from our American Academy one-on-one program. In addition, we plan to rejuvenate our adult program which we expect to stabilize. Before turning the call over to our CFO, I would like to take this opportunity to welcome Mr. Min Xu who has been appointed as Co-CFO to work alongside Jimmy. With that, I will now turn the call over to Jimmy who will discuss our key operating metrics and the financial results.

Jimmy Lai

Thank you, Jack, and hello, everyone. We see positive impact on our financials following the alignment of our strategy to dedicate our resources to the K-12 mass market. Our strategy to streamline our business and deemphasize our American Academy one-on-one program led to sequential gross margin expansion from 62.4% in the fourth quarter of 2017 to 64.6% in the first quarter of 2018, as well as a sequential reduction of RMB47 million in net loss. This is despite our RMB37 million investment in the largest marketing campaign in our company’s history to support our branding effort during the first quarter of 2018. Furthermore, we expect our non-tier-one cities expansion strategy will support our future growth and improve our financial performance. I would now like to walk through our first quarter 2018 financial highlights. Net revenues were RMB262.6 million, a 64.6% increase from RMB159.5 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 the average revenue per active student. The number of active students in the first quarter of 2018 was 190.8 thousand, a 41.8% increase from 134.5 thousand for the same quarter last year. Cost of revenues was RMB92.9 million, a 69.7% increase from RMB54.8 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 increased number of paid lessons. Gross profit was RMB169.6 million, a 61.9% increase from RMB104.8 million for the same quarter last year. Gross margin was 64.6% compared to 65.7% for the same quarter last year. Total operating expenses were RMB280.2 million, a 14.3% increase from RMB245 million for the same quarter last year. The increase was mainly the result of the increase in sales and marketing, product development, and general and administrative expenses. As a reminder, our non-GAAP financial measures exclude share-based compensation expenses. Total share-based compensation expenses were RMB6.6 million for the first quarter of 2018. This compares with RMB13.1 million for the year-ago period. Non-GAAP sales and marketing expenses were RMB170.4 million, a 17.6% increase from RMB144.9 million for the same quarter last year. This increase was mainly due to higher branding and marketing expenses, and was partially offset by capitalized sales personnel expenses of RMB6.7 million in relation to the new accounting standard especially ASC Topic 606 adopted by the company since January 1, 2018. For further clarification, under the new accounting standard among other things, certain sales commissions to the sales personnel and the sales agents are considered incremental cost of obtaining contracts, and therefore will be recognized as an asset given that the company expected to recover those costs. Upon adoption of the new standard, RMB82.7 million of contract cost asset was recognized in the prepaid expenses and other current assets account on March 31, 2018, including the cumulative adjustment of RMB76 million which was recorded as a reduction to the accumulated deficit and a reduction of sales personnel expenses of RMB6.7 million recorded in sales and marketing expenses for the first quarter of 2018. Non-GAAP product and development expenses were RMB50.7 million, an 11.5% increase from RMB45.5 million for the same quarter last year. The increase was primarily due to higher expenses related to technology and course development-related personnel to further strengthen technology platforms and expand curriculum offerings, as well as higher technical services fees. Non-GAAP general and administrative expenses were RMB52.6 million, a 26.4% increase from RMB41.6 million for the same quarter last year. The increase was primarily the result of additional expenses for personnel necessary to support expanded operations, as well as higher costs related to compliance and reporting obligations as a public company. Loss from operations was RMB110.5 million compared with RMB140.3 million for the same quarter last year. Non-GAAP loss from operations was RMB104 million compared with RMB127.2 million for the same quarter last year. Because of the foregoing, net loss was RMB112.7 million compared with RMB140 million for the same quarter last year. Non-GAAP net loss was RMB106.1 million compared with RMB126.9 million for the same quarter last year. Basic and diluted net loss per ADS attributable to ordinary shareholders was RMB5.55 compared with RMB7.05 for the same quarter last year. Each ADS represents 15 Class A ordinary shares. Non-GAAP basic and diluted net loss per ADS attributable to ordinary shareholders was RMB5.25 compared with RMB6.30 for the same quarter last year. As of March 31, 2018, the company had total cash, cash equivalents, time deposits and short-term investments of RMB549 million compared with RMB623.4 million as of December 31, 2017. The company had current and non-current deferred revenues of RMB1.3 billion as of March 31, 2018 compared with RMB1.2 billion as of December 31, 2017. Now for the second quarter of 2018, we currently expect net revenues to be between RMB265 million and RMB275 million, which would represent an increase of approximately 38% to 43% from RMB191.8 million for the same quarter last year. And we are also projecting gross billings to be between RMB385 million and RMB395 million, which would represent an increase of approximately 8% to 11% from RMB355.1 million for the same quarter last year. Of course, the above outlook is based on the current market conditions and reflects the company’s preliminary estimates of market and operating conditions and customer demand, which are all subject to change. Now this concludes our prepared remarks. We will now open the call to questions. Operator, please go ahead.

Operator

We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from Zhonghai Yu of CICC. Please go ahead. Hello. Zhonghai Yu, your line is open. Please go ahead with your question.

Zhonghai Yu

[Foreign Language] I have two questions. The first one is about the guidance. We noticed that the guidance for the second quarter especially in gross billings is a lot more higher than the first quarter. So I’m just wondering which part of our business was the main growth driver? My second question is about the competitive landscape. We noticed that a lot of players are going into this market, including [indiscernible] and also [indiscernible]. So I’m just wondering how will this impact our business. Thanks.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Okay. Thank you for the question. The guidance sequentially increased between 8% and 11% and the key driver came from our K-12 mass market one-on-one product. This product in Q1 in terms of gross billings was 63% of total gross billings. And we expect in the second quarter this percentage will increase. In the meantime, the K-12 mass market product year-on-year gross in Q1 was 34% and again in Q2 we believe this percentage will also further increase.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

The reason for the increase or expansion actually it started in Q4, the penetration – our K-12 mass market product penetration down to the second and third-tier cities because our product has the best value for the price in this area, so very suitable for the second and third-tier cities.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Also in terms of the K-12 mass market product, the second and third-tier cities percentage as a percentage of total gross billings in Q1 was 63%. This number last year same time was 52%. We expect in Q2 it would further increase from 63%.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Of course, if you drill down to further explanation not just for price, we modify our product a little bit in order to make it more suitable for the student in the second and third-tier cities.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Of course, the Hawo small class product will also see a sequential increase but it’s not going to be as big as the K-12 mass market one-on-one product.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

The last part is adult business. The last couple of quarters we’ve been focusing on some adjustment, so it has not been increasing. But starting in Q2 2018 you will see this product to stabilize or increase.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Of course, the potential competition you bring up in the question by Total [ph], they’re still focusing on the premium market North American teacher one-on-one product and this product has not been – as we deemphasized it a couple of quarters ago, so it probably is not going to have too much impact on us. Thank you.

Operator

The next question comes from Shane Zhang of Morgan Stanley. Please go ahead.

Shane Zhang

[Foreign Language] Thank you for taking my question. So my question is can you share some observations of the student acquisition costs and retention in Q1 in the tier-one cities? Thank you.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Thank you for your question. Of course, the traffic in acquisition costs in the tier-one cities has become expensive. As a result, these second and third-tier cities because the traffic costs is the lowest, so as a result the customer acquisition costs is lower but that’s not the main driver. The main driver actually from the second and third-tier cities is a referral rate. We see a higher referral rate in the second and third-tier cities versus the first-tier cities. The Q1 referral rate was 59% and of course the lower-tier cities referral rate is higher than that.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Okay. If we take a closer look for the reason why the lower-tier cities referral rate is higher, first is just ourselves, our product is like we said is a better product value per price. So lower-tier cities parents are more willing to refer our products. When you compare our product with a premium North American product RMB40 per lesson versus RMB120 to RMB130 per lesson, it’s much easier for those parents to refer our product. Number two is the social openness for lack of a better translation in the lower-tier cities there are less social openness when you refer our product to the peers.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

As far as the retention rate, we see no difference between tier-one cities and lower-tier cities.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

But we’re very happy to see the online education product is penetrating in a major way into lower-tier cities.

Operator

The next question comes from Francisco Rodriguez Prada of Ronin Capital [ph]. Please go ahead.

Unidentified Analyst

Hello, everyone. This is Francisco from Spain.

Jimmy Lai

Hi, Francisco.

Unidentified Analyst

Hi, Jimmy. How are you?

Jimmy Lai

There is background noise.

Unidentified Analyst

I’m sorry. Is this any better?

Jimmy Lai

Yes.

Unidentified Analyst

Okay. I just want to say congratulations. The company you guys have built has been a remarkable history. I’d like to ask a few questions. Can you please help us understand how this largest marketing campaign you guys have done recently translate into revenues, gross and especially more importantly free cash flow and margins going forward please?

Jimmy Lai

Okay. Actually in a direct – if you look at the marketing campaign, this is more of a long-term branding awareness that’s probably not a direct correlation between the Q1 marketing campaign and the Q2 revenue. So thus to answer your question, it’s more for a longer term brand awareness campaign. Number two, the gross margin – sorry, Francisco, can you repeat your second question.

Unidentified Analyst

My second question was regarding how do you allocate your resources for your marketing and spending? Is it more depending on how the gross billings’ going to be, do you just allocate a percentage of it to the marketing or do you allocate marketing resources as the opportunities arise?

Jimmy Lai

There are two types of sales and marketing expenses; one of course is branding. Branding is when we see fit, we will invest in the branding. The marketing expense is more related to the student acquisition giving reward to the referral. Second part is more directed to the gross billings. I don’t know if that answered your question.

Unidentified Analyst

Yes. Thank you very much.

Jimmy Lai

Thank you.

Unidentified Analyst

I’m not going to ask you to give us more guidance than one quarter ahead, but will you please tell us what kind of gross billings would you be comfortable with in the future?

Jimmy Lai

No. We just – our objective is to give guidance for the next quarter. That’s been our practice.

Unidentified Analyst

Okay. And I don’t know if I understood the retention rate that somebody before asked, but could you please tell again the retention rate of the students please?

Jimmy Lai

Okay. The question was do we see difference between tier-one cities student retention rate and the lower-tier cities student retention rate and our reply was there’s no difference between tier-one and lower-tier cities.

Unidentified Analyst

What’s more of the range of the retention rate, do you guys disclose that?

Jimmy Lai

No, but it’s a complicated question because students when they come in, they buy various packages and each package come with – depending on duration it will probably have a different retention rate.

Unidentified Analyst

Okay. Can I ask a few more questions?

Jimmy Lai

I’d probably need to say probably one more because we still have analysts in the back as they want to ask questions.

Unidentified Analyst

I can jump in the line and come back later if that’s fine.

Jimmy Lai

Okay. All right, thanks.

Operator

Okay. And next question will come from Alexandre Lanoie of TR Capital. Please go ahead.

Alexandre Lanoie

Good evening. My question is about K-12 small class offering. So basically during the last earnings call, it was mentioned that gross billings for K-12 small class offering was about RMB12 million in December last year. Considering that gross billings for Q1 for that particular product was RMB36.9 million, it seems that small class offering hasn’t gained much traction so far. So I’m curious to know what’s your view on that? Are you satisfied with the progress made and is this a product that you’ll be pushing further into future? Thank you.

Jimmy Lai

Sure. A very good question. We did mention that in the month of December, gross billings was 12 million. The small class offering it’s more similar to the offline small class where there is a window of adding new student of a window for the student due to renewal. So it’s not a monthly linear type of projection. So if you compare apples-to-apples, the – for example, Q4 last 2017 that quarterly gross billings for small class was 20 million and this quarter it was 36 million. So that is actually quite a big advantage in terms of the increase. We are very optimistic about the Hawo small class but the strategy is not to expand it very aggressively. While we’re expanding it, we’re very cautious about fine-tuning all the operating metrics including the utilization rate, renewal rate, student satisfaction. That’s what we – at this stage that’s what we are more focusing on rather than the growth in term of the gross billings number.

Alexandre Lanoie

Okay. Thank you.

Jimmy Lai

Thank you.

Operator

[Operator Instructions].

Hanyu Liu

Thank you once again for joining us today.

Operator

Excuse me, I do see that there is a follow up from Francisco Rodriguez Prada. Please go ahead.

Unidentified Analyst

Yes, a quick one. I would like to ask a question to Mr. Min Xu. What are your first impressions about the team at 51Talk? And also more in general what’s the rationale for having a CFO and a Co-CFO?

Jimmy Lai

Francisco, we’ll be more than happy to have Min chat with you on a personal one-on-one occasion instead of doing this on the conference call. We can arrange a time to chat.

Unidentified Analyst

Okay, fantastic. Is still the road show in the U.S. planned? Are you guys still thinking about that?

Jimmy Lai

We will discuss with you on a personal one-on-one situation.

Unidentified Analyst

Okay. Thanks.

Operator

And we have a question from Erica Zang of Silverhorn Investment Advisors [ph]. Please go ahead.

Unidentified Analyst

Hello, management. So the question is more on the sales and marketing expense. So we see that the sales and marketing expense improved much quarter-on-quarter, but if we consider the branding campaign in Q1 which caused around RMB37 million, it actually improves significantly. So can you give us more guidance to help us to understand the trend of the COE self efficiency, for example, on the developing of conversion rate or cost per newly acquired student? And also what do you see for sales and marketing expenses as a percentage for gross billings in the future? And also one more question on the small class offering. I see that a lot of private and public companies are entering the market. They are larger and strongly funded. So what’s your competitive edge and how can you maintain your leading position in this highly anticipated market as the competition starts to intensify? Thank you.

Jimmy Lai

Thank you. I’ll take the first question and Jack will take the second question. Our sales and marketing expense as a percentage of gross billings was 48% in Q1 2018 which is flat compared with the last quarter June 4, 2017. However, in Q1 we invest in the largest branding campaign in the company’s history where we invested RMB37 million. So if you take out the branding investment and other adjustment, take an apples-to-apples comparison, our sales and marketing expense as a percentage of gross billings reduced from 44% in Q4 2017 to 39% in Q1 2018. There’s about 5 points of improvement. The largest contributor for this marketing efficiency improvement is actually in the increase of referral as we indicated before. Our K-12 referral rate increased from 53% in Q4 2017 to 59% in Q1 2018. In non-tier city with our primary focus market, the K-12 referral rate has actually reached 60%. Our strategy and our goal is that we continue to drive up the referral rate with a goal of reducing our sales and marketing percentage as a percentage to gross billings. However, it’s hard to give you – this is a forward-looking statement. It’s hard to give you a percentage. But our goal is to continue to drive it down. And I’ll let Jack take the second question on the small class and I’ll do the translation.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

When we do this small group class compared with some of the start-up companies in the industry, our advantage is primarily in the three areas. One is our proprietary technology platform which we’ll be investing for five, six years. Our curriculum development team, we have 160 people dedicated to developing curriculum internally. Number three is we – when we did the American Academy, there’s a lot of knowhow in terms of the North American teacher recruiting and training which we’d leverage on this – however, we leverage American Academy one-on-one. So this gives us a better foundation for developing this product.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

The whole class format is based on what we call three fixes; fixed classroom, fixed teacher and fixed schedule. This is combined with three lessons per week, two conducted by foreign teachers and one conducted by a Chinese teacher. So as a result, we can have a higher renewal rate compared with other players in the industry and this gives us distinct advantage.

Jack Jiajia Huang

[Foreign Language]

Jimmy Lai

Of course, this is still early stage product, it represents only a small portion of our total gross billings in net revenue and really don’t expect to see a profit though from this business in the near term.

Unidentified Analyst

Okay.

Operator

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

Hanyu Liu

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. Thank you.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.