COE 51Talk

Operator

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's 2018 Second 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. Judy Piao, Investor Relations for the company. Please go ahead, Judy.

Judy Piao

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 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 applicable law. Please also note that 51Talk’s earnings press release and this conference call include discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial measures. 51Talk’s press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures. I will now turn the call over to our CEO, Jack Huang. Please go ahead.

Jack Huang

Hello everyone and thank you for joining us today 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 billings guidance. We also expanded our margins and reduced our operating expenses, to support a RMB 61.3 million year-over-year reduction in net operating loss. Our growth reflects the success of our strategic initiatives, which are keenly focussed on expanding our K-12 mass-market one-on-one program. During the second quarter, we continued 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 one cities, which accounted for 65.4% 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 has 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 cities, 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.

Jimmy Lai

Thank you, Jack, and hello everyone. For the second quarter of 2018 we continue to grow our revenues and improve our operating results both quarter-over-quarter and year-over-year. As a result, our first half revenues increased 55% and we narrowed our net loss by RMB 93.0 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. These include implementing sales and marketing efficiencies, streamlining our research and development investments, 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 operating capabilities, including reducing costs associated with our new student acquisition channel. With these two businesses accounting for the majority of our revenue, starting from this quarter we are pleased to offer our investors additional transparency’s into our business by breaking out additional metrics surrounding one-on-one program and our Hawo small class offering.In addition to gross billings, 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 result. 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 our 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 second quarter of 2018 was 195.5 thousand, a 28.4% increase from 152.3 thousand for the same quarter last year. Net revenues from our one-on-one offerings were RMB 254.2 million, a 32.6% increase from RMB 191.8 million for the same quarter last year. Net revenues from our small class offering for the second quarter of 2018 were RMB 27.5million.There was no revenue for the company’s small class offering during the second quarter in 2017, as we introduced this offering in July, of 2017. Cost of revenues was RMB 96.5 million, a 35.7% increase from RMB71.2 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 increased number of paid lessons. Cost of revenues from our one-on-one offerings increased by 12.3% to RMB79.8 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 margins 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 258.4 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 exclude share-based compensation expenses. Total share-based compensation expenses were RMB 6.6 million for the second quarter of 2018. This compares with RMB 6.1 million in the same year-ago period. Non-GAAP sales and marketing expenses were RMB 161.9 million, a 6.0% 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 marketing expenses, capitalization and amortization on 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 low expenses related to a 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 operations was RMB 76.5 million, compared with RMB 137.8 million for the same quarter last year. Non-GAAP loss from operations was RMB 69.9 million, compared with RMB 131.7 million for the same quarter last year, because of the forgoing. Our net loss was RMB 73.7million, 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 shareholders was RMB 3.6, compared with RMB 6.9 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 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 investments of RMB 601.5 million, compared with RMB 623.4 million as of December 31, 2017. The Company had current and non-current deferred revenues of RMB 1.4 billion as of June 30, 2018, compared with RMB 1.2 billion as of December 31, 2017. 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 billings to be between RMB 410 million to RMB 420 million, which would represent an increase of approximately 16% to 18.8% from RMB 353.4 million for the same quarter last year.Gross billings 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 billings 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 conditions and reflects our 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.

Operator

[Operator Instructions] The first question comes from Nicky Ge of China Renaissance. Please go ahead.

Nicky Ge

Hi, Jack, Jimmy. Thank you for taking my questions congratulations on solid quarter. I have several questions here. My first question is about our profitability, actually you have seen very nice margin expansion this quarter and also have seen a large increase both from Q on Q, 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 is actually lower than our revenue growth this quarter and our guidance from the last quarter, what is the revenue growth for the full year? And my last question is about the competition, we have seen not only the large [indiscernible] agency developing their online business very aggressively, but also we have seen some innovative machine learning platforms arising in the market also. So could management comment on the competitive landscape of online English study? Thank you.

Jack Huang

Okay. [Foreign Language]

Unidentified Company Representative

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

Jack Huang

[Foreign Language]

Unidentified Company Representative

So similar to other education companies, we get pre-payments from students and then recognize revenue when students take the classes. So there is a difference between gross billing and recognize revenue. 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 to 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 made from our operation during the quarter. So gross billing P&L for 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 fundamental. So achieving one-on-one business gross billing P&L breakeven is a big milestone for us and it is the first time in the company's history.

Jack Huang

[Foreign Language]

Unidentified Company Representative

So circling back to the GAAP P&L breakeven, although we cannot provide a timeline 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.

Jack Huang

[Foreign Language]

Unidentified Company Representative

So when we talk about the company growth, let's focus on the core business, which the 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 in Q3 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 you know, as a fast growing business our K-12 one-on-one mass market is increasing its percentage and it's growing faster than what we expect this trend to continue in Q4.

Jack Huang

[Foreign Language]

Unidentified Company Representative

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

Jack Huang

[Foreign Language]

Unidentified Company Representative

So we believe in terms of k-12 English learning, time is very important for our parents, so they want to see results for their kids and so we believe we have the best partner out there offering live one-on-one classe. And it is true that the many machine learning or AI products are good product, and they could be the good supplement to live classes. But we don't believe they can replace the live classes at this current stage.

Jack Huang

[Foreign Language]

Nicky Ge

Okay. Thank you so much.

Operator

[Operator Instructions] The next question comes from Zhonghai Yu of CICC. Please go ahead.

Zhonghai Yu

I have three questions for you. The first one is about the Economy model and margin, could you share us some colour on the change of the gross margin about small classes the long run? Regarding to my second question about the one-on-one class, we could see that the P&L has reduced largely. Could you please provide us some colour on this? My third questions is regarding to the k-12 education policies. Would like to hear the company’s thoughts on this. And one more thing is that I’ve noticed that company’s prepaid expenses is increasing, is there any reason that cause the expense increase? Thank you! [Foreign Language]

Jack Huang

[Foreign Language]

Unidentified Company Representative

So for our Hawo small classs, since it still at very early stage, so the margin could be very volatile and this is the reason why the small class has increased the scale, and its margin improved quickly. So right now our margins at 40% for a one-on-four class for our mid-term target for our margins is roughly 60%.

Jack Huang

[Foreign Language]

Unidentified Company Representative

So format of our Hawo class is that = every week we have three classes, two foreign teachers class and one Chinese teacher class. The Chinese teacher is full time employee. So the cost of Chinese teacher per class depends on how many students they can support. So the more number of students they support, the more that we can reduce the cost very quickly.

Jack Huang

[Foreign Language]

Unidentified Company Representative

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

Jack Huang

[Foreign Language]

Unidentified Company Representative

So actually, the core of our business, the K-12 one-on-one mass market has a very healthy and sustainable business model. And if we look at our cost structure, there is probably 31.4% of our cost – it is the cost of our sales, the cost of our product and 42.5% is our sales and marketing , these are the percentage of gross billing, and roughly 19% are our R&D and G&A. 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.

Jack Huang

[Foreign Language]

Unidentified Company Representative

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

Jack Huang

[Foreign Language]

Unidentified Company Representative

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

Jack Huang

[Foreign Language]

Unidentified Company Representative

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

Jack Huang

[Foreign Language]

Unidentified Company Representative

Regarding to your third question, first of all, we believe that new policies and regulations are targeting more to offline schools. secondly, what we believe there are 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. based on our understanding, the government is actually encouraging this kind of education and they were likely to welcome more business like us.

Jack Huang

[Foreign Language]

Unidentified Company Representative

We also believed that any kind of regulation will increase the barrier of entrance, and it is actually a beneficial for incumbents. At the same time, we're working with different branches of government and we are looking for ways to improve the business environment.

Jack Huang

[Foreign Language]

Jimmy Lai

Regarding the last question you raised, the increasing pre-paid balance – in our balance sheet. This is primarily a result of the adoption of the 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 represents that portion.

Zhonghai Yu

[Foreign Language] I have one follow-up question. As the company is now focusing on the non-tier cities, 42.5% of the branding that costed on the overall expenses. Right now, the sales leading of the online English learnings are pretty competitive. Could you provide us some color on the future percentage that branding expenses takes among the overall expenses?

Jack Huang

[Foreign Language]

Unidentified Company Representative

So first of all, we would like to clarify that the 42.5% of the expense is not only taking by branding. It's actually kind of a general sales and marketing, which including branding expenses, marketing expenses, which is same as customer acquisition. It also includes our sales, service and even Chinese teacher’s salaries and compensation.

Jack Huang

[Foreign Language]

Unidentified Company Representative

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

Zhonghai Yu

[Foreign Language]

Operator

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

Judy Piao

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 Investor Relations. This concludes this conference call. You may now disconnect your line. Thank you.

Operator

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