China Online Education Group (COE) Q1 2020 Earnings Call Transcript

China Online Education Group (COE -3.31%)
Q1 2020 Earnings Call
May 26, 2020, 8:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's first-quarter 2020 earnings conference call. [Operator instructions] Today's conference call is being recorded. I will now turn the call over to your host, Ms.

Judy Piao, investor relations for the company. Please go ahead, Judy.

Judy Piao -- Investor Relations

Thank you. Hello, everyone, and welcome to the first-quarter 2020 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 website at ir.51talk.com.

Mr. Jack Huang, our CEO; and Mr. Min Xu, our CFO, will begin with some prepared remarks. Following the prepared remarks, Mr.

Liming Zhang, our COO, 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 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 under applicable law.

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

Jack Huang -- Chief Executive Officer

Hello, everyone. Thank you very much for joining our earnings call today. We started 2020 with a strong 52.2% year-over-year growth in net revenues, 10% point higher than the growth rate implied by the high end of our guidance. In particular, K-12 one-on-one mass-market net revenues increased 77% year over year to RMB 404 million.

This performance was driven by, one, our continued strategic focus and successful execution of our K-12 one-on-one mass-market offerings in non-tier 1 cities; two, students taking more lessons at home during the COVID-19 outbreak; and three, an increasing awareness of both our brand and online education. Benefiting from these factors, our gross billings grew sequentially to RMB 597 million. This growth was even more impressive in that it came versus our fourth-quarter peak season. Our K-12 one-on-one mass-market gross billings increased 45% year over year to RMB 564 million, reaching 94% of our total gross billings.

Our first-quarter active students increased to 286,000 from 257,000 for the last quarter, up 11% sequentially. During the virus outbreak, aside from giving out free online classes and one-on-one English lessons to K-12 students in Wuhan a and other impacted regions in China, as we previously announced, we also gave the medical supplies to the Philippines in an effort to contribute to the country's pandemic recovery efforts. Our employees, especially those in Wuhan, overcame many challenges arising from COVID-19 outbreak. In the first quarter of 2020, almost all of our colleagues in Wuhan worked from home, while only about half of the colleagues in other regions could come to the company office.

I am very proud of our employees who have made extraordinary efforts to help students maintain their study continuity through the outbreak. With these efforts, we were able to largely preserve productivity and operational efficiencies during the lockdown period. We worked closely with our Filipino teachers to ensure they could conduct classes effectively at home to meet the rising demand of our students, promoting further integration of the education resource of China and the Philippines. These unprecedented times have further highlighted and reinforced both the value and the natural progression of online education in China.

We have seen increasing penetration of online education in non-tier 1 cities due to the COVID-19 outbreak. This, together with our strong performance in the first quarter, provides us even further confidence in our chosen pathway to sustained top-line growth and profitability, especially as we further fine-tune our products and services and continue to enhance our core business focus on K-12 one-on-one mass-market offerings in non-tier 1 cities. With that, I will now turn the call over to Xu Min.

Min Xu -- Chief Financial Officer

Thank you, Jack. Hello, everyone. Solid first-quarter financial and operating performance helped us begin 2020 on a positive note. In addition to robust growth in net revenues and gross billings, we reported another profitable quarter with non-GAAP net income of RMB 57 million.

Excluding the RMB 16.9 million favorable impact from the coronavirus-related relief policies, our non-GAAP net margin would have been 8.2% compared with non-GAAP net margin of negative 19.5% for the same period last year. The improvement was due to higher lesson consumption and operating efficiency gains during the quarter. Additionally, we achieved record-high operating cash flow of RMB 172.7 million. To keep the company on track for sustainable growth and profitability, we have been proactively adapting our operational strategy.

This has allowed us to minimize the potential business impact caused by the COVID-19 outbreak and maintain high-efficiency at all levels, ultimately elevating our brand recognition as a leading and dependable online education platform in China. Now let me walk you through our first-quarter financial details. Net revenues for the first quarter were RMB 487.1 million, a 52.2% increase from RMB 320.1 million for the same quarter last year. The increase was attributed to an increase in the number of active students, as well as an increase in average revenue per active student.

The number of active students in the first quarter was 287,000, a 26% increase from 227,000 for the same quarter last year. The average revenue per active student in the quarter increased by 20.7% year over year. Gross profit for the first quarter was RMB 343.1 million, a 60% increase from RMB 214.3 million for the same quarter last year. Gross margin for the first quarter was 70.4% compared with 67% for the same quarter last year.

One-on-one offering gross margin for the first quarter was 71.2% compared with 69% for the same quarter last year. The margin expansion was mainly attributable to price increases. 51Talk's small class offering gross margin for the first quarter was 54% compared with 45.7% for the first quarter of 2019. Total operating expenses for the first quarter were RMB 314.9 million, a 13.2% increase from RMB 278.1 million for the same quarter last year.

Sales and marketing expenses for the first quarter were RMB 228.4 million, a 22.6% increase from RMB 186.3 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the first quarter were RMB 226.1 million, a 21.5% increase from RMB 186 million for the same quarter last year. Non-GAAP sales and marketing expenses, excluding branding expenses, were 32.3% of the gross billing for the first quarter compared with 34% for the same quarter last year. Product development expenses for the first quarter were RMB 35.9 million, an 11.9% decrease from RMB 40.7 million for the same quarter last year.

Excluding share-based compensation expenses, non-GAAP product development expenses for the first quarter were RMB 36 million, a 10.4% decrease from RMB 40.1 million for the same quarter last year. G&A expenses for the first quarter were RMB 50.7 million, a 0.9% decrease from RMB 51.2 million for the same quarter last year. Excluding share-based compensation expenses, non-GAAP G&A expenses for the first quarter were RMB 46.7 million, a 3% decrease from RMB 48.1 million for the same quarter last year. In this quarter's income statement, we added other income line above the operating income.

Other income for the first quarter was RMB 16.8 million, which included RMB 10.3 million VAT exemption and RMB 6.5 million super deduction. Operating income for the first quarter was RMB 44.9 million compared with operating loss of RMB 63.8 million for the same quarter last year. Non-GAAP operating income for the first quarter was RMB 51.1 million compared with non-GAAP operating loss of RMB 59.9 million for the same quarter last year. Excluding RMB 16.9 million positive impact from the coronavirus-related relief policies, non-GAAP operating income for the quarter would have been RMB 34.2 million, representing 7% non-GAAP operating margin.

Net income for the first quarter was RMB 50.8 million compared with a net loss of RMB 66.2 million for the same quarter last year. Non-GAAP net income for the first quarter was RMB 57 million compared with a non-GAAP net loss of RMB 62.4 million for the same quarter last year. Excluding the favorable impact of RMB 16.9 million from the coronavirus-related relief policies, non-GAAP net income for the first quarter would have been RMB 40.1 million, representing 8.2% net margin. Diluted EPS for the first quarter was RMB 2.26 compared with EPS of negative RMB 3.25 for the same quarter last year.

Each of our ADS represents 15 Class A ordinary shares. Non-GAAP diluted EPS for the first quarter was RMB 2.54 compared with EPS of negative RMB 3.06 for the same quarter last year. As of March 31, 2020, the company had total cash, cash equivalents, time deposits, and short-term investments of RMB 1.21 billion compared with RMB 1.05 billion as of December 31, 2019. The company had advances from students of RMB 2.26 million as of March 31, 2020 compared with RMB 2.19 billion as of December 31, 2019.

Now let's talk about outlook. We cannot predict whether the coronavirus-related impact we are experiencing in the first quarter will continue or to what extent during the remainder of 2020. However, based on the latest information available, we currently expect Q2 net revenues to be between RMB 460 million to RMB 470 million, which would represent 30.5% to 33.3% year-over-year growth from RMB 352.6 million for the same quarter last year. The above outlook is based on the current market condition and reflects the company's current and preliminary estimates of marketing 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.

Questions & Answers:

Operator

Yes. Thank you. [Operator instructions] And the first question comes from Vincent Yu with Needham & Company.

Vincent Yu -- Needham and Company -- Analyst

Thank you for taking my question. My first question is, one, have we seen any changes in class taking behavior, especially for these new students we gained in first quarter, as more schools have reopened and students have to not only go to school but also take classes after the normal class time in the weekends? My second question is what kind of initiatives or methods we are going to take to maximize the students we gained in first quarter on our platform going forward. Thank you.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So thank you for the question. So let's briefly talk about the general trends of student engagement we see in April and May. So number one, the lesson consumption per active student in Q2, obviously, will be lower than Q1, but it's still much higher than previous quarters. And we're also very confident that new students we acquired in Q1 will be as active as any new students acquired in previous quarters.

And also, we track one very important metrics, which is the lessons taken by our quarterly active students. And what we see this number in the previous quarter, actually in Q4 has grown year over year by 8%, and in Q1, that growth has surged to 30%. So obviously, in the future quarters, the growth of that metrics will not be as high as 30%, but it will certainly be probably -- be above the previous, we mentioned, 8% level.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

Yes. So the reason why we believe it is very important to improve lesson consumption of our students is that we believe the key to study a language is actually the frequency you practice that language. And that's why we put a lot of emphasis on encouraging our students to take more lessons and practice more. And what we believe is that the lesson consumption of our students is actually double the lesson consumption of our peers who are mainly focused on using North American teachers.

Vincent, can you repeat your second question?

Vincent Yu -- Needham and Company -- Analyst

OK. My second question is actually similar to something you have already mentioned, basically asking, how should we -- how can we maintain these students on our platform? I think you mentioned some frequency. Yes.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

OK. So in addition to what we have mentioned to improve the engagement of our students, in the past year, we have actually done a lot of projects trying to improve the students' learning experience on our platform. For example, we're trying to improve the ratings the students are doing for our teachers, and we're improving the QA system of both the teachers and also our service people who are trying to find ways to further improve our services. And also, we came up with -- we actually kind of shift our dynamic courses that's very interactive, that's HY-based, which can really attract a lot of our younger students.

So we're doing all of this to improve their learning experience and to improve our customer satisfaction.

Vincent Yu -- Needham and Company -- Analyst

Well, OK. Thank you.

Min Xu -- Chief Financial Officer

Thank you.

Operator

Thank you. And the next question comes from Fawne Jiang with Benchmark.

Fawne Jiang -- The Benchmark Company -- Analyst

Hey, congrats on a very strong quarter. My question is actually regarding your sales and marketing, I think, efficiency. And Jack, you mentioned that the strong performance in the first quarter was largely driven by a combination of lower-tier penetration plus strengthened branding. Just given the current strong user traffic profile, whether it's any strategic shift in terms of where you spend your margin dollar further on the new user acquisition or incrementally more retaining the current user that's going to your platform, how should we think about the efficiency down the road, whether for the rest of the year or like in the long term? And also, any commentary around your strong profitability in the first quarter? How should we look at the profitability profile for the rest of the year?

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So for your first question, this quarter, the new students we acquired from our non-tier 1 city actually is getting to a very high level, close to 75%. And in the past two to three years, we have consistently focused on the non-tier 1 city. And one of the key reasons we focus on that market is that the customer acquisition cost for that market is actually relatively low. And the customers in that market have a strong intention to refer new students, refer their friends to our platform, and they also have better retention.

So that is why we continue to focus on the non-tier 1 city, and that, actually, is one of the crucial factor that leads to higher sales and marketing efficiencies.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So in terms of our customer acquisition channels, number one, the referral students, the referral percentage of our new students actually is close to 65%. And this is due to the better student engagement. And also, it is we're focusing more non-tier 1 cities, so the people are more willing to refer their friends to our platform. And the second, the Q1 and Q3 are typical quarters that we will spend more on branding, so we're seeing more students coming to our platform because of our kind of TV ads and other ads.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So Q1 is our second profitable quarter and also the third profitable quarter for our one-on-one business. And this is the first quarter we achieved more than 10 million profit, and so we're confident that we will continue to be profitable for the rest of the quarters in 2020.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So besides the net income, we also achieved quite impressive operating cash flow of 173 million, and so that's after a strong operating cash flow of close to 400 million in 2019. And so looking forward to 2020, we should see a quite nice growth from that 2019 number.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So I also want to take this chance to share our strategy and our view on the balance between profitability and growth. So it is our company's view that we -- our strategy is to maintain a very small profit. And we will put the excess profit back into product development, G&A, and sales and marketing to drive further growth, to generate more new students, and to attract more students to our platform. And it is also very important for us to maintain a strong operating cash flow.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

The coronavirus lockdown actually really kind of improved online education penetration in the non-tier 1 cities, and we take this as an opportunity to expand our market share. So our focus will be increasing the number of students. So if we look at our one-on-one business, our one-on-one business, new paying students actually grew to 41% year over year and 21% quarter over quarter in Q1. And if we look further deeper into our core business of K-12 one-on-one mass market new paying students, the number actually grew 49% year over year and 30% quarter over quarter in Q1.

So this is a very strong growth in terms of new paying student number. And we hope this trend will continue, and we look forward to attracting more students to our platform and gaining more market share.

Fawne Jiang -- The Benchmark Company -- Analyst

Thanks, Jack.

Operator

Thank you. And the next question comes from Bo Pei with Oppenheimer.

Bo Pei -- Oppenheimer and Co. Inc. -- Analyst

[Foreign language] So I'm going to translate myself. So my first question is about some of the regions in China already announced the summer break will be delayed for this year. And then what is our premium on the impact to our business? And my second question is about after this COVID-19 impact, are we going to focus on gaining market share with a relatively more aggressive sales and marketing spending? Or we take this advantage to improve our profitability?

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

OK. So yes, so many regions have announced that they're going to start the summer break around mid-July, and some regions announced that they will start the summer end of July. So this is already better than our previous expectations. So we do understand this means that the summer of 2020 will be softer than previous years.

But we're very different from other large class size or more kind of test-focused education companies. And our lesson consumption is actually not much different. And also, as we mentioned before, we already have better engagement from our students. So we believe even though the summer break could be shortened and lead to softer demand, but we believe our strong new students -- new paying students number, as well as the improved student engagement, will more than compensate the potential negative impact.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So to answer your second question, we put priority on gaining market share. So we mentioned earlier that the non-tier 1 city penetration for online education will likely accelerate in the coming quarters and years. So the leaders in this space actually has the best opportunity to benefit from the trend. So we already have nine years operating history and have one of the best brands in the space, and so we will put all our resources trying to take advantage of this opportunity and gain more market share.

So in terms of the profitability, we're very confident that we will be able to achieve probability. At the same time, we aggressively invest in the sales and marketing. So you can see that our cash flow is quite strong, and our operating cash flow in Q4 is RMB 173 million and despite Q1 is a normally soft season. And our capability to make money also showing up on the gross billing contribution we mentioned earlier, which is you take the gross billing times gross margin and minus all the non-GAAP expenses.

In this quarter, we're getting gross billing contribution margin of close to 20%. So even though as of now, the GAAP net margin, there's still a gap between the GAAP P&L net margin versus the gross billing contribution margin, but we do believe in the future, we have the capability to reach that kind of operating margin. And as you can see that Q1, as soon as you see more less consumptions, you immediately see a quite sizable profit. So that's an indication of our capability to make more profit in the future.

Bo Pei -- Oppenheimer and Co. Inc. -- Analyst

Thank you.

Operator

Thank you. And the next question comes from Roger Parodi with Silverhorn.

Jack Huang -- Chief Executive Officer

Hey, Roger.

Roger Parodi -- Silverhorn Principal Investors -- Analyst

Hello, Jack. Hello, Xu Min. Can you hear me?

Jack Huang -- Chief Executive Officer

Yes.

Min Xu -- Chief Financial Officer

Yes.

Roger Parodi -- Silverhorn Principal Investors -- Analyst

Congratulations for the outstanding quarter. You already answered some of the questions that I had, so let me add one. You mentioned that Wuhan team is a big part of your sales team. And obviously, they were in adverse circumstances, how they had to conduct the business during the lockdown.

So when you would assume that all of your sales team would have been at full -- would have been fully operational, how much additional -- let me ask differently. What is the impact, the negative impact that you have that a big part of your sales team actually had to work on under adverse circumstances? That's the first question. The second question is when you now will invest in more growth, who do you mostly compete against? Is it other online education companies, or do you mostly try to get students from off-line companies to try to convert them online?

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So during the COVID-19 outbreak, we did face a large challenge on our operation. So during that break, demand is quite high. In February and March, the free trial lessons demand is 30% to 50% higher than our capacity. And at the same time, 100% of our Wuhan team is working from home, which is leading to less -- lower efficiency.

And so we actually, starting April, so things are getting back to normal. A lot of our offices have [Technical difficulty] And in May, our Wuhan office is back to normal. So you can see a lift in our operating efficiencies in Q2, and so that's quite helpful. So despite our recognized revenue may decline because of fewer lesson consumption, our gross billing actually will grow sequentially.

One of the reason is our improved sales and marketing.

Jack Huang -- Chief Executive Officer

[Foreign language]

Min Xu -- Chief Financial Officer

So talking about the competitive landscape. So that's split into three parts. So the first part is the online peers. So in the non-tier 1 cities, actually, we have better brands than most of our competitors, and we have more competitive products that are more suitable for the mass market.

And second, for the off-line schools, a lot of the -- there are many off-line schools in non-tier 1 cities, but they are very fragmented. And so we mentioned earlier that the trend is that the online education penetration is accelerating, so that trend is really helpful to us and especially for our product. Many of the off-line schools, they actually don't have qualified foreign teacher resources, so that makes our product very competitive. And the third part is actually the incremental demand.

Those students or parents, they haven't sent their kids to neither offline schools or online schools. Many of the young parents that are born in 1980s or even later, they have very strong intention to send their kids to learn English, to improve their probability just to open their eyes and to make their future life better. So these demands, we see probably the large portion of the incremental demand.

Roger Parodi -- Silverhorn Principal Investors -- Analyst

Excellent. Thank you.

Jack Huang -- Chief Executive Officer

Thank you, Roger.

Min Xu -- Chief Financial Officer

Thank you.

Operator

Thank you. And as there are no further questions now, I would like to turn the call back over to the company for closing remarks.

Judy Piao -- Investor Relations

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 or the Piacente Group's investor relations. This concludes this conference call. You may now disconnect your line.

Thank you.

Operator

Thank you.

Judy Piao -- Investor Relations

Thank you.

Duration: 56 minutes

Call participants:

Judy Piao -- Investor Relations

Jack Huang -- Chief Executive Officer

Min Xu -- Chief Financial Officer

Vincent Yu -- Needham and Company -- Analyst

Fawne Jiang -- The Benchmark Company -- Analyst

Bo Pei -- Oppenheimer and Co. Inc. -- Analyst

Roger Parodi -- Silverhorn Principal Investors -- Analyst

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