Sunlands Technology Group (STG) Q1 2018 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to Sunlands' First Quarter 2018 Earnings Conference Call. [Operator Instructions] Today's conference call is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the conference over to your host today, Yingying Liu, Sunlands' Investor Relations Director. Please go ahead.

Hello, everyone, and thank you for joining Sunlands' First Quarter 2018 Conference Call. On the call, our CEO, Tongbo Liu, will give you an update on our operational performance this quarter and update you on our strategic initiatives going forward; and our CFO, Steven Yipeng Li, will give an overview of our financial performance in Q1 and our guidance on Q2. Following their prepared remarks, we will move into the Q&A session. Our Founder and Chairman, Peng Ou; and our Chief Strategy Officer, Selena Lu Lu, will also be available to answer your questions. Before management begins their prepared remarks, I would like to remind you of Sunlands' safe harbor statements in connection with today's conference call. Except for the historical information contained herein, the matters discussed in this conference call are forward-looking statements. These statements are based on current plans, estimates and projections, and therefore, you should not place undue reliance on them. Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those containing any forward-looking statements. For more information about the potential risks and uncertainties, please refer to the company's filings with the Securities and Exchange Commission. With that, I will now turn the call over to our CEO, Tongbo Liu.

Thank you, Yingying. Hello, everyone. Welcome to Sunlands' first earnings conference call as a public company. I'm delighted to say that our performance in the first quarter was very solid. Before our IPO, we were very clear that we see huge potential in the adult education market, and we have always believed that the online education model would drive the consolidation of this huge, fast-growing and fragmented market. We have positioned ourselves better than anyone else to benefit from it. I think our results in the first quarter really back this up. Our aggressive investments in improving the quality of our courses, in our IT platforms and in reaching up the potential markets drove record numbers of students to our platform, generating triple-digit growth in several of our key metrics. Net revenue increased by 161%, net gross billings were up 126% and new student enrollments more than doubled compared to the first quarter last year. Besides these financial numbers, I would like to spend some time talking about a few operational numbers, which indicate some of the drivers behind this high growth rate. First of all, let's look at the back end of our business, which mainly covers the teaching and learning process. According to iResearch, the national average pass rate of STE exam-takers, who had participated in STE tutoring courses, was only 46.5% in 2016. And our student pass rate in Jiangsu Province in 2016 was 71.9%, significantly higher than the national average. In the first half of this year, this number jumped to 79.2%. This increase was due to our focus on teaching philosophy, which boils down to a formula, teaching quality equals teaching time, times teaching efficiency. I can give you 2 numbers to back this up. The first number is the number of quizzes taken per student, which reached 970 in the first quarter this year, nearly triple the number in first quarter last year. The other number is the student satisfaction rate of our teachers, which reached around 98%. Secondly, let's discuss the front end of our business, which mainly consists of sales and marketing activities. Our marketing effectiveness ratio, which is calculated by dividing our marketing spending by our gross billings, remained around 19% compared to 22% in the first quarter of 2017. Considering the fact that in the educational -- in education industry, students are more likely to enroll after Chinese New Year and that we had a late Chinese New Year in 2018, otherwise this percentage can be even lower. Last, but not least, our net cash flow from operations reached RMB 222 million (sic) [ RMB 226 million ] in the first quarter this year. And our deferred revenue reached RMB 2.6 billion, which both demonstrate that we have significant capital to invest in our future strategy. Looking forward to achieve our goal, we will focus on the following 3 areas. First of all, we will continue to recap the market to attract more students who need a bachelor's degree. According to iResearch, in China, there are more than 600 million people between ages of 18 to 48, who do not have a bachelor's degree as of December 31, 2017. And the limited capacity of the traditional higher education sector offered by the government can only meet the needs of only 20% of the people at age 18. We aim to recapitulate people by telling them that through the government-run Self-Taught Higher Examinations, otherwise known as STE, they can get a bachelor's degree and they can take it online. More precisely, we will make them aware that even with just a mobile phone, they cannot only get a higher degree but also get a higher salary and improve themselves. As more people learn about the STE system, the online STE tutoring market is expected to grow to RMB 44.7 billion in 2017. In the second quarter, we will set up new trial classes and upgrade sales and marketing methods to attract more and more customers to STE programs. Secondly, we will continue to invest in the quality of our courses and content. The massive data collected from our student base allows us to analyze their behaviors, preferences and learning outcomes among other things. This, in turn, enables us to continuously optimize our educational content, teaching quality and the overall student experience. For example, with the help of our IT platform, our teachers were able to estimate relatively accurate number of knowledge points in the STE examinations that were held in April, just 1 month ago. And this helped our students focus their learning and improve their average pass rate. In addition, we're also improving the quality and the compensation for our teachers. Lastly, we will keep investing in our IT platform. At the end of last year, we had nearly 600 IT employees, and by the end of this year, this number is expected to double. Our IT team focuses on both the customer side and the operations side of our business to improve our customers' learning experience and the company's efficiency at the same time. Our IT platform, Genesis, is fully integrated into every aspect of our business and provides a seamless experience to our students, and the algorithm behind this is one of the main reasons we were able to achieve such a high pass rate. Sunlands remains a clear #1 player in the STE market. We are bigger than the #2 and #3 players combined, and we believe that as long as we continuously invest in these 3 areas, our first-mover advantages and barriers to entry will become stronger. With that, I will hand over the call to our CFO, Steven, to run through our financials.

Yes. Thanks, Tongbo. Hello, everyone. Thanks for joining us. We are on a very strong financial footing after listing on the New York Stock Exchange. The capital infusion we gained from the IPO combined with our rapidly growing deferred revenue base means we have the strong cash position we need to invest in building our platform, improving our content and continuing to solidify our market-leading position. Now I'd like to briefly walk you through some of the key financial results for the first quarter of 2018. All comparisons are year-over-year and all numbers are in RMB. In the first quarter of 2018, our net revenues increased by 161% to RMB 406 million from RMB 155 million in the first quarter of 2017. The increase was mainly driven by the growth in gross billings, which was attributable to an increase in new student enrollments. The significant increase in new student enrollments in the first quarter of 2018 was driven by our continuous investments in improving the quality of our courses and educational content offerings, improving our IT platform as well as the increase in sales, branding and marketing efforts. Our cost of revenues increased by 263% from RMB 19 million in the first quarter of 2017 to RMB 70 million in the first quarter of 2018. The increase was primarily due to the increase in compensation for our faculty members, which mainly included teachers and mentors, as we continue to retain our existing faculty members and attract new faculty members. Gross profit increased by 146% to RMB 336 million, primarily due to the increase in gross billings and net revenues. Operating expenses were RMB 588 million, representing a 149% increase year-over-year. Of these, sales and marketing expenses increased by 137% to RMB 499 million, primarily due to an increase in sales and marketing compensation and greater investments in marketing initiatives, such as search engine and mobile app advertising. G&A expenses increased by 267% to RMB 78 million, primarily due to hiring more staff to satisfy the requirements of operating as a public company and also, the foreign exchange losses as a result of the decline in the U.S. dollar in the first quarter. Our product development expenses increased by 145% to RMB 12 million, primarily due to compensation for our content professionals and technology development personnel. Net loss was RMB 245 million compared with RMB 99 million in the first quarter of 2017. And basic net loss per share was RMB 55 in the first quarter of 2018. Our deferred revenue balance was RMB 2.6 billion as of March 31, 2018. The deferred revenue consists of tuition fees that we have received from students, but for which services have not yet been provided to the terms of their service of contracts. Due to our significant increase in gross billings, we generated net cash from operating activities of RMB 226 million compared with RMB 140 million for the same quarter of last year. Our capital expenditures were RMB 148 million compared to RMB 2 million in the first quarter of 2017. The increase was mainly due to purchases of buildings and leasehold improvements. Now turning to our guidance for the second quarter. We currently expect our net revenues in second quarter to be between RMB 460 million to RMB 480 million, which would represent an increase of 123% to 133% year-over-year. This outlook is based on current market conditions and reflect our current and preliminary estimates of markets and operating conditions and customer demand, which are all subject to change. And with that, I would like to open up the call to questions. Operator, please?

[Operator Instructions] The first question today comes from Ronald Keung with Goldman Sachs.

Congratulations on the strong first quarter, not only the billings but the very strong enrollment numbers. So I have 2 questions. Firstly -- the first is on your second quarter revenue guidance. Just on the back of the very strong billings in the first quarter, what is your expectation for the growth trend in the second quarter? And as we see the second quarter revenue guidance is lower than the first, I just want to hear any thought process behind your guidance and anything that's related to, for example, the recent press coverage on this user experience? The second question is could you share with us the ASP outlook, particularly for your STE courses, whether the duration of the courses are changing? Or if you can share with us the current split between diploma, bachelor and whether we'll see more of diploma-bachelor joint courses that will drive a higher ASP? [Foreign Language]

Yes, thanks, Ronald, for your questions. Regarding your first question, our guidance for the second quarter, yes, it was actually mentioned that net revenue is a little bit lower than the original guidance. And the reasons for that are mainly due to we are paying more attention to the user experience. We want to -- our students to have better experience. After the IPO, after we became a public company, we were paid more attention by the media, by the public. And we devised some new methods to make sure our students have better experience. Number one, is we offered -- as Tongbo mentioned earlier, we offered a free trial classes to the users, so that they can have some experience before they -- making their decision to become our student. And the second, we offer this zero tolerance strategy. We are starting -- recently, we recorded all of our conversations between our counselors and students to make sure that our students is not being sold as aggressive as before. And then, the third strategy is now we are improving our refund policy. We are improving our refund service of our students so that our students have a shorter time -- weekend time for getting back their refund and also to response to our students regarding their refund in a more timely manner. So all those strategies may have an impact on our short term gross fee revenues, while we fully believe that in the long term, those strategies, those methods are very key to our success and very important to improve the experience of our students. So we are very confident that in the long term, those strategies will be very positive for the company. And regarding your second question for the ASP, you may note that our ASP for Q1 is a little bit lower than last year and that's mainly because we are improving the number of students who are -- who will pay online. We offer a little bit discount to students who pay online. And we don't expect this will continue in the long term. Once the number of students who pay online get to a certain level, we are still very confident that our ASP will improve as we expected in the beginning. We expect our overall ASP for this year will improve 10% to 15%, and now this is still in line with our expectations. And regarding the mix in terms of diploma and degree and the joint program, this is rather the same, very similar to before.

The next question comes from Mariana Kou with CLSA.

This is Mariana. I think my question is a little bit more on the medium-term development. I understand we just now talked about -- a little bit about less aggressive marketing and enhanced kind of return policy. Just wondering how is management trying to balance the 2, between like investing in marketing and also the R&D into core content versus sticking to the market share because definitely you're in a good position, especially for online market. And it's probably a great time to gain more market share as the industry segment continues to develop. So just kind of wondering how you're going to balance the 2 or we're going to prioritize market share first and pretty much kind of with the benefits later? Just a bit more color would be great. And I guess, secondly, also on O2O ASP, I think you previously talked about our ASP is actually quite low compared to our most competitive products given our quality and the results. So just wondering how are we going to, I guess, longer term, could close the gap between our products and also the competitive offerings in the market.

Mariana, I'm sorry, you were not very clear. Could you repeat your questions? Same as Ronald, could you repeat your questions in Mandarin again?

[Foreign Language]

Okay. I'm Tongbo Liu, and I will answer this question. And first, I will mention that the total marketing is huge, the potential market is huge. As I mentioned in my part that in China there are over 600 million people who don't have a bachelor's degree. And the first goal for us is to bring more and more people to get a bachelor's degree through STE program because most of them, they didn't know that they can get a bachelor's degree through STE Program. And the second is that they didn't know that they can do it online. So the first thing is that we should achieve this goal by waking up more and more people. This is the first. And then second is that as you can see our market effectiveness ratio for the first quarter this year is only 19%. That is 3% lower than the first quarter last year. So you can say that as we are growing so fast, as our new student enrollments had over 100% growth, and -- at the same time, our market effectiveness ratio goes down. That means our efficiency for our -- to acquire new students is better and better. This is the second thing I mentioned here. The third thing is that we believe that we can achieve great growth in the next 5 years, and in the meantime, we can achieve -- we can be profitable in 2018, in 2019 and later.

[Foreign Language]

Sorry, Mariana, yes, our Chairman would love to add some insight into your first question. Just wait a moment, please.

[Foreign Language] So actually, this question there are 2 principles. Principle 1 is we will guarantee our quality is much better than the peers, then only on that condition, we will want more and more market share. That's our priority. But on the condition, we can guarantee our quality is much better than the peers. [Foreign Language] As you know, every exam system, we will monitor our pass rate and the student satisfaction rate. [Foreign Language] Always we can guarantee and only if we merit actually, that, that number is much better than that of the peers, then our goal, our priority is to get more market share. [Foreign Language] And the principle 2 is we're also doing some changes to actually increase the number or increase the number of the participants taking the STE exams. [Foreign Language] And this -- these changes are continuous. They often pass for these changes as well. From the front side for our business, we will make it easier for people to join STE plan. [Foreign Language] For example, as our CEO said before, the trial process. [Foreign Language] Through these courses, actually we're encouraging them to take participant -- take part in the STE exam. [Foreign Language] And from the backside of our business, for those ones who have already registered for the STE exam, we will make their courses and projects more fragmented and make it easier for them to learn whenever and wherever. [Foreign Language] And these 2 methods, we believe, actually, in long term will also increase the number of people taking STE exam as well. [Foreign Language] That's all our Chairman wants to add. Thank you.

Mariana, please -- yes, please go after your second question.

[Foreign Language]

Yes, regarding the STE, I think right now the situation is same as before, like we mentioned during our IPO process. The most important thing right now for the company is to shift as many students as possible from off-line to online. So even though, as you may know, our ASP right now is much lower compared to outside players even though we have much higher pass rate and much better student service, but we wouldn't expect to increase our ASP too fast. Like I mentioned earlier to answer Ronald's question is we still expect our ASP will increase 10% to 15% for this year, but we are fully confident in the future, once we get more market share from off-line players, we will increase our ASP even more because there are a lot of room for us to increase our price.

[Operator Instructions] The next question comes from David Li with Lizard Investors.

Couple of questions. First, regarding the financing income. Can you just talk a little bit about how does it work from a regulatory perspective in terms of financing the student tuitions? And what are some of the sort of potential risk? And because you're seeing this thing on the markets where the financing eventually dried up or there were problems with financing. I just want to understand a little about what's regulatory stand on this. And then I have a follow-up.

Okay. Regarding the financing, we -- like, we mentioned before, we don't provide the financing ourselves. We have a third-party private providers who provide this service for our students. And this is a very normal education-related installment services. Our interest rate for this financing is only 5.5% for last year. So it's a very reasonable, very low interest rate. It's nothing like those B2B companies. And we don't take any credit risk. So which means on day 1, we will receive the payment from private providers and the private -- third-party private providers will collect the installments from the students. So this -- from our perspective, since this is a very, again, reasonable education-related installment services, we don't believe there will be any significant policy risks.

Do you feel there to be -- go ahead, sorry.

And one information I want to add here is that the reason we are offering -- the third-party financing method is that our off-line competitor offers that because we charge only around RMB 6,000 for a degree for 1 to 2 years degree. That is very low, and I think that's just our customer's 1-month salary or 0.5-month salary. And -- but for our off-line competitors, they have to offer that method because they charge double, triple of our ASP. So we think that this is essential way for them to acquire new students, but it's not essential for us. Thank you.

But -- could this financing opportunity -- I understand you don't take credit risk. But could this financing activity drive bad behaviors from other competitors where -- or other relationship with the banks where it drives them to offer very, very low-quality offering in the financing? Is this a thing where it could eventually kind of backfire, then government will come down, and say, "Hey, we won't allow you to finance anymore because there's just lot of crappy services out there that, that not -- they don't really provide very high quality at the end?"

Yes, I think, first of all, most important factor for students consider is the quality of content. If they can pass the final exam, if they can get their degree. I think that's the most important thing for the student. Not the financing plan or how much they pay. And yes -- so that's why we -- like Tongbo mentioned, the reason we are providing this third-party financing services to our students is only because all of our competitors off-line players are providing their services to their students. And the second is the policy changes. We actually welcome to the policy change because that will impact all the off-line players first, because their business is heavily reliant on this financing servicing. But for us, like Tongbo mentioned, we only charge RMB 6,000 for 2 years for students to get their degree. So we don't really have to offer these financial services. So if there is the policy change, yes, I think, that will impact off-line players more -- much more compared to us because all of our students actually, they all have jobs, they're all at work. So their ability to pay the service is really fine.

Great. And also on student -- customer acquisition cost. Can you talk a little bit about what -- over time, do you guys have any room to drive this down on a per-unit basis? I forgot the number on it, per new student enrollment. What's it been historically? And over time, how much can you guys drive it down?

Do you mean in terms of absolute dollar amounts of the acquisition cost of students?

Yes, for new students, that's right, over time.

Well, I mean, first of all, I think the most -- the more important ratio we should consider is the acquisition -- student acquisition expenses as a percentage of gross billings, because if we can get more gross billings per student, even the acquisition -- student acquisition expense per student goes up. And I think, as long as this ratio is going down, this should be okay for the company. And while in terms of how to improve the operating efficiency or the marketing effectiveness ratio, I think we have mentioned this earlier in Tongbo's script that we are doing a lot of different things. We are using IT platforms, we are improving our teaching quality and content. We are improving the students experience and all those things will improve our, like, [ awareness ], our referral rate in the future and that will in turn improve that ratio, the student acquisition expenses as a percentage of our gross billings.

Okay. And also on a competitively, what's to me -- Chairman mentioned about your market share is so much higher than just #2 and #3 player combined, can you talk a little bit about any of your peers growing fast as you that are also gaining market share as well? Any significant players out there emerging?

Yes, the short answer is no. We -- right now, we are just so much bigger compared to all the off-line players. We are actually gaining more market share. Yes, so to our knowledge, we -- no, we didn't notice any new significant players, no.

This concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

Once again, thank you, everyone, for joining today's call. We look forward to speaking to you again soon. Thank you, good night.