Hello, ladies and gentlemen. Thank you for standing by for China Online Education Group's 2018 Third 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.

I will now turn the call over to your host, Ms. Judy Piao, Investor Relations for the company. Please go ahead, Judy..

Hello, everyone, and welcome to the 2018 third 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 website at ir.51talk.com. Mr. Jack Huang, our Chief Executive Officer; and Mr. Jimmy Lai, our CFO; and Mr. Min Xu, our co-CFO, will begin with some prepared remarks. Following the prepared remarks, Mr.

Liming Zhang, our Chief Operating Officer, will also join the call for our Q&A session. Before we continue, please note that today's discussion will contain forward-looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties.

As such, the company's results may be materially different from the views expressed today. Further information regarding these and other risks and uncertainties is included in the company's Form 20-F and other public filings as filed with the U.S. Securities and Exchange Commission.

The company does not assume any obligation to update any forward-looking statements except as required under applicable law. Please also note that 51Talk's earnings press release. And this conference call includes 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..

Okay. Hello, everyone and thank you for joining us for quarterly earnings conference call. The third quarter was marked by healthy growth for the company. We continued to execute on our initiatives to expand the reach of our K-12 mass-market offering in non-Tier 1 cities.

Based on the success of this strategy, we once again outpaced our guidance in both gross billings and net revenues. The prevalence of our core K-12 mass-market one-on-one offering continued to increase at a strong pace during the third quarter.

K-12 mass-market one-on-one gross billings grew 65.9% year-over-year in the third quarter, accounting for 78.2% of our comprehensive gross billings, up from 66.2% in the previous quarter. Our strategy to further penetrate lower-tier cities is also paying off.

In the third quarter, non-Tier 1 cities made up 69.4% of our total K-12 mass-market one-on-one gross billings, up from 65.4% and 58.6% in the prior quarter and the third quarter of 2017, respectively.

Our ability to increase gross billings with this program in non-Tier 1 cities is being driven largely by our emphasis on gaining referrals from our existing students and their parents.

Our programs are working, and as we put further emphasis on utilizing our resources to increase the number of referrals we receive, we are seeing our student population continue to grow. As our K-12 mass-market one-on-one programs become more pervasive in non-Tier 1 cities, we expect to see continued accelerated growth.

Our strategy to focus on this segment in these markets enables us to reach key audience in underserved markets that continue to grow our best-in-class programs that are helping shape the online education industry, which remains ripe with opportunities.

With opportunity comes change and regulation, while there is some uncertainty as to what the evolving online education regulations will look like. We are closely tracking government’s updates and recommendations.

As the industry leader and one of the few public Chinese online education companies, we believe that [indiscernible] measures will help all the leading companies in this space, and ultimately unfold the quality that we think our students, our parents, partners, and investors deserve.

Now, before we move on to our financial results, I would like to talk about Jimmy’s retirement. I want to thank Jimmy for his remarkable service over the last, nearly four years. He effectively led us through our successful public listing on the New York Stock Exchange and has made many great contributions to our continued growth.

We are grateful for his leadership and wish him the best in his retirement. Effectively from January 1, 2019, Mr. Min Xu, our co-CFO, will assume the role of CFO. While we are sad to see Jimmy go, we are pleased that Min will be carrying the torch upon Jimmy’s departure. With that, I will turn the call over to Jimmy..

Thank you, Jack. I just want to thank the team at 51Talk and investors for all your support over the years. It has been a great pleasure to work and grow with such a group of dedicated professionals. I truly believe in the culture we have created at this organization and services that we provide. I wish everyone continued success.

I am now pleased to turn the call over to Min, who will discuss our key operating metrics and the financial results.

Min?.

Thank you, Jimmy. You'll be deeply missed. Now I would like to walk through our third quarter 2018 financial highlights. As Jack discussed, we further strengthened our business in the third quarter achieving strong year-over-year growth in both gross billings and net revenues. More and more students are benefiting from our on-line English lessons.

The number of active students during the third quarter increased 18.9% year-over-year to 210,000. Gross billings for the third quarter of 2018 were RMB 424.5 million, a 20.1% increase from RMB 353.4 million for the same quarter last year. I’d like to provide you with a quick breakdown of our gross billings.

Gross billings from our K-12 mass-market one-on-one offering increased 65.9% year-over-year to RMB 331.9 million. Gross billings from our K-12 small class offering increased 139.2% year-over-year to RMB 16.6 million. Gross billings from our adult offering decreased 34.5% year-over-year to RMB 54.7 million.

And the gross billings from our K-12 American Academy one-on-one offering declined 66.1% year-over-year to RMB 21.3 million. Net revenues for the third quarter of 2018 were RMB 303.2 million, a 28.4% increase from RMB 236.1 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 average revenue per active student. The number of active students in the third quarter of 2018 was 210,000, an 18.9% increase from 176,600 for the same quarter last year.

Net revenues from our one-on-one offerings for the third quarter of 2018 were RMB 278.6 million, an 18.9% increase from RMB 234.4 million for the same quarter last year. Net revenues from our small class offerings for the third quarter of 2018 were RMB 24.6 million.

This compares with just RMB 1.7 million for the same quarter last year as this program was launched in July 2017. Cost of revenues for the third quarter of 2018 was RMB 109.6 million, a 21.6% increase from RMB 90.2 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 an increased number of paid lessons. Cost of revenues of one-on-one offerings for the third quarter of 2018 was RMB 92.9 million, a 7.1% increase from RMB 86.8 million for the same quarter last year.

Cost of revenues from our small class offerings for the third quarter of 2018 was RMB 16.7 million, a 387.2% increase from RMB 3.4 million for the same quarter last year. Gross profit for the third quarter of 2018 was RMB 193.5 million, a 32.6% increase from RMB 145.9 million for the same quarter last year.

Gross margin for the third quarter of 2018 was 63.8% compared with 61.8% for the same quarter last year. Gross margin for one-on-one offerings for the third quarter of 2018 was 66.6% compared with 63.0% 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. Gross margin from our small class offering for the third quarter of 2018 was 32.0%. This compares with a negative gross margin of 100.4% for the same quarter last year.

Total operating expenses for the third quarter were RMB 282.2 million, a 1.2% decrease from RMB 285.7 million for the same quarter last year. The decrease was mainly the result of a decrease in product development, and general and administrative expenses, partially offset by increases in sales and marketing expenses.

Sales and marketing expenses for the third quarter of 2018 were RMB 184.2 million, a 10.2% increase from RMB 167.1 million for the same quarter last year.

The increase was mainly due to the higher branding and the marketing expenses partially offset by the RMB 18.6 million net effect of capitalization and amortization of certain sales and marketing expenses under the new accounting standard adopted on January 1, 2018, as discussed in our press release.

Excluding share-based compensation expenses, non-GAAP sales and marketing expenses for the third quarter of 2018 were RMB 182.7 million, a 10.2% increase from RMB 165.8 million for the same quarter last year. During the second half of 2018, we made investments to support our future growth as our business continues to expand.

Specifically, we opened two new offices in the third quarter and added sales and services personnel in these new offices. These important investments are designed to increase our exposure and further penetrate non-tier-one cities, supporting our longer-term growth objectives.

As our new sales and services operations come up to speed in the coming quarters, we expect to see sales efficiency improve with these new offices. Product development expenses for the third quarter were RMB 45.6 million, a 25.9% decrease from RMB 61.5 million for the same quarter last year.

The decrease was primarily due to a decrease in the number of personnel. Excluding share-based compensation expenses, non-GAAP product development expenses for the third quarter of 2018 were RMB 43.4 million, a 26.1% decrease from RMB 58.7 million for the same quarter last year.

General and administrative expenses for the third quarter of 2018 were RMB 52.3 million, a 8.2% decrease from RMB 57.0 million for the same quarter last year.

Excluding share-based compensation expenses, non-GAAP general and administrative expenses for the third quarter of 2018 were RMB 48.9 million, a 7.4% decrease from RMB 52.8 million for the same quarter last year. Loss from operations for the third quarter of 2018 was RMB 88.6 million compared with RMB 139.8 million for the same quarter last year.

Non-GAAP loss from operations for the third quarter was RMB 81.5 million compared with net operating loss of RMB 131.4 million for the same quarter last year. Net loss for the third quarter of 2018 was RMB 90.4 million compared with the net loss of RMB 141.8 million for the same quarter last year.

Non-GAAP net loss for the third quarter was RMB 83.3 million compared with net loss of RMB 133.5 million for the same quarter last year.

Basic and diluted net loss per ADS attributable to ordinary shareholders for the third quarter was RMB 4.5 compared with net loss of RMB 7.05 for the same quarter last year, each ADS represents 15 Class A ordinary shares.

Non-GAAP basic and diluted net loss per ADS for the third quarter was RMB 4.05 compared with diluted net loss per ADS of RMB 6.60 for the same quarter last year. As of September 30, 2018, we have hold cash, cash equivalents, time deposits and short-term investments of RMB 657.2 million compared with RMB 623.4 million as of December 31, 2017.

Our deferred revenues, both current and non-current, were RMB 1.5 million as of September 30, 2018 compared with RMB 1.2 million as of December 31, 2017. Cash flow from operation for the third quarter was negative RMB 2.2 million.

For the fourth quarter of 2018, we currently expect net revenues to be between RMB 286 million and RMB 291 million, which would represent an increase of approximately 9.7% to 11.7% from RMB 260.6 million for the same quarter last year.

And gross billings to be between RMB 481 million to RMB 491 million, which would represent an increase of roughly 22.3% to 24.8% from RMB 393.4 million for the same quarter last year.

Gross billings for our one-on-one business is expected to be between RMB 422 million to RMB 432 million, which would represent an increase of roughly 15.1% to 17.8% from RMB 366.7 million for the same quarter last year.

Gross billings for our small class business is expected to be roughly RMB 59 million, which would represent an increase of approximately 121% from RMB 26.7million 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, 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..

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Tian Huang [ph]. Please go ahead..

Hi manangement. Thanks for picking my call. I had two questions.

First, could management help us to breakdown their gross margin on higher tier cities and lower tier cities? Second, could management also breakout the marketing expense? How many marketing expense was used in the higher tier cities and how many was used in the lower tier cities? Thank you..

Thank you for the questions. So for your first question, our gross margin has been consistent across the market, because we charge the same price and the cost is the same. So in all markets, we have the same margin. And second, we do not disclose the breakdown between the different tier cities.

But as we indicated earlier, we now focus on the lower tier cities, so for the first tier city, we right now spend minimal of the marketing expenses targeting the first-tier cities. So there, some kind of the marketing is not focusing on different regions. So, their part of the marketing expenses will cover the first-tier cities..

Our next question comes from Jerry Hu of Silverhorn. Please go ahead..

Yes, hello, management. This is Roger Parodi. Congratulations for the solid results. Here are my questions. I have a few, maybe I stop in between.

The first one is how do you think about student acquisition costs going forward? In what trend do you see them develop? The second one is, are there any material changes in terms of overall market competition and how is the market competition different in non-tier-one markets versus tier-one markets? And the third one is, how are you driving your referral business and how does it drive your customer acquisition costs?.

All right, so your first question is how the customer acquisition costs trend? So right now, in general, our consolidated costs of customer acquisition has been relatively stable in the past few quarters.

But if you breakdown the cost to acquire customers through regular digital marketing channel, it has been increasing, but is offset by the cost for our referred students.

So because our referral rate has been increasing and our referral cost is naturally lower than the regular digital marketing channel, so we are able to offset that increase in that part to keep our costs stable.

Can you repeat your next question?.

Yes.

Second is the changes in the overall market competition, especially the difference between non-tier-one markets versus tier-one markets? And overall, the market situation as you are in a fiercely competitive market, and there might have been changes over times in terms of how they are funded against how strong the competition is?.

Yes, sure. Yes. So Jack will take the question..

number one, we believe as the education market, any education product has been this word-of-mouth. So we need to be in the right market and provide the right product and the best service. [Foreign Language] So our product is quite popular in lower tier cities, and the referral rate for our core product has been around 70%..

Thanks a lot. And that 70% is really a very impressive number. If you allow, I would have a follow-on question. And that is regarding the government regulation. The offline education industry is now quite heavily regulated.

And how do you see the government developing turning on to the online education space? What are your thoughts about timing when the government might come into this online industry, and do you have any thoughts about this? Are you prepared for it or what are your thoughts?.

[Foreign Language] So as regard to the government regulation, we have been keeping a close eye on any updates and the recommendations from the government. We believe the regulation is actually helpful to the industry. And it is a good way to keep the industry healthy and it also actually increases the barrier of entry.

So in general, it is good for the healthy companies, it is also good for consumers. [Foreign Language] Okay. So if you read the regulation carefully, you will find out the goal for that set of regulation actually is targeting a lot of the tax preparation training, and especially those training that's way beyond the property level.

And so the regulation specifically point out that language, especially spoken language, is classified as the capability improving training, which is actually encouraged by our government.

And so we are very happy to see that the government is putting a lot of emphasis on the language training and we’re going to continue to support any government regulation that’s going to help improve the opportunities for our students' opportunity to get very good education resources, like our Filipino teachers..

Well understood. Do we have time for another question? I had one more, but you told me if there isn’t enough time..

Go ahead..

Thank you, Min Xu. Basically, as I understand, you're currently engaged in two businesses. One is mature, fastly growing business, which is the Philippine one-on-one business. Then you have a less mature; let's call it a startup business, which is the small class business. Overall, of course, we care about the profitability of the individual products.

That's why I have a question regarding the Philippine product. The Philippine product, as I understand, the faster you grow it, of course, the less you can make profitability because additional growth costs, mainly the way I understand it. That's kind of in every internet business the way.

At what point, at what speed would the Philippine business breakeven? Now let's say 30%, 40%, or whatever it is? And how do you see this threshold where you breakeven? How do you see that developed in the future? And can you grow and still turn the profit now and in future?.

Thank you, Roger. It's a million dollar question. So in general, our first priority is to maintain positive gross billing P&L contribution. Given a positive gross billing P&L contribution will then put all available resources to achieve the highest possible growth rate.

Just a reminder, our gross billing P&L contribution is calculated as gross billing times gross margin, and then subtract our sales and marketing, R&D and G&A expenses. So just like gross billing is a leading indicator of recognized revenue, the gross billing P&L contribution is also a leading indicator of GAAP probability.

So as long as we focus on gross billing P&L contribution, the GAAP probability will follow. That's the color we can provide right now..

Our next question comes from Zhonghai Yu of CICC. Please go ahead..

[Foreign Language].

Okay. So we want to just quickly do a translation. So the question is that, last week we heard two pieces of news. One is that the online regulation may require the same time requirement namely that you have to finish your training by 8:30 P.M.

So will this cause some impact to your business operation? And second is that, the government may require all teachers to have teacher certificate. And even the foreign teachers will need a specific certificate issued by a special government agency.

So is this going to cause any trouble for 51Talk?.

So number one, there’s a lot of attention on the potential government regulation both on offline schools and online schools. And there are many different readings and different understanding, and we've seen a ton of them. So we believe the best way is to wait for the official document from our government branches and agencies..

[Foreign language] So with regard to their timing requirement, our one-on-one class time schedule is very flexible. So right now, actually most of our K-12 students will be taking their lessons between 6 P.M and 8:30 P.M. In addition, we do have adult students who will most likely take our evening lessons starting from 8:30 and later.

So this is actually a very good setup. And we potentially can put some way to help optimize the teacher utilization..

[Foreign language] Okay. So with regard to the teacher certificate, it's always been required for any foreign teachers teaching offline in China to have the foreign expert certificate in order to work in China. And with regard to the foreign teachers outside of China, we're not sure this could be the requirement.

No matter what the decision is, we have plans to be in compliance, and we will follow the government regulation..

[Foreign Language] Okay. So just a quick translate. So the follow-up question is for many teachers in the Philippines.

Do they have teacher's certificates right now?.

[Foreign Language] So it is very common that our teachers have international language certificates such as Tesol and Toefl. And we're encouraging more teachers to get those certificates right now. [Foreign Language].

[Operator Instructions] Our next question comes from [indiscernible] from Tibet Capital. Please go ahead. [Indiscernible] your line is open, again from Tibet Capital. [Operator Instructions] This concludes our question-and-answer session since there are no further questions. I would like to turn the call back over to the company for closing remarks..

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

Thank you. This concludes the call. You may have a nice day..