Business context and reporting period
China Online Education Group (51Talk; NYSE: COE) filed this Form 20-F for the fiscal year ended December 31, 2018. It operates an online English-learning platform primarily serving students in China, with live one-to-one and small-class lessons. The filing provides annual results, not a separate set of fourth-quarter financial statements; Q4 figures below are identified where disclosed.
Results are presented under U.S. GAAP. Unless otherwise stated, amounts are in RMB millions. U.S. dollar equivalents are included where useful; the filing translates 2018 amounts at RMB6.8755 per US$1.
Financial and operating performance
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Net revenue | RMB1,145.5m (US$166.6m) | RMB848.0m | +35.1% |
| Gross profit / margin | RMB734.6m / 64.1% | RMB533.9m / 63.0% | Profit +37.6%; margin +1.1 percentage points |
| Operating expenses | RMB1,139.3m | RMB1,104.7m | +3.1% |
| Operating loss | RMB404.7m | RMB570.8m | Loss narrowed |
| Net loss | RMB416.7m (US$60.6m) | RMB580.8m | Loss narrowed 28.3% |
| Operating cash flow | RMB29.8m | RMB55.1m | Down 45.9% |
- Revenue growth was attributed mainly to more active students. Gross billings, a cash-receipts measure net of refunds, increased 19.3% to RMB1,703.0m.
- Cost of revenue rose 30.8%, slower than revenue growth; paid lessons booked increased from 18.2m to 23.3m. Management attributed the gross-margin improvement mainly to a lower revenue contribution from the lower-margin American Academy offering.
- Sales and marketing expense rose 11.3% to RMB731.2m, but fell to 63.8% of revenue from 77.5%. Product development expense fell 17.1% to RMB185.0m, alongside reductions in technology and course-development staff. General and administrative expense was broadly flat at RMB223.1m.
- Interest income was RMB9.2m; net interest and other expense was RMB9.9m. A RMB7.4m impairment loss related to an investment in American International Schools, LLC, which management concluded was unlikely to repay on time.
- Operating cash flow remained positive despite the net loss, supported substantially by a RMB474.3m increase in deferred revenue from advance customer payments. The cash-flow measure therefore should not be read as equivalent to earnings or recurring free cash flow.
Liquidity, debt and balance sheet
- At year-end, cash and cash equivalents were RMB413.1m, time deposits RMB162.7m and short-term investments RMB136.3m, totaling RMB712.1m (about US$103.6m).
- Current liabilities were RMB1,885.6m, including deferred revenue of RMB1,676.1m. The company reported net current liabilities of RMB931.0m, up from RMB716.0m in 2017. Total liabilities were RMB1,972.9m; shareholders’ deficit was RMB962.6m.
- The company had RMB69.0m (US$10.0m) outstanding on a two-year, floating-rate facility of up to US$13m, due in March 2020. The facility was fully drawn during 2018 and partly repaid; the filing says the company complied with its quarterly refund-rate and gross-billings covenants at year-end. Dasheng Zhixing guarantees obligations up to US$15.6m.
- Management stated that available cash, deposits, short-term investments and expected operating cash flow were sufficient for anticipated needs over at least the next 12 months. The statements were prepared on a going-concern basis, notwithstanding the accumulated losses and net current liabilities.
Operating indicators and material changes
- Active students increased 24.1% to 310,000 in 2018; paying students decreased from 172,500 to 169,600. Average spending per paying student rose from RMB8,200 to RMB10,100.
- K-12 students accounted for 89.1% of gross billings in Q4 2018, compared with 80.3% in Q4 2017. They represented 83.7% of active students in Q4 2018, versus 74.0% a year earlier. Q4-specific financial results are not clearly provided in the filing text.
- Small-class revenue grew to RMB100.7m in 2018 from RMB12.3m in 2017. Its gross margin turned positive at 32.5%, but the segment still recorded an operating loss of RMB133.0m. One-to-one revenue was RMB1,044.8m, with a 67.2% gross margin and RMB271.7m operating loss.
- The company adopted ASC 606 on January 1, 2018 using the modified retrospective method. It recorded a RMB76.0m reduction to opening accumulated deficit for capitalized contract-acquisition costs; deferral and amortization of eligible costs reduced 2018 sales and marketing expense by RMB61.7m. Management recognized no prepaid-credit breakage revenue in 2018.
Outlook, risks and unusual items
- No quantified revenue, profit or cash-flow guidance is provided. Management described plans to grow the student base, expand K-12 and course offerings, improve the platform and learning experience, and control costs; it also said losses could continue.
- Education regulation is a significant uncertainty. The filing discusses evolving rules for online education and after-school tutoring, including potential licensing, course-filing and teacher-qualification requirements. It also describes uncertainty over the company’s VIE structure and the Foreign Investment Law adopted in March 2019, effective January 1, 2020.
- The company relies on contractual arrangements rather than direct ownership to control key PRC operating entities. Regulatory or court challenges, or failure of VIE counterparties to perform, could limit operations, access to revenues or consolidation of those entities.
- Management and the auditor identified a material weakness in internal control over financial reporting related to insufficient U.S. GAAP and SEC-reporting expertise. Management concluded disclosure controls and internal control were ineffective as of December 31, 2018; remediation was underway, but completion was not assured. The auditor’s opinion on the financial statements was unqualified, and it did not audit internal control effectiveness.
- The company accrued RMB29.6m for estimated underpaid PRC employee-benefit contributions at year-end. Authorities could require additional payments, late fees or penalties. The filing also flags uncertainty about whether sales and marketing outsourcing could be treated as labor dispatch.
- Other disclosed risks include currency exposure without hedging, competitive and customer-retention pressures, dependence on teachers in the Philippines, data-security and network risks, and limited insurance coverage. The filing reports no legal proceeding management considered likely to have a material adverse effect.
- The company reported no dividend plan. It also disclosed an RMB88.1m purchase commitment, mainly for non-cancellable advertising, and RMB59.0m of operating lease commitments at year-end.
Important facts for investors to verify
- Whether growth in active students, average spending and gross billings is translating into sustainable revenue growth and improved cash generation, particularly as paying-student count declined.
- How much operating cash flow depends on advance collections and deferred revenue, and whether refund rates or gross billings could pressure the credit-facility covenants.
- Whether the company can reduce losses while funding marketing and small-class expansion; verify the small-class segment’s path from operating loss to profitability.
- Progress in remediating the material weakness and whether future filings demonstrate effective financial reporting controls.
- Required licenses, course filings and teacher credentials for online K-12 offerings, and any developments affecting the VIE structure or ability to move cash from China.
- The status of the RMB29.6m employee-benefit accrual and any additional liabilities, fines or labor-classification issues.
- The collectability and any recovery of the impaired American International Schools investment, and the company’s liquidity after debt service and committed advertising and lease payments.