China online education: Class war

“After spending so much money, I haven’t found a path to growth. I don’t know if I will lose my freedom for this, but I am prepared. I don’t think I should sleep here, I should go to prison,” said Kailei Zhang, founder of China-based online tuition platform Xueba100.com, in a public letter of apology issued in early January.

Zhang’s contrition was caused by Xueba halting operations, causing some 10,000 teachers and 3,000 staff to lose jobs and leaving 50,000 students with no classes to attend. Hundreds of parents demanded their money back.

It is an odd development when set against the surge in demand for online education services in China last year after schools were suspended due to COVID-19. Investors leaped on the trend, with online platforms accounting for 89% of the RMB116.4 billion ($18 billion) deployed in education last year, according to iResearch Consulting.

Online education revenues have expanded at an annual rate of 34.5% over the past four years, reaching RMB257.3 billion in 2020.

Xueba’s failure is even more surprising given its status as an industry pioneer. Xueba, Yuanfudao and Zuoyebang were known as the “three little dragons” of Q&A search engines that helped students with their homework. Xueba counted Sinovation Ventures, Vertex Ventures, Qiming Venture Partners, Trustbridge Partners, and China Merchants Capital as investors.

But the “three dragons” responded to the rise of online classes – first recorded, then livestreamed – in different ways. Yuanfudao and Zuoyebang have become two of the largest players in the large-class K-12 space, raising billions of dollars. Xueba opted for the one-to-one tuition route and last received funding in 2017.

“The Q&A search engine model naturally leads to large classes, not one-to-one tuition,” says David Wei, founding partner of Vision Knight Capital. “One-to-one is more about enhancing your strengths as a student, while large classes make up for your shortcomings. If you are searching for homework answers, you probably need large-class training.”

Fundamental weakness

Other investors familiar with Xueba offered AVCJ some more clues. The company ranked third in the one-to-one K-12 space, after Zhangmen and Qingqing Education, but investors in Zhangmen say they didn’t regard Xueba as a serious rival.

“Around 2018, Xueba pivoted towards business services, but this business was sold to ByteDance. When it returned to one-to-one, it was two or three years behind the market leader in terms of scale and operational efficiency,” says Jian Sun, a managing director of Huaxing Growth Capital.

Other industry participants pick holes in the economics of Xueba’s model, which involved taking advance payments of up to RMB10,000 for 100 classes. Zhang admitted the company had come close to bankruptcy at least five times.

“Upfront payments mean easy cash inflow, but it is the equivalent of borrowing money from parents. Companies might use this capital to acquire new customers instead of fulfilling the contract. If your unit economics aren’t positive and your fundraising can’t keep up, there will be liquidity problems,” says Hao Li, a managing director at Lighthouse Capital.

Xueba is not the only online education platform in difficulty. Magic Ears, a provider of English tuition for young children, was exploring multiple M&A options prior to its acquisition by math specialist Wandou Siwei last October.

Huohua Siwei, a competitor of Wandou, was offered the business but turned it down due to a lack of synergies, according to one investor in the company. Huohua concluded that Magic Ears’ problems stemmed from the small-class format not being suitable for teaching youngsters English speaking and listening – lessons are half the price of one-to-one tuition but there are at least four children in the class.

Other problem cases include Hyphen, an online one-to-one platform backed by TAL Education Group. It merged with Qingqing Education last June following layoffs. Mingxi, a Chinese language tuition business for children, filed for bankruptcy in February 2020 and was rescued by Shenzhen-listed Soushen Education, while US-listed Puxin Education divested its online school business to GSX TechEdu.

“This trend started in mid-2020 and it’s likely more and more small companies will exit the market given cash flow concerns,” says Alex Liu, an education analyst at China Renaissance Securities.

Money talks

As the Xueba case study illustrates, reasons for failure can be idiosyncratic. However, there is one key reason why 2020 became a year of reckoning for small to mid-sized online players: rising customer acquisition fees. Just as the pandemic was driving students online – often to free classes – fierce competition saw customer acquisition costs rise 2-3x year-on-year during the summer of 2020, according to Vision Knight’s Wei.

Almost every popular TV variety show or drama is sponsored by an online education brand; elevators, bus stops, and subway stations are covered in their advertisements.

Then there are the incentives. Yuanfudao charges only RMB30 for a live broadcast winter vacation course that runs for 24 hours – and throws in 22 pieces of school stationery for free. A limited-time special offer from Zuoyebang comprises 33 math and language classes, plus a 12-piece teaching aid gift box, for RMB49. The likes of Youdao and Shaonian Dedao are charging less than RMB10 a class.

“Courses priced at RMB9 or RMB19 are specially designed to attract customers,” says Peter Li, a partner at CMC Capital Group. “One of the most important indicators is the conversion ratio from those courses to regular price courses.”

A young mother tells AVCJ that she enrolled her daughter in a series of platforms marketed by WeChat and Tencent Video. “I was astonished by the packages offered. The books alone are far more expensive than the fees I paid,” she says.

In this kind of environment, an online platform that cannot afford to reach out to customers has no chance. Scale – or a large war chest – wins out. Of the RMB103.4 billion invested in online education last year, 80% went to the top five players, according to iResearch. TAL and Yuanfudao raised RMB33.3 billion and RMB24.3 billion, respectively.

With all the capital gravitating towards large K-12 players, early-stage investors are looking elsewhere. Terry Tian, a partner at Vision Plus Capital, made one education investment in 2020 – in a vocational education business.

“Online education might seem very hot, but we are wary of backing small companies. They are in difficulty. Their marketing effectiveness has decreased due to higher customer acquisition fees,” Tian explains. “More importantly, their conversion rates have fallen sharply.”

Battles between well-funded start-ups willing to accept low margins if it means taking market share are not unusual in China’s technology sector. They are also notoriously expensive.

As a US-listed business, GSX’s filings show just how much. The company’s large-format live-streamed K-12 classes were profitable for multiple quarters following its 2019 IPO. But in the third quarter of 2020, GSX recorded a net loss of RMB932.5 million as sales and marketing expenses hit RMB2 billion, a 522% year-on-year increase.

Youdao, an e-learning unit of NetEase, and Koolearn Technology Holding, an online-focused subsidiary of New Oriental Education & Technology, recorded substantial losses for the same quarter following strong post-IPO performance. The summer of 2020 was to blame.

Speaking in an earnings call, Xiangdong Chen, founder and CEO of GSX, cited third-party estimates that China’s top 10 online education institutions may have spent more than RMB10 billion on marketing in July and August. This is twice the comparable figure for 2019, which – at RMB4 billion – was already an industry record.

“With the competitive landscape still undecided, no company will choose profit but not growth,” observes Lu Lin, a partner at Northern Light Venture Capital.

Public market investors seem to appreciate this. After Youdao posted a net loss of RMB866 million for the third quarter on the back of a sixfold increase in marketing spend, its stock gained 19% in a day. The 159% year-on-year increase in revenue to RMB896 million and a 437% expansion in customers on regular-price K-12 courses appear to have been prioritized.

“Competition will be fierce in 2021 and the market won’t rebalance probably until 2022. Once the outlook stabilizes, companies like Yuanfudao may quickly become profitable,” says Li of CMC.

Battles to come

There is still a lot to fight over. In offline education, New Oriental and TAL are the clear leaders but with a combined market share of less than 10%. In the online K-12 space, Yuanfudao, GSX, Zuoyebang, and online units under TAL and New Oriental control about 80% of the market. And COVID-19 has offered a glimpse of the scale of the opportunity.

“If you offered large players 10 users for $100 each or 70 users for $300 each, they would take the latter. The pandemic has driven people to online education, so the pie is getting bigger, and these companies dare to spend more money. The pace of customer acquisition and conversion is still rising,” says Lighthouse’s Li.

China’s internet giants have been drawn into the battle. Yuanfudao is backed by Tencent Holdings; Zuoyebang is backed by Alibaba Group and Baidu. ByteDance has decided to go it alone. The company identified education as a strategic pillar last year and subsequently launched Dali Education. It has said the new business will remain unprofitable for at least three years.

If high-cash-burn rates are inevitable for the time being, investors must find a way of getting comfortable with them from a long-term perspective. Jay Gu, head of education investment at Loyal Valley Capital, puts it like this: If a company has one million users and a 75% renewal rate, 250,000 users will leave the platform each term. If the new customer conversion rate is 20%, 1.25 million users must be targeted to fill the gap. To maintain 100% growth, another five million users must be signed up to trial classes.

The more challenging part is managing rapid growth. “How do you go from 2,000 to 10,000 teachers and maintain a high level of service? When there is one teacher to 1,000 students and teaching assistants for smaller groups of students, how do you make it work seamlessly? When opportunities arise, only great management teams can figure out what to do quickly,” says Julian Cheng, co-head of China at Warburg Pincus.

Meanwhile, regulators are not happy with the high-cash-burn dynamic. China’s Central Commission for Discipline has publicly criticized the habit of spending money on advertising rather than improving service quality.

Industry participants expect more rules, but they don’t believe the approach will be heavy-handed. As early as 2018, off-campus training institutions were banned from charging upfront payments for courses of more than three months. Few companies comply with the rule and no punishments of note have been administered.

"The government hopes that private companies can promote positive change in the education industry. Therefore, the regulator will be cautious in launching new policies, and supervision will be discreet,” says Lighthouse’s Li.

Further afield

For investors that want to avoid the mainstream K-12 space, there are other options, notably early childhood education. It is suggested growth could be even faster than in K-12 as couples born after 1990 become parents. They grew up with the internet and therefore are more likely to be open to online solutions.

Huohua Siwei and Wandou Siwei, the dominant players in children’s math, are already attracting high-profile investors. KKR and Tencent backed the former’s $400 million Series E, while the latter secured a $180 million Series C last November led by Softbank Vision Fund. English tuition is also popular, with Jiliguala and Palfish – also known as Banyu – recently securing Series C rounds of $100 million-plus.

Specialist art education, aimed at children of all ages, is getting traction too, as evidenced by a $210 million Series D for Meishubao led by The Rise Fund. Not everyone is convinced by niche operators in arts and crafts, though.

“These apps require a lot of investment in technology, and the cost of customer acquisition is very high because the number of tutors is finite and there are so many competitors. Ballet and piano lesson apps might have been nice to have during second-quarter lockdowns, but we don’t know how sticky that behavior will be,” says Collwyn Tan, Hamilton Lane’s co-head of Asia investment.

Early childhood education platforms now face a competitive threat from the mainstream K-12 players. Yuanfudao, for example, has launched an English teaching vertical and invested in Huohua Siwei. The motivation is obvious: claim students early on and there is a higher chance of converting them to K-12 courses down the line.

“If K-12 really pushed, logically speaking, early education can hardly be an independent vertical. I am more optimistic about the combination of online and offline models that can achieve differentiation and be more resistant to giants’ attacks,” says Loyal Valley’s Gu.

Other options for investors include picking business models that rely on “privately-built traffic” generated outside of the traditional silos or backing start-ups that serve the incumbent giants rather than go up against them. Jia Cong, a vice president of BAI, was drawn to Palfish because the company established its own traffic pool through digital content such as picture books for children. “[This] greatly reduced the cost of acquiring customers that were driven up by giants burning money,” she explains.

Vision Knight invested in Shaonian Dedao for the same reason. Although the company is a K-12 player, Wei observes that its knowledge-sharing app is the big draw, attracting about half of the new customers. “An education company must have the ability to build its own traffic pool, rather than buying traffic from giants,” he says.

In the service provider space, Aixuexi Education Group, a supplier of online teaching materials, claimed to be the largest unicorn in China’s 2B education space following its $200 million Series D last November. Meanwhile, Eeo Education, which recently closed a $265 million Series C, provides a Zoom-style platform that helps offline schools move classes online.

“We are selling shovels to the gold diggers. There are thousands of companies in the after-school tuition space across second, third, and even fourth-tier cities. They had no choice but to move teaching online during COVID-19, which meant more demand for online tools,” says J.P. Gan, a founding partner at Ince Capital Partners. He notes that Eeo’s customer base grew tenfold to 60,000 schools in response to COVID-19.

As with other technology-enabled industries, online education will not stand still. Asked for their big-picture predictions, investors settle on the notion of full-category competition, with multiple products offered under individual brands to maximize cross-selling.

Seeing the future

While entertainment platforms like YouTube or Bilibili are reservoirs of traffic, education start-ups offer products that are no more than pipelines; when a class ends, customers don’t stick around, explains Northern Light’s Lin. A full-category platform has more touchpoints, so retention should be easier, a key consideration given high customer acquisition costs.

Moreover, the dominance of Yuanfudao or Zuoyebang is not preordained, although they have advantages. A full-category platform could emerge from anywhere. “New Oriental and TAL are both full-category offline, but they had different starting points. New Oriental came from TOEFL [Test of English as a Foreign Language] and GRE [Graduate Record Exams], while TAL was from school math Olympiad training,” Lin adds.

Regardless of how investors look to plot the future of online education, they should remember that it is fundamentally different from e-commerce or other areas where companies have sacrificed near-term profitability in the hope of achieving long-term scale.

“The platform effect of online education is very low,” observes one investor. “I use WeChat because my friends are all on WeChat, but educational products are low-frequency and have high-unit prices. Only the top-quality products are considered scarce, so parents compare them and transfer all the time. Scale will not become a barrier.”

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• Topics
• Greater China
• Technology
• Consumer
• Expansion
• China
• Education
• China Renaissance
• Lighthouse Capital
• Vision Knight Capital
• Hamilton Lane
• Warburg Pincus Asia
• Northern Light Venture Capital
• Vision Plus Capital
• China Media Capital