Deal focus: Yuanfudao stakes its claim

Even by the standards of the longtime leaders in China’s private education space – TAL Education Group and New Oriental Education & Technology Group – Yuanfudao is a valuable asset. The K-12 online education provider recently closed a $1 billion funding round led by Hillhouse Capital at a valuation of $7.8 billion. TAL and New Oriental, both US-listed and profitable, have market capitalizations of $30.8 billion and $17.6 billion, respectively.

Yuanfudao’s recent funding round amounts to a bold statement about the potential of online K-12 education. As recently as 2018, China’s overall K-12 industry was worth RMB500 billion ($70 billion) and the online segment accounted for just 9% of that, according to a report by China Merchants Bank. However, gains made by the one significant listed online K-12 player may reflect how investors expect the industry to evolve.

GSX Techedu, a large-class K-12 tuition provider, went public in the US last year with a market capitalization of about $2.4 billion. Ten months on, this figure has risen to $8 billion, despite recent US stock market turmoil.

Yuanfudao and GSX are two of five companies that together control about 80% of the large-class K-12 space. The other three are Zuoyebang, a platform that spun out from domestic search giant Baidu, and online units under TAL and New Oriental.

Model of choice?

GSX is the only one currently generating a profit thanks to a differentiated business model. GSX is short for “gen shei xue,” which translates from Chinese as “Who do you follow to learn?” and captures the essence of the company: It recruits star teachers to build up a loyal following. As of December, GSX had 56 full-time exclusively contracted instructors who lead courses with 600-980 enrolled students. They are supported by 232 general instructors and more than 3,700 tutors.

Scale brings obvious cost advantages but relying heavily on star teachers can be a weakness as well as a strength: they may set a ceiling for future growth, and if one leaves, many students could leave as well. “The success of an educational institution should be based on a standard and systematic procedure to ‘produce’ good teachers, instead of relying on individual star teachers. In this way, the development can be consistent and scalable,” says Li.

Yuanfudao is loss-making due to heavy spending on customer acquisition – subsidized fees – in a bid to win market share. But CMC assesses this metric alongside unit economics and long-term value. If a student is signing up for a range of different subjects (generating significant unit economics) and sticks with the company for multiple academic years (brings long-term value), the acquisition cost is justified.

“We can calculate the sizeable life-time value out of each customer you acquire, and we see strong profitability in the K-12 space. Investors are making large-scale investments because they are confident of getting a big return later,” says Li.

Moreover, online players are better positioned to consolidate and achieve significant size than their offline peers. The offline segment is by nature fragmented: New Oriental, for example, is a leading player but it only has a 3% market share because ensuring nationwide coverage while maintaining a high quality of service is incredibly difficult. An online provider isn't constrained by geography.

Gross billings for online K-12 tuition are projected to grow from RMB30.2 billion in 2018 to RMB367.2 billion to 2023. For the large-class category only, billings will rise from RMB15.1 billion to RMB202 billion. At present, the large-class space is dominated by five companies that have fully capitalized on their early-mover advantage.

“It will be very hard for new players to reach the same level because customer acquisition fees are much higher than several years ago. The data have already been accumulated by large players, which creates a formidable barrier to entry for newcomers looking to deliver equally competitive products and services. It’s such a big space for a very small number of players, so each one has the potential to grow, ”says Li.

Yuanfudao has effectively taken a different path by prioritizing the building of a platform and system that can accumulate a large student base. Founded in 2012, two years before GSX, the company provided an online database of preparation tests for high school and college entrance examinations. Two tools became especially popular: Yuantiku, the practice paper database; and Xiaoyuansoti, a platform that allows users to upload snapshots of their exercise books and look for answers to problems they are trying to solve and also relevant video tutorials.

Yuanfudao soon realized that this early success couldn’t directly lead to profit, with only 5% of users willing to pay for the service. Yuanfudao then established a C2C tutoring platform that targeted its existing customers. Teachers could sell courses of lessons through the platform, paying a commission to Yuanfudao on each transaction. It didn’t work out either because many teachers offered the same courses, making it hard for students to find the most appropriate material. Retention rates were low and the complaint rate was high.

In 2016, the company launched its own tutoring service. To date, it has recruited about 400 instructors and thousands of tutors to operate a similar large-class model to GSX. A year later, Xiaoyuankousuan, an artificial intelligence-enabled service that corrects homework for young children was launched.

Staying competitive

Yuanfudao became China’s first private online education unicorn in 2017 on closing a $120 million round. This was followed by a $300 million investment led by Tencent Holdings in 2019 at a valuation in excess of $3 billion. The investment amounts have dialed up in response to the company’s fast revenue growth. It is said to have generated RMB3-4 billion in 2019, up from RMB120 million in 2016. The goal for 2020 is to reach RMB10 billion.

“Yuanfudao’s products and services are the best in the industry from many aspects. Its key performance indicators are better than peers,” says Li. According to local media reports, the company’s customer retention rate is about 80%, higher than most online players.

Opinion is divided among industry participants as to whether the large-class model will ultimately be supplanted by smaller format classes that cost more but claim to offer better learning outcomes. Li observes that the large-class approach is proven, while smaller format is not.

Whatever the model, the long-term challenge for online education platforms remains customer acquisition and retention. Even though the COVID-19 outbreak has improved the segment’s visibility to parents and students, many of the new customers may return to their normal offline routines once the pandemic ends.

Yuanfudao was among the first to take advantage of the marketing opportunity presented by COVID-19, offering free online classes. Five million participants logged on for the first class and the system duly crashed. Investors are not worried by the slip-up: IT systems can easily be upgraded, but a brand able to attract that volume of users is rare indeed.

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• Topics
• Greater China
• Expansion
• Technology
• Consumer
• China
• Education
• Growth capital
• Hillhouse Capital Management
• China Media Capital