RLX Technology Inc.

Hello, ladies and gentlemen. Thank you for standing by for RLX Technology, Inc.' 's second quarter 2021 earnings conference call. At this time, all participants are in listen-only mode. After management's remarks, there will be a question and answer session. Today's conference is being recorded and is expected to last for about 40 minutes. I will now turn the call over to your host, Mr. Sam Tsang, head of investor relations of the company. Please go ahead, Sam.

Thank you very much. Hello, everyone, and welcome to RRX Technologies' second quarter 2021 earnings conference call. The company's financial and operational results were released through new PR newswire services earlier today and have been made available online. You can also view the earnings press release by visiting the IR section of our website at iout.relaxedtech.com. Participants on today's call will include our co-founder, Chairperson of the Board of Directors, and Chief Executive Officer, Ms. Kate Wang, Chief Financial Officer, Mr. Chao Lu, and myself, Sam Tsang, Head of Investor Relations. Before we continue, Please note that today's discussion will contain four looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. These statements typically contains words such as may, will, expect, targets, estimate, attempt, belief, potential, continued, or other similar expressions. Forward-looking statements involve inherent risks and uncertainties. The accuracy of these statements may be impacted by a number of business risks and uncertainties that could cause actual results to differ materially from those projected or anticipated, many of which factors are beyond our control. The company, its affiliates, advisors, representatives, and underwriters do not undertake any obligation to update this forward-looking information, except as required under the applicable law. Please note that RRX Technologies' earnings press release and this conference call include discussions of unaudited GAAP financial measures as well as unaudited non-GAAP financial measures. Our LX Technologies press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited GAAP measures. I will now turn the call over to Ms. Kate Wen. Please go ahead.

Thank you, Sam. Hello, everyone. Thank you for joining our earnings conference call today. As most of you are aware, two major regulatory developments took place around the second quarter of 2021. The first was March 22nd, when the authorities made an announcement seeking public comment on a proposal to revise relevant regulations to strengthen the separation of e-cigarettes and solve the quality and safety risks and force advertising problems, among others. We believe that such regulatory framework is both necessary and beneficial. for the long-term healthy development of the industry. It serves to eliminate the risks associated with uncertainties regarding the legitimacy of this product category. It can also help avoid incidents and setbacks that have occurred in some other overseas markets. and ensure the long-term vitality of the industry in China. As of today, no details on the regulatory framework have been released yet, and we will closely monitor and follow up on any further announcements. The second development took place in May and June, when the Chinese National Health Commission published the China report on health hazards of smoking 2020, mentioning about vaping products. The media and the public and some adult smokers and adult users of vaping products were confused by certain out-of-contact historical information in the report about the harm reduction benefits of using vaping products. Inactive publicity has sustained since the release of the report. We have been working closely on the relevant scientific research in consumer communication to provide better information and unbiased knowledge on related topics. RELAX was founded to serve adult smokers with state-of-the-art products in an unwavering pursuit of scientific advances to deliver harm reduction benefits to our users. To that end, in the second quarter, we continued devoting resources to key operational areas, including science research and development, product innovation, quality assurance and control, and brand building. Moreover, as a public company, we have further strengthened our operational and financial internal controls to better protect our shareholders' value. In the second quarter, we maintained our momentum in attracting and developing high caliber talent and grew our workforce by 27%. These highly skilled individuals joined us from leading companies across FMCG, technology, and pharmaceutical industries. They're pleased to see like-minded Thailand joining our course. And together, we have achieved a satisfactory net revenue growth of 6% from 2.4 billion RMB in the first quarter to 2.54 billion RMB in the second quarter. With that, I will now turn the call over to our CFO, Lu Chao. He will elaborate further on some initiatives taken during the past quarter and go over our operational and financial results in more detail. Lu Chao, please go ahead.

Thank you, Kate, and hello, everyone. It has been my pleasure and privilege to have worked at RELAX for over a quarter by now. To quote Steve Jobs, the only way to be truly satisfied is to do what you believe is great work. At Relax, we are doing great work by providing products of the highest quality and safety standards to adult smokers for harm reduction for themselves and for their loved ones around them. I am glad that I have joined this cause. Now, let me share some specifics regarding the initiatives we have taken in the second quarter. Following that, I will walk you through our financial results. In the past quarter, we continued the expansion of our offline distribution network and retail channels. While we saw some weakness in product procurement by branded stores in the second half of the quarter, most likely due to negative publicity on the evapour industry and the absence of clarity on the regulation front. We firmly believe that the steady expansion of our distribution network and retail channel is key to our long-term growth and competitiveness. We hope that with the passing of time and fading out of publicity effects, the per-store procurement of branded stores will soon regain momentum. On the product front, we have focused on both device and flavor innovation. We are working on a rich pipeline of product offerings to cater to distinct user groups with differentiated preferences and price sensitivity. We expect these product offerings to be launched in stages to further drive penetration and enhance user retention. We also take pride in our reputation consistently delivering high-quality products and investing heavily to improve quality control measures as we seek to further elevate user experience and inspire deeper user loyalty. We conduct rigorous quality assurance and control throughout our entire production cycles and have developed three production plans to further strengthen our QA and QC capabilities. Our QA and QC systems consist of five laboratories with 197 quality control checks to ensure that every intake of our aerosol represents the safest and finest of vaping experience. Currently, we have over 110 professionals managing our entire quality control process, which includes raw materials, production, and finished products. In terms of scientific research, on July 3rd, 2021, we jointly published a research paper in the SCI Journal, Ecotoxicology and Environmental Safety with Sun Yat-sen University, titled Comparison of Biological and Transcriptomic Effects of Conventional Cigarette and Electronic Cigarette Smoke Exposure at Toxicological Dose in BEAS2B cells. The research paper revealed that, based on equivalent nicotine content, an acute exposure in cigarette smoke condensate has significantly larger impact on cell effects and gene expression profile compared to e-cigarette smoke condensate. Further demonstrating the harm reduction effects of e-vapor products versus combustible cigarettes. On August 4th, 2021, our eVapor clinical trial was successfully registered with the China Clinical Trial Registration Center and the WHO International Clinical Trial Registration Platform. Our trial is the first eVapor clinical research project in China to have passed both ethical and expert reviews. and to be approved for implementation, filling the void in domestic eVapor clinical research. It is also a pioneering scientific study in the China eVapor industry. Looking forward, we will keep investing in in-house lab research related to product quality and safety, physiochemistry, pathological and clinical elements, and the evaluation of long-term use of eVapor products. In keeping with our commitment to social corporate responsibility, we remain dedicated to building and strengthening our trusted brand by consistently adhering to our strong ethical principles. On June 1st, immediately after the enactment of law on the protection of miners, Relax was the first among all our peers to call on all industry participants to thoroughly study the regulations and strictly abide by all of them. In July, several provinces in China were affected by extreme weather and natural disasters, resulting in hundreds of casualties. We once again acted swiftly by donating millions to China's Siyuan Foundation for Poverty Alleviation for an emergency supply. In addition, We were also deeply concerned about our partners' losses and decided to set up Henan Relax Stores Relief Fund to help them recover their businesses. Now, turning to financial performance, our top-line quarter-on-quarter growth slowed down in Q2 due to external factors, as mentioned by Kate previously. The impact of these factors are difficult to predict and may linger after the second quarter as well. However, we remain devoted to continuously driving user penetration among adult smokers as we firmly believe that the science and benefits of harm reduction will prevail over misconception and false information. I will now provide a summary overview of our financial results for the second quarter of 2021. Net revenues increased by 6 percent to RMB 2.54 billion in the second quarter of 2021 from RMB 2.4 billion in the first quarter of 2021. The increase was primarily due to an increase in net revenues from sales to offline distributors, which was mainly attributable to the expansion of the company's distribution and retail network. Growth profit increased by 3.8 percent to RMB 1.15 billion in the second quarter of 2021, from RMB 1.1 billion in the first quarter of 2021. Growth margin was stable at 45.1 percent in the second quarter of 2021, compared to 46 percent in the first quarter of 2021. Operating expenses were RMB 167.2 million in the second quarter of 2021, representing a decrease of 86.3 percent from RMB 1.22 billion in the first quarter of 2021. The significant decrease in operating expenses was primarily due to the recognition of share-based compensation expenses of positive RMB 172.5 million. Representing one, share-based compensation expenses of positive RMB 51.5 million recognized in selling expenses. Two, share-based compensation expenses of positive RMB 41.4 million recognized in general and administrative expenses. And three, share-based compensation expenses of positive RMB 79.7 million, recognized in research and development expenses. The significant fluctuations in share-based compensation expenses were primarily due to the changes in the fair value of the share incentive award that the company granted to its employees, as affected by the significant fluctuations of the share price of the company. Selling expenses decreased by 56.8% to RMB 126 million in the second quarter of 2021, from RMB 291.5 million in the first quarter of 2021. The decrease was primarily driven by one, the fluctuations of share-based compensation expenses, and two, a decrease in salaries and welfare benefits, partially offset by an increase in branding material expenses. General and administrative expenses decreased by 93.5% to RMB 46.1 million in the second quarter of 2021, to RMB 712.8 million in the first quarter of 2021. The decrease was primarily driven by, first, the fluctuation of the share-based compensation expenses, and second, a decrease in salaries and welfare benefits. partially offset by an increase in legal and other consulting fees. Research and development expenses decreased by 102.3 percent to positive RMB 4.9 million in the second quarter of 2021, from RMB 211.6 million in the first quarter of 2021. The decrease was primarily driven by, first, the fluctuation of the share-based compensation expenses, and second, a decrease in salaries and welfare benefits, partially offset by an increase in depreciation and amortization expenses. Income from operations was RMB 979.3 million in the second quarter of 2021, compared with loss from operations of RMB 111.9 million in the first quarter of 2021. Income tax expense was RMB 204.2 million in the second quarter of 2021, compared with RMB 176.3 million in the first quarter of 2021. The increase was primarily due to an increase in taxable income. U.S. GAAP net income was RMB 824.3 million in the second quarter of 2021 compared with U.S. GAAP net loss of RMB 267 million in the first quarter of 2021. Non-GAAP net income was RMB 651.8 million in the second quarter of 2021, representing an increase of 6.8 percent from RMB 610.5 million in the first quarter of 2021. U.S. GAAP basic and diluted net income per American depository share were RMB 0.595 and RMB 0.591, respectively, in the second quarter of 2021. compared to U.S. GAAP basic and diluted net loss per ADS of both RMB 0.174 in the first quarter of 2021. Non-GAAP basic and diluted net income per ADS were RMB 0.47 and RMB 0.467 respectively in the second quarter of 2021. compared to non-GAAP basic and diluted net income for ADS of both RMB 0.398 in the first quarter of 2021. As of June 30, 2021, the company had cash and cash equivalents, restricted cash, short-term bank deposits, short-term investments, and long-term bank deposits. of RMB 14.88 billion compared to RMB 14.44 billion as of March 31st, 2021. As of June 30th, 2021, approximately US dollar 1.64 billion was denominated in US dollars. This concludes our prepared remarks today. We will now open the call to questions. Operator, please go ahead.

We will now begin the question and answer session. To ask a question, you may press star then 1 on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. For the benefit of all participants on today's call, if you wish to ask your question to management in Chinese, please immediately repeat your question in English. Again, it is star then one to ask a question. At this time, we will pause momentarily to assemble our roster. The first question comes from Lydia Ling with Citi. Please go ahead.

Hi, management. This is Lydia from Citi, and thanks for the presentation and taking my questions. I have two questions. The first one is, given the slowdown in the second quarter, Could you elaborate more on the third quarter to date trend and also your outlook on the second half given currently like the frequent negative publicity and also regulation environment? And my second question is on the expansion. So could you actually tell us about how many stores do open in second quarter and also what's your opening plan in the second half given current market conditions? And also, how is your distributor sentiment on the new opening? Thank you.

I'm sure. Thank you very much, Lydia. So, regarding the first question, it's mainly regarding first quarter trend and also the second half outlook. So, as of now, eBay products remain under-penetrated among advertisers in China. So, our company believes that. time-reduction products, including e-vapor products, are better alternatives for adult smokers in China. We remain committed to the trend of adult smokers converting from cigarettes to e-vapor products, and we are confident in the medium- and long-term prospects of the industry, as well as our future performance. So, to directly answer the question regarding our first-quarter-to-date trends specifically, we have witnessed the stabilization of operating and financial metrics in recent weeks as we continue to engage and retain our users. So we are very confident on the future outlook of the company. So regarding our second question, it's mainly on the store numbers, opening plan, distributor sentiments, et cetera. So I mean, for our overall store opening logic, we believe that our current model is very sound Our model largely depends on where there are enough users using our products in order to support a branded partner store in the given area or a district. So, for newly opened branded partner stores, we monitor and evaluate the store productivity in combination with other macro and micro factors. So, for example, if the store productivity of the newly opened stores is better than the expected productivity curve, so we will allow some new stores to be open and vice versa. So we do have, like, various color label tags in different districts or areas based on the existing stores' productivity in order to micromanage and witness or manage any kind of globalization between existing and new stores. So we indeed closely monitor the single store economic model of our current branded planet stores. So thank you very much for your question.

The next question comes from Charlie Chen with China Renaissance. Please go ahead.

Thank you, management, for taking my question. I got two questions here. First of all, I want to ask about the performance of your products in different categories, like the premium products versus the mainstream products, which you launched about a quarter ago. So how's that developed so far? And my second question is regarding the retail price. As we observed, some of the competition in certain areas are quite intense. So do you see any retail price softness or rather volatility in some of the markets? And also, is there any special situation where distributors may do parallel trading, which means they are selling their products at a lower price outside of their authorized areas? Does that situation or things happen in your market? Thank you.

Sure. So, thank you very much, Charlie. So, regarding the first question is on a product front. So, we have been providing diversified product portfolios. with various price points, functionality, and features. So we do see that more and more users as markers with different sets of user groups trying to use our products as their harm reduction alternatives. So regarding our new products, so we do see that there have been positive feedback and contribution from both our users and retailers. So we will continuously, cautiously, to monitor our user behavior and trend, trying to optimize our product mix while further launching new product lines. So on the second question is on pricing, actual retail selling price, and where there are unauthorized sell by distributors to unauthorized areas. So first one is on pricing. So we have been closely monitoring the pricing across the value chain. especially the actual selling price and discounts of our products from retailers' point of view. So we indeed initiated a program to monitor the actual selling price of each layer of our value chain in the second quarter of 2021. We do see that most of our retailers, especially branded partner stores, have been following suggested retail selling price in their actual sales to adult smokers. So regarding any unauthorized sales of distributors to unauthorized areas, so we have been actually implementing effective measures in technology and control. We have a unique QR code system for each of our product lines. So if we found any of our distributors or retailers report any cases that they see unauthorized products being appeared, we could reveal the identity of distributors selling such products and solve the issue accordingly. So thank you very much for your questions.

The next question comes from Stephanie Lam with Haitong International. Please go ahead.

Hi, management. Thank you for taking my questions. I have two questions for my end. My first question is regarding on store opening subsidy. We noticed that some of our peers have offered more store opening subsidies in the past couple of months. May we know what is the management views on this as well as our approaches on store opening subsidies? Second question is regarding on the raw material cost pressures and gross margin. Given the cost hike of raw materials, may we know if we have lift up the wholesale prices to franchisees and distributors in order to pass the cost on? and how should we estimate the margins trend going forward? Thank you.

Sure. Thank you very much, Stephanie. So, on the first one is on our subsidies, given our competitive landscape. So, you do see that our store subsidies have remained consistent, and our subsidies per store have decreased consistently since we have introduced our brand new partner stores model back in early 2019. We have been assessing and grant store subsidies largely based on the micro-environment and single-store economics of our branded planet stores. So, I mean, for the past two years, our peers have offered far more subsidies to potential store owners driven by their intention to penetrate the market and make a presence. However, these larger subsidies frequently did not translate into market share growth of their brands. Given the current developments of the industry, we have recently seen our peers start to decrease their subsidies to potential brand-apprentice stores. In the medium and long term, we believe that store subsidies will be more rational and will become more dependent on the single-store economics of each brand's brand-apprentice stores. So, regarding the second question is on the raw materials increase and whether it increase our pricing and margins. So, given the macro situation, so the price of raw materials, for example, like chips, batteries, have been on an upward trend since the beginning of the year. As a result, some of our suppliers have experienced an increase in procurement costs throughout the supply chain. However, so far, we didn't really experience a significant increase in unit cost due to the price of raw materials so far. And therefore, we have not increased the wholesale price of our products being sold to our distributors. But of course, we will closely monitor the latest supply chain development as well as our suppliers' operating issues. Given the cost optimization initiatives of our entire industry value chain, for example, like automated production, cost-saving product design, we believe the long-term unit cost of the industry, including ours, will be further optimized. Thanks very much for your question.

The next question comes from Junhao Fan with CICC. Please go ahead.

Hi, thanks management for taking my questions. I'm Junhao from CICC. I also have two questions. The first one is, we know that there are more and more e-cigarettes in the market. How would the management estimate the future competitive landscape among Chinese e-cigarette brands? And my second question is, since many similar vape cartridges are in the market, which can also be used in our RACs devices, like weak. What actions would our RACs will do to solve this problem? That's my two questions. Thank you.

Thank you very much, Jin Hao. So, I mean, on the first one is on the competitive landscape of the Chinese e-welfare markets. So, I believe the competitive landscape of the markets will be increasingly complex. requesting each brand or market participants to put more efforts and further innovate in aspects such as commercial strategy, product innovation, and efforts in scientific research. So we believe that with our leading position, strong brand equity, extensive retail network, and product innovation capabilities, we can remain or expand our market leadership in the China market. So regarding the second question, I'm not sure if I hear correctly. It's on the compatible POS that you have mentioned. So I mean, for unauthorized compatible POS, we do see that they pose a greater risk to eVapor users' health, given that the product quality and safety may not be guaranteed. These compatible POS are also largely sold in illegal retail channels which may be accessible to underage users. So as a brand, we have been collaborating with various partners and parties to prohibit illegal sales of unauthorized compatible cloths and have filed patent claims and lawsuits against brands that may have used our patents or brands without our permission. So I mean on commercial-wise, we also have expanded our product portfolio to cater to diversify needs of the eVapor users in China in multiple aspects, including the availability of flavors, price points, and functionality. We do believe that these commercial strategies have been and will continue to be effective in combating unauthorized compatible cartridge that currently exists in the market. So, thanks very much for your questions.

The next question comes from Louise Lee with Bank of America Securities. Please go ahead.

Hi. Thank you, management, for taking my questions. I have two questions here. So, firstly, I know that we actually set up an electronic secret clinical trial lab several weeks ago. So what is the major purpose or the potential benefit of this? And secondly, is about the regulation of the potential impact. So what will happen if the whole industry is under the regulation of China tobacco? Thank you.

Sure. Thank you very much for this. So it's nice to have you. So for our first question, it's on the lab that Chao mentioned in the opening remarks. Trial is actually the first evaper clinical trial project in China for evaper products that have passed both ethical and expert reviews and have been approved for implementation. So we believe that this laboratory and research can showcase our leading capabilities in scientific research and clinical trials. So as a company, we believe that facts speak louder than words. We hope more and more clinical trials on evapoproducts to be carried out in upcoming years with increasing fact-based, science-based communication across various parties. And more and more adhersion workers can use evapoproducts as their harm reduction tobacco alternatives. So, regarding the second point on the regulations front, So, on March 22, so the MIIT released the draft rules regarding evaper products. So, as mentioned in the last earnings call, we have already submitted our feedback regarding the proposed revision of the implementation plan. So, currently, there's no updates on the regulations and no new implementation details have been revealed. We support the regulatory measures mentioned in the announcement, including the proposal to regulate the operating activities of the e-vapor industry and tackle potential product safety issues of e-vapor products, false advertisement, et cetera. So, thank you very much for your questions.

As there are no further questions now, I would like to turn the call back over to the company for closing remarks.

So thank you once again for joining us today. So if you have any further questions, please feel free to contact our LX Technologies Investor Relations team through the contact information provided on our website, our TPG Investor Relations. Thank you very much.

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