Operating In The Shadows Of Education Crackdown, iHuman Nears Profit Milestone

Key Takeaways:

• iHuman made a net profit in the third quarter, swinging from a loss a year earlier, as cost savings outweighed a decline in revenue
• The company faces a long list of regulatory risks, led by the educational nature of its apps that could subject them to more stringent rules

By Warren Yang

A major milestone is in sight for iHuman Inc. IH as it nears its first annual net profit in its life as a young publicly traded company. But in the process of reaching that goal, the maker of “edutainment” apps is having to constantly navigate a regulatory minefield in China’s sensitive education sector that could upend its business at any time.

A major mine from that field blew up in the face of a much larger industry providing after-school tutoring services to K-12 students last year after Beijing suddenly banned most such services. iHuman has avoided fallout from that fiasco, which effectively killed an entire industry once worth billions of dollars. But the dangers always lurk in the background due to the fickle and unpredictable nature of China’s regulators.

iHuman, which makes apps that help kids improve in areas like reading and logic, made a net profit of 39.5 million yuan ($5.5 million) in the third quarter, pulling a 180-degree turn from a net loss of a similar size a year earlier, according to its latest quarterly results released last Thursday. Those results showed the company earned a 74 million yuan profit for the first nine months of the year, putting iHuman on track to make its first-ever annual net profit since it went public in 2020.

iHuman’s strong third-quarter bottom line owes in large part to cost-cutting, rather than revenue growth. In fact, the company’s sales during the three months fell 2.9% year-over-year to 251.5 million yuan, marking the first decline in its quarterly revenue since its IPO. The decline was a natural progression from lackluster growth in the first half of the year, a far cry from the triple-digit growth that it frequently logged in the past two years.

The sudden drop in iHuman’s revenue may seem perplexing, if not alarming. It’s true that many businesses in China suffered under Beijing’s strict Covid control policies that only now are starting to ease, though not before contributing to the country’s economic slowdown. If anything, internet companies like iHuman should be key beneficiaries of lockdowns and other restrictions on mobility that have fueled growth in demand for online products that don’t require human contact.

iHuman also sells cognitive development materials and devices through brick-and-mortar channels. But it has drastically scaled down the offline business, which led to significant gains in its gross margin and allowed it to keep boosting revenue through the pandemic.

So, what exactly is behind iHuman’s slowdown? It actually appears to be the result of a conscious decision by the company to prioritize profitability over revenue growth.

Firstly, the company’s cost of revenue — or expenses incurred for generating sales, including commissions to app stores — decreased at a faster rate than its revenue decline. That allowed iHuman to further improve its gross margin to more than 70% from an already-solid 69.6% in the third quarter of last year.

Slashing costs

More significantly, iHuman slashed its operating expenses, which in the past exceeded its gross profit, by more than 38%. Cost cutting has become a common theme among money-losing Chinese companies this year, as they try to show investors they can become profitable soon, even in the face of a fast-slowing Chinese economy.

iHuman’s cuts were led by a 45% drop in costs for research and development, primarily through savings from payroll and outsourcing expenses. It also reduced sales and marketing expenses by 38% by using an “economical and optimized advertising strategy.”

“The continued improvement in profitability was primarily driven by our sound operating efficiency initiatives,” iHuman CFO Vivien Wang said in the company’s latest earnings announcement. “We better aligned our cost structure with our strategic priorities and improved our operational efficiency by further streamlining key business processes and workflows.”

Investors appeared to appreciate iHuman’s renewed focus on profitability, as well as its previously announced plan to repurchase its shares through the end of next year. The company’s stock dropped about 7% after its earnings release, but more than made up the lost ground the next day with a 12.4% jump.  

While the short-term picture looks good, iHuman faces a wide range of longer-term risks due to its operation in a vast regulatory gray area in China. The company describes itself as an “edutainment” provider and seems to try hard not to link its apps directly to the sensitive education sector, which is subject to a long list of regulatory requirements. Following last year’s clampdown on the sector, even overseas language-learning apps like Duolingo, Memrise and Beelinguapp have vanished from major Android app stores in China.

iHuman says its apps are not explicitly subject to these rules. But it also warns that Chinese regulators could decide at any time that its apps are for educational purposes, which would bring the company lots of headaches. There are also a slew of other rules that could apply to iHuman, ranging from requirements for online publishing to those for protection of minors from addictive products.

Like many companies that face such regulatory risks domestically, iHuman is trying to expand overseas. But the company doesn’t give any figures for its non-Chinese operations, implying they are negligible so far, and it remains to be seen how much traction it will gain outside China.

iHuman shares are down more than 80% from its IPO price. Such a poor performance isn’t uncommon for Chinese stocks, which have been battered by the country’s economic slowdown and soured sentiment among U.S. investors toward the group due to long-running friction between Beijing and Washington. The heavy regulatory uncertainty surrounding education stocks is also a factor depressing the company’s value.

Still, it’s noteworthy that iHuman stock isn’t faring particularly well compared to some of the purely educational companies that took a major direct hit from the crackdown. iHuman shares now trade at a price-to-sales (P/S) ratio of about 0.8, below the 2 for TAL Education TAL and 1 for Gaotu Techedu GOTU.

iHuman’s low valuation perhaps suggests that investors are pricing in all the risks that the company faces, along with its small size compared to the other two former giants. Such caution may be well justified, given how much trouble Chinese regulators have caused for companies in recent years, even though reaching profitability can be a laudable achievement.