Earnings Call Transcript - API Q3 2021

Operator, Operator

Thank you for joining us, and welcome to the Agora Inc. Third Quarter 2021 Financial Results. All participants are currently in a listen-only mode. I will now hand the conference over to your first speaker, Ms. Fionna Chen. Please proceed.

Fionna Chen, IR Representative

Thank you, operator. Good morning, everyone, and thank you for joining us for Agora's third quarter 2021 earnings conference call. Our earnings results, press release, SEC filings and a replay of today's call can be found on our IR website at investor.agora.io. Joining me today are Tony Zhao, Founder, Chairman and CEO; Jingbo Wang, our CFO. Reconciliations between our GAAP and non-GAAP results can be found in our earnings press release. During this call, we will make forward-looking statements about our future financial performance and other future events and trends. These statements are only predictions that are based on what we believe today, and actual results may differ materially. These forward-looking statements are subject to risks, uncertainties, assumptions and other factors that could affect our financial results and performance of our business, and which we will discuss in detail in our filings with the SEC, including today's earnings press release and the risk factors and other information contained in the final prospectus relating to our initial public offering. Agora holds no obligation to update any forward-looking statements we may make on today's call. With that, let me turn it over to Tony. Tony, please.

Tony Zhao, Founder, Chairman and CEO

Thanks, Fionna, and welcome, everyone, to our earnings call. In the past two months, we hosted our RTE2021 conference in both the US and China, which attracted thousands of developers, product managers, entrepreneurs and investors worldwide. At the conference, we announced the advancement of real-time engagement use cases, which covers over 20 industries and more than 200 use cases in entertainment, social, IoT, education, finance, healthcare, enterprise collaboration and even smart cities. We also released important new products such as Fusion CDN live streaming, which I will talk about later. Now about our Q3 performance, we delivered another quarter with outstanding results. I'm pleased to report that our revenues for the third quarter were $45 million, up 46% year-over-year. At the end of September, we had more than 372,000 rejected apps on our platform. Our number of active customers reached more than 2,500, adding over 700 year-over-year. Next, I want to highlight our advancements on product and use cases in Q3. On the product side, we released two important new products this quarter. First, we recently unveiled full-path accelerator or FPA, our global end-to-end network acceleration product. Unlike traditional network accelerators that mainly improve backbone transmission from one region to another, FPA takes the entire transmission path into consideration, including backbone and last mile, and optimizes the speed and the reliability of transmission in a holistic fashion. FPA is based on our proprietary software-defined real-time network and can accelerate any kind of data, not just video or audio, and for any application, whether it's gaming, e-commerce, collaboration or metaverse. With just a few lines of code, developers can integrate FPA into their application and let all their users enjoy a smooth and responsive experience no matter where they are. Second, we announced our Fusion CDN live streaming product at the RTE2021 conference. Together with our current interactive live streaming product, we can now deliver a complete solution for live streaming use cases, from low latency streaming with our interactive live streaming API and standard latency streaming with our Fusion CDN product. It is important to note that our Fusion CDN is not mere repackaging of traditional CDN or a content delivery network. Our Fusion CDN leverages our proprietary SD-RTN network to enhance the resilience of data transmission and adaptively chooses the best CDN for downlink distribution depending on end users' location, therefore achieving superior end-to-end performance compared to traditional CVM. It also works seamlessly with our existing products, reducing the complexity of integration for developers. Currently, both FPA and Fusion CDN live streaming products are available in China, and we are working very hard to bring both products to developers in US, European and other markets in the coming quarters. In addition, we also launched our brand-new Extensions Marketplace at the RTE2021 Conference. Our Extensions Marketplace gives developers access to an ecosystem of partner extensions, which enhance real-time engagement such as AI-based noise filter from both, face filters from Banuba and a world changer from WordSmart. This marketplace is the first of its kind in the RTE category, allowing developers to instantly activate extension capabilities and accelerate time-to-market for their innovative applications. Moving on to new use cases, we are very happy to see that social deduction games are gaining popularity in more and more regions. Wildlife Studios is one of the largest mobile gaming companies in the world. They recently launched the suspect game using Agora to power the native voice chat among players. The voice chat provides players with a frictionless experience and saves them from having to use a third-party tool to talk to each other during a game and helps to differentiate suspects from other social deduction games. We see this as evidence of the convergence of social deduction games. We believe there will be more in other regions. Recently, we have seen an accelerating trend of real-time engagement in extended reality environments, creating the infrastructure of metaverse. A good example is our partnership with Dreamline maker, a leading virtual idol operator in China. We worked jointly to deliver a best-in-class solution for virtual idol concerts. Performance of the virtual idol is driven by a human performer through motion capture, and Agora powers the transmission of motion data and audio data to the physical concert site and simultaneously streams the concert to the audience online. Virtual idols can engage with their audience in detailed 3D environments, which bridges the gap between the physical and the virtual worlds, creating a beautiful fantastic world for users. We are also working closely with several network operators to build a fully interactive spatial audio solution. In the real world, we can easily distinguish sound coming from different directions and such directions change when we move our bodies, when the speaker moves. If we were to build a truly immersive network, its audio must take into account the locations and interactions of all users and the surrounding environment. And this is exactly what we are working on. Our solution constantly tracks users' movements in real time, synchronizes every user's location with others and updates the spatial audio they hear accordingly. If we extend our presence a little bit, people always talk about metaverse like the ones we saw in Ready Player One. In my view, the industry needs to solve and list the following three problems, namely real-time media connectivity, virtual environment construction and large-scale control signaling, before we can have a Ready Player One like experience. Agora has built industry-leading technology in all these three areas. For example, we have been raising the bar for real-time video and audio experiences. Our content moderation, virtual background and social audio products, together with extensions from our partners can significantly simplify virtual environment construction. And our full-path accelerator and signaling products are designed exactly for enabling low-latency control signals at scale. Our plan is to further enhance our capabilities in these areas and become an instrumental infrastructure provider for the metaverse. Next, I want to update everyone on our business in the US and the Rest of World market. The US and the Rest of World has been a key strategic focus for Agora. In the past three years, we have invested significant resources into this market and have increased its revenue contribution from less than 10% to nearly 30%. However, I believe we are far from reaching our full potential in this market, given the rapidly increasing RTE penetration and our technology advantage. In the past few months, we have worked very hard to bring in additional talent and better align our strategy and the priorities within the team. Reggie Yativ, CRO and the COO of our subsidiary in the US, will depart at the end of the year for personal reasons related to relocation. Reggie will transition his operational responsibilities to Stanley Wei, our Chief Strategy Officer, who has a lot of entrepreneurial experience in both Silicon Valley and China. We will continue to hire additional highly qualified leaders to further strengthen our team in the US and the Rest of World market. Lastly, I would like to take the opportunity to thank all of our customers and developers around the world for choosing Agora to power your real-time engagement applications. I also want to thank all the Agorans for their hard work and dedication to our customers' success. I am extremely excited about the opportunity ahead of us and look forward to co-innovating with our customers and the developers together. Now, let me turn things over to Jingbo who will review our financial results.

Jingbo Wang, CFO

Thank you, Tony. Hello, everyone. Let me start by reviewing financial results for Q3, and then I will discuss our outlook for the full year. Total revenue grew 46% year-over-year and 6% quarter-over-quarter to $45 million in the third quarter of 2021. The number of active customers reached more than 2,500, excluding some inactive accounts, up 41% year-over-year. The growth in revenue and active customers was mainly driven by continued adoption of our technology by developers as well as the emergence and growth of new use cases. Revenue growth in the quarter was negatively impacted by the new regulation on the K-12 academic tutoring sector in China, and we expect such impact to be more significant in the next two quarters as the government continues to enforce regulation. Our trailing 12 months constant currency dollar-based net expansion rate is 1.4% excluding Easemob. As we mentioned in previous earnings calls, in order to help investors better understand our organic growth, excluding the impact from one-off events such as a complete lockdown in China in the first half of 2020 due to COVID-19, we calculated adjusted total revenues for these periods. If we use adjusted total revenues, the adjusted expansion rate would be 126%. Moving on to costs and expenses, for my following comments I will focus on non-GAAP results, which exclude share-based compensation expenses, acquisition-related expenses, amortization expenses of acquired intangible assets and income tax related to acquired intangible assets. Non-GAAP gross margin for the third quarter was 65.5%, which was 2.7% higher than Q3 last year and 4% higher than Q2 this year. As we mentioned in previous earnings calls, increases were mainly driven by technical and infrastructure optimization, as we have been implementing since the beginning of this year. Non-GAAP R&D expenses were $22.9 million in Q3, up 112% year-over-year, as we continue to hire talented employees and strengthen our R&D team as well as the consolidation of Easemob's R&D team. Non-GAAP R&D expense was 50.9% of total revenues in the quarter compared to 35.1% in Q2 last year. Again, our strategy is to focus on long-term growth opportunities and innovation instead of maximizing short-term profitability. We've been investing significant resources in our R&D capabilities in order to further strengthen our technology leadership, provide a more diverse product portfolio and empower emerging use cases around the world. Non-GAAP sales and marketing expenses were $11.1 million in Q3, up 88% year-over-year, mainly attributable to team expansion and increased advertising and event expenses, including expenses related to the RTE2021 conference in the year. Sales and marketing expenses represented 24.6% of total revenues in the quarter compared to 19% in Q3 last year. Non-GAAP G&A expenses were $6.8 million in Q3, up 121% year-over-year, mainly due to team expansion and professional service fees. G&A expenses represented 15.1% of total revenues in the quarter compared to 10% in Q3 last year. Non-GAAP operating loss was $11.1 million, translating to a 24.6% non-GAAP operating loss margin in the fourth quarter compared to an operating loss margin of 23.3% in Q2 this year and an operating loss margin of 0.8% in Q3 last year. Turning to cash flow, operating cash flow was negative $14 million in Q3 compared to negative $1.9 million last year. Free cash flow was negative $15.6 million compared to negative $5.1 million last year. Moving on to the balance sheet, we ended Q3 with $767 million in cash, cash equivalents, and short-term investments compared to $827 million at the end of Q2. Net cash outflow in the quarter was mainly due to free cash flow of negative $15.6 million, consideration paid for Easemob acquisition of $20.9 million, and long-term investments of $20.8 million. Now turning to guidance, COVID-19 is still an unprecedented situation where historical experience may not apply. Our guidance on full-year revenues reflects various assumptions that are subject to change based on the uncertainties related to the impact of the COVID-19 pandemic. In addition, as we mentioned earlier, we expect new regulation on the K-12 academic tutoring sector in China will have a significant negative impact on our revenue in the near term. With that, we expect total revenues for full-year 2021 to be in the range of $163 million to $165 million. In closing, we are proud of the execution and strong performance in Q3 and continue to be confident about the long-term prospect of our business. Thank you to our entire core team and everyone attending the call today, and hope you're healthy and safe. Let's open it up for questions.

Operator, Operator

Our first question comes from Yang Liu at Morgan Stanley.

Yang Liu, Analyst

Thanks for the opportunity to ask questions. I have two questions, both related to the overseas business. The first one is, given the pretty fast reopening post-COVID in the overseas countries, do you see any sign of slowing down in terms of growth in the overseas market? And what is the current outlook for this line going into 2022? And what should be the growth driver going forward? And the next question is, what does the margin look like for the overseas business now as we see a very big jump in the blended gross margin this quarter? Is it helped by the overseas scale ramp-up?

Tony Zhao, Founder, Chairman and CEO

I will start with the first part. Our overseas business continues to experience strong demand from developers in the US, APAC, and other regions, with many new use cases emerging. Some of these were highlighted in our recent release outlining real-time engagement use cases. In this quarter, revenue from outside China increased by 90% year-over-year and represented nearly 30% of our total revenues. The US and the rest of the world are our strategic focus, and we plan to make further investments to expand in this market. Many markets, such as the US, have largely reopened, and others are in the process of resuming work and school. We have noticed that reopening often leads to a short-term decline in demand for use cases like education, virtual events, or virtual collaboration. However, demand for social and gaming applications is less impacted. Looking long term, the extended work-from-home scenario has altered lifestyles, suggesting that digital transformation will persist beyond the pandemic. Our lives will be permanently different, particularly regarding the hybrid model of work—combining remote and in-person work. Live streaming e-commerce and other innovative business models will continue to gain traction. Social and gaming use cases will likely face less impact and will grow at a faster pace. We expect to see a significant increase in real-time video and audio engagement in our daily lives and work. Regarding use cases, we've published an atlas covering those in real-time engagement. In the last quarter, we highlighted some emerging examples, such as online karaoke and live gaming experiences. There are more rapidly growing use cases, such as the global convergence of applications. An example of this is World of Game, a popular social deduction game that began in China about four years ago. This quarter, we saw Wildlife Studios from Brazil launch a similar game called Suspect using our platform, which has been very successful. Additionally, we have signed several large online education clients in Asia Pacific, whose use cases are quite similar to those of Chinese education companies, reflecting this global convergence. On the collaboration front, there are more specialized solutions, such as a leading graphic design platform where designers can collaborate on the same canvas and communicate via real-time voice supported by our technology. In terms of IoT, we have applications like smart vehicles, where manufacturers can use our platform for real-time monitoring, allowing car owners to connect with their vehicles through mobile devices to check their surroundings in real-time for any issues. There are also several metaverse-related use cases, including Dreamline, a virtual idol live streaming service, along with multiple other applications launching this quarter.

Jingbo Wang, CFO

Sure. So on the second question on gross margin, certainly, since the beginning of this year our gross margin has been improving across all regions in China, the US, and APAC. It's really driven by limitless technical optimization and improved capacity planning and management. Currently, gross margin outside China is still slightly lower than the gross margin in China. This is because, from a technical perspective, China is one big region. Outside China is now one region, it's 10 to 20 testing regions. The scale of our operation in most of these regions is significantly smaller than our scale in China. So, we don't enjoy the same level of economy of scale. So, we expect that as we continue to scale our business outside China, gross margin will eventually catch up with what we are seeing in China.

Operator, Operator

Our next question comes from Emerson Chan from Bank of America Securities.

Emerson Chan, Analyst

I have a few questions. My first question is related to our Q4 outlook. I think we have achieved a pretty solid growth in Q3 despite the compliance challenges. If you look at our full-year guidance, it implies Q4 is expected to decline sequentially quite a bit. So I wonder what are the key drivers behind the sequential decline in Q4 and what we are seeing in business in Q4 versus Q3 so far? That is my first question. My second question is a follow-up on our GP margin outlook, whether we believe our GP margin will continue to improve in the future or we will invest our margin upside for growth, given I believe the R&D expenses are still in early stages yet? So just wonder how management tries to balance between gross margin and investments.

Jingbo Wang, CFO

Thanks. So, I will take the first two questions. So on the first question regarding Q4 revenue outlook, as we mentioned in our last earnings call, K-12 education in China represented about 25% of global revenues in Q2. In light of the new regulations that came out in July, we revised our full-year revenue guidance in our last earnings release. We have revised the guidance to $159 million to $161 million. Now looking back, K-12 education revenue in Q3 was better than our earlier expectations because many tutoring service providers were able to finish their classes in the summer vacation. Now as we go into Q4 and see that the government is moving to enforce new regulation, we have seen that usage from the K-12 education sector has dropped to a lower level. So, we have updated our full-year revenue guidance to $163 million to $165 million to reflect our best estimate at this point. However, as similar to our situation last quarter, it is very hard to predict how exactly the sector will evolve and play out for the remainder of this quarter and in the coming quarters. On the second question on GP margin, as I explained, the improvement in GP margin was mainly due to technical optimization. So looking forward, there are multiple, several factors at play here. First of all, the lower usage from education customers in China will reduce the utilization rate of our infrastructure. So, that's a negative impact on our GP margin. On the other hand, we are trying very hard to optimize our costs to offset some of that impact through internal strategies. I think our strategy has always been that we intend to maintain a healthy and fair GP margin, instead of maximizing our pricing. So generally, as we have done in the past, we will pass on our cost savings to our customers, delivering really the most competitive and the best performance to price ratio for our customers.

Bin Zhao, CRO

All right, about the vertical solution and SDKs, we have dozens of different vertical solutions, as mentioned earlier, like education APIs, live audio cast, karaoke, LTE solutions, multiple IoT solutions. We also offer a lot of different SDKs to support diverse development platforms or environments, like Unity or Unreal or CoCos or Flutter as needed, etc. Those SDKs and the vertical solutions provide use case specific features and higher-level APIs so that the developers can integrate and go live with fewer lines of code and much less effort. The key benefits of those solutions are ease of use for developers. We have, by far, the most comprehensive vertical offers compared to competitors.

Operator, Operator

Our next question comes from Vincent Yu from Needham & Company.

Vincent Yu, Analyst

Thank you, management, for addressing my questions. I have two inquiries. First, we've noticed some weakness in the live streaming industry in China. What can we expect regarding the trend of this revenue source for our business? Second, I would like to follow up on our overseas business. Specifically, regarding online conferences or virtual showcasing applications of our product, can we expect strong insights on progress in terms of securing orders in key markets like the US?

Bin Zhao, CRO

About live streaming, as an industry, it is still growing but has reached a relatively mature stage. We think it's actually positive for us because users are no longer excited by traditional forms of live streaming such as talent shows or game forecasting. Live streaming operators now need to constantly come up with new engaging experiences to attract users. The most engaging experience is always real-time interactive ones. Essentially, we are not relying on the expansion of the user base of live streaming; rather we are relying on the penetration of RTE within its user base. For example, the karaoke use case we were just promoting in the last few months or the interactive games inside our live streaming experience are all kind of new, and we see very strong demand for using those use cases. I also mentioned the virtual idol live streaming or more interactive experience on e-commerce apps; those are all very active areas internally in the live streaming industry. Around the progress is about overseas demand. As I mentioned earlier, we see our US-Rest of World business with a faster growth rate and even bigger potential in front of us. Our app registration is currently 12,000 per month, of which two-thirds are from the US-Rest of World. It’s much clearer that the registration comes from China. So we are also working with several large customers on social and media use cases. Jingbo also talked about some of those progresses reflected in our growth rate of US-Rest of World. But we believe the US and Rest of World market has an even bigger potential. One of the drivers of US-Rest of World is the convergence of use cases globally. As I mentioned earlier, I’ve talked about how social deduction games, although it took years, but now appear in South America and other parts of the market. We believe it's validation of our logic that these use cases would be replicated in different regions. Another example is online education. We see a clear trend that the online classroom service is being replicated to other regions of the world. So, those are all growth drivers for the US-Rest of World, but the natural demand and unique use cases are also strong indicators of the potential of the market.

Operator, Operator

Our next question comes from Bing Duan at NOMURA.

Bing Duan, Analyst

Management, thank you for giving me the opportunity for asking questions. I have two questions. One is regarding the net dollar retention rate. We see some sequential slowdown in the third quarter. The adjusted dollar-based net retention rate is now around 126%. So just curious, what’s the major reason behind that? And how do we think about the trend in the next few quarters and the major drivers? The second question is about our pricing. So, do we see any changes in the pricing for our large or strategic customers in major industry verticals? And what about the trends and how do we think about the impact on the gross margins?

Jingbo Wang, CFO

Sure. So I'll take those questions. Yes, it's true that we've seen a sequential decline for looking at the adjusted expansion rate because the raw expansion rate was really affected by the spike in demand in the first half of last year in China. So, the adjusted number will reflect the organic growth better. Actually, 126% is a pretty healthy level and it's actually in line with the expansion rates we saw pre-COVID. We think that's the kind of normal range we are seeing for this business and in line with our expectation going into the future. So, we don't really think there's anything wrong with the number. In the next few quarters, if we look at the raw expansion rate, it'll be under additional pressure due to the new education regulations in China. It is estimated to become a big drag on the expansion rate. So in terms of pricing, as I explained earlier on, the GP margin, I think it's very similar to other RTE PaaS cloud services. Here, our aim is to provide customers with the PaaS performance-to-price ratio, the PaaS value per dollar. So, we have never had a strategy to maintain the same price or to continue to maximize the price. I think that will be very much where we see in the RTE PaaS business. We have generally passed on our own cost savings to our customers, which has resulted in a gradual drop in price year-over-year, which again is similar to many other cloud services like AWS. And with what we saw in this year and last year was no different and it's exactly healthy for the growth of the entire market.

Operator, Operator

Our next question comes from Allen Li at JP Morgan.

Allen Li, Analyst

Thanks management for taking my questions. I have two questions. The first one is on your CDN initiative. So just wondering, will we do the CDN business by ourselves or we just leverage our technological capability to help clients choose the best CDN vendor? So what's our business model here? And the second one is on the headcount. So, could you give us some color on your headcount plan for next year?

Bin Zhao, CRO

I'll explain on the Fusion CDN offering. I want to emphasize again, it's a very innovative product. It's not a mere aggregation of the CDN services. But you're right, we won't build our CDN network. It's going to be integration of existing CDN provider services, but we add a lot more on top of it. One thing is to leverage our SD-RTN network to optimize the upstream quality and efficiency. We have SDK embedded into customers' apps where a CDN provider does not have that kind of presence. And leveraging that SDK, we have a much better chance to detect and monitor the downlink performance of all CDN services and dynamically choose the best quality and also the best cost for our app developers and customers. Combine all those, it becomes a very good offering for developers to provide a high-quality and cost-effective solution for their low-latency streaming services. This will naturally expand our existing offering in the market. Regarding headcount for next year, obviously, as Tony talked about, we are very optimistic about our business across China, the US, APAC, Europe, and South America. We continue to see very strong developer sign-ups, customer POCs and projects across the board. The business in China is more challenging due to the change in educational regulations. So, we will be more cautious about our headcount next year. In the past two years, we roughly doubled our headcount from 400 to 800, and with the acquisition of Easemob, another 200, so we are now at about 1,000. We do not plan to significantly expand our headcount again next year. The increase will mainly come from the US-Rest of World market, and the increase in the China market will be very moderate.

Operator, Operator

There appear to be no further questions. So I'll hand back to management for closing. Thank you.

Fionna Chen, IR Representative

Thank you, operator. Thank you, everyone, for attending today's meeting. Again, if you have any further questions, you may rely on our materials being posted on our IR website or directly email us at investor@agora.io. Thank you again very much. Thank you. Have a nice day.

Bin Zhao, CRO

Thank you.

Jingbo Wang, CFO

Thank you.

Operator, Operator

Thank you so much. This does conclude today's conference call. Thank you all for joining. You may now disconnect.