Youdao, Inc. Q1 FY2020 Earnings Call

Good day and welcome to Youdao First Quarter 2020 Earnings Conference Call and Webcast. Today's conference is being recorded. At this time, I would like to turn the conference over to Pei Du, Investor Relations Director of Youdao. Please go ahead.

Thank you, Mark. Please note the discussion today will contain forward-looking statements relating to future performance of the company and are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities Litigation Reform Act. Such statements are not guarantees of the future performance and are subject to certain risks and uncertainties, assumptions and other factors. Some of these risks are beyond the company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. A general discussion of the risk factors that could affect Youdao's business and financial results is included in certain filings of the company with the Securities and Exchange Commission, including our Annual Report filed on Form 20-F. The company doesn't undertake any obligation to update this forward-looking statement, except as required by law. During today's call, management will also discuss certain non-GAAP financial measures for comparison purposes only. For the definition of non-GAAP financial measures and a reconciliation of GAAP to non-GAAP financial results, please see these 2020 first quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. Besides, a webcast replay of this conference call will be available on Youdao's corporate website at ir.youdao.com. Joining us today on the call from Youdao's senior management is Dr. Feng Zhou, our Chief Executive Officer; Mr. Lei Jin, VP of Operations; Mr. Peng Su, our VP of Strategy and Capital Markets; Mr. Wei Li, our VP of Finance. I will now turn the call over to Dr. Zhou to review some of our recent highlights and strategic direction.

Thank you, Pei Du, and thank you all for participating in today's call. Before we begin, I would like to remind everyone that all numbers are based on renminbi. I would like to begin by offering my deepest sympathy to all the families affected by the coronavirus. We have been warned as a society by the global pandemic. As Chinese cities have gradually reopened, we continue to take steps to ensure the safety of our staff and students. We provided free online courses from January to February and we are proud to have quickly changed course to prioritize relief and provide support to those cities that were hardest hit, as well as our broader community. As an online service company, our operations were less impacted than some other businesses. We closed the first quarter with strong financial and operating results. Growth from our core online learning business accelerated. Online courses generated gross billing of RMB519 million, up 287% year-over-year, and up 50% quarter-over-quarter, stronger than 211% year-over-year growth in Q4, 2019. Gross margins from our Learning Services segment also rose to 52% in the first quarter of 2020, as we continue to benefit from economies of scale. This is a large step up from 30% in Q4, 2019 and 17% in Q1, 2019. Our intelligent learning devices also grew rapidly despite the virus's impact during January and February. Revenue from devices reached RMB53 million, up 189% year-over-year. Operating cash flow was nearly RMB50 million for the quarter, marking Q1 as our first quarter of positive operating cash flow since operating at scale. Longer term, we are seeing improving cash streams, but do expect to see some seasonal fluctuation. Looking at our business segments, for online courses, gross billings from K-12 courses reached RMB192 million and adult courses were at RMB254 million, up 330% and 300% year-over-year respectively. The growth came mainly from innovation in course content and product. Let me highlight a few areas of significant progress for Youdao. First, we released a new version of junior high school Math and high school English courses. In particular, the Math course features localized content delivered by both our instructors and teaching assistants. The courses quickly became popular and joined the ranks of junior high school Chinese and Physics courses, which have been best-selling courses since last year. Second, more and more courses feature real-time, AI-driven interactions during and after the live courses. For example, in our new elementary math courses, students alternate between listening to the instructions and practicing using our live stream personalized exercises. It is an important upgrade to the industry standard dual-teacher large class format, which we call the interactive large class model. As for content in new adult courses, we introduced the English Resuscitation Camp in Chinese, based on Ying, and English oral training courses, which are being taught by two relatively new instructors. These two popular courses are already profitable in Q1 partly because they gained a significant number of users from our dictionary and other apps. These users are interested in learning the language and overseas culture and lifestyle, which are offered by these courses. This shows that as we serve our users with more and more apps and with courses in different ways, synergy within our business segment continues to grow. In line with our growth goals and to support our increasing enrollment, we grew our educator team to 164 instructors and 865 teaching assistants during the first quarter. We have also improved their training, quality control, and incentive goals. More recently, we also began our brand campaign for Youdao Premium Courses. In mid-April, we partnered with a renowned Chinese women's volleyball coach, Lang Ping, to be our brand spokesperson. Initial feedback has been positive. Our partnership with Lang Ping is set to mark key quarters, and we look forward to a fruitful relationship. Let's turn to another segment, our Intelligent Learning Devices. In Q1, revenue from our Intelligent Learning Devices reached RMB53 million, up 189% year-over-year. The increase was primarily driven by sales of our Youdao Dictionary Pen 2, which has become known among students and parents as an indispensable and fun device. Online distribution was strong in Q1. Offline distribution was negatively impacted by the closures caused by the coronavirus in January and February, but by March offline distribution had returned to previous levels. We plan to launch new devices later this year to support students' learning needs. In terms of our app, we introduced a major version of our dictionary app, bringing more functionalities like document translation to the front page. We also launched AI essay assessment, a feature that automatically grades and offers suggestions for improving English essays submitted by the users. This feature leverages our proprietary AI technology and uses state-of-the-art transformer architecture and transfer learning techniques. We also made progress with our organic traffic conversion, with our conversion rates from this channel increasing by 5% year-over-year. As a result, K-12 total gross billings from organic traffic grew 236% year-over-year during the first quarter. Also, thanks to the pandemic, Chinese University MOOC has provided teaching tools and teaching infrastructure throughout China, helping 60,000 instructors at 1,200 universities to facilitate over 120,000 courses. As one of the most commonly used learning platforms for colleges, Chinese University MOOC had over 40 million registered users and approximately 14 million daily active users at its peak during the first quarter. At the end of April, we released the overseas version of Chinese University MOOC and received positive feedback from the Chinese Ministry of Education. Now for our Online Marketing segment. Our advertising revenues were RMB99 million in the first quarter, up 10% year-over-year and 1% quarter-over-quarter. In the coming period, we expect the advertising sector to continue to face macro challenges and to manage these fluctuations with flexibility. 2020 is no doubt a very unique year for all of us. For the education industry, it may well be a pivotal year where online education adoption and product innovation greatly accelerate. We believe Youdao is well-positioned to capture this opportunity. We are confident that we have a strong pipeline of courses and products for the rest of the year. Our teams are hard at work to get them ready for the summer and fall months. We cannot wait for more students and parents to try them. With that overview, I will now turn the call over to Su Peng to review our financial results. We will then open the call up for questions.

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from our 2020 first quarter. We encourage you to read through our press release issued earlier today for further detail. We start the year off on a strong note with healthy gains across many of our primary financial metrics as our business scales rapidly. On a year-over-year basis, we grew our revenue, gross billings before revenue, gross margin, and we had positive operating cash flow for the period. For the first quarter, total net revenue was RMB541.4 million or US$76.5 million. This represents an increase of 139.8% from the fourth quarter of 2019. If we look at this growth by segment, net revenue from our learning services and product grew 226.4% year-over-year to RMB442.1 million or US$62.4 million. We attribute this growth to strong growth in K-12 paid student enrollment and gross billing per paid student enrollment of Youdao Premium courses on a year-over-year basis. Net revenue for online marketing services was RMB99.3 million or US$14 million, up nearly 10% compared to the same period of 2019. For the first quarter of 2020, our total gross profit slightly improved reaching RMB235.7 million or US$33.3 million compared with RMB52.9 million for the first quarter of 2019. Gross margin for learning services and products improved to 48.7% for the first quarter of 2020, up from 18.5% for the first quarter of 2019. The large margin growth was primarily attributable to effects of economies of scale and further optimization of our business and faculty compensation structure. Gross margin for online marketing services was 20.5% for the first quarter of 2020, compared with 30.8% for the first quarter of 2019. The decrease was mainly the result of more revenue generated from advertisements through third-party Internet properties and international markets, which carry lower gross margins. For the first quarter, total operating expenses were RMB411.7 million or US$58.1 million compared with RMB131.9 million for the same period last year. We continue to invest in technology, student acquisition, and acquiring new talented teachers to support our growing business over the long term. In tandem with this investment, we are increasing our top line and structuring our model to become more efficient and recognize economies of scale. With that in mind, sales and marketing expenses for the first quarter were RMB299.2 million compared with RMB64 million in the first quarter of 2019. Research and development expenses for the first quarter were RMB84.1 million compared with RMB54.9 million in the first quarter of 2019. Our operating loss margin was 32.5% in the first quarter of 2020, compared with 35% for the same period of last year. For the first quarter of 2020, our net loss attributable to ordinary shareholders was RMB169.4 million or US$23.9 million, compared with a loss of RMB102 million for the same period last year. Non-GAAP net loss attributable to ordinary shareholders for the first quarter was RMB161.9 million or US$22.9 million, compared with a loss of RMB101.2 million for the comparable period last year. Basic and diluted net loss per ADS for the first quarter was RMB1.52 or US$0.21. Non-GAAP basic and diluted net loss per ADR for the first quarter was RMB1.45 or US$0.20. Our net cash generated from operating activities for the first quarter was RMB49.7 million or US$7 million. Looking at our balance sheet. As of March 31, 2020, our contract liabilities, which mainly consist of our deferred revenues for our online courses, were RMB603 million or US$85.2 million, compared with RMB456.8 million as of December 31, 2019. At the end of the period, our cash, cash equivalents, time deposits, and short-term investments totaled RMB1.7 billion US$236.8 million. Again, we are focused on meeting our long-term objectives. We will continue to prudently manage our costs and strike a balance between top line growth and expense. This concludes our prepared remarks. Thank you for your attention. We will now like to open the call for your questions. Operator, please go ahead.

And the first question we have will come from Sheng Zhong of Morgan Stanley. Please proceed.

Hi, management, thank you for taking my question, and congratulations on the strong gross billing growth and gross margin improvements. We also see that the sales and marketing spending also increased a lot like you said you're doing a brand campaign. So may I ask your plan for the summer on the summer promotion and especially this summer holiday could be shorter than usual. So what is the plan for K-12 student acquisition for summer? And my second question is, can you give more color about your young children's program? You developed a lot of good interactive classes and apps. So on this part of business, what's your target and future plans? Thank you.

Thank you, Sheng Zhong. Regarding the summer, yes, so obviously, the teams are working hard on this right now. We have different marketing budgets for the summer campaign. So as we talked about before, summer is the right time to acquire users. Users that enter our service during the summer typically have higher lifetime values. Last year was the first time we did a summer customer acquisition campaign. This year, we're more experienced, so we will likely allocate a larger budget for that. We believe we will have better, more successful campaigns. With that said, we always look at the unit economics of our business very carefully. Essentially, we allocate a large budget, then we operate on a week-to-week basis, looking at the results and adjusting the plan accordingly. We have been doing a lot of preparation for the summer. For example, if you look at our teaching assistant numbers, they have grown and continue to grow. We have added centers in Shenzhen and Chengdu to last year's three cities, Xi'an, Nanjing, and Guangzhou. So right now we have five teaching assistant centers across the country. You talked about a shorter than usual summer. Currently, we believe there will be a limited impact of this change because parents and students are still very engaged in their learning. Without major changes to their behavior, we believe the summer may see changes, but the impact will be limited. We will have five weeks of summer courses from July to the end of August. That's the current plan. Another thing is that if you compare online courses to offline, there will be more flexibility for changes for online companies. So we think we have more flexibility there. Regarding the second question on young children's programs, which we call STEAM courses, we think they represent a promising segment. In Q1, three courses have been completed in their first stage of content investment: Kids Programming, Youdao Fun Reading, and Youdao Science. We think they are ready to scale. Thank you.

Next we have Mark Li of Citi.

Hi, management, congratulations on the results. I hear you're sharing about the content development and student interaction class progress. May I know for this course transformation, what is your plan for the teacher and teacher assistant numbers? What's your plan for later this year because of this course development? Thank you.

Yes. Thank you, Mark. You are asking about the interactive large class content model we talked about. We think these are important and promising improvements to the product model, which will be increasingly important this year and going forward. As many players in the market are successful in scaling up their businesses, parents will look for differentiated product offerings that engage their kids in learning and offer superior learning results. Our data shows that when we add interactions to these courses, we have more engaged students and better future results. The contents are produced in tandem with our teaching staff, who remain at the center of the learning experience. We will hire more instructors this year and increase the number of teaching assistants as we scale up the business. The instructors' numbers do not correlate directly with student numbers, but the teaching assistants usually scale linearly with the number of students. We expect to hire more instructors and teaching assistants this year, with a larger growth for teaching assistants. Of course, we will also focus on how to improve operating efficiency. We believe this will be a strength of our team because we are effective at utilizing technology to improve efficiency. I hope that answers your question.

Next we have Alex Xie of Credit Suisse. Alex, your line might be muted.

Hi, management, thank you for taking my questions and congratulations on very strong results. My first question will be about GP margin. The GP margin improvement in the learning services segment is really impressive. Would you please show a bit more color on the GP margin of your K-12 courses? I think it should be even higher than the learning services. How much of your learning services GP margin improvement is from the teaching staff compensation structure change as a percentage of the revenue? Secondly, I would like to ask about Youdao Premium Courses. I think that in this quarter both student enrollment and ASP grew significantly quarter-over-quarter. Do you think this is mainly due to the traffic surge post-COVID-19? Or how do you view the outlook? Is the momentum sustaining? Thank you.

Yes, regarding GP margin, I'll give some general remarks and Yong will provide further details. Overall, the learning services gross margin is 52%. Unfortunately, we do not disclose separate numbers for individual segments. As you can see, it's a significant growth. We are improving on economies of scale, and some of our instructor contracts, which came into effect on January 1st this year, are driving this. We expect to achieve industry standard margin levels over time but recognize that they may fluctuate in the short-term. Yong?

Yes. Thank you, Dr. Zhou. I would like to give more details. We expanded our GP margin of our learning services through the following points. First, the benefits of our revenue increase definitely this quarter. We expect that the online large class education format will be more widely adopted. Second, we continue to optimize our compensation structure. More instructors have accepted a lower revenue share for our top-performing staff. Finally, we continue to improve our operational efficiency. For example, we are optimizing payment and cost management, and learning materials that also result in cost savings. However, as mentioned by Dr. Zhou, our gross margins will fluctuate on a short-term basis. Sometimes revenues can temporarily affect our income statement. Thank you.

Yes. Regarding the second question about the ASP and future changes, the ASP for Youdao Premium Courses grew by 158%, from RMB627 to RMB1,618 this quarter compared to the first quarter last year. Adult purchases’ ASP also grew, from RMB450 to RMB2,000. The mix changes in our adult courses are due to shifting from college English test courses to more courses tailored to working users. These new courses have higher ASP. Quarter-over-quarter, K-12 courses also grew. This trend has benefited from the surge in traffic due to the coronavirus. We believe the effect from the pandemic will remain for a few more quarters but will decrease in significance. We will continue to focus on delivering higher quality and better service, ensuring a sustained tailwind for our business. I hope that answers your question.

Next we have Thomas Chong with Jefferies.

Thanks, management, for taking my questions. I have a question regarding the trend in operating expenses. How should we think about marketing expenses as a percentage of revenue in the coming quarters, and can you comment on trends regarding operating cash flow, as well as the timing for profitability? Thank you.

I will take the first question about marketing, and then Jin Lei will talk about the operating cash flow. Thank you for the question. In terms of marketing expenses, we always look at the business from the perspective of long-term growth. With our better business fundamentals now, including better conversion and retention rates, we've allocated a larger budget for summer because we view this year as the right time to acquire users and set up for long-term growth. However, we will ensure that the marketing dollars spent correspond to good unit economics and deliver positive outcomes.

In terms of operating cash flow, as our business fundamentals improve, we have achieved positive operating cash flows in the first quarter. We expect operating cash flow to improve over time along with our overall performance, though there may be short-term fluctuations. In Q1, we achieved positive operating cash flow due to strong performance, higher gross margins due to economies of scale, and improved cash flow management. Looking forward, we expect continued improvement in our cash flows despite some short-term fluctuations. Regarding the timeline for profitability, we do not provide specific guidance, but we expect improvements as business fundamentals continue to strengthen. We will continue to invest in R&D and marketing to serve more users and accelerate growth. Thank you.

Next, we have Vincent Gao of CICC.

Congrats on the positive operating cash flow. My first question is on competition. What is your view on the current competitive landscape and what strategies do you have to differentiate yourself from other players? The second question is on curriculum development; you have focused heavily on educational content and technology. Could you share any recent progress and future plans?

Thank you, this is Feng Zhou. On the competitive landscape, I cannot comment on specific competitors but can speak to general trends. 2020 is shaping up to be a key year as more consumers are looking for online courses. We are lucky that we are ready in terms of content, teaching personnel, and service capabilities. Differentiation is key as parents and students will seek unique offerings to stand out. We believe delivering the best experience and outcomes will give us an advantage. For example, we have top-notch instructors who create content collaboratively with our team, while we iterate based on user feedback. A recent course, our junior high school Chinese course, has received excellent reception, demonstrating our effective content development. Regarding curriculum and teaching content, we use a workflow cost iteration system, which allows us to fine-tune courses based on various evaluations to ensure we achieve quality standards. Thank you.

Next we have an unidentified analyst from HSBC.

Thank you for taking my question here. Could you clarify about the organic app? What percentage of users are organic, and what are the retention rates from these users? Also, can you update us on your user acquisition strategy this year compared to online peers who are using innovative ways to grow new users?

We have been in business for a long time. Regarding the first question about our organic user conversions, we mentioned earlier that organic traffic grew by 226% year-over-year compared to the first quarter of 2019. This indicates good conversion from organic traffic to enrollments. We expect this growth trend to continue. Regarding retention rates for organic users, we don't break down this data specifically, but those users tend to have a strong value regard for our product since they are often already familiar with our apps. We also have over 100 million monthly active users through our apps, which positions us uniquely for organic growth. We expect to balance our marketing allocation for growth while leveraging our existing user base. Thank you.

Hi, good morning management. Thank you for taking my question and congratulations on a very strong quarter. My question is regarding the industry outlook. What do you think the industry outlook will be in three to five years? Should we expect the average size of an online large class to grow larger or should we anticipate more diversified and innovative product offerings? Appreciate your insights and what is your corresponding strategy?

Yes, this is Feng Zhou. We still view the industry as being in its early stages with relatively low penetration. For the overall tutoring industry, we have a long runway ahead of us. With that said, differentiation is imperative as users become better informed about their online options. The industry is largely content-driven, which presents opportunities. We believe that providing equal or superior online learning experiences compared to offline education will be crucial. For example, our interactive large class model allows us to add real-time engagement to course offerings, overcoming the challenge of student attentiveness in an online environment. Moreover, implementing AI technology to enhance the learning experience remains key in differentiating our products. I hope that answers your question.

Thank you once again for joining us today. If you have any further questions, please feel free to contact us at Youdao directly or reach out to TPG Investor Relations. Have a good day. Thank you.

We thank you all for your participation in today's conference call. Again, the call is now ended. At this time, you may disconnect your lines. Thank you. Take care, have a great day everyone.