Youdao, Inc. Q3 FY2020 Earnings Call

Good day, and welcome to the Youdao 2020 Third Quarter Earnings Conference Call. Today's conference call is being recorded. At this time, I would like to turn the conference over to Regina. Regina, please go ahead.

Thank you, operator. Please note the discussion today will contain forward-looking statements related to future performance of the company, which are intended to qualify for the Safe Harbor from liability as established by the US Private Securities Litigation Reform Act. Such statements are not guarantees of future performance and are subject to certain risks and uncertainties, assumptions, and other factors. Some of those 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 does not undertake any obligation to update this forward-looking information, except as required by law. During today's call, management will also discuss certain non-GAAP financial measures for comparison purposes only. For definitions of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2020 third 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; and Mr. Wayne 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, Regina, 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. Online education is more relevant today than ever before and it is profoundly transforming how people learn. We accelerated our rapid growth momentum in the third quarter and generated total revenue of RMB 896 million. Gross billings from online courses reached RMB 955 million, up 228% year-over-year and 76% quarter-over-quarter, supported by our large-scale marketing and branding campaign during the summer. Growth in our K-12 segment was particularly strong, reaching a record high. Gross billings from this group were RMB 676 million, up 369% year-over-year and 120% quarter-over-quarter, respectively. K-12 paid enrollments reached 499,000, up 52% quarter-over-quarter. The K-12 gross billings proportion of Youdao Premium Courses increased to 77% from 67% in the same period last year. ASP for the K-12 segment was slightly down, primarily due to the increased proportion of primary school enrollments, which have relatively lower ASPs than our high and junior high school courses. Also, 22% of all newly enrolled students' gross billings came from organic traffic for Q3, which grew 188% year-over-year. Gross margins also continued to improve with product improvements and larger scale. Overall gross margin was 45.9% and the gross margin for our learning services was 53.9%, up 220 basis points from Q2. We expect to maintain this growth momentum of our GP margin, mainly due to further improvement of economy of scale. We continue to strengthen our star instructor and teaching assistants’ teams. More than 70% of our current instructors come from Tsinghua University, Peking University, or a top 50 university in the world. This year, we hired only about 0.3% of all instructor candidates. We are committed to continue hiring elite instructors and to offer high-quality courses. Regarding TA teams, we continue to expand our capacity. Total TAs reached 3,368 at the end of Q3 at operation centers around the country. On the product side, our K-12 math courses made significant progress in Q3. The number of paid enrollments for math students in grades 1 to 12 increased in the third quarter by over 800% year-over-year. For primary school, we added more interactions in classes for key knowledge points. For junior high school, we started to offer regional and textbook-specific courses. For high school, several newly recruited star teachers are available for students to meet diverse demands. We released a new set of kids' programming courses, including Python programming and a custom hardware programming kit in Q3. Student retention of the programming course exceeded 85%. Q3 is the main quarter for our summer marketing campaign. The campaign included online performance advertisements, TV sponsorships and ads, etc. We expect this marketing campaign to be the largest for fiscal year 2020. In Q3, brand and performance advertisement spending on courses amounted to RMB 881 million. Although increased spending led to more short-term losses, it helped drive scale and was done under strict unit economics requirements. We analyzed front-loaded marketing spending in this quarter, and the total expected returns over the next several quarters for each project to ensure it is healthy. Turning to our adult segment, gross billings increased to RMB 201 million, up 185% year-over-year and 34% quarter-over-quarter. We continue our twofold strategy here. One, we focus on high-value courses, such as skill-learning and interest-oriented courses, and shift away from low-value courses such as college English. Second, we leverage our expertise in content development in this area to launch and quickly iterate new course offerings. Our staple courses continue to do well. For example, Logical English grew over 100% in gross billings year-over-year. The practical English courses released this year, including English Recitation Camp and Oral English Training have ramped quickly, which has become the major component of our adult with over five times growth year-over-year in gross billings. Our intelligent learning devices also grew at an accelerated pace in Q3, with revenues reaching RMB 163 million, up 289% year-over-year and 89% quarter-over-quarter. We shipped about 250,000 units of our Dictionary Pen 2.0, up 59% from Q2. Over 70% of our dictionary pens were purchased by or for K-12 users. We continue to integrate software and hardware here to deliver even more seamless experiences. For example, you can now scan words or phrases with your Dictionary Pen and read the results on your phone screen, which is even faster than using the pen alone. In Q4, we are launching a new Dictionary Pen and we are confident that it will further strengthen our leading position in intelligent learning devices. Let me say a few more words about how we look at learning devices. During the last two years in the market, we have clearly witnessed the introduction of a flourishing set of smart learning devices that parents and kids both love. We believe every kid will eventually own one or more of these devices. And these devices will be more and more tightly integrated with online learning services, leading to important cross-selling and other opportunities. At Youdao, with our expertise in AI, learning content, hardware design, and brand recognition, we believe we are well positioned to lead this fledgling area. Overall, our strategy this year is to seize key expansion opportunities. One important principle we base many decisions on is the principle of value accumulation. We have put a lot of effort into ensuring that, along with revenue growth, we also accumulate a large amount of value regarding product innovation ability, customer base expansion, teaching expertise, learning content, learning-oriented AI technology, distribution channels, and so on. Accumulating all this value enables us to offer constantly better courses now and long into the future to a huge population of parents willing to pay for high-quality education products. With that overview, I will now turn the call over to Su Peng to review our financial results. We will then open to questions.

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from our 2020 third quarter. We encourage you to read through our press release issued earlier today for further details. We continued to scale our operations in the third quarter achieving considerable year-over-year growth. Our strong technology, curriculum, and supporting intelligent devices and apps are well suited for exponential growth as we pursue additional marketing and branding activities to support our growth. For the third quarter, total net revenues were RMB 896 million or US$132.0 million. This represents an increase of 159% from the third quarter of 2019. Looking at this growth by segment, net revenues from our learning services and products grew 239.1% year-over-year to RMB 763.5 million or US$112.4 million. We attribute this growth to a sharp uptick in K-12 paid student enrollments and gross billing per paid student enrollment of Youdao Premium Courses on a year-over-year basis. Net revenue for online marketing services was RMB 132.6 million, or US$19.5 million, an increase of 9.8% compared with the same period of 2019. For the third quarter of 2020, our total gross profit greatly improved, reaching RMB 411.6 million, or US$60.6 million, up 361.2% compared with the third quarter of 2019. Gross margin for learning services and products improved to 48.8% for the third quarter of 2020, up from 27.5% for the third quarter of 2019. The large margin growth was primarily attributable to improved online course margins, better economies of scale, and further optimization of our business and faculty compensation structure. Gross margin for online marketing services was 29.5% for the third quarter 2020 compared with 22.6% for the third quarter 2019. The increase was mainly the result of more revenue contribution from brand advertising services, which carry higher margins. For the third quarter, total operating expenses were RMB 1.3 billion, or US$192.3 million, compared with RMB 324.0 million for the same period last year. We continue to invest in our future and top-line expansion. In addition to our investments in technology and acquiring talented teachers to support our growing business over the long term, we greatly ramped our sales and marketing efforts focused on student acquisition and expanding our brand awareness. This was especially important to accelerate during our busy summer campaign. These investments had immediate positive impact on our growth, which we expect to be long-lasting. In tandem with these investments, we are also structuring our model to become more efficient and recognizing economies of scale. We'll continue to invest in our future growth, as appropriate. With that in mind, sales and marketing expenses for the third quarter were RMB 1.1 billion compared with RMB 231 million in the third quarter of 2019. Research and development expenses for the third quarter were RMB 121 million compared with RMB 74.9 million in the third quarter of 2019. Our operating loss margin was 99.8% in the third quarter of 2020 compared with 67.9% for the same period of last year. For the third quarter of 2020, our net loss attributable to ordinary shareholders was RMB 877.8 million, or US$129.3 million, compared with a loss of RMB 242.2 million for the same period last year. Non-GAAP net loss attributable to ordinary shareholders for the third quarter was RMB 865.7 million, or US$127.5 million, compared with a loss of RMB 238.8 million for the comparable period last year. Basic and diluted net loss per ADS for the third quarter was RMB 7.73, or US$1.14. Non-GAAP basic and diluted net loss per ADS for the third quarter was RMB 7.63, or US$1.12. Our net cash used in operating activities for the third quarter was RMB 593.4 million, or US$87.4 million. Looking at our balance sheet, as of September 30, 2020, our contract liabilities, which mainly consist of deferred revenue for our online courses, were RMB 1.1 billion, or US$156.9 million, representing an increase of 133.3% from RMB 456.8 million as of December 31, 2019. At the end of the period, our cash, cash equivalents, time deposits, and short-term investments totaled RMB 1.1 billion, or US$166.9 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions.

Thank you. We will now begin the question-and-answer session. The first question today comes from Brian Gong with Citigroup. Please go ahead.

Thanks, management, for taking my questions. My first one is still about the competition. Can management provide updates on the recent competitive landscape and the outlook? Additionally, how does management anticipate the trend in student acquisition costs for the first quarter and next year? What will our marketing budget look like for the fourth quarter and next year? Thank you.

Yes, this is Feng Zhou. So, first, a couple of points on the competitive landscape. What's obvious is the sector as a whole is growing quickly, probably quicker than last year. The sector is investing money, not earning money yet. I think players are willing to invest because two things: one is, parents are willing to pay for really high-quality education, and so profitability in the long run is very much there. The second is total market size potential is huge. These two factors remain true and are very much true in 2020. That’s why we invested in marketing in the summer and that’s what I think everyone is thinking about. So, we're bullish about the future. Additionally, we see greater concentration in 2020 compared with last year in the sense that we only have five or six main players kind of doing K-12 large courses. With the investment we made in marketing in Q3, we significantly increased our customer base with very competitive customer acquisition costs. So, we have better reach and leverage. I don't want to comment too much on our peers. In terms of future competition in Q4, it is important to realize we are still in the early stages of creating content, acquiring customers, and monetizing it. We expect many things to change, with numerous new ways to do these things emerging, and we are doing performance ads to acquire new customers. We are also looking at O&O and other expansion ways. It is not just a math question of putting money on one side and acquiring that many students; our approach is dynamic, focusing on healthy and robust growth.

Thank you, Doctor, and Brian, for your questions. Regarding the colors for the marketing expense for the upcoming quarters, we don't give any official guidance to the market per our company’s policies. However, for Q3, it was our biggest investment season due to the summer campaign. On a full-year basis, we significantly enhanced our marketing investment in Q3 this year. We believe it is highly valuable for us to acquire new students with healthy unit economics. For the K-12 business, it's not just a one-time track model. We estimate the lifetime value of K-12 students to cover all sales and marketing costs with one to two repurchases. Our summer marketing campaign yielded great outcomes, achieving over 400% increase in enrollments during Q3. Our math product also saw over 800% year-over-year enrollment growth. We are dedicated to maintaining our fast and healthy growth and will continue to invest in projects with healthy unit economics. Additionally, we do not rely solely on sales and marketing; we also rely on our apps. As Dr. Zhou mentioned, we shipped over 250,000 units of our Dictionary Pen 2.0, with over 70% of users being K-12 students. We are also exploring more synergy between our intelligent devices and online services. For student acquisition costs, Q3 saw higher costs due to increased demand, which normalized post-summer. During the school year, students and parents typically wait for the winter season before choosing after-school programs. We actively try to use multiple customer acquisition channels, and we will closely monitor customer acquisition costs to keep our business growing healthily.

Yes, definitely. Thank you. Very helpful.

Next question comes from Sheng Zhong with Morgan Stanley.

I have a couple of small questions. The first one is a follow-up about the internal MAU customer conversion. So, you have quick MAU growth. And also, you have smart devices shipment to students. Can you share the number? How much percent of your enrollment is from your MA and your internal traffic? And do you have any expectation on this number going forward? The second is, you have a very strong gross margin improvement in the past few quarters, especially in the premium online courses. So, what's your view about the normalized gross profit margin for your online courses? Lastly, can you share some color on your retention rates for this fourth semester for winter courses? Thank you very much.

Regarding converting MAUs from our organic traffic to paying users, I can provide one data point: 22% of all our billings in Q3 came from internal traffic, which is a 188% growth over the same period last year. In terms of long-term, if you compute that number as a percentage of MAU of over RMB 100 million, it's still very low, less than 1%. There is still a lot of room for growth, and we believe a couple of percentage points is doable. This is partly due to the big price gaps between the free products and courses costing several thousand RMBs. We're becoming quite experienced at this now. The data shows we have opportunities to offer more relevant courses to facilitate conversion. Regarding learning devices, we feel it's a good source of organic conversion too, given the over 250,000 dictionary pens sold in Q3. As for gross margins in the long run, right now, we are around 50%, and we believe 60-70% is completely doable, based on many various factors. Lastly, regarding retention, we have begun signing up current students for winter and spring courses in late October. Preliminary data suggests significant increases in both new students and improved retention rates compared to the past year. We feel positive about our results at the end of the retention period in January.

The next question comes from Alex Xie with Credit Suisse.

Congratulations on the quarter. My question will be about the competitive landscape. Several of the new players in this market made the comment that the top four players in K-12 have advantages, and the non-top four will become bigger and bigger, and we will also see several players raising funding recently. So, what will be the positioning of Youdao in this market? How do you think about competitive advantages in this kind of environment? Thank you.

About the competitive landscape, I would say we do not operate purely around market share. Our competitive strength focuses on three areas: high-quality content, product innovation, and great technology. We don't intend to cover all grades and courses; our focus is currently on junior high and high school. From our track record, our emphasis on quality has enabled us to deliver bestseller courses like Logical English and our junior high school Chinese course. Innovation has helped us create new categories like the dictionary pen that has been growing quickly. In Q3, we added many students because we believe our products offer great value and retention. We expect to continue expanding our scale and have a strong product pipeline for both K-12 and adult courses. We will grow our business through quality product development rather than simply spending on sales and marketing.

I have a follow-up on this question. Given the recent funding raises among several new players, what do you consider as the conditions for Youdao to raise funding, or are there conditions under which you would not consider raising funding? Thank you.

We are satisfied with our current cash position. If you look at our operating cash flow for the first three quarters, it is actually a healthy process for us. We have ways to raise funding if we need, but we will keep that in mind. Our controlling shareholder, NetEase, has always been very supportive of Youdao's business and fully believes in our vision. They will always have our back.

The next question comes from an unidentified analyst with CICC.

I have two questions. First, we noticed strong growth in our learning devices. What is the reason for that, and what will be Youdao's future strategy for this business? What potential market share do we expect to capture in the future? The second question is about the gross profit margin. We have observed a significant improvement in the gross profit margin. Could management provide the average number of students per course for K-12 courses? Additionally, what is the average number of students served by each teacher? Thank you.

This is Su Peng. For the intelligent devices, as Dr. Zhou mentioned, this sector was developed by the Youdao team. The Q3 shipment numbers for the dictionary pen show fast growth. We are fully confident that numbers will continue to grow. We are expecting to build up more intelligent pipelines in the future that will combine with online education services. The market potential is tremendous. As for GP margin improvement, we have indeed seen significant growth due to economies of scale and restructuring of our business and faculty compensation structure. Regarding average class sizes, we have offered many star teachers in the past quarters. While that number has increased slightly, we have to pre-hire employees to serve students, which means some tutors may still be in training. The operating efficiency improved significantly compared to the same period last year, and we are confident about gradually increasing our GP margin in the next few quarters.

We will have a new version on December 1. We are very pleased with the innovation in this new version. It's crucial to understand that these devices are more than just hardware; they integrate unique content and technology. This results in good margins and strong user loyalty.

Next question comes from Binnie Wong with HSBC.

I have a question regarding the competitive landscape. How do you see that evolve into 2021, especially when many private players have been raising capital? Do you think we will step up marketing expenses to drive faster growth or look at strategies that can yield more? Additionally, can you provide cross-selling ratios from the Youdao app, the dictionary app to the premium courses? We noticed premium course growth accelerated to 300% year-over-year from a 200% growth last quarter. What are some key factors behind this growth? Thank you.

This is Wayne. As mentioned previously, the competition landscape is changing quickly. Companies with capital will be in a better position to face competition. We feel comfortable with our current cash level, as we have positive cash flow from earlier quarters and financial support from our parent company, NetEase. While we don't expect huge cash inflows for the 2020 fiscal year, we have seen our learning services and products business grow quickly. As for competition in user acquisition, it seems companies are picking higher paying users due to favorable market conditions. They are also diversifying acquisition channels for better cost-benefit balances. The market size potential is massive, and as competition becomes more concentrated, if our unit economics are healthy, we will continue to take advantage of these opportunities for growth.

I have a follow-up question.

What's your follow-up question?

I have a follow-up question. What's your follow-up question?

In Q3, we significantly raised our sales and marketing efforts, and we see Q3 as the largest investment of 2020. Looking ahead to next year, we also anticipate opportunities to attract users in the following summer. However, we intend to approach this thoughtfully; we are aware of the importance of healthy unit economics and have prepared budgets for future quarters. We will take action when we see adequately positive returns on our investments. Given that our marketing spending is front-loaded, success in future quarters will guide decisions on additional marketing investments based on user engagement.

Indeed, while sales and marketing are drivers of business growth, fundamental product quality and differentiation are critical to the overall market structure. Approval from students and parents hinges on the quality and effectiveness of the services we provide. That is why our focus has been on enhancing our number of star teachers, increasing our number of teaching assistants, along with our sales and marketing efforts during the summer.

The next question comes from Thomas Chong with Jefferies.

My question is about our advertising services. Given our large user scale, can you comment on how these business lines will trend in the coming quarters? Separately, regarding our free cash flow, do we have a timeline for breakeven or achieving positive cash flow?

For advertising services, although there is fierce competition, we believe there are strong opportunities, especially among younger generations. We have seen impressive revenue growth and improvements in GP margins this Q3 compared to last year. We are confident about healthy growth for our advertising business moving forward. However, our online courses are expected to grow much faster than advertising, meaning that, as a percentage, advertising will likely trend downward in coming quarters, which we feel is a healthy outcome as our primary focus remains on courses and education-related business, including intelligent devices.

This concludes our question-and-answer session. I would now like to turn the conference back over to Regina for any additional or closing comments.

If you have any further questions, please reach out to Youdao directly or contact our investor relations team in China or the US. Have a great day.

This concludes our conference. You may now disconnect. Thank you for attending.