Youdao, Inc. Q1 FY2021 Earnings Call

Good day, and welcome to the Youdao 2021 First Quarter Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Jeffrey Wang, Investor Relations Director of Youdao. Please go ahead.

Thank you, operator. Please note the discussion today will contain forward-looking statements relating to the future performance of the company, which 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 future performance and are subject to certain risks and uncertainties, assumptions, and other factors, some of which 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. 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 the definitions of the non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2021 first-quarter financial results news release issued earlier today. As a reminder, the 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 are 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, Jeffrey, 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. We achieved sound and sustainable growth across our businesses in the first quarter of this year. Total revenue in Q1 was RMB 1.3 billion. Net revenue from K-12 is RMB 639 million, up 217% year-over-year. Meanwhile, gross billings from K-12 reached RMB 442 million in this quarter, up 130% year-over-year. Paid student enrollments from K-12 climbed to 306,000, up 100% year-over-year. With larger scale, we have achieved higher operating efficiency. Gross billings from K-12 and adult segments reached approximately RMB 742 million. Brand and performance advertisement spending on courses amounted to approximately RMB 556 million. Compared with Q3 2020, the last quarter with mostly new student acquisitions and almost no renewals, our return on investment, or ROI, improved by more than 30%. Gross billings from the adult segment reached RMB 299 million in the first quarter of this year, up 17% year-over-year. Remember that the outbreak of COVID-19 in Q1 2020 led to a higher base and thus more moderate year-over-year growth of the adult segment. Margins were also improving. Gross profit margins from learning services reached 65% in the first quarter of this year, up from 51% in Q1 2020. It is the best level since we became public. Operating loss margin narrowed down to 23.9% in the first quarter of this year compared with 32% in Q1 2020. With that financial overview, I would like to review some business highlights. Looking at our K-12 segment, we launched the industry’s first localized version of junior high school Chinese with 2 instructors during the spring semester in Q1. One instructor covers nationwide content and the other covers localized content. More than 50% of our junior high school Chinese course students opted for this localized version of junior high school Chinese, reflecting high interest in this course format. Course participation and satisfaction data were also promising. As for high school and primary school segments, we continued to polish courses and offered more tailor-made math content to students of different learning levels. Gross billings of high school math increased by over 210% year-over-year in Q1 2021. We had 197 instructors and 4,093 tutors at the end of Q1 2021. For our extracurricular segments, Youdao Weiqi, or Youdao Zongheng in Chinese, we maintained a strong momentum from last quarter and achieved more than 100% quarter-over-quarter growth in gross billings. In the meantime, Youdao Zongheng sponsored the Jiangsu Weiqi Youth Team, and we signed Ke Jie, 8-time Weiqi world champion as our brand spokesperson. As for our adult segment, in March 2021, we established the Adult Education business unit. This put several teams under the same umbrella, including the adult-oriented courses in Youdao Premium Courses, NetEase Cloud Classroom, and China University MOOC. New courses will be released under the NetEase Cloud Classroom brand, concentrating our investments in a single brand. According to our data, the Extraordinary Memory course has become the #1 memory-oriented course in the industry, only 3 quarters into its operation. Our intelligent learning devices also grew at an accelerated pace in Q1. I’d like to highlight that gross profit margin hit 44% in the first quarter, a record high for our devices compared with 25.6% in Q1 2020. In March, we introduced Youdao Dictionary Pen 3 Pro, further supporting bilingual translation of Japanese and Korean to meet the demand of more language learners. We shipped over 297,000 units of our Dictionary Pen series in Q1, up 198% year-over-year. We are only getting started. We have more device products in the pipeline for 2021, and our teams are very excited about them. As for our mobile learning apps, we launched a short video feature called WOW Community, WOW Trend in Youdao Dictionary. Users and content creators could finally share short videos about learning and fun things in their lives in Youdao Dictionary. This led to users staying much longer on Youdao Dictionary. This, along with other improvements of our apps, facilitated organic traffic growth. In the first quarter of this year, 26% of all newly enrolled students’ gross billings came from organic traffic. Gross billings from the K-12 segment generated by organic traffic increased by 129% year-over-year. Let us quickly discuss the potential additional regulations on the AST market. The new regulation is not out yet. Obviously, we will not know the details until it is made available. With that said, we continue to hold a cautiously optimistic attitude towards business operations under the new regulatory environment. We believe the purpose here is to curb unorderly competition and promote healthy developments of the industry. This will ultimately benefit highly compliant players of scale in the mid to long term. We believe our product and strategy are very competitive with our high-quality content and increasingly advanced application of AI technology. Our diversified business lines, including learning devices and adult courses, could help us better navigate the evolving online education industry. Now let us turn our attention to other aspects of the company. We pay attention to fulfilling social responsibilities while we operate our business. In Q1, we made several donations, including to Leibo Middle School in Liangshan, Sichuan province. NetEase donated RMB 66 million to the Yau Shing-Tung Science Foundation to support its math research. We are looking forward to further cooperation with Mr. Yau’s team in AI and basic education areas. As we are still working towards profitability, in Q1, we secured additional funding to support our long-term plan. We raised approximately USD 232 million through a follow-on offering in February. NetEase recently offered us a USD 300 million loan facility agreement. In addition, a bank group provided a commitment letter in April with a 3-year USD 150 million revolving loan facility under the guarantee of NetEase. In total, that is over USD 680 million of additional funding. Looking ahead, we are confident we can build on our position as a top-quality course provider and producer of industry-leading intelligent learning devices and products to meet our customers’ needs. Our diversified business model, along with products and technologies that truly improve learning efficiency, will help us navigate the evolving AST and EdTech market. 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 2021 first quarter. We encourage you to read through our press release issued earlier today for further details. We started the year with a robust first quarter with multiple operational and financial achievements. Total gross billings from our online courses reached RMB 808.7 million for the first quarter, up 55.9% from Q1 2020. Gross billings from our premium courses rose to RMB 741.5 million, up 66.2% year-over-year. Our K-12 segment continued to lead our growth, reaching RMB 442.2 million in gross billing in the first quarter, up 130.2% year-over-year. Paid student enrollments from our K-12 group reached 306,000 in Q1, up 100.3% year-over-year. Paid student enrollments for premium courses were up by 75.6% year-over-year. 29% of our K-12 newly enrolled students’ gross billings came from organic traffic for Q1, which grew 129% year-over-year. This growth shows not only our determination, but also our ability to quickly expand our business, and that our model is working. For the first quarter, total net revenue reached a record RMB 1.3 billion or USD 204.5 million. This represents an increase of 147.5% from the first quarter of 2020. Looking at this growth by segment, net revenue from our learning services was RMB 998.9 million or USD 152.5 million, up 156.8% from the same period in 2020. We attribute this growth to the increased revenue generated from our online courses, which were further driven by a substantial increase in paid student enrollments for the K-12 courses of the Youdao premium courses. Net revenue from our learning products was RMB 201.9 million or USD 30.8 million, up 279.8% from the same period in 2020, driven by increased sales of our Youdao Dictionary Pen of over 297,000 units in the first quarter. Net revenue from our online marketing services was RMB 139.1 million or USD 21.2 million, representing a 40.1% increase from the same period in 2020. For the first quarter of 2021, our total gross profit greatly improved, reaching RMB 767.5 million or USD 117.1 million, up 225.6% compared with the first quarter of 2020. Gross margin for learning services increased to 65.6% for the first quarter of 2021, up from 51.9% for the first quarter of 2020. The growth was primarily attributable to better economies of scale and the further optimization of our faculty compensation structure. Gross margin for learning products increased to 44.1% for the first quarter from 25.6% for the same period in 2020. The growth was driven by tremendous growth in sales of our Youdao Dictionary Pen Version 3, which carries a higher gross margin profile than other learning products. Gross margin for online marketing services was 16.4% for the first quarter of 2021 compared with 20.5% for the same period in 2020. The decrease was mainly due to the increase in performance-based advertisements through third-party Internet properties, which carried lower margins. For the first quarter, total operating expenses were RMB 1.1 billion or USD 166.1 million compared with RMB 411.7 million for the same period last year. We continue to invest in our future and top-line expansion, specifically technology, acquiring talented teachers, and sales and marketing efforts focused on student acquisition and expanding our branding awareness. In Q1, brand and performance advertisement spending on courses amounted to approximately RMB 555.9 million. With that, for the first quarter, our sales and marketing expenses were RMB 883.9 million compared with RMB 299.2 million in the first quarter of 2020. Research and development expenses were RMB 155.1 million compared with RMB 84.1 million in the first quarter of 2020. Our operating loss margin was 23.9% in the first quarter of 2021 compared with 32.5% for the same period last year. For the first quarter of 2021, our net loss attributable to ordinary shareholders was RMB 325.8 million or USD 49.7 million compared with RMB 169.4 million for the same period last year. Non-GAAP net loss attributable to ordinary shareholders for the first quarter was RMB 307.8 million or USD 47 million compared with RMB 161.9 million for the comparable period last year. Basic and diluted net loss per ADS for the first quarter was RMB 2.75 or USD 0.42. Non-GAAP basic and diluted net loss per ADS for the first quarter was RMB 2.6 or USD 0.4. Our net cash used in operating activities for the first quarter was RMB 517.8 million or USD 79 million. Looking at our balance sheet as of March 31, 2021, our contract liability, which mainly consists of deferred revenue for our online courses, was RMB 1.2 billion or USD 186.5 million compared with RMB 1.4 billion as of December 31, 2020. At the end of the period, our cash, cash equivalents, time deposits and short-term investments totaled RMB 2.2 billion or USD 333.7 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

The first question comes from Sheng Zhong with Morgan Stanley.

I have 2 questions. The first one is, can you share more details about the current promotion and advertisement status in the market? And what’s your promotion plan for the summer holiday? Do you have any budget you can share with us regarding marketing? And secondly, we know there were a lot of uncertainties about the regulation. Can you please share some more about your operation, like the retention rate after your localized content? Also, what’s your current growth target for the K-12 after-school tutoring business? At the same time, we see with the regulation tightening or uncertainty, a lot of competition has increased in the non-K-12 segment, including the hardware learning devices and adult education. So what’s your view about these sectors, the growth, and whether you will also invest more in this non-K-12 business?

Thanks, Sheng. So regarding the current proposed promotional activities in the market, yes, the first is that currently we are running advertisements on non-mainstream media only. Recent changes do not allow the AST business to run ads on mainstream media anymore right now. So we’re running ads on non-mainstream media, and also the scrutiny for the materials, the ad materials, has become stricter. From our side, we have always been fully compliant with the regulation. So we think it’s a smooth process for us. We do need some changes, but the changes are not much. This is the current update on the ads. As you probably know, we have suspended advance enrollments and fee collection for the fall semester as required by the authority. These courses will be sold at a later time. Right now, only spring and summer semester courses are being sold. Overall, we have already been compliant with the current regulation. Regarding the new regulation, it’s not out yet, so we don’t know the details. As I said in the prepared remarks, we are cautiously optimistic about the coming future operation, in particular, the summer operation. Yes, so there’s a cost to being compliant under stricter regulation. However, we have several reasons that we think we can be cautiously optimistic about. First, leading companies have a history of being more compliant compared with the smaller ones. Thus, relatively speaking, the leading companies could be at an advantage when the new regulation is out. Also, we have a diversified business line. This is a choice we made a couple of years ago, not necessarily for regulation compliance, but to broaden our potential for innovation. Diversification obviously has its benefits when there is more regulation. Our learning devices and adult education business will probably not be impacted by this round of regulation as far as we know. For the summer, basically, the current actions the teams have taken are that we have several plans ready. The structure of the courses will be a little bit different, but we believe we will have solid plans to execute when the regulation comes up. We remain cautiously optimistic. Lastly, I want to mention that the industry has a sort of theater effect. It’s not a good thing. So everybody goes forward. For example, institutions compete to set their enrollment dates earlier and earlier every year. Now the enrollment dates have been pushed back kind of together. We think this leads to more orderly business. The closer it gets to when the course starts, the better the conversion rates. That’s our view on regulation. As for the summer plan, we have a couple of plans ready. We will know which plan to execute when the regulation actually comes out. I think you also asked about more competition in the non-K-12 front, hardware, adults. This overall direction plays in our favor because we have been working on the hardware business for almost 4 years now. We all know that it’s really hard to make devices. A lot of challenges include managing inventory, supply chains, and quality issues. We have gone through all that, so we think it’s positive that more people are paying attention to learning devices. When others go to advertisements, it also helps people pay more attention to this whole segment. We believe it’s a way to build the segment as an industry. We are not worried about more competition. We will treat every competitor very seriously and pay a lot of attention, but we think it’s a good thing that people are increasingly paying attention to these segments. It’s a testament to the strategy we set some time ago.

Yes. Just one more point to add with Dr. Zhou’s comments. Yes, as far as compliance is concerned, Youdao right now is strictly in compliance with all existing regulations as well as being fully confident we will comply with all upcoming regulations in the future. Also, just like Dr. Zhou mentioned, there may be some effect on mainstream media advertisements, but right now, for new media platforms and the Internet, social networks aren’t impacted. We can execute our customer acquisition plan without issue for now. We are watching closely for regulation movements and will ensure compliance with any upcoming regulations.

The next question comes from Brian Gong with Citigroup.

So my question is still regarding regulation. Given the current regulatory environment, can management share our growth strategies going forward for the entire company? Have we figured out any new ways to gain students? Another quick question is about our GP margin of learning services, which jumped a lot in the fourth quarter? How should we look at the trend ahead?

Okay. I’ll take the first question. Regarding new ways to acquire customers, we are looking at many different fronts, including customer referrals and expanding our existing customers. These efforts have recently picked up really well. Another area we are focusing on is converting our organic users. As we just talked about, 26% of K-12 gross billing comes from our organic traffic. In Q1, the WOW community, the short video community on the dictionary, is a good example of that effort because video is becoming really popular as the cost of bandwidth has come down to near zero, especially among the younger generation who love watching videos on their cell phones. Q1 was the quarter where we released it, and we have already seen promising results. As we said, the average time a user spends on the Dictionary has doubled because of this feature. It is a very effective feature that allows us to show a lot of content. One of the key types of content is converting users to our courses. We also have some progress on offline channels, with several approaches yielding good results, while others are still in the works. Overall, the teams are confident they can make significant strides. Even if we experience some setbacks from regulatory changes, other channels can make up the losses. So we are cautiously optimistic about that. I don’t know, Su Peng, if you have anything to add.

Yes, I just have one more point to add regarding our growth strategy. Besides Dr. Zhou’s comments about handling the K-12 business, we also operate several different businesses under Youdao, like adult education and hardware. We don’t see these areas being significantly impacted by upcoming regulations. We have built experience and insights over the years in operating these businesses. Our strategy involves rebuilding some barriers in these sectors to drive total business growth, ensured by both K-12 demands and growth from adult education and hardware.

As for the second question, the gross margin of our learning services has shown good performance this quarter. It is the first quarter to achieve over 50% gross profit margin in the learning services segment. We believe the key point is our capability to offer good quality services at a good price, driven by our skilled instructors, technology, and the synergy of our projects with other businesses. We are committed to the strategy and will continue to invest more. The continued economic scale on revenue and the improvement in our compensation structure mainly contributed to the improvement in gross profit margin. This quarter’s high gross profit margin is attributed to our high revenue base of our online courses because more courses were delivered in Q1. We believe there is some seasonality in the learning services gross profit margin. In the long run, we expect the annual gross margin on our learning services to stabilize around 60% this year. I think this is helpful for your question.

The next question comes from Hongyi Zhao with CICC.

First, congratulations on the great performance this quarter. I have 2 questions. First, since you have introduced many business strategies for the non-K-12 business, does this mean, based on the policy uncertainty for the K-12 business, are we going to switch our attention or put more investment into the adult business and learning products in the future? What’s the strategy for the long term? Second, are we considering developing more offline strategies, such as opening experience stores as part of our traffic acquisition strategy?

Yes, I will take the first one. Regarding investments in the non-K-12 segment, we will keep executing our plan for 2021, which took into account the growth needs of both the hardware and adult segments for us. Currently, we do not foresee significant changes to our investment strategy in other segments compared to K-12. Both hardware and adult education are interesting and promising areas. I would like to highlight our thinking behind the adult education segment: we believe in its long-term potential, and we have leading assets and experience in this space. Lifelong learning in China is expected to take off as the economy continues to grow, and more people recognize the need to become lifelong learners. Our adult education products are well-positioned for this trend. In examining the sector’s history, we note that successful businesses have developed in ESL and civil servant exam test preparation—these are billion-dollar businesses. New verticals and new models for existing ones are likely to evolve. Our strategy involves reimagining existing verticals and identifying potential new ones. For instance, our ESL courses, such as the popular Youdao’s English course, are already successful examples of innovation.

Regarding our offline strategies and growing customer acquisition methods: we have reported in recent quarters about setting up offline execution stores, which are not learning centers since we don’t deliver services there. We are exploring effective strategies for offline customer acquisitions across different provinces. We’ve seen promising feedback during our testing phase over the last few months; however, our scale is still relatively small. We’ll provide more updates as we gather scalable data.

The next question comes from Jessie Xu with Nomura.

We noticed that the revenue growth of smart devices has been very strong for the past few quarters. Should we expect the momentum to continue? Additionally, are there opportunities for cross-selling with Youdao premium courses?

Thanks, Jessie. Yes, the revenue growth of smart devices is looking very good. Traditionally, Q4 is a strong quarter, and Q1 numbers reflect our satisfaction with the performance. We have new products upcoming this year, though we don’t disclose specifics before they launch. Different categories of products will be released this year, aimed at serving various needs. Typically, we see stronger revenue in Q3 and Q4, marking the start of a new academic year and a robust e-commerce quarter. So Q3 is expected to be a crucial quarter for our smart devices. The team is filled with ideas and projects. We think this will be a fruitful year for learning devices.

To elaborate on our smart devices offerings, we are enhancing the list of apps available on our devices, providing more user-friendly functions. Our focus remains on productivity and continuously updating our existing products, like the Dictionary Pen series. We delivered an effective learning experience combining all our smart devices and apps, enhancing synergy particularly between the Dictionary app and Youdao Dictionary Pens. Dictionary Pen users now find their personal learning summaries and vocabulary notebooks integrated within the Youdao Dictionary app.

The next question comes from Charlotte Wei with HSBC.

Congratulations on a very strong quarter. I have a small follow-up question regarding regulation. There are news reports stating that online education players are not allowed to offer classes below cost. Is this a confirmed rule or just a rumor? How will this affect the strategy of entry courses to attract new users? Also, how are our summer promotion plans progressing?

Regarding the sale of courses below cost, we are in ongoing discussions with the authorities. For now, I am being conservative. For our summer courses, we have actually raised the prices of some courses after reviewing them. We are awaiting clarification from the authorities on this issue and other matters, and we expect to receive guidance soon. The key point here is that our conversion funnels for acquiring new customers remain robust. Our teams are experienced enough to adapt to changes in user acquisition channels and course pricing as needed.

I have one more question regarding the K-12 business. I’m wondering what is the revenue contribution percentage from non-subject tutoring?

Yes, regarding non-subject tutoring, we have received promising feedback on our programs, especially for preschool and primary school aged students. We see significant potential in this area driven by demand from parents and users. We expect to enhance our capabilities in performance-based programs catered to young students, leveraging our experience developed over several years. We are in a strong position for this program.

The next question comes from Linda Huang with Macquarie.

I have one question. This is regarding our gross billing. For this quarter, we saw gross billing grow by 56%, which seems to be the slowest growth since we went public. How should we interpret this number? Is there any reason behind the slowdown for gross billing, and should we be concerned that our growth is likely to moderate in the coming quarters? Additionally, for enrollment, we have seen almost a 100% increase this quarter, but compared to previous quarters, it’s almost half of the 200% to 300% growth. Should we expect a moderating trend in growth?

The first is about total gross billing. Indeed, we’ve seen moderation in growth compared with the same period last year. This is due to the adult business, which only saw double-digit growth in Q1, a result of COVID-19 impacting the last year’s figures. Specifically, our K-12 segment still grew by 130.2% year-over-year, reflecting strong performance. If we focus solely on K-12, we would see strong momentum. For enrollment, Q1 is not the major season for customer acquisition and we believe there is still excellent growth potential. Historically, we accelerated growth from Q1 to Q4, so we expect the same pattern for this year. However, factors like the surrounding environment and regulations could potentially impact growth rates.

And that concludes the question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

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 in China or the U.S. Have a great day.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.