Youdao, Inc. Q3 FY2022 Earnings Call

Good day and welcome to the Youdao 2022 Third 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 related to 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 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 U.S. 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 non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2022 third 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 is Dr. Feng Zhou, our Chief Executive Officer, Mr. Lei Jin, our President, 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 the financial information and non-GAAP financial information mentioned in this release is presented on a continuing operations basis, and all numbers are based on Renminbi, unless otherwise specifically stated. We had a strong third quarter with solid financial and operating results. Our net revenues reached a record-high of RMB 1.4 billion, up 35.0% year-over-year. Total gross margin climbed to a record-high of 54.2%, improving 1.6% year-over-year. These results were attributable to the strong performances of our new services and smart devices. Sales of digital content services reached over RMB 400 million with a gross margin ratio exceeding 60%. For smart devices, the first 100,000 units of the newly launched Youdao Dictionary Pen X5 have been sold out, propelling net revenues from smart devices to RMB 356.5 million in Q3, a new record. In fact, net revenues from the Youdao Dictionary Pen series in Q3 this year have grown tenfold compared with Q3 2019 after Youdao Dictionary Pen 2 was launched. The first 10,000 units of the Youdao Smart Learning Pad Y10 released in August have also been sold out, reflecting strong demand for this new category. In terms of our operating loss, it narrowed to RMB 219 million with an operating loss margin narrowing by 6.1% year-over-year to 15.6%. We have improved the margin structures of our business lines while growing their top line at the same time. For example, in Q3, for digital content services, Youdao Dictionary Pen and Youdao Listening Pod, their net revenues could cover their costs and operating expenses, respectively. Today we announced that the board of directors has authorized the Company to adopt a share repurchase program in the near future in accordance with applicable laws and regulations for up to US$20 million of its Class A ordinary shares including in the form of ADS during a period of up to 36 months. We are bullish about the future growth of the business. With that overview, I would like to share more color on our business lines in Q3. Smart devices revenue reached RMB 356.5 million in Q3, a new record for the sector and up 40.1% year-over-year. Gross margin of smart devices reached 40.4%, up 6.7% year-over-year, mainly due to the launch of new products. The application of advanced AI technology and unique learning content makes us confident that the gross margin of smart devices will be around 40% in the long run. Our new flagship Dictionary Pen, Youdao Dictionary Pen X5, is a great showcase of our strength in R&D and product innovation. In fact, in September, we couldn't make enough X5s due to strong demand. Not only did X5 feature even better translation precision, support for over 100 languages and a whole-new design, it also includes the world's first smart dictionary pen operating system. It allows users to download apps to customize the dictionary pen to their liking with endless possibilities. Many top content providers were already onboard, including Ximalaya FM, RAZ English, NetEase Cloud Music, and Kaishu Storytelling. They all created apps using our easy-to-use Software Development Kit and offered them on Youdao Dictionary Pens, creating a unique ecosystem that will grow stronger when more consumers and developers join in. Recently, we launched Youdao Smart Learning Pad X10, our second learning pad product, with significantly improved AI precision learning, larger screen, more storage and other improvements. In the long term, the learning pad has significant market potential. According to Frost & Sullivan, the expected volume of education tablets is likely to reach 7.26 million units in 2025, with total sales of RMB 25.4 billion. Our AI adaptive learning feature provides high-quality personalized learning for students and has received very positive feedback from consumers. Over time, we expect the Youdao Smart Learning Pad to become as popular as our Youdao Dictionary Pen. Then let’s turn to learning services. Net revenues from learning services reached a record-high of RMB 888.5 million in Q3, up 37.2% year-over-year, with a relatively flat gross margin of 64.5%. Breaking this down a bit further, net revenues from STEAM courses increased by more than 200% year-over-year and accounted for over 25% of the net revenues of this segment. We continued to make progress on the Youdao Go course. In collaboration with the Chinese Weiqi Association and the Jiangsu Chess Sports Association, we held the National Children’s Weiqi Open Championship in Q3, which was highly recognized by the General Administration of Sport of China. As for adult courses, we see a downward trend in gross margins year-over-year, mainly due to the macro environment. We are actively realigning our resources to focus on growth areas in this segment. Graduate school entrance exams and vocational courses are two bright spots. Their gross billings increased by over 150% and over 200% year-over-year respectively. Looking forward, we are confident in our operations in Q4. The transition from regulatory changes last year is mostly finished. For the last four quarters, we have maintained our investment level for our business, kept innovating in challenging times, and this allowed us to gain share in the market. It was made possible by the long-term investment in AI technology and a diversified product portfolio, and also by firm support from our parent NetEase group. Going forward, we believe we are in a good position today to achieve sustainable growth and drive towards profitability with a portfolio of strong products and businesses. Our team continues to capitalize on tailwinds including the quick adoption of smart learning devices, digital content services, and STEAM courses. We look forward to bringing our products and services to more and more consumers. With that, I will turn the call over to Su Peng to give you more details on our financial performance.

Thank you, Dr. Zhou, and hello everyone. Today I will be presenting some financial highlights for the third quarter of 2022. We encourage you to read through our press release issued earlier today for further details. For the third quarter, total net revenues were RMB 1.4 billion, or US$197.2 million. This represents an increase of 35% from the third quarter of 2021. Net revenues from our learning services were RMB 888.5 million, or US$124.9 million, representing a 37.2% increase from the same period in 2021. We attribute this growth to the strong sales performance from the new services initiated after the implementation of the "Double Reduction" Policy. Net revenues from our smart devices were RMB 356.5 million, or US$50.1 million, up 40.1% from the same period in 2021, driven by the popularity of the newly launched products in 2022. Net revenues from our online marketing services were RMB 157.5 million, or US$22.1 million, representing a 14.9% increase from the same period in 2021. The increase was mainly attributable to the increase in performance-based advertisements through third parties' internet properties. For the third quarter, our total gross profit was RMB 760.2 million, or US$106.9 million, representing a 39% increase from the third quarter of 2021. Gross margin for learning services was 64.5% for the third quarter of 2022, compared with 65% for the same period in 2021. Gross margin for smart devices was 40.4% for the third quarter of 2022, compared with 33.7% for the same period in 2021. Gross margin for online marketing services was 27.1% for the third quarter of 2022, compared with 29.2% for the third quarter of 2021. For the third quarter, total operating expenses were RMB 979.2 million, or US$137.7 million, compared with RMB 772.6 million for the same period of last year. With that, for the third quarter, our sales and marketing expenses were RMB 709.8 million, compared with RMB 553.4 million in the third quarter of 2021. Research and development expenses were RMB 212.9 million, compared with RMB 163.6 million in the third quarter of 2021. Our operating loss margin was 15.6% in the third quarter of 2022, compared with 21.7% for the same period of last year. For the third quarter of 2022, our net loss from continuing operations attributable to ordinary shareholders was RMB 183.9 million, or US$25.9 million, compared with RMB 225.3 million for the same period of last year. Non-GAAP net loss from our continuing operations attributable to ordinary shareholders for the third quarter was RMB 164.4 million, or US$23.1 million, compared with RMB 200.2 million for the same period of last year. Basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for the third quarter of 2022 was RMB 1.49, or US$0.21. Non-GAAP basic and diluted net loss from continuing operations per ADS for the third quarter was RMB 1.33, or US$0.19. Our net cash used in continuing operating activities was RMB 294.1 million, or US$41.3 million, for the third quarter. Looking at our balance sheet, as of September 30, 2022, our contract liabilities, which mainly consist of deferred revenue generated from our learning services, were RMB 996.5 million, or US$140.1 million, compared with RMB 1.1 billion as of December 31, 2021. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB 953.1 million, or US$134 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.

Our first question comes from Brian Gong with Citigroup.

Congratulations on the solid results. So I saw the revenue increased roughly in the third quarter and may I know what's the main contributors to our rapid transition? And how should we look at the growth trend in the future?

So as for Q3 growth, data content services and smart devices are the two main drivers for this quarter for our growth. And both are based on our strength in technology R&D, as you know. So digital content services are doing well. So compared with the online services that we offered before, the difference is they are mostly prerecorded video content or interactive learning or STEAM content STEAM courses. As with our courses before, they are live courses mainly. So the form is different. So it's a new product after last year. So in Q3, digital content services have maintained strong momentum. So sales reached over RMB 400 million compared with over RMB 200 million in Q2. So basically doubled quarter-to-quarter. So while gross margin also rose from over 50% in Q2 to over 60% in Q3. Moreover, net revenues from digital content services can cover their costs and operating expenses in Q3. So this supports our bottom line improvements in this quarter. Secondly, Smart Devices revenues are at, as you can see, a record high of RMB 356 million, up 40% year-over-year in Q3. Moreover, this growth also comes with healthy operating metrics. So net revenue from Youdao Dictionary Pen and Youdao Listening Pod, for these two products, they can also cover their own costs and expenses in Q3. One product that's pretty important is the Dictionary Pen X5 launched in August. So this new generation of Dictionary Pen supports online translation of over 100 languages and is equipped with the world's first Dictionary Pen operating system, a smart operating system. So after its release, it's already the top seller of Dictionary Pens or electronic dictionaries on both JD.com and Tmall, selling out the first batch of 100,000 units quickly. So the launch of another product is the Youdao Smart Learning Pad Y10, and also more recently, X10. So this marked our entry into the learning tablet market and the first batch of 10,000 Y10 units sold out in about 2 months. So that gives our teams more confidence in this category. So our plan is to have a steady flow of new smart learning device products to drive sustainable growth in this category. Recently after Q3, we launched three more new products. That is Youdao Dictionary Pen P5 for more advanced learners and professionals. And also, Youdao Smart Learning Pad X10, which I just mentioned. So with the learning dashboard that further improves the AI precision learning experience and lastly, an upgraded version of Youdao Listening Pod with new English and Chinese content in line with textbooks. Also with more advanced AI technology helps users improve listening and speaking skills in both English and Chinese. So given the strong pipelines we sold more than 100,000 units of Youdao Dictionary Pens in the Singles Day on November 11 shopping festival this year, so over 100,000 Youdao Dictionary Pens. Yes. So that's an overview of drivers of growth for Q3.

Our next question comes from Hongyi Cao with CICC.

Congratulations on the good performance. We can see the strong growth of net revenue, but Youdao still faces an operating loss. So my question is, what are our strategies for improving the loss-making factors?

That's a very natural question. So first, I would say that driving towards profitability is a priority for us. The operating loss in Q3 mainly came from our early-stage products and businesses. These include STEAM courses, Youdao Smart Learning Pad of the new device, and education digitization solutions. These are the three significant loss makers. Yes, we have plans for profitability for each product area here. So let me break that down a little bit. Our STEAM courses are growing fast, and we believe they have a bright future. For this segment, what we are doing is optimizing our product offerings and marketing tactics. And we're seeing continuous improvements in return on investments every month. The Go courses are more mature overall compared to the STEAM courses. Our other STEAM courses such as chess programming, science music, and Chinese painting are mostly still in their early days. The investments we made in these areas are paying off. Youdao Go and its compelling app have accumulated over 1.6 million users and are already the leader in online Go learning in China. That's for the STEAM courses. For Smart Learning Pad, it is a strategic product for us and is in the early stages. The opportunity here is that the learning pad market is going through a generational transformation from a hardware and content-based business to a technology-centered, AI adaptive learning-based business. We are taking advantage of this transformational opportunity, and it is a very good investment for us. Very importantly, the first two products, Y10 and X10, are off to a good start, and we believe they have a bright future. As for the third category, the education digitization solutions, we recently reduced our resources here. There is progress in our products and services. Our campus board education digitalization solution with Vision analytics was released and started to enter schools, and schools like them. However, due to macroeconomic challenges, the landscape has been different from our projections one or two years ago. Yes, spending on digitalization solutions has been slower than we expected. Our goal here is to find better product positions in this challenging environment with less resources and achieve profitable growth. If we add up all our business that's operating profitably and also these three loss makers together, we've been able to narrow our net operating cash outflow to RMB 294 million in Q3. Operating loss also improved to RMB 219 million with operating loss margin improving 6.1% year-over-year. Going forward, the plan is to operate prudently, grow the business while, at the same time, drive towards profitability. I hope that answers the question.

Our next question comes from Thomas Chong with Jefferies.

In Q2, I think we mentioned that we are confident in the prospect of the second half of this year. Would you please share your Q4 expectations?

Yes, I think you have seen our Q3 numbers. The solid Q3 financials and operating results give us confidence in Q4. So net revenue reached RMB 1.4 billion in Q3, which is up 35% year-over-year. So one thing is even if you compare the net revenue in Q3 to Q3 last year and Q3 2020, without effect to the recent disposal of our academic AST business, revenues still increased by 1.1% and 56.5%, respectively. In Q4, we will keep focusing on the healthiness of our key financials and operating indicators, that's for sure. As for learning services, Q4 is the retention season for STEAM courses, which is expected to have a positive effect on cash flow and other financial metrics. Besides, digital content services released in Q2 have performed well in sales and gross margin over the past two quarters. In terms of smart devices, Q4 is typically the season with the November 11 and December 12 shopping festivals. Our smart device sales performed well during the November 11 shopping festival with aggregated sales of RMB 100 million on Tmall, JD.com, and Douyin, up over 80% year-over-year. So in terms of Youdao Dictionary Pen, it has retained the leading position in sales in its category for three consecutive years in both Tmall and JD.com. Youdao Listening Pod also ranked number one in sales in this category on JD.com. I think this all bodes well for Q4. Today, we announced that the Board of Directors has authorized us to adopt the share repurchase program in the near future for up to US$20 million. It basically reflects management's confidence in the business, both in the short term and in the long term.

This is Su Peng. Just one more comment to add after Dr. Zhou on our expectation for Q4. We expect to maintain the momentum of business growth in digital services, smart devices, and the rest of the sector. We feel confident about this growth and see great potential in the market from customer demand. That's why we are confident. We still have enough capabilities to invest in our new categories in the learning products as well as the new service initiatives after the policy change. If you look at our balance sheet, we still have almost RMB 1 billion cash in our balance sheet, as well as we do have about USD 230 million revolving flow from the net school that gives us more capabilities to invest and wait for feedback from the market, and we feel promising about the market in the long run. I hope that answers your question.

Our next question comes from Linda Huang with Macquarie.

My question is regarding the learning devices because we launched a very successful learning tablet in the second quarter. So can you share with us how do you think about the future of this product, especially management, you just mentioned a sizable addressable market? What kind of market size can we capture in the long term? And we also hope that management can share with us what is the product strategy? Maybe you can explain your products and pricing strategy?

This is Su Peng. First of all, we are confident about our Youdao learning pad products because we see great demand in the smart market. If you refer to Frost & Sullivan, the expected volume of education tablets is likely to reach about 7 million units by 2025, with total sales above RMB 25 billion, as I mentioned. As we mentioned in the last call, we actually feel confident in our products. Last time, we released our new product, the Youdao AI Smart Learning Pad, and it's Y10. It was released in August and has been sold out for the first batch of 10,000 units. I think that reflects strong demand from this new category. More recently, we just released our next-generation Youdao Learning Pad, called X10. We believe we have upgraded it with better features and functions. There will be more precision for AI diagnostics, and we think it will be more suitable for students’ learning road maps. We try to build a road map for individual students to provide highly customized services based on our technology. That's why we are confident in our products. Even right now, we still see significant market demand week by week. We think this showcases our successful product strategy, and we will keep investing in this market, upgrading our products, and providing more diversified services to our customers. That's our perspective on this strategy.

Yes. So let me add a few points. The addressable market for learning tablets is probably larger than that for the Dictionary Pen, potentially 5 to 10 times larger. That's a very good market to be in, provided we can capture shares from it. We believe we are well positioned to get our tablets into the hands of many consumers because it's an AI-driven product. From our experience over the past few years, whenever we develop really useful AI experiences, like with the Dictionary Pen, for example, where we offer very quick translation lookup—this has always been well received. For instance, our recent Dictionary Pen P5 can scan multiple lines in one swipe. Whenever we can create experiences like this, we become stronger in the market, resulting in better product reputation and lower marketing costs. We plan to execute the same strategy for the learning pad. The first two products provided new experiences for our users. Additionally, we are using a rapid product development pace, as we've already released five different SKUs this year, which is faster than last year. Our teams have gained more expertise, improved supply chain management for learning hardware, and acquired more IP and patents. All of this puts us in a good position to achieve a leading status in the learning tablet market.

Yes, Linda. Just one more point to add here. If you look back at our strategy for the Dictionary Pens, we have increased the number of units sold by tenfold over two years. We expect that the AI tablets market is a long-term strategic investment for us. We will be patient and aim to replicate our successful strategy with the Dictionary Pen for our smart tablets. We are currently in the investment stage, so it's just beginning, and we expect to see strong demand and positive market feedback. That's our expectations for these new categories.

The next question comes from Lian Duan with Huatai Securities.

In recent quarters, we saw adult courses face some challenges. What is our strategy for improving the business?

This is Lei Jin. Yes, your question is about the adult courses facing challenges. Given the macroeconomic factors and the pandemic, we are adjusting our strategy from interest-related courses to segments where students have a better chance of getting jobs. Graduate school entrance exam preparation and vocational education, such as digital skill improvement, are booming demand areas. There is a record high number of registrants for graduate school entrance exams this year, with 4.5 million candidates and a 21% growth year-over-year—double the number from 2017. It is likely to grow further in the coming years because higher education correlates with better profitability. Our Youdao campus recruitment post-graduate resumes have accounted for over 70% of total candidates for the past five years. Our graduate school entrance exam course is focused on personalized service. Knowing that choosing a suitable college and subject is crucial, our AI assistant application consulting service offers tailored advice to students based on their academic performance and large data on college recruitment. Our OMO services create a comprehensive experience through online learning and offline summer camps, especially during the pandemic. In Q3, over 50% of the gross billings came from this organic traffic, which increased over 150% year-over-year.

Your next question comes from Candis Chan with Daiwa.

Great. Good evening, management. Congratulations on the solid set of results. We see that for this quarter, the gross margin of Learning Services indeed has been very strong at close to about 65%. I wonder whether this margin level will be sustainable in the following quarters? Any insights on the margin trend of learning services for next year would be great.

Thank you for your question, Candis. This is Wayne. You're seeing our gross margin for Q3 arrived at around 55%, up 13% quarter-over-quarter, mainly contributed to the benefit from economic scale from the higher revenue base and improved margin for digital content services. We are pleased to see the gross margin return to a similar level as last year after a transitional period following the release of the double reduction policy last year. In the last quarter, we had a relatively low revenue base for learning services, resulting in reduced gross margin performance during that quarter. With the launch of our new services and digital content services since Q2, sales increased very quickly, reaching over RMB 400 million in this quarter, along with an increased gross margin from 50% in Q2 to over 60% in Q3. We expect to enjoy good benefits from economic scales and higher gross margins, both for Q4 and next year. Although business fluctuations are expected, we are very confident in the revenue growth of learning services as well as in its gross margin. I'd like to add some insights into our Smart Devices gross margin performance as well. In this quarter, the gross margin of smart devices increased to around 40% from 34% for the same period last year, which primarily resulted from the sales of X5 that carry a higher gross margin. Youdao has advanced AI technology that enhances learning content and is good at technology innovation, giving us a competitive advantage in product pricing. We also anticipate higher gross margin achievements for our smart devices. That's all. Thank you for your questions.

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

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.