Youdao, Inc. Q1 FY2023 Earnings Call

Good day, and welcome to the Youdao 2023 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 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 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 2023 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, 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. Q1 net revenue was RMB1.2 billion, a decrease of 3.1% year-over-year. Loss from operations was RMB195.8 million, up 56.5% year-over-year. Net cash used in continuing operating activities was RMB437 million, an increase of 2.7% year-over-year. During the first half of the quarter, our learning services and smart devices businesses faced significant challenges due to the pandemic. However, the challenges gradually eased in the second half, and our business returned to growth. Despite the headwinds, our digital content services maintained a strong trajectory. In fact, its gross margin approached 70% and net revenues covered the costs and operating expenses for three consecutive quarters. Furthermore, gross billings from learning services, excluding adult courses, increased over 40% year-over-year in Q1, rising by over 70% in February and March after falling by over 20% in January. In Q1, our advertisement business was a bright spot with net revenues of RMB218.1 million, representing a 79% year-over-year growth. This was mainly attributed to the expansion of customers led by the significant upgrade of advertising technology since Q4. We foresee continued positive momentum in this sector. In Q1, we also made notable progress with generative AI and large language model technologies that offer breakthrough abilities in knowledge reasoning, language tutoring, and other applications. This marks a significant inflection point in our six-year journey of applying modern artificial intelligence to education, which began with the release of Youdao Neural Machine Translation technology in 2017. As one of the first companies to release generative AI powered education products, we recently launched Youdao AI Speaking in Youdao Dictionary Pen. Leveraging our proprietary generative model, we also unveiled AI Box for Youdao Desktop Translation, which utilizes our generative AI technology. The AI Box feature received an overwhelmingly positive response and contributed to a nearly 200% year-over-year increase in translation subscription fees. Looking ahead to the full year of 2023, I am confident in the growth and improved overall health of our business and also fruitful applications of generative AI in our products. Regarding AI, we remain committed to abiding by related laws and regulations to ensure that our technology is developed and utilized in an ethical and responsible manner. Furthermore, our controlling shareholder NetEase Group will continue to support our long-term development. I would like to provide more details on our business segments in Q1. We generated RMB732.4 million in net revenues from learning services, which represented an 11.3% year-over-year decrease primarily due to the pandemic. Nonetheless, as we just mentioned, gross billings from learning services, excluding adult courses, increased over 40% year-over-year in Q1, indicating positive momentum. Our STEAM courses continue to see notable achievements contributing to the overall gross billings growth. In Q1, our flagship Youdao Literature, Youdao Go product gained even more popularity, while the Minecraft collaboration project, Youdao Literature-Creative Writing, Youdao Go have received positive feedback from more users. Additionally, the Champion Class of Youdao Go released in Q4 of last year had already coached award-winning students who secured the top spots in a youth group championship at the British Junior Go Championship. Our child-oriented digital online reading service, Youdao Fun Reading, demonstrated promising growth in Q1 by utilizing AI algorithms to recommend books to readers of diverse ages and interests. The gross billings of Youdao Fun Reading rose by almost 40% year-over-year. Furthermore, we were recently designated as a GESP certification service center of the China Computer Federation, signifying our recognition and leadership in competitive programming education. In terms of Youdao courses, our postgraduate entrance exam courses sustained healthy momentum in Q1, posting mid-double digit percentage growth in gross billings of professional courses for postgraduates entrance exam year-over-year. Regarding smart devices, net revenue was RMB212.7 million in Q1, representing a 16% year-over-year decline due to the pandemic. However, the sector saw a rebound of more than 20% year-over-year in the activation of dictionary pens in March. The rapid recovery indicates that both the education needs of our customers and our distinctive product design and features allow the device business to demonstrate resilience against the macro headwinds and a challenging consumer electronics market. We continue to improve the dictionary pens experience with over-the-air updates to the dictionary pen OS. In addition to the AI speaking feature we just mentioned earlier, users can now access other new applications such as Baidu Net Disk and the Chinese Children's Encyclopedia. Furthermore, Youdao Dictionary Pen X5 and P5 ranked highest among a number of dictionary pens, based on tests conducted by the China Academy of Information and Communications Technology, underscoring our product leadership. In addition, we recently upgraded our Smart Learning Pad by launching a comprehensive data-based learning dashboard and other significant updates. This dashboard enables parents to conveniently monitor their children's study plans and daily learning progress. Looking ahead to the remainder of 2023, assuming no unexpected macro events, we anticipate a continuation of the recovery in education, consumer demand, and a robust market demand for digital learning products, including both our online learning services and smart learning devices. Moreover, generative AI technology will play a significant role in driving more consumer demand for digital learning products. We also expect continued growth from our longstanding advertising business, which will contribute to our overall expansion and profitability. At Youdao, we will continue to leverage our technological leadership and innovation capabilities to deliver industry-leading experiences that serve our users, consumers, and stakeholders while driving sustainable growth. We will continue to provide high-quality education services and deliver pioneering solutions that have a positive impact on society.

Thank you, Dr. Zhou, and hello everyone. Today I will be presenting some financial highlights from our first quarter of 2023. We encourage you to read through our press release issued earlier today for further details. For the first quarter, total net revenue was RMB1.2 billion, or US$169.4 million, remaining stable compared with RMB1.2 billion for the same period of 2022. Net revenue from our learning services was RMB732.4 million, or US$106.6 million, representing an 11.3% decrease from the same period in 2022, primarily due to the decreased revenue derived from adult and vocational courses and other courses compared with the same period of 2022. Net revenues from our smart devices were RMB212.7 million, or US$31 million, down 16% from the same period in 2022, primarily due to decreased demands for the learning products in the first quarter of 2023. Net revenues from our online marketing services were RMB218.1 million, or US$31.8 million, representing a 79.7% increase from the same period in 2022. The increase was mainly attributable to the increased demand for the performance-based advertisements through third-party Internet properties. For the first quarter, our total gross profit was RMB601.9 million, or US$87.6 million, representing a 6.2% decrease from the first quarter of 2022. Gross margin for learning services was 62% for the first quarter of 2023 compared with 33.9% for the same period in 2022. Gross margin for smart devices was 39.6% for the first quarter of 2023 compared with 33.7% for the same period in 2022. Gross margins for online marketing services were 29.1% for the first quarter of 2023 compared with 33.7% for the same period in 2022. For the first quarter, total operating expenses were RMB797.6 million, or US$116.1 million, compared with RMB766.9 million for the same period of last year. With that, for the first quarter, our sales and marketing expenses were RMB565.2 million compared with RMB506.4 million in the first quarter of 2022. Research and development expenses were RMB182.8 million compared with RMB203 million in the first quarter of 2022. Our operating loss margin was 16.8% in the first quarter of 2023 compared with 10.4% for the same period of last year. For the first quarter of 2023, our net loss from continuing operations attributable to ordinary shareholders was RMB204.4 million, or US$29.8 million, compared with RMB95.4 million for the same period of last year. Non-GAAP net loss from continuing operations attributable to ordinary shareholders for the first quarter was RMB193.9 million, or US$28.2 million, compared with RMB70.9 million for the same period of last year. Basic and diluted net loss per ADS from continuing operations attributable to the ordinary shareholders for the first quarter of 2023 was RMB1.67 or US$0.24. Non-GAAP basic and diluted net loss from continuing operations per ADS attributable to the ordinary shareholders for the first quarter was RMB1.59, or US$0.23. On net cash, cash used in continuing operating activities was RMB437 million or US$63.6 million for the first quarter. Looking at our balance sheet. As of March 31, 2023, our contract liabilities, which mainly consisted of deferred revenues generated from our learning services, were RMB832.2 million, or US$121.2 million, compared with RMB1.1 billion as of December 31, 2022. At the end of the period, all cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB601 million or US$87.5 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to our questions. Operator, please go ahead.

Thank you. And we will now begin the question-and-answer session. Our first question today will come from Brian Gong of Citigroup. Please go ahead.

Thanks management for taking my question. Just a very simple question. This year, the macro is quite weak. So what are the reasons that management is quite confident about development for this year? And what are the key drivers for growth ahead? Thank you.

Thank you, Brian. In Q1, we faced a few short-term challenges due to the pandemic's impact on our primary businesses that is learning services and devices. However, strong advertising results partially offset that decline. Both learning services and devices rapidly recovered in the second half of Q1. So we expect that the negative impact of Q1 to be a one-time event. Our confidence for the full year 2023 comes from several reasons. First, for learning services, we see strong demand, and we have a strong and growing product lineup. As we mentioned earlier, learning services in gross billings, excluding adult courses, grew by over 40% in Q1. That's quite strong growth. The growth is driven by both robust demand and the rollout of new and updated digital content services, including updates to Youdao Literature digital content for high school and also Youdao Fun Reading, as we mentioned, and we have more new learning services in the pipeline for later this year. So we are confident about learning services growth. Secondly, for devices, we are also seeing a good recovery. Dictionary pen activations in March were up 20% year-over-year. We plan to release new devices in Q3. Updates to existing devices through software and also new devices this year will drive growth, given our high market share in the dictionary pen market and the other products we have. Thirdly, regarding ads, back in Q4, we reported accelerated growth from ads at around 58% year-over-year. In Q1, that was even higher at 80%. We believe we are in a cycle of advertisement growth due to two factors. One is our significant algorithm updates to the platform in Q4 that proved effective, allowing us to attract more customers and budget. In the current macro environment, businesses are leaning towards performance ads, which is our main form of advertisement service we render to our customers. Performance ads are what businesses are relying on to accelerate their recovery. Although we had a kind of a hiccup in Q1, as I have outlined, we think that the overall business is in a healthy state. We are executing towards our goals this year, and we are quite confident about our development for the full year 2023. I hope that answers your questions. Thank you.

Brian, just one more point to add to Dr. Zhou's comments. As we just mentioned in the call, and if you go back to see the performance and the different mindsets in the first quarter, I think that's because we did a number of course readings that can help indicate the trends of our business. In January, course readings from our learning services, excluding adult courses, showed about over 20% in January. And right after that period, in February and March, the course readings from the same sectors just rose by over 70%. You can see the different performance in January compared with February and March. That's the reason why we expect this short-term impact to be a one-off event for this year. Thank you.

Thank you. That's very helpful.

Our next question today will come from Katie Yuan of CICC. Please go ahead.

Thanks for taking my question. Just a quick question regarding the AI. So would you please introduce our latest progress with artificial intelligence as it is the most promising and eye-catching for the investors now? Thank you.

Yes. There’s a lot of attention on generative AI. People say that education is one of the first areas that it’ll have a big impact, and yes, we agree with that. We believe generative AI is something we see every 10, 20 years or maybe more. We plan to leverage generative AI as a competitive advantage. The impact of generative AI on education and learning cannot be understated. We are committed to driving innovation in this space. To this end, we announced the educational large language model project. The aim is to develop and apply large language model technology to enable personalized learning and tutoring; a tutor that has a deep understanding of the learning materials, can quickly grasp the student's learning style and needs and provide effective teaching. This kind of AI tutor, I would say, is the Holy Grail of education technology. Products that harness the power of this kind of generative AI will be in high demand in the market. We are already making some rapid progress. We recognize that speed and fast iteration are essential in developing any kind of new groundbreaking technology. We have already released several generative AI powered new products and features. As we mentioned earlier, there is the AI Box feature in Youdao Desktop Translation, Youdao AI Speaking in Youdao Dictionary Pen, and there is a generative AI-based Go game review and suggestions in our Go course. We have several of these products released. Since the launch of AI Box less than a month ago, it has been used almost 1 million times. That is promising early momentum. I also want to add that at Youdao, applying AI to education has already been a six-year journey. We are good at it, and now the progress will be accelerated. It began in 2017 with the release of the Youdao Neural Machine Translation technology. In 2018, we applied transformers, the current most popular generative AI kind of underlying technology, to our translation engine. In 2019, we embedded transformers into the dictionary pen. In 2020, we developed a transformer-based high-quality voice recognition engine. In 2022, we moved that voice recognition engine to the device side in Dictionary Pen P5. We believe we already have a head start in this area. Because we have made many investments into technology, especially on transformer technology, we do not expect to need to increase overall R&D expenses to deploy generative AI. We will be leveraging our existing investments and redeploying and optimizing resources in the process to deliver. Finally, I would like to reiterate that we remain committed to abiding by related laws and regulations regarding AI to ensure that our technology is developed and utilized in an ethical and responsible manner. Thank you.

Thank you.

Our next question will come from Howard Zhu of Macquarie. Please go ahead.

Hi. I'm Howard from Macquarie. Thanks for taking my question. I just wanted to know what the main reason is for the decline in revenue in smart devices in Q1. You had talked about it a bit. Could you elaborate a bit more? Thank you.

Thank you. This is Feng Zhou. As we mentioned earlier, smart devices revenue was down 16% in Q1, mostly due to the pandemic. In January and early February, consumer demand was very weak, and many offline channels, many electronic stores were not open for business. However, demand quickly recovered, and channels started operating normally close to the start of the spring school semester. In March, business rebounded with over 20% year-over-year growth in new activations of dictionary pens. So that's how the quarter looks month-by-month; it's already recovering. We think consumer demand and channels are where we want them to be since March. Our teams are working hard to drive growth with product innovations. We received very positive feedback on the newly launched AI Speaking and Baidu Net Disk features we added to the dictionary pen. Because of all the publicity about generative AI, users are really eager to try features like AI Speaking. Baidu Net Disk has been the most requested feature because a lot of users already use it to store learning materials. The ecosystem is growing nicely. If you look at the growth of the overall dictionary pen user base, we have nearly 40% year-over-year growth in the monthly active users of active dictionary pen users in Q1. This means more customers bought the device, and more importantly, they are actively enjoying the product and are satisfied with the experience. This is great, and this is what brings more business for us down the road. Compared to other consumer electronics, smart educational devices demonstrate resilience under tough macroeconomic circumstances. Our new smart devices are expected to be released in Q3, so we look forward to these new products bringing even better experiences to our users. In terms of sales channels, we have expanded our reach by utilizing more live streaming channels. Our partnership has led to nearly 20 live streaming sessions featuring our dictionary pens. The collaboration has helped to boost our sales and strengthen our brand's influence. We will be doing more of that, so we expect device revenue to gradually recover. We are confident in the long-term prospects of smart learning devices. Hope that answers your question. Thank you.

Yes. Thank you very much for the answer.

Our question today will come from Candis Chan of Daiwa. Please go ahead.

Great. Thank you management for taking my question. So congratulations on the very strong revenue growth of the online marketing services. Can management give us more granularity of the growth behind and for instance maybe even more driven by the macro recovery or advertiser sentiment, or is it something more related to the devices or an app that we are seeing greater traffic? Thank you.

Thank you. This is Lei Jin. As for the advertising business, customer value is our first priority. We have been making a big effort to create and add value for the customers; an 8% year-over-year increase from the revenue outside shows we are on the right track. There are three reasons for the growth. The first is macro recovery of demand, especially for fast-moving consumer goods. This has resulted in revenue growth from the performance-based advertisements. The second is performance-based advertising was further improved in Q1. The system was upgraded in last Q4, and it has provided the most timely and accurate computation data for our customers. They have given us positive feedback on the increased precision of marketing capabilities through AI technology. Certainly, our AI advertising capabilities have increased our ability to better match advertisers with regulators. Our audience mainly consists of colleges, graduates, young professionals, and young couples. This has helped our team. Our customers have recently been very successful marketing to their audiences in sectors like fast-moving consumer goods and cosmetics by leveraging AI technology to make more accurate predictions and recommendations, which leads to better matching for our users and customers. The positive momentum for this sector is expected to continue to grow. Thank you.

Thank you very much.

And that concludes the question-and-answer session. I would like to turn the conference back over to management for any additional or 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 Piacente Financial Communications in China or the U.S. Have a great day.

The conference has now concluded. We thank you for attending today's presentation. You may now disconnect your lines.