Youdao, Inc. Q2 FY2023 Earnings Call

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 the future performance and are subject to certain risks and uncertainties, assumptions, and other factors. Some of these risks are beyond the company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. A general discussion of the risk factors that could affect Youdao's business and financial results is included in certain filings of the company with the 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 second 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. In Q2 2023, our net revenues came in strong and reached RMB1.2 billion, representing a year-over-year increase of 26.2%. Loss from operations narrowed to RMB289.1 million, marking a year-over-year improvement of 36.5%. Net cash provided by continuing operating activities stood at RMB133 million, reflecting growth of 27.6% year-over-year. We are on a clear path to achieving profitability. As for our business segments, learning services and online marketing services continue to be our current main driver of growth, both reaching record levels of sales. In the meantime, we're making solid progress in learning devices, R&D, and we are leading the charge to apply AIGC in education by rapidly releasing applications of generative AI. In the first half of the year, we see an overall positive trend in key financial indicators. Net revenues amounted to RMB2.4 billion, indicating an increase of 9.9% year-over-year. Loss from operations in the first half reduced to RMB484.9 million, improving by 16.4% year-over-year. Net cash used in continuing operating activities reached RMB304 million, marking a 5% year-over-year improvement. For our learning services segment, Q2 sales of digital content exceeded RMB800 million, reaching a record high. Customer retention rates across the services were over 60%, leading to over RMB200 million in operating cash inflow for this area. In addition to our learning content, we launched an AI University Application Adviser in Q2 to support students in their college selection process. Users were quick to adopt this tool, leading to over 2 million page views. Online marketing services maintained the rapid growth momentum from the last two quarters. Net revenues reached RMB303.6 million in Q2, a historical high, representing an increase of 98.7% year-over-year. Moreover, gross profit margin improved by 4.2 percentage points year-over-year. These achievements were primarily due to advancements to our ad platform driven by AI algorithms. First, we used proprietary AI technology to effectively identify and track the topics and products matching the audiences of specific key opinion leaders, with accuracy rates approaching 90%, resulting in more precise ad placement. Second, AIGC not only reduced the time for producing ad materials by more than 80%, which drove better user satisfaction, but also reduced production costs for certain ad materials by over 90%, driving the improvement in gross margin. The positive trend in digital content services and online marketing services in Q2 is expected to continue in the second half. Regarding our STEAM courses, on the policy front, the Ministry of Education announced that starting from June 20th this year, primary and secondary schools will add new programming courses to their curriculum. This new policy is expected to further expand the demand for programming content and services from families. Youdao recently hosted the 7th 'Wisdom Cup' Computer Programming Contest for primary and secondary school students in Beijing's Haidian District in Q2, which showcased Youdao's influence in the field of programming. In addition, both programming and Go courses performed well with retention in Q2, with the retention rate for the advanced classes approaching 70%. Besides, a student from the champion class won the Go Championship at Jiangsu Mind Sports Games. In terms of smart devices, total revenues of smart devices were down by 7.4% in Q2 year-over-year. We are still in a transitional period for device business, mostly due to sluggish consumer spending in recent months and our stricter sales & marketing budget control. Both Youdao Dictionary Pen and Youdao Listening Pod performed well during the June 18th Shopping Festival, topping the chart for four consecutive years and two consecutive years respectively on JD.com for both sales volume and number of units sold in this category. In addition, Youdao Listening Pod was updated to support Youdao Learning OS, featuring additional apps such as 'Chinese Children's Encyclopedia,' 'Collins Big Cat Reading,' and 'Youdao AI Listening,' further enriching users' experience. More recently, in August, we released Youdao Dictionary Pen X6 Pro and Youdao Listening Pod Pro. We believe in the long-term prospect of learning devices as they are convenient, helpful, and affordable for consumers. We are focusing on two things to drive growth and profitability. One is new products, which we will have more to be released in Q4. And second is optimization to our marketing and sales, which is underway. Then let's discuss our progress with AI. As a leading education technology provider in China, we have always been proud of our capabilities in technological innovations. We believe large language models and AIGC present a great innovation and growth opportunity for us. In July we announced our proprietary large language model Ziyue optimized for education applications and have successfully deployed it in six applications starting from the second quarter. We believe we are among the fastest in adopting LLM and making the most solid business progress in this area in China. I am happy to report that one of Ziyue's applications, the AIBox feature in Youdao Translation, has already driven nearly 100% year-over-year growth of translation subscriptions, and over 200% year-over-year growth of subscription fees. AIBox provides very convenient in-application AI features like sentence refinement, grammar correction, writing suggestions, and summarization. In July, we also launched the first digital human language coach in China named Echo. Echo teaches spoken English one-on-one. And thanks to large language model technology, she understands the learner very well, is fun to talk to, and provides high-quality feedback and really helps the learners improve their language acquisition. Echo made its debut at the World Artificial Intelligence Conference in Shanghai, receiving great enthusiasm from the audience and media. Two weeks ago, Echo became generally available in Youdao Dictionary Pen X6 Pro. The reviews so far are great and we expect Echo and more AIGC launches to drive our business growth in the coming months. Looking ahead, we believe education could be among the top verticals for large language models. This technology provides great potential for personalization of the learning experience, effective guidance throughout the learning process, and integration of knowledge across subjects. That summarizes our business operations in Q2. At a high level, our strategy this year is two-fold. Firstly, we prioritize driving healthy growth by offering high-quality digital content services. Secondly, we dedicate efforts to accelerate the integration of generative AI into our products and services. In Q2 our teams made significant progress in both areas. The user demand for high-quality learning products and services remains consistently high. Leveraging our strengths in content creation, user understanding, and technological capabilities, we are committed to continuously delivering exceptional products that address the needs of our users. Finally, I would like to share Youdao and the NetEase Group have both approved a proposed amendment to the aforementioned US$300 million revolving loan facility to extend the maturity date of the facility, including the loans already drawn from it, until March 31, 2027. In addition, we announced that the Board of Directors has approved an amendment to the foregoing program to increase the total authorized repurchase amount by an additional US$20 million. These demonstrate the long-term support from NetEase and the confidence from Youdao's management. Thank you. And now is Peng Su to give you an update on our financials.

Thank you, Dr. Zhou, and hello, everyone. Today I will be presenting some financial highlights from the second quarter of 2023. We encourage you to read through our press release issued earlier today for further details. For the second quarter, total net revenues were RMB1.2 billion, or US$166.4 million, representing a 26.2% increase from the same period in 2022. Net revenues from our learning services were RMB680.9 million, or US$93.9 million, representing a 20.8% increase from the same period in 2022, primarily driven by the strong sales performance of digital content services compared with the same period of 2022. Net revenues from our smart devices were RMB222.2 million, or US$30.6 million, down 7.4% from the same period in 2022, primarily due to the decreased demands for intelligent learning products in the second quarter of 2023. Net revenues from our online marketing services were RMB303.6 million, or US$41.9 million, representing a 98.7% increase from the same period in 2022. The increase was mainly attributable to the increased demands for performance-based advertisements through third parties’ internet properties. For the second quarter, our total gross profit was RMB567.2 million, or US$78.2 million, representing a 38.4% increase from the second quarter of 2022. Gross margin for learning services was 57.4% for the second quarter of 2023, compared with 52.2% for the same period in 2022. Gross margin for smart devices was 35.8% for the second quarter of 2023, compared with 30.6% for the second quarter of 2022. Gross margin for online marketing services was 31.9% for the second quarter of 2023, compared with 27.7% for the second quarter of 2022. For the second quarter, total operating expenses were RMB856.3 million, or US$118.1 million, compared with RMB864.9 million for the same period of last year. With that, for the second quarter, our sales and marketing expenses were RMB587.7 million, compared with RMB596 million in the second quarter of 2022. Research and development expenses were RMB205.1 million, compared with RMB208.4 million in the second quarter of 2022. Our operating loss margin was 24% in the second quarter of 2023, compared with 47.6% for the same period of last year. For the second quarter of 2023, our net loss from continuing operations attributable to ordinary shareholders was RMB299.2 million, or US$41.3 million, compared with RMB453.9 million for the same period of last year. Non-GAAP net loss from continuing operations attributable to ordinary shareholders for the second quarter was RMB283.6 million, or US$39.1 million, compared with RMB435.8 million for the same period of last year. Basic and diluted net loss from continuing operations per ADS attributable to ordinary shareholders for the second quarter of 2023 was RMB2.45, or US$0.34. Non-GAAP basic and diluted net loss from continuing operations per ADS attributable to ordinary shareholders for the second quarter was RMB2.32, or US$0.32. Our net cash provided by continuing operating activities was RMB133 million, or US$18.3 million, for the second quarter. Looking at our balance sheet, as of June 30, 2023, our contract liabilities, which mainly consist of the deferred revenues generated from our learning services, were RMB1.2 billion, or US$167.3 million, compared with RMB1.1 billion as of December 31, 2022. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB680 million, or US$93.8 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.

And our first question today will come from Brian Gong with Citi. Please proceed.

Good evening management. Thanks for taking my questions. I have a very quick one on our plan on AIGC technology. What AI applications will be launched in the second half of this year, and what impact will they have on our business in your view? Thank you.

Hi, Brian. Yes, this is Feng Zhou. Yes, we announced our proprietary large language model Ziyue for education in July. We are looking to leverage this breakthrough technology to drive both short-term and future growth. So we have plans for both the coming months and also for the longer term. So in the short-term, we've already launched six applications for the year, including our digital human language coach named Echo, AIBox 2.0, and AI Translation, etc. So the first line of work for us is to deploy these applications to more of our services, apps, and devices and start to drive business growth with these new capabilities. So in fact, it is already driving growth as early as in Q2. For example, AIBox 1.0 already drove nearly 100% year-over-year growth of translation subscriptions and over 200% year-over-year growth of subscription fees in Q2 as we just discussed in March. We've also launched Echo, our digital human language coach and English grammar instruction feature in the latest Youdao Dictionary Pen X6 Pro, launched earlier this month. Echo is the first large language model based human language coach in China. So this is a groundbreaking product. It is liked a lot by our customers from our feedback. In our AI Grammar instruction feature is also the first of its kind in learning devices. Our users tell us that they really like these two new features because they are really helpful and engaging. We will continue to upgrade these features over the coming months. And we plan to launch and monetize them on other platforms, for example, on phones. So Echo and other features will be on phones too. One of the strengths of AIGC's products from our observation is that consumers are willing to pay for them, because they're really useful and helpful. This has been shown to be true by the tremendous growth of products like Midjourney and ChatGPT. So we do not need to go through the feature use model to kind of indirectly monetize these products, instead they could be monetized directly from day one. So, this shortens the investment cycle of these products. We're running entirely new applications. I am also happy to share that we plan to launch more applications in Q4 this year. There are other aspects of the English language learning that AIGC can really help with, not only grammar, and there are other subjects that we should provide AIGC products for. Our teams are now more familiar with how these language models work and have accumulated substantial experience in their applications. So we are able to quickly iterate and build more applications. So more applications will come in Q4 this year. So in short, we are off to a good start of the project. So we entered the market early and it is already driving growth, and it has great long-term potential. So looking further ahead, our generative AI represents a transformative opportunity for the education technology sector, as well as a lot of other industries, as we all know, it has the potential to allow much more personalized learning and to increase the productivity of the overall education process. So we are also studying early in our efforts with the aim to drive long-term future growth. So for that purpose, the basic LM technology is important. And we believe what's more important is the application scenarios. As we are looking at a lot of the different scenarios in education and because we're early into the game, our teams have more experience. So we believe we can maintain the early lead that we already have in this area. So overall, we are bullish about combining large language models in education. And we will keep innovating in this era. Yes, thank you.

Thank you. That's very helpful.

Our next question today will come from Kelly Wang of CICC. Please go ahead.

Good evening, management. This is Caini Wang from CICC. Thank you for taking my questions. So in terms of the smart devices, things we have released the Youdao Dictionary Pen X6 Pro and Listening Pod Pro earlier this month. So would you mind providing an update on the user feedback for this new smart devices? And also, as we saw a slight decline in revenue in the smart devices sector this quarter, does management still maintain confidence in the long-term prospects of this business which might give us more color on this? Thank you.

Yes, this is Feng Zhou again. As you mentioned, we launched the Dictionary Pen X6 Pro and Youdao Listening Pod Pro earlier this month. I’d like to provide a quick update. The X6 Pro Dictionary Pen, our flagship product, has received positive feedback for its top features: a 100-day ultra-long standby time, English grammar instruction, video capabilities, a human language coach, and test and lab analysis from our popular five three series. The users are particularly excited about these features. Notably, the AIGC language coach ranks among the top features and is very well received. For the first 30 days of August, driven by the popularity of X6 Pro and X6, our new Dictionary Pen activations increased by over 20% year-over-year. Regarding the Youdao Listening Pod Pro, the AI player and AI dialogue were highlighted as the most popular features based on user feedback, contributing to a year-over-year increase in new activations of our listening pod line during the initial 20 days of August. As I mentioned in my prepared remarks, we have more new devices planned for release in Q4, and we are eager to introduce these to our customers. Now, regarding the current market environment, the consumer electronics industry has shown some weakness recently due to macroeconomic factors. While the demand for smart learning devices has proven to be relatively resilient compared to other categories, it has also been impacted to a degree. We are closely monitoring market conditions and optimizing our operations. In Q2 and Q3, our priority is user satisfaction and profitability. We shifted away from low return on investment sales channels and reduced our costs, leading to slightly lower year-over-year device revenues. We believe this approach aligns with our goals of sustainable growth and achieving company-wide profitability. We are also adjusting our price points; for instance, the new X6 Dictionary Pen is priced at RMB499, a competitive price point and one that provides us with good profitability. This demonstrates our commitment to optimizing our pricing strategy. The X6 and the flagship X6 Pro are currently very popular products. To summarize, we are focused on user satisfaction and profitability rather than just absolute growth. We are managing our R&D processes and maintaining discipline in sales and marketing costs. Looking at the long-term, learning devices have a relatively low penetration rate, offering significant growth opportunities. Market size growth observed in recent years supports this positive outlook. According to a report from the Internet Society of China, the market for learning devices is projected to grow from RMB24.9 billion in 2019 to an estimated RMB43.1 billion in 2022. Youdao is well-positioned to be a leading brand in this sector, supported by our broad user base, strong product design capabilities, and commitment to advanced technologies such as large language models. We believe the current slowdown is temporary, and we remain optimistic about long-term opportunities. I hope that answers your question.

Yes, and Caini, this is Peng. I want to address a point that was added after Dr. Zhou's comments. We believe the X6 Pro is completely different and the most innovative Dictionary Pen compared to all the Dictionary Pens released in the past year. It was designed to help students learn English more effectively. Currently, we are not only enhancing the dictionary functions but also introducing a service contract similar to the Echo, along with an interactive language training program and a grammar instruction program. These features are incredibly beneficial for students learning a language. We believe that after testing these additions, we can foster more interaction between users and our hardware, helping us understand their long-term needs better. We expect our new products to be significantly different from previous ones, and we remain confident about mid-term growth. With the expected advancements in automation, we will be able to integrate more large language model features into our hardware. Thank you.

Yes, more exciting products, I mean, yes, later Q4. Yes.

Got it. Thank you. That's very clear. And we look forward to them.

Our next question is from Thomas Chong of Jefferies. Please go ahead.

Hi, good evening. Thanks, management for taking my questions. My question is regarding the online marketing side. What was the driving practice behind the rapid growth in revenue from online marketing services over the past three quarters? Furthermore, what are the key directions for the later half of this year? Thank you.

Hi. This is Lei Jin. The online marketing services have already shown robust growth for three quarters in a row with a surge of nearly 100% for Q2. And Q2 is the fourth quarter, for which online marketing revenue exceeded RMB300 million. Internally, there are mainly two factors that drive the growth. Firstly, the advancement of AI technology has improved the margin of accuracy of our ad platform. We can effectively reach the users across various major platforms. Our use of AI technology allows us to accurately identify the relevant streams associated with the audience, achieving an accuracy rate of nearly 90%. This enables us to deliver highly targeted advertising and help our clients reach their target audience faster and more accurately. Secondly, we upgraded the data and analytics capabilities of our ad platform. This has become more and more convincing that we can enhance and optimize the traffic under advertisement materials based on our effectiveness, resulting in improved advertising performance. Externally, despite a sluggish consumer environment, there is still a strong consumption trend among young people aged between 18 and 35 in gaming, cosmetics, and fast-moving consumer goods. Our ad clients would like to capitalize on the purchasing intent of young people. As for Youdao, a lot of young people are using our products, and we have a deep understanding of them. In the second half of the year, we will focus on two key directions with ads. Firstly, we will focus on overseas ad marketing. This is a strong demand. We have an advantage in terms of resources, language capabilities, and experience in this field. With our in-house AI technology, we can connect with over 1 million users worldwide, directly reaching more than 2 billion users in our 55 countries and regions, and those are reaching Chinese brands for overseas expansion. Secondly, we will further enhance our data capabilities. Since the upgrade of the ad platform in Q4 last year, we have seen huge benefits from real-time and accurate data in helping our user decision-making and posting on ad revenue. By the end of this year, we will strive to further enhance our ad platform to give our clients better marketing performance. Thank you.

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

Great. Thank you for taking my question. I have a question regarding the learning services. Can management talk about our coming focus regarding the learning services in the second half of this year, both on the K-12 and also the education segment? Thank you.

Digital content services are the largest part of our learning service business segment. As highlighted in our prepared remarks, digital content services are a notable strength, with sales reaching RMB800 million in Q2, marking a record high for us. Retention remains strong at around 60%. In Q2, we introduced the AI University Application Adviser to assist students with their college choices, which we believe will be important going forward as it allows us to reach a larger user base. Since its launch, it has already received over 2 million page views, as noted earlier. Looking at the digital content service over the last five quarters, we’ve seen robust growth as our learners continue to embrace this new interactive online learning format. This approach differs from traditional online learning, incorporating video materials, personalized practice, and AI feedback. It’s encouraging to see more users adopting this model, contributing to our rapid business growth. We anticipate that digital learning content and learning services overall will continue to perform well in the second half of the year. To enhance learning, we plan to invest in educational R&D to create high-quality content and improve our personalized assessment and feedback system, which is a strong aspect of our offerings. Additionally, our partnership with Shaanxi History Museum for immersive learning through Youdao Literature has been successful, and we have more plans for IP collaborations this year to provide users with increased opportunities to learn about Chinese culture through immersive experiences. The second aspect of our learning services is the STEAM courses, primarily focusing on Go courses and children’s programming. Youdao has achieved GSP certification, becoming a service center for the graded examination in software programming, as recognized by the China Computer Federation in the first half of the year. Moreover, as an exclusive online education partner, Youdao hosted the seventh Wisdom Cup, as previously mentioned. In the upcoming months, we will continue to leverage our strengths in the STEAM segment, which features our two leading online course systems for students interested in Go and competitive programming. We’ve already upgraded our programming process for the summer and will focus on upgrading our fall and winter courses during the second half. Additionally, we are planning to offer more offline activities and events for our STEAM customers. We have successfully held offline events like Go Game and competitive programming events for several years, and they gained significant popularity this summer as families showed a keen interest in community engagement. Given our large online learning audience and experience organizing such STEAM events, we are determined to provide more opportunities for engagement and growth in this area. Finally, regarding adult courses, we made noteworthy strides in Q2. Despite economic challenges, we introduced a digitized product for math preparation for the postgraduate entrance exam, offering knowledge teaching, step-by-step guidance, and personalized practice. This product has been well received, achieving a next-day retention rate of over 50%. Looking to the second half of the year, we will continue to prioritize postgraduate entrance exam courses in the adult segment due to strong demand. We expect the number of college graduates and postgraduate exam participants to surpass 12 million and 5 million, respectively, in 2024, both setting historical records. We are committed to further exploring and expanding our digital products, particularly to enhance our English preparation for postgraduate entrance exams. That summarizes our plans for learning services. I hope this answers your question.

Great. Thank you very much.

The next question will come from Lian Duan of Huatai Securities. Please go ahead.

Good evening management. Duan Lian from Huatai Securities. Thanks for taking my questions. Just a quick one. With the ongoing investments in AI, will this result in a significant increase in R&D expenses in the second half of this year?

This is Wayne. Thank you for your question. I will take your question. In terms of R&D investment, we are prudent with it and we believe our investment should continue to be more focused on education rather than widespread applications. As just mentioned by Dr. Zhou, our recent AI investment mainly focuses on fixed applications such as large language model-based translation, English grammar instruction, and AIGC. Just a reminder that this is not our first time we invested in AI area. Youdao has been planning in implementing AI technology and such technologies have been widely applied in our learning services and smart devices. At the same time, we have received benefits from adopting more effective methods, which enhance our R&D efficiency. For example, in the first half of this year, although we deployed our proprietary large language model in certain education scenarios, we still experienced around a 6% year-over-year decline in R&D expenses compared to the same period last year, which was mainly contributed to our efficiency improvements with more comprehensive experience in AI investment and savings through applying AIGC technology. The introduction of AIGC has resulted in a notable enhancement in work efficiency. For instance, the incremental implementation of AIGC has led to a 50% increase in the efficient production of content for our course teaching materials. We anticipate that such improvements will continue in the future. Both cost saving in AI investments and the application of AIGC technology enables us to accumulate potential technological capabilities for further advancement. By the end of this year, we plan to launch more AI applications as we continuously balance our investment in large language models and their applications. We believe our team will gain more experience with it and will develop a clear understanding of investment yields with greater effectiveness. We expect the effectiveness of the application side will continue to improve. Going forward, we are continuously on the clear path to achieving profitability, and we will continue to optimize the structure of our R&D investments. For example, we will be eliminating R&D expenditure on those unclear perspective projects, so that we can allocate the savings to our preferred AI projects. Above all, we will enhance investment in AI. But we do not expect a significant year-over-year increase in overall R&D expense in the second half of this year, which is helpful. Thank you.

Thank you.

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. Thank you for attending today's presentation. You may now disconnect.