Youdao, Inc. Q1 FY2024 Earnings Call

Good day, and welcome to the Youdao 2024 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 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 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 company filings 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 2024 first quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. 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, 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 to everyone for joining today's call. Before we start, I want to remind everyone that all figures are in Renminbi unless stated otherwise. We had a strong performance in the first quarter of 2024, with net revenues of RMB 1.4 billion, reflecting a year-over-year growth of 19.7%. Our operating income was RMB 29.9 million, recovering from a loss of RMB 195.8 million in the same quarter last year. This marks our first profitable first quarter and our second consecutive quarter of profitability. In terms of cash flow from operating activities, we saw RMB 391 million, which is a seasonal low for cost renewals but still represents a 10.5% year-over-year improvement. Let's now discuss the progress across our business lines. Learning Services generated RMB 718 million in revenue, remaining nearly unchanged from last year. Within this segment, digital content services thrived, with Q1 revenues reaching RMB 499.8 million, an 11% year-over-year increase. We have maintained a gross margin above 70% for three quarters in a row, and the profits from digital content services have covered costs and expenses. In terms of product upgrades, we improved Youdao Lingshi in Q1 with a tiered teaching approach tailored to individual student needs. Recently, we finished the spring renewals for Youdao Lingshi students, achieving a historic retention rate exceeding 70%, which is over 10 percentage points higher than last year. This retention is extremely high for this age group and can compete with offline services while offering better margins. We also launched 'Virtual Tour of Twenty Four Cities' for Youdao Literature to help students enhance their reading and writing skills. Additionally, through our AI capabilities, we provided over 30,000 high-quality writing improvements in Q1, which is an 80% increase from the previous quarter. Moving on to our AI-driven apps and services, we have talked extensively about our AI initiatives, particularly our large language model projects. Youdao is well-positioned to deliver AI experiences to users in China and beyond, which will drive growth given our large user base and extensive experience in algorithm-driven products. We are developing our models and applications simultaneously at a quick pace. I'm excited to report that sales from our AI-driven subscription services rose to about RMB 50 million in Q1 for the first time, which is a phenomenal year-over-year increase of over 140%. This segment has experienced over 50% year-over-year growth for five consecutive quarters, and we anticipate this trend to continue. Our AI-driven subscription offerings include Youdao Dictionary, Youdao Desktop Translation, Hi Echo, and several international apps for translation, language learning, and other services. We are still early in this journey, but the future looks very promising. We believe consumer-focused products represent the biggest growth opportunity for AI currently, and combining large language models with subscriptions presents a natural growth route. For instance, using our proprietary large language model Ziyue, we have improved the accuracy of Chinese-English translations to about 98%, boosting subscriptions. We also launched an upgraded Hi Echo in collaboration with the IELTS organization, featuring modules for IELTS speaking practice, simulated exams, and a bilingual teaching mode to better serve Chinese learners. Furthermore, Quest Mobile identified Hi Echo as a leading application in the education sector for AI-generated content. Our online marketing services segment has shown exceptional growth, with net revenues hitting a record RMB 492.7 million in Q1, an impressive year-over-year growth of 125.9%. This segment has consistently grown over 50% year-over-year for six straight quarters, driven mainly by the strong performance of Real-Time API (RTA) and the rapid growth of domestic Key Opinion Leader (KOL) advertising, both of which saw over 100% year-over-year growth in Q1, showcasing the segment's strength and our ability to leverage emerging trends. Looking ahead, we see numerous opportunities for further growth, such as tapping into industry trends like Data Management Platforms (DMP) and enhancing our collaboration with the NetEase Group. This partnership allows us to access their extensive traffic and customer base. In Q1, less than 10% of our ad revenues came from NetEase, highlighting significant growth potential as we deepen our partnership. Moreover, our AI capabilities will enable more accurate and efficient advertising placements, creating a win-win situation that fuels growth for both parties. In the smart devices realm, net revenues were RMB 181.2 million in Q1, marking a year-over-year decline of 14.8%. However, it's promising that the decline rate has slowed by 30 percentage points compared to the previous quarter, indicating stabilization. On the product side, we recently launched the Youdao Dictionary Pen S6 Pro, which quickly became the top-selling dictionary pen on JD.com shortly after its release. While challenges remain in this segment, we are optimistic about the medium to long-term prospects for our learning devices, supported by our dedication to product innovation and a deep understanding of the educational technology market. As always, I want to share some reflections on our overall strategy. Our recent financials suggest that we are on the verge of achieving sustainable profitability. A crucial strategic question is how we can exceed the sustainable profitability threshold and create long-term growth in this competitive education and technology landscape. Our strategy is to maintain fiscal discipline and concentrate on a select few businesses with strong growth and competitive advantages. We have pinpointed three areas for increased focus and resources. First, we are dedicated to digital content services, especially Youdao Lingshi for high school students, which has established itself as the leading player in this domain. We see a healthy growth trajectory ahead for Lingshi. Second, our focus is on online marketing services, which are nearing RMB 500 million in quarterly revenues. Two primary growth drivers are supporting us: tech-driven advertising product innovations, including applications of RTA, DMP, and generative AI, as well as opportunities for customer acquisition as we scale and attain market leadership. Lastly, we are prioritizing AI-driven subscription services, which are currently generating approximately RMB 50 million in quarterly total sales. Although smaller now, this segment is rapidly growing, with over 100% year-over-year growth this quarter. It will be a vital channel for our AI investments to yield returns. I am excited to announce that we will launch 'Mr. P AI Tutor,' the first all-subject AI tutor in China, as a free mobile app in June. We encourage you to try it when it’s available and share your feedback. In closing, we are focused on driving strong growth by providing premium online learning services and leading AI innovations, while ensuring we maintain financial discipline. The future is bright for AI-driven learning, advertising, and consumer services. Now I will hand the call over to Su Peng for more detailed insights into our financial performance. Thank you.

Thank you, Dr. Zhou, and hello, everyone. Today I will be presenting some financial highlights from the first quarter of 2024. We encourage you to read through our press release issued earlier today for further details. For the first quarter, total net revenues were RMB 1.4 billion, or USD 192.8 million, representing a 19.7% increase from the same period of 2023. Net revenues from our learning services were RMB 718 million, or USD 99.4 million, representing a 2% decrease from the same period of 2023. Net revenues from our smart devices were RMB 181.2 million, or USD 25.1 million, down 14.8% from the same period of 2023, primarily due to decreased demands for the learning products in the first quarter of 2024. Net revenues from our online marketing services were RMB 492.7 million, or USD 68.2 million, representing a 125.9% increase from the same period of 2023. The year-over-year increase in revenues from online marketing services was primarily due to the increase in the sales of performance-based advertisements through third parties' Internet properties, which was driven by our continued investments in cutting-edge AI technology. For the first quarter, our total gross profit was RMB 681.5 million, or USD 94.4 million, representing a 13.2% increase from the first quarter of 2023. Gross margin for learning services was 63.1% for the first quarter of 2024, compared with 62% for the same period of 2023. Gross margin for smart devices was 32.6% for the first quarter of 2024, compared with 39.6% for the same period of 2023. Gross margin for online marketing services was 34.3% for the first quarter of 2024, compared with 29.1% for the same period of 2023. For the first quarter, total operating expenses were RMB 651.6 million, or USD 90.2 million, compared with RMB 797.6 million for the same period of last year. With that, for the first quarter, our sales and marketing expenses were RMB 455.4 million, compared with RMB 565.2 million in the first quarter of 2023. Research and development expenses were RMB 146.7 million, compared with RMB 182.8 million in the first quarter of 2023. Our operating income margin was 2.1% in the first quarter of 2024, compared with operating loss margin of 16.8% for the same period of last year. For the first quarter of 2024, our net income attributable to ordinary shareholders was RMB 12.4 million, or USD 1.7 million, compared with net loss attributable to the ordinary shareholders of RMB 204.4 million for the same period of last year. Non-GAAP net income attributable to the ordinary shareholders for the first quarter was RMB 20.3 million, or USD 2.8 million, compared with non-GAAP net loss attributable to ordinary shareholders of RMB 193.9 million for the same period of last year. Basic and diluted net income per ADS attributable to the ordinary shareholders for the first quarter of 2024 were RMB 0.11, or USD 0.02 and RMB 0.10, or USD 0.01. Non-GAAP basic and diluted net income per ADS attributable to ordinary shareholders for the first quarter was RMB 0.17, or USD 0.02. Our net cash used in operating activities was RMB 391 million, or USD 54.1 million, for the first quarter. Looking at our balance sheet, as of March 31, 2024, our contract liabilities, which mainly consist of deferred revenue generated from our learning services, were RMB 769.1 million, or USD 106.5 million, compared with RMB 1.1 billion as of December 31, 2023. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB 326 million, or USD 45.2 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.

Yes. Congratulations on decent results. My question is regarding digital content services, which have demonstrated revenue growth over the past several quarters. So could the management share what are the primary factors driving future growth?

Thank you, Brian. This is Su Peng. The first is about the digital content services, particularly Youdao Lingshi, which are the most in demand and financially robust parts of our learning services. In the last year, our net revenue from digital content services was around RMB 2 billion, up about 11% year-over-year. Additionally, digital content services generated profit for the full year last year. In the first quarter of this year, our net revenue from digital content services reached close to RMB 500 million, reflecting around 11% year-over-year growth as well. And we do not only keep the revenue growth at the same level but significantly improve profitability at the same time. We expect to expand the profitability of digital content services quickly this year. The factors driving the growth of digital content services, definitely, first is because we see a strong demand from the market. That's the best signal from the market regarding our services. The second is, definitely, we provide pretty unique value to our customers through our products. For example, with our AI capabilities, we can offer users academic diagnostics, personal learning test plans, recommend access following video content consumption, and also the AI-based college admissions advisor, providing comprehensive services such as college application assistance, course selection advice, as well as college admissions policy guidance. I think we will continue to focus on the profitability of each product. For key products and services such as Lingshi, we will allocate more resources and efforts to strive for fast growth this year. We see significant potential for offline services as well. Through these initiatives, we aim to reach a broader range of students and provide more high-quality consulting services. While our digital content learnings are primarily delivered online, we believe that the integration of online and offline services will offer better services to all the students and customers as well. With that, we are pretty confident about the profitability of our digital content services and expect to see rapid improvement in the full year of 2024.

Brian, this is Feng Zhou. Yes, I just want to add one point. As Su Peng just said, we are working on offline services for Lingshi right now. We already have about 10 cities in service currently. This is an important initiative for the team. We think online courses are great and fundamentally more efficient. Looking at Lingshi, a lot of the course content is actually delivered with pre-recorded videos, which are preferred by users because they allow them more freedom in scheduling their time. Although we recognize that many students and parents prefer offline, face-to-face services, we feel that a combination of online and offline will bring substantial value and open new avenues of growth for the business.

Our next question comes from the line of Caini Wang, CICC.

I have just one question about our online marketing services. Our online marketing services have been experiencing rapid growth for six consecutive quarters. How could we achieve sustainable growth in the future?

This is Lei Jin. As we discussed during last quarter's call, Youdao's ad business is a performance-based ad platform. We aggregate traffic from both within Youdao and outside of Youdao to serve our customers' marketing needs. Our competitive strength lies in the unique combination of technology, customer service, and operational skills. In the first quarter of this year, our advertising business achieved net revenue of nearly RMB 500 million and a gross margin of 34.3%. Both of these figures are record highs. Additionally, this segment generates meaningful profit. Looking ahead, there are three key factors that will drive sustainable growth in the future. The first is continued technological improvement. In Q1, we expanded the Real-Time API (RTA) to cover industries such as entertainment, social media, automotive, and e-commerce. Covering over 10 sectors now. The proportion of RTA ad revenue has increased to around 30% in Q1. The implementation of our RTA data strategy has improved conversion efficiency by over 50% for some clients. Looking ahead, RTA revenue is expected to further increase. By continuously optimizing our AI algorithms and data analysis, we can better meet the diverse needs of our clients and improve advertising effectiveness. The second is the further expansion of customer acquisition opportunities. The proportion of advertising traffic and revenue from the NetEase Group was relatively small, indicating significant growth potential in the future. We will better utilize the traffic resources within the NetEase Group, which are relatively more predictable and controllable compared to purely external traffic. Furthermore, by strengthening our collaboration with the NetEase Group, we will gain deeper insight into the needs of gaming industry users, which will help us expand our client base in the gaming sector. Finally, overseas marketing expansion. In terms of global Key Opinion Leader (KOL) marketing, we have access to over 5 million global internet celebrities, including more than 1,000 exclusive ones. This allows us to provide clients with personalized KOL marketing solutions, including KOL selection, marketing strategy development, video content planning, and optimization of KOL content performance. Our leading AI technology will further empower global KOL marketing efforts to support the rapid international extension of Chinese enterprises. Youdao ADS launched China's first 5-star overseas marketing platform in Q1. Youdao ADS has already supported several Chinese companies overseas, including NetEase Games, BRD, Anker, and Shein in their global expansion efforts. Currently, the global KOL marketing business is still in its early stages, presenting substantial growth potential in the future.

The next question comes from the line of Thomas Chong with Jefferies.

My question is about the main products for our AI-driven subscription services.

We apply AI and large language models heavily in multiple business lines, including advertising courses and subscriptions in apps. AI subscriptions cover the last category. As we discussed in prepared remarks, AI subscription sales have been rapidly growing, up 140% this quarter year-over-year, reaching about RMB 50 million. To break it down a little bit for you, here are the major products that contribute to that. First is Youdao Dictionary and Youdao Desktop Translation. The Dictionary is our flagship mobile app and Desktop Translation is our most popular app for PCs and Macs. According to Quest Mobile, they have over 100 million combined monthly active users and are the top translation apps in China. Last year, we introduced the AI translation feature powered by our large language model to web users. In Q1, we significantly improved translation quality, achieving a 98% accuracy rate for English-Chinese and Chinese-English translations, and rolled it out to all users of Youdao Dictionary free of charge. For more demanding scenarios, paid subscription users enjoy more usage quotas. User feedback has been overwhelmingly positive, leading to a lot of new subscriptions. Currently, these two apps are the largest contributors to our subscription sales, and we expect substantial growth as our large language model gains more capabilities and expands into new usage scenarios. Second, there's Hi Echo. It is the world's first digital human language coach, introduced last year. We recently launched a module tailored for IELTS preparation in collaboration with the British Council. This module, available through a separate subscription, helps users better prepare for the IELTS exam through personalized exercises, customized feedback, and simulated mock exams. We expect the new offering to further boost sales of Hi Echo. For international users, we also have several popular apps. iRecord is an excellent app for capturing high-quality voice recordings and transcribing them accurately through automatic speech recognition. Currently, iRecord ranks in the top two places in the voice recording apps category in North America. LectMate is an innovative app designed to help overseas college students comprehend lectures more effectively using voice recognition and large language model technologies. It is ranked #2 in its category in North America. Finally, there's Mr. P AI Tutor. As discussed in our prepared remarks, we will be launching the app version of Mr. P AI Tutor in June. Compared with the end of last year, we have further optimized our language model for K-12, achieving improved accuracy in problem-solving. Accuracy of problem-solving has increased by 3%, and our serving cost has decreased by over 50%. These six apps are our main offerings for AI subscription services. Subscriptions are a very natural monetization approach for AI and large language models. Currently, subscriptions are experiencing rapid growth, and we have a pipeline of new features and products under development. This year, we already see a clear growth trajectory. Yes, I hope that answers your questions.

The next question comes from Bo Zhang at Huatai Securities.

This is Zhang Bo from Huatai. My question is regarding the net revenue from smart devices, which has seen a year-over-year decline. What is our outlook for the future development of this segment?

Yes, we shared in our last call that we concluded the optimization of our sales channels for learning devices at the end of last year. We exited some low-return sales channels, which has significantly improved the bottom line of the hardware segment but led to a year-over-year decline of sales. As we build new sales channels and release new products this year, we are in the process of driving the recovery of the business. In Q1, we expanded into new healthier offline and online sales channels and released three new products: the A6 Pro Dictionary Pen, the E6 Listening Pod, and the X20 Learning Pad. The result is that the year-over-year decline decreased to 14.8%, over 30 percentage points less than Q4. The A6 Pro quickly became the top-selling dictionary pen on Douyin and JD.com after its launch. More recently, we launched the S6 Pro, which surpassed the A6 Pro and became the #1 dictionary pen. A6 Pro and S6 Pro are affordable and mid-priced dictionary pens priced at RMB 349 and RMB 599, respectively. We made a conscious choice here to build high-quality products even at affordable prices. We do not intend to engage in a race to the bottom by undercutting each other with lower prices. The result is that customers have responded positively, and the A6 Pro and S6 Pro swiftly became the #1 sellers after their releases. I believe this is excellent news. The A6 Pro now covers a price range that we were not serving before, expanding our customer base. The S6 Pro is our top-selling mid-priced product. In the summer, we have some very innovative new products in the pipeline for the new school year. I'm optimistic about their outlook as there are several factors that are working in our favor. One is our established leadership position in categories like dictionary pen best-selling products. Secondly, our ability to apply AI and the large language models to these devices is appealing to parents, who are increasingly interested in useful features. Third, our sales and marketing channels are now more established and efficient than before. So while the device team has a lot of work ahead, we are eager to launch these new products. Stay tuned for more updates.

The next question comes from the line of Ya Jiang, CITIC.

My question is about the outlook. Could the management share some insights into the outlook for 2024?

Thank you. This is Su Peng. I think for the outlook for this year, the full year 2024, as Dr. Zhou discussed in the prepared remarks, we will dedicate resources to digital content services, online marketing services, and AI-driven subscription services. Firstly, for digital content services, it is our top priority for business development. We will develop and seize the increased demand by continuously improving our products with our AI capabilities and expanding our presence in the offline market. We are confident in further improving profits from digital content services this year. Secondly, as for the online marketing services, we believe it has made significant strides since last year. We are focused on the long-term growth of our advertising business through RTA technology and generative AI applications. Additionally, we will strengthen our partnership with the NetEase Group in traffic, advertisement placements, and other areas. Our investment in AI has been ongoing, and we expect to generate more results from AI subscription services this year. We will continue to iterate and develop new products, further advancing AI monetization. Total sales of AI subscription services are expected to maintain rapid growth momentum throughout this year. Finally, we have been working hard to achieve profitability this year. We have been diligently focusing on controlling operating costs and improving operational efficiency. This effort has already yielded significant results, as evidenced by our achieved profitability for two consecutive quarters for the first time. Moving forward, we will maintain cost-effective management while striving to increase revenue. That's our outlook for the full year of 2024.

The last question for today comes from the line of Linda Huang, Macquarie.

Management, this is Macquarie, Linda Huang. I want to ask about operating expenses because I noticed a decent decline for sales and marketing as well as R&D. So I just want to know about the trend for these OpEx items for the rest of the year and how we should think about the expense-to-revenue ratio.

Thank you for the question. This is Wayne. I will take your question. Marketing efficiency is a crucial metric and a key indicator of our profitability. We are dedicated to improving online customer acquisition efficiency. We continuously explore various innovations to optimize marketing efficiency, including diversified marketing channels to leverage our advanced AI technology and continuously enrich content to improve product experience. However, we face challenges such as rising acquisition costs due to intense competition. Let me elaborate on the three areas mentioned. First, we are diversifying user acquisition channels. For instance, in learning services, online education companies have inherent advantages in channel innovation compared to offline education institutions, allowing us to reach customers beyond geographic boundaries and actively capture traffic on high-traffic platforms. In contrast, offline institutions are limited by physical location constraints. In recent years, acquisition channels have diversified, including KOL (Key Opinion Leader) marketing, live streaming, and integrated online and offline environments. Such innovations enable us to reach a broader and more relevant audience, thereby reducing acquisition costs and improving conversion rates. Secondly, we are leveraging AI capabilities in our products. The application of AI technology can reduce material preparation costs and enhance user experience, thus attracting more users and increasing conversion rates. For instance, we employed an AISC refinement function to improve user experience during trial lessons by providing timely feedback, thus enhancing conversion efficiency. We believe that our advanced AI technology and large language models can help build a stronger product ecosystem, further enhancing marketing efficiency. Thirdly, we aim to enhance user experience through innovative premium content. Key competitors pay a lot of attention to achieving excellent conversion rates through advertising. Innovative premium content is crucial for satisfying customer needs. For example, Youdao Lingshi transitioned from traditional lead streaming online processes to innovative pre-recorded content embedded with AI technology such as adaptive question banks, addressing concerns about inflexible schedules and offering a personalized user experience. This transformation has successfully met user needs and gathered widespread acclaim. In 2022 and 2023, sales and marketing expenses accounted for approximately 46% and 42% of our total revenue, respectively. In Q1 2024, it further decreased to 33%. We are confident in maintaining this optimization trend in the long run.

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 Pearson Financial Communications in China or the U.S. Have a great day.