Earnings Call Transcript - DAO Q1 2025

Operator, Operator

Good day, and welcome to Youdao's First Quarter 2025 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Jeffrey Wang, Investor Relations Director. Please go ahead.

Jeffrey Wang, Investor Relations Director

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 2025 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 Senior President; 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.

Feng Zhou, CEO

Thank you, Jeffrey, and thank you all for participating in today's call. Before we begin, I would like to remind everyone that all numbers are based on renminbi unless otherwise specifically stated. In the first quarter, we significantly boosted profitability while executing our AI native strategy through product development. Operating income reached a Q1 record of RMB 104.0 million, a surging 247.7% year-over-year. Net revenues were RMB 1.3 billion, declining 6.7%, primarily due to decreased learning services revenue. Operating cash outflow narrowed by 34.7% to RMB 255.5 million, reflecting stronger financial efficiency. Product R&D accelerated in Q1. We launched Confucius-o1, our first open-source reasoning model. We trialed with key clients Youdao MagicBox, an AI-powered ad creative suite. We also introduced SpaceOne, our first large-screen tutoring pen. These advances reinforce our AI native strategy that is applying large language model technology to critical learning and advertisement scenarios, serving real-world challenges, driving user satisfaction and business growth. Now let's look at our business lines. In the first quarter, although net revenues from the Learning Services segment declined by 16.1% year-over-year, the rate of decline narrowed by approximately 5 percentage points compared to the previous quarter. Net revenues covered the segment's costs and operating expenses and yielded meaningful profits. Within the Learning Services segment, net revenues from digital content services were RMB 410.8 million in Q1. The product team enhanced Youdao Lingshi, college planning solutions using our proprietary Confucius LLM. The upgraded AI college admission advisers now feature 6 integrated components, 24/7 online Q&A services, comprehensive university and program databases, specialized proprietary courses and materials, professional assessment tools, and an AI-powered recommendation system for school selection and predictive admission analytics. This comprehensive ecosystem has significantly improved our differentiated user experience, contributing to over 25% year-over-year gross billing growth in Q1 and recently improved retention rates. In STEAM courses, our programming courses saw strong gross billing growth of over 40% year-over-year, fueled primarily by strong demand for GESP, which is great examination of software programming preparation courses and more efficient customer acquisition channels. Our AI-driven subscription services generated nearly RMB 70 million in Q1 sales, growing over 40% year-over-year. On the model development front, we open-sourced Confucius-o1 in Q1, a lightweight 14 billion parameter reasoning model that delivers competitive K-12 performance while being significantly more cost-effective and easier to deploy than larger alternatives. We also enhanced our flagship translation model through multi-model fusion and online direct preference optimization (DPO) training, achieving quality improvements, cost reductions, and increased adoption. The translation model now processes over 1.5 billion tokens daily as of April, representing 100% growth since Q1. Additionally, we recently started self-hosting full-size DeepSeek-R1 inference for our products, instead of relying on third-party DeepSeek model services, improving license fee and stability while reducing costs at the same time. Moving on to our applications, the upgraded Mr. P AI Tutor now features a multi-model visual system with over 92% accuracy for K-12 problem solving, up from 85% last year and is available across both the Mr. P app and our hardware devices. We recently launched Youdao AI podcast assistant, an innovative audio synthesis platform that instantly converts text documents like PDF, word files, and web pages into studio-quality podcasts, earning a featured recommendation on the Apple App Store. We also introduced our AI-powered academic paper plagiarism detection system, which detects AI-generated content in academic writing while providing actionable suggestions to enhance originality and quality. Turning to online marketing services, Q1 net revenues rose 2.6% year-over-year to RMB 505.4 million. Our performance-based advertising client base grew by 20% year-over-year in Q1, reflecting the successful scaling of our client acquisition efforts, a key driver for future performance and ad growth. In overseas advertising, we have recently secured Official Google Partner Certification, complementing our existing TikTok partnership. These collaborations provide access to premium ad inventory and optimization tools, enabling more impactful international campaigns. Technology remains at the heart of our advertising strategy. Leveraging our Confucius LLM, we launched Youdao MagicBox, an AI-powered creative suite that automatically produces high-quality ad assets, including images, videos, and dynamic templates. This innovative solution is poised to play a pivotal role in transforming content creation workflows. In addition, we have deepened the collaboration with NetEase Group through 2 operational initiatives. First, we strengthened our partnership with NetEase Games, driving over 50% year-over-year growth in advertising revenue from gaming industry clients. Second, we enhanced the collaboration with NetEase Cloud Music, expanding the range of advertising scenarios available to advertisers. Gross margin from online marketing services moderated to 30.5% in Q1, an approximately 4 percentage point decline year-over-year. This primarily reflects our strategic emphasis on client acquisition, as newer clients typically impact margins during initial onboarding. Looking ahead, we anticipate the segment's gross margin to stabilize between 25% to 35% in the medium- to long-term. Our Smart Devices segment delivered RMB 190.5 million in Q1 revenues, representing a 5.1% year-over-year growth. In February, we introduced Youdao SpaceOne, an AI-powered large-screen tutoring pen featuring our Confucius multi-model LLM. This innovative device offers precise image recognition, photo-to-speech conversion, and voice dictation capabilities, significantly broadening application scenarios while improving the learning experience. The product's strong market reception was evident as the initial inventory sold out within 10 days, contributing to over 20% year-over-year growth in our dictionary pen revenue during the quarter. Moving forward, we will accelerate the integration of our ambitious large language model across both learning and advertising verticals, executing our AI native strategy to elevate user experiences while driving greater growth. Having achieved our first full year operating profit in 2024, we are now strategically positioned to maintain this positive trajectory, targeting accelerated profit growth and achieving operating cash flow breakeven for full year 2025. With that, I'll pass the call to Su Peng for a detailed review of our financial performance. Thank you.

Peng Su, Senior President

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from the first quarter of 2025. We encourage you to read through our press release issued earlier today for further details. For the first quarter, total net revenues were RMB 1.3 billion or USD 178.9 million, representing a 6.7% decrease from the same period of 2024. Net revenue from our learning services was RMB 602.4 million or USD 83 million, representing a 16.1% decrease from the same period of 2024. The year-over-year decrease was mainly because we continue to take a strategic approach to customer acquisition, focusing on higher ROI engagements. Despite the short-term revenue decline, this strategy has enhanced the overall resilience and operational efficiency of our business. Net revenue from our smart devices was RMB 190.5 million or USD 26.3 million, up 5.1% from the same period of 2024, primarily driven by the increase in sales of Youdao Dictionary Pen in the first quarter of 2025. Net revenue from our online marketing services was RMB 505.4 million or USD 69.6 million, representing a 2.6% increase from the same period of 2024. For the fourth quarter, our total gross profit was RMB 614.2 million or USD 84.6 million, representing a 9.9% decrease from the same period of 2024. Gross margin for learning services was 59.8% for the first quarter of 2025 compared with 63.1% for the same period of 2024. Gross margin for smart devices was 52.3% for the first quarter of 2025 compared with 32.6% for the same period of 2024. Gross margin for online marketing services was 3.5% for the first quarter of 2025 compared with 34.3% for the same period of 2024. For the fourth quarter, we reduced our total operating expense to RMB 510.2 million or USD 70.3 million, compared with RMB 651.6 million for the same period of last year. Looking at our expense in more details, sales and marketing expense declined to RMB 357.6 million compared with RMB 455.4 million in the first quarter of 2024. Research and development expense decreased to RMB 115.5 million compared with RMB 146.7 million in the first quarter of 2024. Our operating income margin was 8% in the first quarter of 2025 compared with 2.1% for the same period last year. For the first quarter of 2025, our net income attributable to ordinary shareholders was RMB 76.7 million or USD 10.6 million, an increase of over 6 times from the RMB 12.4 million for the same period of last year. Non-GAAP net income attributable to the ordinary shareholders for the first quarter was RMB 81.7 million or USD 11.3 million, significantly increased from RMB 20.3 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 2025 were RMB 0.65 or USD 0.09 and RMB 0.64 or USD 0.09, respectively. Non-GAAP basic and diluted net income per ADS attributable to ordinary shareholders for the first quarter was RMB 0.69 or USD 0.01 and RMB 0.68 or USD 0.01, respectively. Our net cash used in operating activities was RMB 255.5 million or USD 35.2 million for the first quarter. Looking at our balance sheet, as of March 31, 2025, our contract liabilities, which mainly consist of the deferred revenue generated from our lending services, were RMB 711.2 million or USD 98 million compared with RMB 961 million as of December 31, 2024. At the end of the period, our cash, cash equivalents, current and non-current restricted cash, and short-term investments totaled RMB 424.5 million or USD 58.5 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.

Operator, Operator

Your first question comes from Brian Gong with Citi.

Brian Gong, Analyst

A quick question on AI. I noticed our AI thinker integrated ahead of our peers in the first quarter. So, from a medium- to longer-term perspective, how does management view the differentiation between your large language model fusions and other large language models in educational scenarios?

Feng Zhou, CEO

Brian, let me take the question. From day one of the large language model development back in early 2023, we've emphasized the importance of embracing open technologies. This year, the release of DeepSeek R1 provided the perfect opportunity for us to exercise that strategy. That is why we are the first in the ad tech industry to integrate it into our LLM stack and Mr. P AI Tutor in Q1, giving users options of models to solve K-12 problems. At the same time, our proprietary model, Confucius, has been evolving since 2023. In January, we released a major leap with Confucius-o1, actually before the DeepSeek R1 release. Confucius-o1 was the first open-source educational reasoning model capable of step-by-step exposition while being far more GPU-efficient than general-purpose models. This next-generation Confucius is now also deeply integrated across our learning services, AI-driven subscriptions, and smart devices, solidifying our leadership in deploying large language models for education in China. Let me highlight three key advantages of combining open and proprietary technologies for you. First, we believe this dual approach enhances user experiences. Confucius delivers faster responses while DeepSeek R1 often provides more comprehensive answers. We've observed that users very naturally adopt Confucius for quick checks and DeepSeek for in-depth explanation, with actual usage currently split roughly evenly. Second, we believe open technologies accelerate our teams and technology growth. Just as Google Android leverages the Linux kernel, we benefit from the broader ecosystem while contributing back. This dynamic environment pushes our teams to iterate faster, keeping us at the forefront of innovation. Thirdly, Confucius excels in education-specific scenarios. Thanks to the continuous refinements, it outperforms general-purpose models in a few very important areas. First is translation quality. Confucius leads the industry in translation accuracy, a core capability for our platforms while operating at a fraction of the cost of general-purpose models. As noted earlier, we've completed our year-long transition from NMT to LLM translation, now processing over 1.5 billion tokens every day. The second strength of Confucius models is Q&A accuracy. With recent multimodal upgrades, Mr. P AI Tutor achieves over 92% accuracy in K-12 problem solving, representing a 7-point year-over-year improvement and significantly surpassing stand-alone DeepSeek performance in these scenarios. We're also optimizing our use of DeepSeek by migrating DeepSeek R1 inference to our fully internal deployment. We've achieved 99.9% availability, lower latency, and greater cost efficiency with further optimization still ongoing. Our progress has gained a lot of recognition; Time Magazine recently ranked Youdao as the world's #2 ad tech company among over 7,000 firms, underscoring our leadership in LLM deployment and operational excellence. Moving forward, we will deepen our focus on educational verticals, enhancing Mr. P's accuracy while also expanding Confucius into more areas, including lesson planning, grading, and assessments. Exciting products and model updates are coming this summer, and we look forward to sharing them soon. Thank you.

Operator, Operator

Your next question comes from Liping Zhao with CICC.

Liping Zhao, Analyst

My question is about your learning services. I noticed that the net revenue from the learning service segment remained in a year-over-year decline during the first quarter. When do you project the segment's revenue to return to growth?

Peng Su, Senior President

Thank you, Brenda. This is Su Peng. I will handle the question first. I think our adjustment for the learning services segment initiated last year remains ongoing right now. We have intensified our focus on services with robust demand and significant growth potential, such as Youdao Lingshi, while scaling back non-essential offerings. As we mentioned in the last two quarters, it will be accomplished this year. Although the net revenue from the learning services segment still declined on a year-over-year basis in Q1, the rate of decline narrowed by roughly 5% compared to the previous quarters. This improvement was primarily driven by the resilient performance of Youdao Lingshi during this quarter. We believe there are several points to support the sustainable growth of Youdao Lingshi's business. First, China's paid college entrance exam advisory service market has demonstrated significant growth potential in recent years, driven by evolving college and school selection rules under new Youdao policies and the family's urgent needs to bridge information gaps. In Q1, we launched an upgraded AI college admission adviser, powered by our large language models, offering users professional, efficient, and tailor-made one-stop services. This service gained immediate user recognition and drove Youdao's Q1 gross billing to grow by over 25% year-over-year. Looking forward, we expect sustained rapid growth for our AI college admission advisers. Our computer model, in continuous advancement, will further refine the recommendation accuracy of our pricing, at less than 10% of the traditional advisory fee, making quality guidance accessible to more families. Additionally, we just noted that the recent education construction plan online has been released, emphasizing the cultivation of top-tier innovative talents and including outstanding talent programs for exceptional high school students. We will actively monitor policy developments and leverage our premium resources and product expertise to capitalize on these emerging opportunities. In summary, we anticipate completing our segment restructuring in the second half of this year with revenue stabilization expected thereafter. For our flagship Youdao Lingshi services, we project both revenue and profit to achieve year-over-year growth this year. Thank you, Brenda.

Operator, Operator

Your next question comes from Thomas Chong with Jefferies.

Thomas Chong, Analyst

My question is about online marketing services. As we see, revenue from online marketing services has remained at around RMB 500 million for 6 consecutive quarters. When does management anticipate a reacceleration in revenue growth?

Lei Jin, President

This is Lei Jin. Assuming stable market conditions and the execution of our business plan, we expect online marketing services revenue will show stronger growth momentum in the second half of this year compared to the first half, driven by three key factors. First, accelerated overseas advertising expansion. After obtaining Google's official partnership status in Q1 and completing certification, we are now implementing collaborative initiatives that should contribute meaningfully to H2 revenue. Additionally, our TikTok advertising revenue maintained strong growth in Q1, a trend we expect to continue through the year-end. Second, updated AI-powered advertising solutions. Our Q1 launch of Youdao MagicBox and the AI-driven one-click AD Creator tool marked the first step toward our enhanced capabilities. We are currently developing our AI advertising optimizer, with a beta version launching in Q2 and a full release planned for H2. This system will automatically generate comp strategies, including targeting scenarios and budget allocation aligned with advertiser objectives, while continuously optimizing through real-time RLM insights and adaptive recommendation models. Third, deepening the collaboration with NetEase School. In Q1, we leveraged our algorithmic and data analytics expertise to enhance the efficiency of NetEase's gaming promotions. For global promotions, our overseas influencer network now encompasses 15 million creators across 75 countries, reaching over 2 billion users directly. NetEase advertising with us grew steadily in Q1, and this positive trajectory is expected to continue. Regarding tariff impact, while the uncertainty duties may present challenges for acquiring overseas e-commerce clients, this segment currently represents a minimal portion of total advertising revenue, making the overall effect notably stable. We should note that H2 performance remains subject to macroeconomic conditions in domestic and international markets, which could introduce operational variabilities. Thank you.

Operator, Operator

Your next question comes from Bo Zhang with Huatai Securities.

Bo Zhang, Analyst

My question is, last year was Youdao's first full year of profitability. Among the four quarters, the second quarter reported an operating loss. Is there a possibility of profitability in the second quarter this year?

Wayne Li, VP of Finance

This is Wayne Li. I will take your question. Our financial performance throughout 2024 and Q1 2025 demonstrates significant and sustained profitability improvement. This progress validates the success of our strategic initiatives across three critical areas: first, sharpening focus on high-margin digital content, advertising, and AI-powered subscriptions; second, comprehensive AI native transformation boosting operational efficiency; and the last one is simplified cost optimization. By concentrating resources on Youdao online marketing services and other key initiatives, we've successfully contained the losses from non-core operations. Our AI integration has revolutionized multiple business functions, from cost operations to advertising production and R&D, delivering higher efficiency and profitability levels compared to our historical performance. Historically, Q2 has remained unprofitable mainly due to two seasonal reasons. First, Q2 is traditionally the weakest quarter for revenue generation from learning services and smart devices. Second, substantial sales and marketing campaigns for summer enrollment typically begin in June. For Q2 this year, we will maintain our strategic priorities, such as large language model deployment and cost development, while further optimizing our cost structure in line with our full-year profitability goals. Our ongoing investments in core offerings may temporarily affect our competitive position but are aimed at driving full fiscal profitability. In summary, we expect to reduce Q2's operational losses year-over-year while acknowledging potential macroeconomic uncertainty that may affect results. I hope this is helpful. Thank you.

Operator, Operator

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

Jeffrey Wang, Investor Relations Director

Thank you once again for joining us today. If you have any further questions, please feel free to contact us now at Youdao directly or reach out to Piacente Financial Communications in China or the U.S. Have a nice day.

Operator, Operator

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