Earnings Call Transcript - DAO Q4 2023

Operator, Operator

Good day, and welcome to the Youdao 2023 Fourth Quarter and Full Year 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.

Jeffrey Wang, Investor Relations Director

Thank you, operator. Please note that discussion today will contain forward-looking statements related to future company performance, which are intended to qualify for the Safe Harbor from liability as established by the U.S. Private Securities Litigation Reform Act. Such statements are not guarantees of future performance and are subject to certain risks and uncertainties, assumptions, and other factors. Some of these risks are beyond the company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. A general discussion of the risk factors that could affect Youdao's business and financial results is included in certain filings of the company with the U.S. Securities and Exchange Commission. The company does not undertake any obligation to update this forward-looking information, except as required by law. During today's call, management will also discuss certain non-GAAP financial measures for comparison purposes only. For the definitions of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2023 fourth quarter and full year 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.

Feng Zhou, CEO

Thank you, Jeffrey, and thanks to everyone for joining today's call. Before we start, I'd like to remind you that the financial information and non-GAAP financial data mentioned in this release are presented on a continuing operations basis, and all numbers are in renminbi unless stated otherwise. We had a strong financial performance in Q4, achieving the highest income from operations and operating cash inflow ever. Net revenues reached RMB 1.5 billion in Q4, up 1.8% year-over-year. Income from operations was RMB 76.3 million, which is a 209.2% increase compared to last year. Our operating cash inflow reached RMB 160.6 million, rising by 91% year-over-year. For the entire year of 2023, key financial metrics improved significantly. Net revenues hit RMB 5.4 billion, an increase of 7.5% year-over-year. While the loss from operations was RMB 466.3 million, it was reduced by 39.8% year-over-year. Operating cash outflow stood at RMB 438.1 million, improving by 17.6% year-over-year. We executed our strategy to grow in key areas, such as digital content and online marketing services, while also building a foundation for future growth through AI technology. We continue to work towards profitability and have already launched two major versions of our large language models, setting a solid groundwork for 2024 and an AI-driven future. Now, I'd like to discuss our progress in the fourth quarter, specifically regarding our large language model projects. Last month, we released Ziyue 2, our second language model for education, featuring substantial enhancements in conversational abilities, knowledge-based question-answering, and text processing. Using this new model, we launched Hi Echo 2, which features extensive updates to digital human characters, scenarios, conversational capabilities, and a new teaching mode. Additionally, we introduced Mr. P AI Tutor, a conversation and camera-based tutoring application for all K-12 subjects. This AI tool expands the capabilities of Ziyue from language learning to real-time multi-modality tutoring, covering one of the largest scenarios in K-12 education. We are excited to be the first in China to offer an AI tutor covering all subjects and look forward to reaching more users with this technology. We have also open-sourced two technologies, EmotiVoice and QAnything, since Q4, receiving over 10,000 stars on GitHub and demonstrating our technological prowess. Our large language model technology is already contributing to tangible business growth. For example, our translation subscription fees have doubled year-over-year since we integrated LLM features, achieving over 100% growth for three consecutive quarters, primarily driven by LLM-powered AIBox and recently launched translation features. In the Learning Services segment, net revenues were RMB 784 million, remaining largely stable year-over-year. Our data content services are performing well with net revenues of RMB 508.3 million, reflecting a 13.4% year-over-year increase in Q4. The gross profit margin exceeded 70%, and the net operating cash inflow from digital content services surpassed RMB 200 million. Notably, Q4 net revenue was sufficient to cover costs and operating expenses. Departments such as Lingshi and Youdao Literature are continually refining their products and services for users. In terms of business updates, I'm pleased to report that our consultation service for strengthening core academic disciplines achieved a retention rate of around 75% in Q4. Additionally, since we introduced AI writing refinement in Q3, we have delivered over 25,000 high-quality refinements, receiving widespread acclaim from our users. For 2023, digital content services generated net revenues of RMB 2 billion, up 11.7% year-over-year, also covering the full year's costs and operating expenses. Regarding STEAM courses, our CSP score prediction system for competitive programming achieved 200% year-over-year user growth. The retention rates for advanced-level programming and Go courses hovered around 70%. In 2023, 340 students from our programming courses earned awards in the CSP competition, with 106 securing the top prize. This success underscores the high quality of our courses and services. Youdao Zongheng received second prize in the 2023 China New Information Consumption Competition. In the online marketing services segment, Q4 net revenues reached a record high of RMB 474.1 million, marking an impressive year-over-year growth of 96.9%. Our online marketing services have experienced over 50% year-over-year revenue growth for five consecutive quarters, primarily due to our advanced AI technology and improved data infrastructure, which have strengthened our RTA technology capabilities, expanded our client base, and broadened application areas. AI is increasingly integrated into our advertising services; currently, about 20% of our advertising materials utilize AI workflows. Additionally, net revenues from online marketing services in the gaming, entertainment, sports, and O2O sectors rose by over 200% year-over-year. In the Smart Devices segment, net revenues totaled RMB 222.4 million, reflecting a decline of 45.3% year-over-year. Our focus on optimizing low return on investment sales channels has successfully reduced overall channel inventory, which impacted Q4 revenue. However, the financial health of this segment has improved on a quarter-over-quarter basis as we completed reshaping our sales channels. Recently, we launched the Youdao Smart Learning Pad X20, featuring Mr. P AI Tutor powered by our LLM Ziyue, which is the first learning pad in the industry with a comprehensive AI tutor for all subjects. We believe the challenges in the Devices segment are temporary. On February 21, we launched the Youdao Dictionary Pen X6 Pro, equipped with more AI and LLM features. I'm pleased to report that A6 Pro sold over 50,000 units in the first week, marking our most successful launch in history. As you can see, we are accelerating our product launches. In prior years, most new products debuted in the summer, but this year, we kicked off strong with the A6 Pro and E6. Our efforts in AI are yielding results, making our devices more appealing with features unique to Youdao products, such as AI grammar instruction, AI word instruction, and Mr. P AI Tutor. These features drive user satisfaction and sales growth, reinforcing our confidence in the future of learning devices. In terms of education digitalization solutions, we achieved over RMB 100 million in contract sales in 2024. Since launching Youdao Fun Sports, it has been adopted by over 100 schools, with a utilization rate over 95%. Looking ahead, we observe a steady increase in user demand for digital learning content and services across various subjects and age groups since last year, post-COVID. Youdao is well-positioned to seize this opportunity. With our experienced teams and established content, our digital learning segment is already on a growth trajectory. This year, we will continue to focus on key content areas, particularly Lingshi and literature, while developing new content. Another important factor is our unique strengths in AI technology. We are committed to maintaining our leadership in educational LLM as we experience a technological wave similar to LLM. Being a first mover provides significant advantages, and we see its impact on our business accelerating over time. Our quick ramp-up in 2023 for LLM technology and products is evident as we rolled out our model and launched multiple industry-first products promptly. As we deepen our understanding of the technology, we anticipate that LLM will further enhance the leadership of our products, including learning devices, online marketing services, and learning applications. Overall, we believe we are in a strong position to lead the development of a new generation of AI-powered, high-quality, content-based learning experiences for users both nationally and globally. Thank you, and I will now turn it over to Su Peng for an update on our financials.

Peng Su, VP of Strategy and Capital Markets

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from the fourth quarter and the full year of 2023. We encourage you to listen to our press release issued earlier today for further details. As Dr. Zhou mentioned, for the fourth quarter, total net revenue was RMB 1.5 billion or USD 208.5 million, representing a 1.8% increase from the same period of 2022. Net revenue from our learning services was RMB 784 million or USD 110.4 million, representing a 2.8% decrease from the same period of 2022. Net revenue from our smart devices was RMB 222.4 million or USD 31.3 million, down 45.3% from the same period of 2022, primarily due to our continuous efforts to streamline marketing channels with low returns on investment for the intelligence learning products in the first quarter of 2023. Net revenue from our online marketing services was RMB 474.1 million or USD 66.8 million, representing a 96.9% increase from the same period of 2022. The year-over-year increase in revenue from the online marketing services was mainly attributable to the increased demand for performance-based advertisement through third-party Internet properties. For the fourth quarter, our total gross profit was RMB 738.8 million or USD 104.1 million, representing a 4.6% decrease from the first quarter of 2022. Gross margin for learning services was 63.6% for the first quarter of 2023 compared with 64.1% for the same period of 2022. Gross margin for smart devices was 38.3% for the first quarter of 2023 compared with 46.2% for the same period of 2022. Gross margin for online marketing services was 32.7% for the first quarter of 2023 compared with 29.2% for the same period of 2022. For the fourth quarter, total operating expense was RMB 662.5 million or USD 93.3 million compared with RMB 750 million for the same period of last year. Looking at our expenses in more detail, our sales and marketing expenses were RMB 441.4 million compared with RMB 515.9 million in the first quarter of 2022. Research and development expenses were RMB 168.1 million compared with RMB 179.5 million in the first quarter of 2022. Our operating income margin was 5.2% in the first quarter of 2023 compared with 1.7% for the same period of last year. For the first quarter of 2023, our net income from continuing operations attributable to ordinary shareholders was RMB 56.5 million or USD 8 million compared with RMB 12.3 million for the same period of last year. Non-GAAP net income from continuing operations attributable to ordinary shareholders for the first quarter was RMB 69.3 million or USD 9.8 million compared with RMB 31.1 million for the same period of last year. Basic and diluted net income from continuing operations per ADS attributable to ordinary shareholders for the first quarter of 2023 was RMB 0.47 or USD 0.07. Non-GAAP basic and diluted net income from continuing operations per ADS attributable to ordinary shareholders for the first quarter was RMB 0.58 or USD 0.08. Our net cash provided by continuing operating activities was RMB 160.6 million or USD 22.6 million for the first quarter. Turning to our full-year results. Our total revenue for 2023 increased by 7.5% to RMB 5.4 billion or USD 759.1 million. Net revenue from our learning services for 2023 was RMB 3.1 billion or USD 443.4 million, remaining flat compared to 2022. Net revenue from our smart devices for 2023 was down 27.6% year-over-year to RMB 909.2 million or USD 128.1 million. Net revenue from our online marketing services for 2023 was up 98.1% year-over-year to RMB 1.3 billion or USD 187.6 million. Total gross profit for 2023 was RMB 2.8 billion or USD 389.8 million, compared with RMB 2.6 billion in 2022. Total operating expenses for 2023 decreased to RMB 3.2 billion or USD 455.5 million compared with RMB 3.4 billion in 2022. Net loss from continuing operations attributable to ordinary shareholders for 2023 was RMB 549.9 million or USD 77.5 million and basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for 2023 was RMB 4.53 or USD 0.64. Looking at our balance sheet, as of December 31, 2023, our contract liabilities, which mainly consist of deferred revenue generated from our learning services were RMB 1.1 billion or USD 148.3 million compared with RMB 1.1 billion as of December 31, 2022. At the end of the period, our cash, cash equivalents, reserved cash, time deposits, and short-term investments totaled RMB 527.1 million or USD 74.2 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the floor to your questions. Operator, please go ahead.

Operator, Operator

We will now start the question-and-answer session. The first question is from Brian Gong with Citi Group.

Brian Gong, Analyst

I have a question on our large language model. Youdao is pretty committed to AI and we also launched our own large language model this year. Can management share our NIM monetization channels for the year? Thank you.

Feng Zhou, CEO

I'll take this question. Yes. First, there is a consensus in the AI industry that education is one of the most important areas for large language model applications. Sam Altman talks about it. Bill Gates also mentions education and healthcare as the most important areas. So the overall focus is to capture truly important use scenarios in education and then monetize that. We basically think about this in two ways, two kinds of LLM projects. One is value-adding projects to our existing businesses, and the other is completely new initiatives. For the first category, we have a couple of channels. One of the very important ones is smart devices. A notable trend is that LLM features are quickly becoming major selling points for our devices. For example, AI features like AI grammar instruction have become the most used features and major selling points for Youdao Dictionary Pen since last year. I compare this to the Youdao Dictionary app, how we won the dictionary market. So that was done with two features: one was web interpretation, and the other was machine translation. Having effective solutions for specific learning scenarios that users care about has significantly expanded our market share and monetized technology. Of course, we also monetize apps through subscriptions. AIBox has become a key feature driving over 100% growth in subscription revenue year-over-year for the last three quarters. This has also contributed significantly to our growth in online marketing. Currently, over 20% of our advertising materials incorporate generative AI workflows. So that covers the first category, how we apply AI to our existing businesses. The other category, which may have a more prolonged impact, entails completely new products. We have Hi Echo, the English learning app, along with Mr. P AI Tutor as a stand-alone product. I believe these apps encompass vast usage scenarios. For example, the spoken English learning scenario is a significant business opportunity. If we study our competitors, we see that a Korean app in this domain has achieved around USD 20 million in annual revenue. So I believe there's a bright future for AI-powered language learning. Furthermore, Mr. P AI Tutor covers an even larger scenario, addressing home tutoring. If a student is at home doing exercises and has a question, the AI tutor can answer it much more effectively than parents or the student could. This idea is profound as it tackles one of the most critical challenges in home education. In summary, the two channels or categories we're exploring are as follows: one has an immediate impact on our business, while the other is more long-term but potentially larger in scope. I am optimistic about the influence LLM will have on our business going forward.

Operator, Operator

The next question is from Caini Wang with CICC.

Caini Wang, Analyst

My question is about our learning services revenue in 2023 being flat compared to 2022. I would like to know what the focus will be for our Learning Services segment in 2024. Thank you.

Feng Zhou, CEO

Yes. So I will take this question as well. In 2023, regarding our data content services, this has been the major contributor to net revenue in our learning services. We have redefined digital content services within the learning services sector, comprising any new services that were launched post the policy change. These primarily include Lingshi and Youdao Literature, alongside some other smaller courses—not including adult courses. For 2023, net revenues from content services reached RMB 2 billion, reflecting an 11.7% year-over-year growth with a gross margin around 70%. This segment has met our expectations. In 2024, we will focus on enhancing Digital Content services within our Learning services. Here are a few key points regarding our priorities: first, consumer demand is strong in this area, and we aim to improve services to meet diverse user needs. Youdao Lingshi is already leading in the industry, and our Youdao Literature course is also quite popular. As we gain more users, we will provide more personalized services tailored to different user needs. Youdao Lingshi recently introduced a small class course format for students with advanced learning needs, garnering positive feedback. Youdao Literature has also launched a major revision of the course, broadening its target age groups and providing users choix in terms of time investment. Essentially, as these products solidify their leadership positions in the industry, we can enhance them to satisfy diverse user needs across different cities, demographics, and budgets. We see promising opportunities ahead. Secondly, we will focus on introducing new SKUs this year. The learning needs of families in China have evolved rapidly over the past two years due to factors like the macro environment, policy changes, and trends like AI. Our teams have the insights to spot opportunities for new SKUs focused on non-curricular learning for K-12 students, aiming to deliver high-quality learning resources in STEM and humanities, thus fostering lifelong learning competencies. For our new projects, we adopt an agile and lean approach, starting small and growing organically. We currently have several projects in the incubation process and expect them to yield results in upcoming quarters. Third, an important area of focus will be applying AI to differentiate our products and improve productivity. With our large language model technology, we can implement AI diagnostics, tutoring, personalized exercises, and much more. Applying AI is fundamentally about enhancing learning outcomes and productivity. Beyond motivation, which is a strength of human teachers in engaging students, teaching is a labor-intensive endeavor. Our focus is on activities crucial for learning outcomes requiring significant teacher workload. If we can achieve that, we can deliver significant advantages. For example, the idea behind AI writing refinement has already seen 25,000 student writings refined in a single quarter, saving the equivalent of over 12,000 hours of teacher labor while improving student writing skills. We have more projects like this in the pipeline, which we believe will increasingly impact our business this year.

Peng Su, VP of Strategy and Capital Markets

Yes, I can add more detail based on Dr. Zhou's comments regarding digital content services. Most people are aware of the recent news from the government, which confirmed the implementation of reforms in college entrance exams this year. These reforms involve reductions in the number of questions, adjustments in scoring, and other innovative problem-solving approaches. Each time college entrance exams undergo updates, there’s typically a spike in demand for consulting on how to adapt to these new testing formats throughout the year. Internally, we have enhanced our digital content services to account for these changes and provide consulting to assist families in preparing for the new college entrance exam format. Additionally, we see further opportunities arising from our plan to strengthen basic academic disciplines, where we have established a strong reputation for our consultation services, and we anticipate this will drive digital service growth in 2024.

Operator, Operator

The next question is from Thomas Chong with Jefferies.

Thomas Chong, Analyst

Following the rapid growth of online marketing services in 2023, what are the new growth drivers that we should expect in 2024?

Lei Jin, President

This is Lei Jin. In 2023, the advertising market experienced solid growth across various products, with major domestic players like Tencent and Baidu growing by about 20% or 25% in their ad businesses. Performance-based advertisement has been a significant growth driver for this trend. Our integration of AI into our ad business resulted in much higher growth compared to regular market levels. We achieved continuous quarter-over-quarter growth every quarter in 2023, with net revenues reaching RMB 1.3 billion for the entire year, marking nearly 100% growth year-over-year. Beyond our AI capabilities, our thorough understanding of client demand, effective utilization of data, and focus on ad performance have been key drivers behind this success. In 2024, we will continue to emphasize digital advertising, concentrate on ad performance, and strengthen our competitive advantages while exploring new growth in two areas. First is the overseas market. Youdao ADS provides digital marketing solutions for brand promotion among Chinese enterprises, global influencer marketing, and overseas ad placement. Our extensive business in the translation field allows Youdao ADS to excel in providing translation services for 108 languages. Furthermore, our proprietary AI technologies, recommendation algorithms, and neural network translation systems have connected us to over 1 million high-quality influencers across various industries globally. This enables us to reach over 2 billion users in more than 25 countries, assisting in the global growth of Chinese brands. Notably, we have recently been authorized as an advertising agency for TikTok, which will facilitate our future expansion in international markets. Secondly, we are exploring potential in vertical industries, such as online gaming. We have notable advantages in serving game clients, including capabilities in ad material production and a deep understanding of gaming content marketing. In the latter half of last year, we began closer collaborations with NetEase Games, and moving forward, we will leverage our robust AI capabilities to deliver comprehensive services to clients in vertical industries, further tapping into the growth of our advertisement business. Thank you.

Feng Zhou, CEO

Yes, this is Feng Zhou. I’d like to add a point. We frequently get asked about the reasons and methods behind our significant advertisement business growth. The key to our past and future advertisement success is our ability to combine robust business operations with deep ad technology. Youdao's ad business is unique—we are not merely a monetization team or a branding agency; we are a technology-driven performance ad platform. In addition to managing our assets and traffic, we also deliver performance ads for third-party traffic. Each page view and click contributes to our revenue. In such a business model, efficiency is critical. This is where our AI and large language model capabilities fit in, helping to enhance the ad delivery process to maximize efficiency and value creation. Many ad companies may excel in business operations but lack robust technical capabilities, and vice versa. However, our team has honed both - strong business operations and a deep understanding of ad technology over the years. This is why we have seen such significant growth in the past year, and it will define our success in the future as well. I hope this clarifies how we perceive the ad business.

Operator, Operator

The next question is from an unidentified analyst with Citi.

Unidentified Analyst, Analyst

Well, I have only one question. With the improved cash flow observed in 2023, could management provide an outlook for cash flow in 2024? Thank you.

Yongwei Li, VP of Finance

Thank you for your question. This is Wayne. I will take your question. Operating cash flow is treated as a key health indicator for our company, and we are pleased to note a significant improvement in our operating cash flow in 2023 compared to prior periods. The operating cash outflow in 2023 was narrowed by nearly 20% year-over-year. Notably, in Q4, the operating cash inflow reached a record of around RMB 161 million, rising by net 1% year-over-year. This indicates that the business is progressing toward a healthy direction. Both the Learning services and Online Marketing services contributed to achieving positive operating cash inflow, which bolsters our confidence in further improvement in operating cash flow for 2024. We expect to sustain this positive momentum for our operating cash flow in 2024. First, we will continue to enhance our ability to generate cash inflow by leveraging AI technology and optimizing business operations. Additionally, improvements in product performance and sales channel management within the Smart Devices segment are anticipated to boost cash generation from this segment. It's also worth noting that cash flow tends to vary quarterly, exhibiting stronger seasonality in the second and the fourth quarters, likely due to user acquisition and retention activities in the Learning Services segment during these periods. Furthermore, from a long-term perspective, NetEase has been providing financial support to us, such as a revolving loan facility amounting to $300 million, as disclosed in our earnings release, with a maturity date of March 31, 2027. This assistance will facilitate the development of Youdao's business, especially for long-term investments in core technologies and resources. In summary, we are very confident in our cash flow for 2024. Thanks.

Operator, Operator

And that concludes the question-and-answer session. I would like to turn the conference back over to the management for any additional or closing comments.

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 at Youdao directly or reach out to Pearson Financial Communications in China or the U.S. Have a great day.

Operator, Operator

Ladies and gentlemen, thank you for joining the conference. It is now over. You may disconnect your telephones. Thank you.