Earnings Call Transcript - DAO Q4 2022

Operator, Operator

Good day, and welcome to the Youdao 2022 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 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 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 2022 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. 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. Our financial performance in Q4 was strong, producing record high net revenues and achieving our first-ever income from operations. Net revenues soared to a record RMB 1.5 billion in Q4, up 38.6% year-over-year. Income from operations reached RMB 24.6 million compared with the loss from operations of RMB 248.3 million in the same period of 2021. Total gross margin climbed to 53.3%, rising by 11 percentage points year-over-year. In terms of cash flow, we achieved an operating cash inflow of RMB 84.1 million. These results were primarily driven by the solid performance of our new services and smart devices. Sales of digital content services reached over RMB 600 million. Besides, the gross margin has been above 60% and net revenues have covered the cost and operating expenses for two consecutive quarters. As for smart devices, strong new product sales approaching 100% year-over-year growth on November 11 Shopping Festival facilitated the growth of net revenues from this segment to the best level of RMB 407 million in Q4. Then let me walk through the key financial metrics for our second half 2022. Net revenues reached RMB 2.9 billion in second half of 2022, increasing 36.8% year-over-year. Gross margin was 53.7%, improving 6 percentage points year-over-year. Loss from operations reached RMB 194.4 million, narrowing by 59% year-over-year. Operating cash outflow improved to RMB 210 million, a decline of 63.8% from the second half of 2021, which included discontinued operations. For the fiscal year of 2022, our key financial indicators improved significantly. Net revenues reached RMB 5 billion, up 24.8% year-over-year. Gross margin was 51.6%, improving 2 percentage points year-over-year. Loss from operations was RMB 74.7 million, narrowed by 17.9% year-over-year. Operating cash outflow improved to RMB 603.1 million, a decline of 55.2% from 2021, which included discontinued operations. Then I would like to add more color to our business progress in Q4. Net revenues from smart devices hit RMB 407 million, up 28.1% year-over-year. Dictionary Pen sales exceeded 400,000 units, the majority of which were the new products launched in 2022. Product-wise, we launched Youdao Dictionary Pen P5 in Q4, specifically designed for professionals, updated with 5 million professional terms in 16 professional fields. It provides translation into over 100 languages and enhances recognition accuracy through more advanced natural language processing. We also launched Youdao Smart Learning Pad X10 in Q4 which created AI-supported Learning Dashboards for better personalized learning experiences. As we entered the field of education tablets in Q3, the compound monthly growth rate of sales units exceeded 100%. Moreover, in the first three months after launching the Learning Pad X10, its compound monthly growth rates of sales units was nearly twice that of the Y10 for the same period. As for our learning services, net revenues reached RMB 806.3 million in Q4, up 39.2% year-over-year. The gross margin of learning services climbed to 64.1%, improving 13 percentage points year-over-year. We have been exploring the digitization of our learning services and have made significant progress. In Q4, we upgraded Youdao Literature-Creative Writing, which was co-developed by Youdao and Minecraft Education Edition. The digitized content effectively enhances learners' interaction and engagement, making learning materials easier to understand and more attractive. I encourage you to view the video on our IR website. In addition, the Champion Class of Youdao Go was released in Q4 with a teaching team led by World Champion, Ke Jie. The Youdao Go courses create a learning path starting from entry-level to advanced levels followed by champion-level classes. The successful adaptation of these progressive courses drove the gross margins up by over 50% year-over-year in Q4. Besides, the retention rate of the advanced level class reached over 70%. In terms of adult courses, we released upgraded solutions to the postgraduate entrance exams. It offers comprehensive solutions from Target Consultation to Hybrid Tutoring by AI and humans. Students are thrilled with these new features, leading to gross margins up by nearly triple digits year-over-year in Q4. Meanwhile, gross billings from vocational courses such as IT, Internet, and construction courses increased over 100% year-over-year in Q4. Looking back, we stuck to a customer-oriented philosophy and enhanced customer experiences with upgraded services and smart devices facilitated by technology and innovation in 2022. We released the world's first Dictionary Pen OS and launched digital content services that enhanced learning efficiency and effectiveness, which was supported by customers and ultimately reflected in our financials. Moreover, the share repurchase program demonstrated management's confidence in the future growth of the business. Looking ahead, we will continue to leverage cutting-edge technology and innovation to promote the sustainable development of smart devices, digital content services, and STEAM courses, further improving our business health and financial performance. With that, I will turn the call over to Su Peng to give you more details on our financial performance. Su Peng?

Peng Su, VP of Strategy and Capital Markets

Thank you, Dr. Zhou, and hello everyone. Today I will be presenting some financial highlights from our 2022 fourth quarter and full year. We encourage you to read through our press release issued earlier today for further details. For the fourth quarter, total net revenues were RMB 1.5 billion or $210.8 million. This represents an increase of 38.6% from the fourth quarter of 2021. Net revenues from our learning services were RMB 806.3 million or $116.9 million, representing a 39.2% increase from the same period in 2021. We attribute this growth to the strong sales performance from the new services initiated after the implementation of the Double Reduction Policy. Net revenues from our smart devices were RMB 407 million or $59 million, up 28.1% from the same period in 2021, driven by the popularity of Youdao's newly launched products, such as the Youdao Dictionary Pen X5. Net revenues from our online marketing services were RMB 240.8 million or $34.9 million, representing a 58.6% increase from the same period in 2021. The increase was mainly attributable to the growth in performance-based advertisements through third parties' internet properties. For the fourth quarter, our total gross profit was RMB 774.7 million or $112.3 million, representing a 74% increase from the fourth quarter of 2021. Gross margin for learning services was 64.1% for the fourth quarter of 2022, compared with 51.4% for the same period in 2021. Gross margin for smart devices was 46.2% for the fourth quarter of 2022, compared with 30.8% for the same period in 2021. Gross margin for online marketing services was 29.2% for the fourth quarter of 2022, compared with 32.6% for the same period in 2021. For the fourth quarter, total operating expenses were RMB 750 million or $108.7 million, compared with RMB 693.6 million for the same period of last year. With that, for the fourth quarter, our sales and marketing expenses were RMB 515.9 million compared with RMB 420.4 million in the fourth quarter of 2021. Research and development expenses were RMB 179.5 million compared with RMB 170.2 million in the fourth quarter of 2021. Our operating income margin was 1.7% in the fourth quarter of 2022 compared with an operating loss margin of 23.7% for the same period of last year. For the fourth quarter of 2022, our net income from continuing operations attributable to ordinary shareholders was RMB 12.3 million or $1.8 million, compared with a net loss from continuing operations attributable to ordinary shareholders of RMB 215.9 million for the same period of last year. Non-GAAP net income from continuing operations attributable to ordinary shareholders for the fourth quarter was RMB 31.1 million or $4.5 million compared with non-GAAP net loss from continuing operations attributable to ordinary shareholders of RMB 168.2 million for the same period of last year. Basic and diluted net income per ADS from continuing operations attributable to ordinary shareholders for the fourth quarter of 2022 was RMB 0.1 or $0.01. Non-GAAP basic and diluted net income from continuing operations per ADS attributable to ordinary shareholders for the fourth quarter was RMB 0.25 or $0.04. Our net cash provided by continuing operating activities was RMB 84.1 million or $12.2 million for the fourth quarter. Turning to our full-year results. Our total revenues for 2022 increased by 24.8% to RMB 5 billion or $726.8 million. Net revenues from our learning services for 2022 were RMB 3.1 billion or $447.2 million, up 26.3% from 2021. Net revenues from our smart devices for 2022 grew by 28.2% year-over-year to RMB 1.3 billion or $182.2 million. Net revenues from our online marketing services for 2022 were up 13.2% year-over-year to RMB 672.4 million or $97.5 million. Total gross profit for 2022 was RMB 2.6 billion or $375 million, compared with RMB 2 billion in 2021. Total operating expenses for 2022 increased to RMB 3.4 billion or $487.3 million compared with RMB 2.9 billion in 2021. Net loss from continuing operations attributable to Youdao's ordinary shareholders for 2022 was RMB 720.9 million or $104.5 million, and basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for 2022 was RMB 5.83 or $0.84. Looking at our balance sheet, as of December 31, 2022, our contract liabilities, which mainly consist of deferred revenues generated from our learning services, were RMB 1.1 billion or $154.7 million, compared with RMB 1.1 billion as of December 31, 2021. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB 1 billion or $147.4 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

Our first question today will come from Brian Gong of Citigroup. Please proceed.

Brian Gong, Analyst

Good morning. Good evening, gentlemen. Thanks for taking my question. Congratulations on the solid results. So my question is about the outlook for this year. What are management's expectations for the revenue for 2023 and what are the key drivers of the new services this year? Thank you.

Feng Zhou, CEO

Hello, Brian. Yes. So, our mission is to make learning happen and we are doing that with the other business that we do, including our devices, our artificial intelligence-based learning services, and also our teaching staff. So we believe at this particular time, we are in a good position to both grow the impact of our business and also improve our financial metrics, including top and bottom line cash flow for this year. So, you asked about the drivers for learning services. So this is our largest sector, and I see several things that work in our favor, but I'll talk about two major drivers. One is digital content services. We have discussed this form of product for several quarters. We have popular products in this form, including Youdao Literature and Youdao Go. In 2022, it has proven that interactive content instead of live classes like courses-learning are a great way of delivering learning services. These services have consistently expanded for us in 2022, and customers really like them. We expect them to be the preferred way for us to offer new learning services in 2023. Our teams are constantly looking for new content opportunities and also using AI-assisted ways to create digital content, as well as using immersive learning methods of delivering this new content, tailored to specific user needs. So we will continue to scale our digital content services by both adding new content and iterating on existing ones. So we are bullish on this area. It's already proven, and our teams have many ideas; we will do a lot of work in this area. The second driver I see is STEAM: science, technology, engineering, art, and mathematics—extra-curricular kind of content. As student learning in China evolves, families are more and more willing to invest in STEAM learning like art, engineering, and other extra-curricular activities. We offer very good computer programming courses that will be our focus for 2023. We already have a leading and healthy Go game and chess course business that grew by over 50% in Q4. Therefore, this is a very special service with excellent teaching staff, leading AI learning technology, and a thriving learning community. The user experience during the process is what we excel at. Users' satisfaction allows us to double the size of the business in 2022, which testifies to families’ preferences for this extra-curricular content. So we will continue to look for opportunities in this area. Importantly, we achieved profitability in Q4, which speaks to our focus on maintaining a healthy operation of our business. Our focus is on not just absolute gross numbers but the unit economics of our various services and user satisfaction. We have always maintained this focus at NetEase and Youdao, and we believe this will lead to a bright future for us this year and beyond. I hope that answered your question.

Peng Su, VP of Strategy and Capital Markets

Yes. I guess, Brian. So if you look at the revenue in the first half of 2022, it grew about 12% compared with the first half of 2021. But in the second half, the revenue growth rate reached almost over 40%, at 37% in the second half of 2022 compared to the second half of 2021. Reviewing all the numbers, including the revenue of our learning services, smart devices, as well as online marketing services, all saw much faster growth in the second half compared to the first half. Also, the net loss in the first half was roughly about RMB 600 million, but in the second half, it narrowed down to below RMB 200 million, and we also decreased our cash outflow by over RMB 100 million in the second half compared to the first half. So I think we built strong momentum in the second half, and we expect to maintain that momentum in 2023. This points to our focus on healthy operations and solid financial performance. Thank you. I hope that answers your question, Brian.

Brian Gong, Analyst

Yes. That's very helpful.

Operator, Operator

Our next question today will come from Liping Zhao of CICC. Please go ahead.

Liping Zhao, Analyst

Good evening, Dr. Zhou and Su Peng. Thanks for taking my questions. So my question is about your AI R&D. I've read two recent media reports that your company has invested in AIGC in the education scenario. Could you please share more color on that topic? Thank you.

Feng Zhou, CEO

Thanks. It's a hot topic. Yes. Everybody is talking about it. I believe AIGC and large language models are going to have a significant impact on our education technology, and even many other technology and product areas. This is a long-term development. This year, we will see new products; next year will likely bring forth several new ideas from different companies, but it will take a while to mature. We are carefully monitoring this area. What I can say is that we are prepared and we have the necessary technology foundations. We have experience in implementing various important pillar technologies related to modern language model innovations, including transformer models and large language datasets. Our teams have experience in these areas thanks to our work in translation, AI-powered learning devices, and grammar correction, among others. It is still evolving and won't change everything overnight as many media outlets seem to suggest. However, it holds great promise. The fundamental difference about this wave of technology is its versatility and generality. It allows one or several models to tackle dozens or even hundreds of different problems. In the past, we needed to build separate models for each function, but now, one or a few models can generally suffice. We believe this will greatly impact education technology-related businesses in the coming years, and when concrete opportunities materialize, we will be in a good position. Yes. Thank you.

Liping Zhao, Analyst

Thank you.

Operator, Operator

Our next question today will come from Thomas Chong of Jefferies. Please go ahead.

Thomas Chong, Analyst

Hi. Good evening. Thanks management for taking my questions. My question is will there be any new smart devices introduced in 2023? Which SKU will be the key contributor in the smart device segment for this year? Thank you.

Feng Zhou, CEO

Yes, Thomas. Let me take this question. As you've seen, Youdao Dictionary Pen, Learning Pads, and Listening Pods performed quite well in Q4. We reached record revenue for the devices sector, which reflects the effectiveness of our strategy despite the challenging macro environment. We focused on a few key products and delivered meaningful innovation in each new product. Parents want the best products for their children rather than low-quality alternatives. If we can achieve this, our products will perform well in the market. New products will always contribute to our growth, but I first want to emphasize our new generation hardware and software platform. Our latest X5 and P5 Dictionary Pen are based on this new platform, which ensures we have the capabilities we need for our current and future products. We have collaborated closely with our chip partners to enhance the neural processing unit, improving efficiency in running AI computation models. This has allowed us to reduce translation error rates further by over 60% while increasing device speed by 50%. This platform is important as it enables innovation and shared features across our products. It operates on our Youdao OS, allows shared apps, and brings in content from high-quality providers. Furthermore, the platform provides a robust cost structure reflected in Q4 results as X5 and P5 improved our device gross margin, reaching 46%. Therefore, using this new hardware platform for more products is a priority for us in 2023. The Youdao Learning Pad is expected to be a significant growth contributor this year, given our extensive product portfolio, sales expertise, and experienced teaching staff. Our X10 and Y10 SKUs currently cover mid-market price points, and we plan to introduce new products to cover diverse price points. Lastly, we are also exploring new category opportunities, and we will share more when we can. Thank you.

Peng Su, VP of Strategy and Capital Markets

And Thomas, this is Peng, just one point to add here. If you look at our learning products' development process, we released our Dictionary Pen Version 2 in the middle of 2019. In language learning, there are four capabilities: listening, reading, writing, and speaking. We started with the Dictionary Pen to help users with reading and writing, and we later released the Listening Pod to cover the listening and speaking functions for potential and existing users. Now we are integrating these learning products with the Learning Pad and expanding beyond language learning. Our journey began with a focus on language learning, leveraging our Youdao Dictionary app. As we evolve, we are increasing our capabilities across the educational landscape. I hope this clarifies our strategy for releasing more learning products in the future.

Thomas Chong, Analyst

Thank you.

Operator, Operator

Our next question today will come from Linda Huang from Macquarie. Please go ahead.

Linda Huang, Analyst

Thank you very much for the opportunity to ask the question. Mine is regarding the online marketing business because we see that Q4 number is quite impressive, especially for the year-on-year revenue growth. Can the management help us to walk through what is the key reason behind that? And how sustainable is the business going into 2023?

Lei Jin, President

Thank you, Linda. This is Lei Jin. Our advertisement segment is a modest segment for us. It is relatively smaller than our linear service and smart devices segment. However, it has been stable and consistently growing. This quarter, the advertising business performed very well. The net revenue from this segment increased almost 60% year-over-year, reaching RMB 240 million in Q4. We have always been focused on customer value and a technology-driven approach to digital marketing, which is paying off. More clients are focusing on the return on investment of their marketing. Internally, we've upgraded our advertising system to deliver more timely and accurate commercial data, improving performance for our performance-based advertisements and providing better ROI to our clients. Externally, we've noted an increase in marketing demand from the online entertainment industry in the fourth quarter, primarily driving our ad revenue. The number of clients increased by around 20%, and spending on advertisements also rose. For the outlook in 2023, I am cautiously optimistic. We expect revenue from online marketing services to continue to grow year-over-year this year, even amidst a challenging macro environment. The good news is that several economic policies have been rolled out since the Chinese New Year, and we're seeing more advertising budgets from online entertainment clients as well as increased budget from the financial and transportation industries, especially for performance-based advertisements. This is a positive start. Thank you. Hope this information is helpful.

Feng Zhou, CEO

Thank you.

Linda Huang, Analyst

Thank you very much. Yes, thank you.

Operator, Operator

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

Candis Chan, Analyst

Great. Hi, management. Thank you for taking my question and congratulations on the strong set of results. My question relates to the gross margin trend for each segment for 2023, as we have noticed great improvement in gross margin for learning services and smart devices this year. Can you share about the trend going forward? Thank you.

Feng Zhou, CEO

Thank you for your question. Yes, we achieved excellent performance in our overall gross margin in 2022, reaching around 52%, up from 50% last year. The increase in our gross margin was mainly driven by improvements in both learning services and smart devices. Regarding expectations for the future, let's begin with our learning services, where we achieved healthy sales in our digital content service in 2022. We expect to reach a higher revenue base in 2023, leading to additional benefits from scales, increasing our gross margin further. We noted a decreasing trend in the percentage of revenue shared with our instructors year-over-year, which further supports our expectations for gross margin increases in learning services over the long run. For the smart devices segment, the average gross margin in 2022 was 39%, slightly up from 37% in 2021. We are pleased to report that in Q4, gross margin for our smart devices reached 46% after we launched the X5, the updated version of the Dictionary Pen. We regularly update our smart devices, and new product launches typically lead to higher gross margins initially due to their higher pricing, better platform performance, and popular reception. Hence, we expect gross margins for smart devices to stabilize at or above 40%, maintaining competitiveness. Overall, we still expect reasonable improvements in the margins of our learning services and smart devices annually, while our advertising segment margins will likely remain flat compared to last year. I hope this is helpful.

Operator, Operator

Ladies and gentlemen, this will conclude our question and answer session. At this time, I would like to turn the conference back over to management 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 at Youdao directly or reach out to Piacente Financial Communications in China or the U.S. Have a great day.

Operator, Operator

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