Earnings Call Transcript - DAO Q3 2024

Operator, Operator

Good day, and welcome to the Youdao 2024 Third 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, sir.

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 2024 third quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. A webcast replay of this conference call will also 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.

Dr. 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. We are thrilled to announce an outstanding third quarter. Net revenues for the quarter reached RMB1.57 billion, marking a 2.2% increase year-over-year. Our profitability improved remarkably. Income from operations reached RMB107.3 million compared with a loss of RMB57.7 million in the same period last year. This represents our first profitable third quarter and sets a new quarterly record for income from operations. We are on track to achieve our first full year of operational profitability this year. Additionally, operating cash outflow narrowed to RMB85.4 million, an improvement of 71% compared to the same period last year. Now let's review the major developments across our business lines. Net revenues from learning services were RMB767.9 million, down 19.2% year-over-year, primarily due to our proactive focus on high-demand services and a reduction in low return on investment customer acquisition operations during the summer. Notably, customer retention continued to improve. Therefore, the overall financial health of our Learning Services segment significantly improved in Q3. Within this segment, net revenues generated by digital content services, namely online courses, were RMB513.7 million. These revenues covered the costs and operating expenses and yielded meaningful profit. Our team focused on improving the products of Youdao Lingshi. We expanded our knowledge video library to nearly 40,000 targeting students of different learning levels. Additionally, we doubled the question bank to around 100,000 questions. Leveraging our advanced large language model, our AI can now automatically collect and categorize users' mistakes, adding new questions to enhance personalized learning experiences. We also released new small class study experiences, including personalized monthly learning plans developed by our experienced learning counselors and AI-recommended quizzes. This provides students with a welcoming and motivating learning experience that delivers great results and high retention rates. In the meantime, Youdao Literature continued to expand the use of AI writing refinements in Q3, leading to a 7 percentage point increase in conversion rates. We expect sustained strong demand for online learning services in the coming years. The key to success lies in our ability to deliver high-quality service and learning outcomes at scale. While we have made significant progress in online learning innovations, as evidenced by rapidly improving retention rates and positive customer feedback, there remains substantial room for further innovation. Fortunately, we now have new AI tools at our disposal, and customer demand remains robust. We look forward to serving learners and families with innovative online learning solutions in the years ahead. Sales of our AI-driven subscription services in the Learning Services segment continued to grow rapidly, approaching RMB70 million in Q3, representing over 150% year-over-year growth. This marks the seventh consecutive quarter of more than 50% year-over-year growth. On the product front, we released new AI translation upgrades in Youdao Dictionary and Youdao Translation. These updates include multilingual translation support, customized glossaries, and multi-model input capabilities for images and documents. To date, our AI document translation service has processed over 100 million documents. Youdao Dictionary introduced an AI-powered voice simultaneous interpretation feature powered by our large language model Ziyue. This feature has seen over 4 million users in its first quarter and has become the most popular paid feature in Youdao Dictionary. Hi Echo also gained prestigious recognition this quarter and was prominently featured on the Apple App Store homepage. It also ranked in the top 10 for next-day retention on a renowned AI application ranking chart. Following this launch, Mr. P AI Tutor received an enthusiastic reception, with nearly 20 million users in the third quarter and a monthly compound growth rate exceeding 100%. For online marketing services, net revenues reached RMB489.4 million in Q3, representing an increase of 45.6% year-over-year. Gross margin increased to 36.3%, up 4.4 percentage points year-over-year. This growth was mainly driven by our expansion into new sectors and leveraging data applications and AI to optimize ad performance, pushing RTA revenues to a historical high and an over 100% increase year-over-year. Additionally, we observed positive developments in overseas advertising, which accounted for approximately 20% of the ad revenue in the third quarter. Robust demand in games and related industries fueled growth, driving overseas KOL ad revenue up by over 50% year-over-year. We also upgraded our anti-fraud system for advertising in Q3, integrating real-time monitoring across multiple dimensions, optimizing quality control and identifying potential audiences. We expect ongoing algorithm upgrades and enhanced service quality to support the long-term growth of our online marketing services. In the Smart Devices segment, net revenues reached RMB315.3 million in Q3, up 25.2% year-over-year, marking the highest revenue since 2023. Alongside this growth, this segment's overall health has significantly improved with gross margin rising to 42.8%, also reaching its highest level since 2023. In terms of product upgrades, we launched the latest generation of our flagship dictionary pen, the X7 Pro. This high-end device features a comprehensive 78 million word database and an AI camera that supports advanced LLM functions such as Mr. P AI tutor and AI translation. Notably, the X7 series has become the first learning device in the industry to support offline large language model translation with accuracy surpassing online neural machine translation. The strong performance of our new products drove over 50% year-over-year net income growth for Dictionary Pens in Q3. Building on this success, I'm pleased to announce that we will launch a new product in the fourth quarter. Please stay tuned for further details. That’s the summary of our progress in Q3. As discussed on this call earlier this year, we have two key objectives for 2024: rapidly integrating generative AI technology across our businesses to enhance competitiveness, both now and in the future, and operational focus on streamlining our business lines to achieve full year operating profitability. With robust results from Q3, we are making significant strides towards meeting these goals. By the end of the third quarter, cumulative income from operations had reached RMB64.6 million, a significant improvement compared to the RMB542.6 million loss from operations in the same period last year. I'm confident that we will achieve full year operational profitability this year. Looking ahead, we are committed to the continued implementation of our large language models, Ziyue, to enhance user experience and create greater value through digital content services, AI-driven subscription services, and smart devices. In our online marketing services, we aim to explore new domestic opportunities while also expanding internationally to better support client success. Lastly, financially, we remain dedicated to prudent operations and strengthening our profitability. With that, I will turn the call over to Su Peng to provide you with more detailed insights into our financial performance. Thank you.

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 third quarter of 2024. We encourage you to read through our press release issued earlier today for further details. For the third quarter, total net revenue was RMB1.6 billion or $224.1 million, representing a 2.2% increase from the same period of 2023. Net revenue from our learning services was RMB767.9 million or $109.4 million, representing a 19.2% decrease from the same period of 2023. The year-over-year decrease reflects our commitment to a more selective customer acquisition approach, prioritizing higher return on investment engagements. This strategy has helped enhance our overall resilience and efficiency of our business. Net revenue from our smart devices was RMB315.3 million or $44.9 million, up 25.2% from the same period of 2023, primarily driven by the popularity of the new Youdao products launched in 2024. Net revenue from our online marketing services was RMB489.4 million or $69.7 million, representing a 45.6% increase from the same period of 2023. The increase was mainly attributable to increased demand for performance-based advertisements through third-party internet properties, which was driven by our continued investment in cutting-edge AI technology. For the third quarter, our total gross profit was RMB789.5 million or $112.5 million, representing an 8.2% decrease from the third quarter of 2023. Gross margin for learning services was 62.1% for the third quarter of 2024 compared with 67.8% for the same period of 2023. Gross margin for smart devices was 42.8% for the quarter of 2024 compared with 42.6% for the same period of 2023. Gross margin for online marketing services was 36.3% for the third quarter of 2024 compared with 31.9% for the third quarter of 2023. For the third quarter, we reduced our total operating expense to RMB682.2 million or $97.2 million compared with RMB917.3 million for the same period of last year. Looking at our expenses in more detail, sales and marketing expenses declined to RMB519.6 million compared with RMB674.2 million in the third quarter of 2023. Research and development expenses were decreased to RMB119.6 million compared with RMB187.3 million in the third quarter of 2023. Our operating income margin was 6.8% in the third quarter of 2024 compared with an operating loss margin of 3.7% for the same period of last year. For the third quarter of 2024, our net income attributable to ordinary shareholders was RMB86.3 million or $12.3 million compared with net loss attributable to the ordinary shareholders of RMB102.9 million for the same period of last year. Non-GAAP net income attributable to the ordinary shareholders for the third quarter was RMB88.7 million or $12.6 million compared with non-GAAP net loss attributable to the ordinary shareholders of RMB67.3 million for the same period of last year. Basic and diluted net income per ADS attributable to the ordinary shareholders for the third quarter of 2024 was RMB0.74 or $0.11. Non-GAAP basic and diluted net income per ADS attributable to the ordinary shareholders for the third quarter was RMB0.76 or $0.11. Our net cash used in operating activities was RMB85.4 million or $12.2 million for the third quarter. Looking at our balance sheet, as of September 30, 2024, our contract liabilities, which mainly consist of the deferred revenue generated from our learning services, were RMB839.7 million or $119.7 million compared with RMB1.1 billion as of December 31, 2023. At the end of the period, our cash, cash equivalents, current and non-current restricted cash, time deposits and short-term investments totaled RMB489.4 million or $69.7 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions.

Operator, Operator

The first question comes from Brian Gong of Citigroup.

Brian Gong, Analyst

I have a very quick question. We have noticed that many of our peers have been increasing investments in the cost-related business, right? So can management share our strategies on this? And are we planning to increase our investment in the learning service sector in the future?

Peng Su, VP of Strategy and Capital Markets

Thank you, Brian. This is Su Peng. I will handle the question first. I think aligned with our strategy of achieving the positive full year operating profit in the near future, we focus on strong demand services, which are scaling back on the low return customer acquisition efforts during the last summer. We believe that healthy and sustainable development is more essential for long-term success. As you may notice, Youdao Lingshi is definitely a strategic priority for our business. Although there are some short-term headwinds, we remain optimistic about the medium and long-term growth. We expect to sustain strong demand for the online learning services in the coming years. Ensuring the financial health of our business, we will facilitate the development of the learning service, particularly in Lingshi. We believe that is our long-term strategy. We believe that increasing our market shares over the mid-term to the long term will primarily come from providing differentiated and high-quality products and services to the users and improving their learning outcomes. We think our flagship products offer a unique combination of AI tiered learning videos and comprehensive learning consulting services. Through the AI enhancements and ongoing product upgrades, we enable the users to achieve personalized education, improve learning efficiency and outcomes. The comprehensive services, including learning diagnostics, learning path planning, paired learning videos, AI-created recommendations and AI collection and categorization of students' mistakes, and learning consulting services, one-on-one class study experiences and also the AI college admissions advisers. I think that's the kind of full services generated and driven by our AI. We will definitely continue to invest in our products and services, which have strengthened our users' loyalty, evidenced by the upgrade in retention rate for the first quarter. The current retention rate for Lingshi has already hit about 70% by now, although the retention period has not finished yet. It's already over 5% compared with the same period of last year. Looking ahead, I am confident in Lingshi's development for the next year. On one hand, we will continue to focus on our personalized, pre-recorded video learning, leveraging our AI capabilities and upgrading and enhancing our users' learning experience. On the other hand, we will explore more offline opportunities, offering services to our customers. I think that's our priority. And in the long term, I expect we will increase investments in product upgrades and also customer acquisition following the strategy of the total company. Thank you.

Dr. Feng Zhou, CEO

This is Zhou Feng. Let me add one point. Yes, for Youdao Lingshi, marketing and customer acquisition, particularly in the summer, are very important for its growth and performance. So there were some challenges on this front this summer. On the other hand, we always believe that customer satisfaction and retention are more important and fundamental. So as long as our retention is leading and our satisfaction is leading, I believe we will always find ways to grow the business and grow the student base. If you look at the numbers that Su Peng just shared, in the recent retention period, we've already reached 70% retention. That's very good and already competitive. So I think that is the key thing and we are building future growth on solid foundations. Thank you.

Operator, Operator

The next question we have comes from Brenda Zhao of CICC. The next question we have comes from Thomas Chong of Jefferies.

Thomas Chong, Analyst

We are pleased to see that the smart devices sector has resumed year-on-year growth in the third quarter. Can we expect this growth to be sustainable?

Dr. Feng Zhou, CEO

Yes. Net revenue from smart devices reached RMB315 million in the third quarter, up 25% year-over-year. I believe several factors contributed to the rebound of device revenue. The first one is positive outcomes from our strategic focus and channel reorganization. Earlier this year, we reviewed our device business, and we decided that we needed to focus the team's work. We want to do fewer things and do them really well. Since then, I think increased focus of our operations, in particular, more focus on the dictionary pen products really paid off well in Q3. The new X7 and X7 Pro are among our most successful launches ever. The high-end product X7 Pro, equipped with the new AI camera and a suite of exciting AI features, received widespread acclaim from users. This positive reception drove net revenues and gross margin and the gross margin of smart devices and revenue have reached the highest levels since 2023. During the recent Double 11 shopping festival, I also want to share that our dictionary pen again secured the top spot in terms of sales volumes in its category on both Tmall and JD.com for five consecutive years. Furthermore, our newly launched dictionary pen X7 Pro achieved the highest single product sales in its category on both Tmall and JD.com. These accomplishments reflect our continued dominance in the market with outstanding performance. We expect revenues from smart devices to continue to grow in the fourth quarter. The second factor is enhanced team capabilities. The team, I think, is much more important than the product or the strategy. Our device team has seen ups and downs, particularly facing pressure since last year, leading to a lot of reflections, re-planning, and changes in our execution. I am pleased to see that in such a challenging environment, our team has shown remarkable resilience. They asked the right tough questions and executed on the new focusing strategy. So I believe the team executed really well across functions, including product design, R&D, supply chain, sales, and marketing, leading to a significant recovery of the business. I believe any team that was able to go through downturns and re-emerge stronger is more likely to succeed in the future. Looking ahead, from a product pipeline perspective, we expect to launch a new product in Q4 with more new products scheduled for Q1 as well. For our dictionary pens, we emphasize cost-effectiveness for mid-range products and high quality and differentiation for high-end products. The whole product line will employ more large language model features to greatly enhance user experiences. We are convinced that LLM has a lot more to offer for education products for years to come. The team will be busy integrating more of such features into the products in the coming quarters. We are on the right track, and I believe we are headed toward leading products, better financial health, and profitability for the device segment. Thank you.

Operator, Operator

The next question we have comes from Brenda Zhao of CICC.

Brenda Zhao, Analyst

I noticed your online marketing service continued to see strong growth momentum. However, as the business had a high base in the fourth quarter of last year, where should we anticipate the future growth potential of this advertising business?

Lei Jin, President

This is Jin Lei. Net revenue from online marketing services has recorded rapid growth for eight quarters, primarily driven by advancements in AI, including ongoing algorithm optimization and enhanced data applications. Additionally, our team's execution has steadily improved. Looking ahead, I believe there is significant growth potential for both domestic and international advertising in the medium to long term. In the domestic market, we anticipate substantial opportunities in several sectors. First, the online entertainment industry, such as gaming and social media. This summer vacation, we drove the gaming ad revenues to a historical high in Q3. In addition, enhanced data analysis and optimized algorithm models have improved monetization rates by over 90%. Second, AI tools. Since the rapid development of domestic large language models in the latter half of last year, major tech companies have significantly increased marketing budgets for their AI tools. This trend has driven rapid growth during the last several quarters. Future demand for AI tools advertising is expected to remain strong. Third, the automotive industry. Consumption-stimulating policies are anticipated to benefit the automotive and related services sectors, likely driving an increase in advertising demand. In the international market, we became a primary agent for TikTok in the first half of this year. Recently, we established initial intentions for cooperation with several global tech giants, with formal partnerships expected in the near future, providing a solid foundation for our future global expansion. In the meantime, growth in our advertising business also faces certain short-term challenges. For example, as you mentioned, ad revenue set a very high base in the fourth quarter of last year, and e-commerce advertising has not been robust during the recent Double 11 shopping festival. In addition, recent updates on international macro factors have added uncertainty to overseas advertising. However, from a financial health perspective, the profitability of the advertising business is expected to remain solid in the fourth quarter. This focus aligns with our broader strategic objectives for the year and remains a key metric under the current conditions. Thank you.

Operator, Operator

The last question we have comes from Bo Zhang of Huatai Securities.

Unidentified Analyst, Analyst

This is Jambua. My question is about what the management's outlook is for the fourth quarter?

Wayne Li, VP of Finance

Thank you. This is Wayne. As we mentioned before, we have focused on digital content services, online marketing services, and AI-driven subscription services this year, particularly on advancing generative AI to achieve full-year operating profitability soon. Over the past three quarters, we have seen significant improvement in our financials. Net revenue for the first three quarters reached RMB4.3 billion, showing an increase of about 10% year-over-year. We achieved positive cumulative income from operations of around RMB65 million, compared to a loss of approximately RMB543 million during the same period last year, which is a notable improvement. Our strong financial performance clearly shows that our strategy combining AI technology and education is effective, and we are confident about achieving our profitability goal this year. Moving forward, we will continue to integrate generative AI technology across our business to boost competitiveness. In terms of learning services, we expect high demand for online learning services to continue for the coming years, and we are optimistic about the medium- to long-term growth potential of our learning services. Our success will depend on our ability to deliver high-quality services and learning outcomes at scale. As mentioned earlier, our high school business remains our top priority. The demand in this area is strong and is likely to persist. We have been building a top-notch instructor team and incorporating AI features into our learning services for years. The strong advantages we have in AI technology give us confidence in enhancing our competitive edge in the high school sector. Regarding our AI-driven subscription services, we are committed to improving our current offerings while also exploring new ways to enhance user experiences in learning, work, and daily life. For the fourth quarter, we still anticipate significant year-over-year growth in total sales of AI-driven subscription services. For online marketing services, we have experienced rapid growth and improved profitability for eight consecutive quarters. In the short term, our advertising business serves as a primary source of revenue and a vital profit center. Long-term, we will continue to explore strategic growth opportunities in both domestic and international markets. We will provide updates on significant developments as they occur. Lastly, for smart devices, we see AI-integrated smart devices as a major opportunity. While smartphones and tablets continue to dominate usage scenarios, the market for traditional smart devices is contracting. However, integrating AI into smart devices allows for innovation, including the development of devices that are either smaller than smartphones or larger than tablets to meet user needs. Additionally, edge-based large language models offer new possibilities for smart devices. Our Dictionary Pen X7 series has become the first educational device to support offline large language model translation, achieving accuracy that exceeds online machine translation. We are exploring further integration of edge-based large language models into our smart devices to enhance user experience. In the long run, our experience in educational technology, supply chain management, and sales channels lays a solid foundation for sustainable growth in our smart devices segment. We are also planning for next year and look forward to sharing more insights during the next earnings call. Thank you.

Dr. Feng Zhou, CEO

Let me add a little bit more information. This is Zhou Feng. If you look at our financial performance this year and last year, you can see that we improved the overall financials a lot this year. We are growing the business and operationally profitable over two or three quarters this year so far and on the right track for Q4 and the full year. In addition to that, we have created new products and high-growth revenue streams like new online courses, RTA ads, international KOL ads, AI-driven subscription services, and high-end dictionary pens. These will drive our growth in the immediate future, and we will have more to discuss in future calls. Putting this together, it means our focusing strategy this year and also our bet on large language model applications since last year, these two strategies have really been working. AI plus education is an exciting opportunity and is already having a great positive impact on our business. So Youdao aims to lead in the AI plus education sector in China. Thank you.

Operator, Operator

That concludes our question-and-answer session. I would now like to turn the conference back to Jeffrey Wang 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 PSN Financial Communications in China or the U.S. Have a great day.

Operator, Operator

Thank you, sir. Ladies and gentlemen, that then concludes today's conference. Thank you for joining us. You may now disconnect your lines.