Earnings Call Transcript - DAO Q2 2020

Operator, Operator

Good day and welcome to the Youdao 2020 Second Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Pei Du, Investor Relations Director of Youdao. Please go ahead.

Pei Du, Investor Relations Director

Thank you, operator. Please note the discussion today will contain forward-looking statements related to 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 filings of the company with the Securities and Exchange Commission, including our annual report filed on Form 20-F. The company doesn't 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 definition of non-GAAP financial measures and the reconciliation of GAAP to non-GAAP financial results, please see the 2020 second quarter 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, VP of Operations; Mr. Peng Su, our VP of Strategy and Capital Markets; and Mr. Wei 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, Pei Du, 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. Our business continues to grow at a rapid and healthy pace. Our second quarter shows the strength of our online education courses and products. And despite the current uncertainty of the macro environment, the online education industry's transformation is well underway. Youdao is well positioned to emerge as a leader amid this change. First, looking at online courses, our gross billings have more than tripled year-over-year, reaching RMB 542 million in Q2. Gross billings from K-12 reached RMB 307 million, up 29% year-over-year and up 60% quarter-over-quarter, driven by strong retention and larger scale marketing. In addition to junior high school, math and physics are strong and several other courses contributed significantly to our second quarter growth, primarily high school Chinese and primary school math. Our retention rate also improved by 1,000 basis points in the April to May retention season due to more and better courses and a more streamlined service. Summer enrollment for high school students, which used to start in Q2, was pushed back to Q3 due to COVID-19 as the semester ended later in most cities in China. Gross billings from our adult segment also increased to RMB 150 million, up 189% year-over-year based on the strong performance of our practical English courses. We released another new practical English course title in Q2, bringing the total to five courses, catering to different customer groups. Young white-collar workers are increasingly looking to learn English online. We're working hard to capture this opportunity and drive growth by focusing on creating high-quality content. Building up our servicing capacity is the current priority for the company, as we work to significantly scale our business this year. In Q2, the total number of tutors increased to 2,699, in part to prepare for summer enrollment. This is also three times the number of tutors we had in Q1. Our new tutors have been integrated smoothly as we focused on leveraging hiring managers and improving our experienced tutors last year to prepare for a larger team this year. We also significantly increased our ability to offer more personalized service in Q2 by offering stratified services to students within different grades. For the second quarter, gross margins for learning services were flat with Q1 at 52%. While we continue to benefit from economies of scale, margins were partially offset by expenses from more servicing personnel. In the meantime, with improving unit economics, we maintained positive operating cash flow for the second quarter in a row, which came in at just under RMB 93 million. We continue to invest in product and technology innovation. We're in a year-long process of rolling out more interactive large class features to more subjects and more grades. In our high school Chinese courses, we launched a feature called Intelligent Memorization Plan using ASR technology. This is highly integrated with its course content, and students can practice efficiently at their own pace. This contributed significantly to our double-digit increase in retention in high school Chinese. Similarly, our primary school math has highly tailored interactive exercises that can be generated in real-time for different levels of students, all based on feedback data. For instance, to develop kids' number fluency, we offer interactive exercises using a vertical strategy playbook and gamified role player-to-player games. After we made these upgrades, our conversion rates in primary school math increased by 4%. Turning to our intelligent learning devices, sales in this category also developed, reaching RMB 86 million, up 2.5 times year-over-year. We released the Dictionary Pen 2.0 Pro in June, with more premium content and Japanese and Korean language supports, which were the #1 requested features. Our Dictionary Pen 2.0 Pro also carries a higher selling price than its early versions. During the online shopping festival on June 18, the Youdao Dictionary Pen 2 series were ranked the #1 electronic dictionary in terms of sales by both JD.com and Tmall. As for our learning apps, in Q2 we grew our MAU to 122 million, up 11% year-over-year. We continued to build our Youdao Dictionary app to incorporate more comprehensive offerings as we work to bring this popular tool into the realms of super apps in the learning category. Some of the new features included an English oral proficiency assessment feature, an English listening mock test and a postgraduate admission Internet portal. In addition to launching a number of new features, we have strengthened the connection between the Youdao Dictionary and our premium courses in Q2. Gross billings of new paid enrollments from internal traffic increased by 127% year-over-year. Turning to our marketing business, our online advertising revenue reached RMB 103 million, down 28% year-over-year but up 4% from Q1. We expect to see continued volatility in this segment with the ongoing impact of macro uncertainties. Looking ahead, the summer enrollment season is already underway. Our experience shows that customers acquired in the summer are more willing to pay for more courses and renew in the future. Our data in the first half of this year shows that the positive trends in online learning are accelerating regardless of the fluctuating impacts of COVID-19. With this in mind, we are moving ahead with the summer campaign we talked about in Q1. We plan to significantly increase our paying customer base this year and Q3 is an important quarter for achieving this goal. We're taking a threefold approach to this campaign: First, a brand marketing campaign with TV ads, residential ads, community ads, etc. Second, engaging in online multichannel performance-based customer acquisition activities. And third, user conversion on our owned and operated assets. Our goal with our marketing activities in the second half of the year will be to acquire significantly more customers and increase our brand equity while maintaining a focus on healthy unit economics and return on investment over the longer term. The investments we are making now are designed to support our stable and sustainable growth as we build our student community and brand reputation. With that overview, I will now turn the call over to Peng Su to review our financial results. We will then open the call up for questions.

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 2020 second quarter. We encourage you to read through our press release issued earlier today for further details. We continue to scale our operation in the second quarter, achieving considerable year-over-year growth across our business. We are well poised to continue our growth trajectory supported by our strong technology and curriculum and as we amplify our marketing effort to further bolster our student base for the second half of the year. For the second quarter, total net revenue was RMB 623.3 million or $88.2 million. This represents an increase of 93.1% from the second quarter of 2019. Looking at this growth by segments, net revenue from our learning services and products grew 190% year-over-year to RMB 520.1 million or $73.6 million. We attribute this growth to a sharp uptick in K-12 paid student enrollments and the gross billing per paid student enrollments of our premium courses on a year-over-year basis. Net revenue for online marketing services was RMB 103.2 million or $14.6 million, a decrease of nearly 28.1% compared with the same period of 2019. For the second quarter of 2020, our total gross profit greatly improved, reaching RMB 281.5 million or $39.8 million, up 165.4% compared with the second quarter of 2019. Gross margin for learning services and products improved to 48.5% for the second quarter of 2020, up from 29.5% for the second quarter of 2019. The large margin growth was primarily attributable to improved online courses margin, better economies of scale and the further optimization of our business and faculty compensation structure. Gross margin for online marketing services was 28.5% for the second quarter of 2020 compared with 37% for the second quarter of 2019. The decrease was mainly the result of the lower gross margin revenue generated from the increased distribution of advertisements through third-party Internet properties. For the second quarter, total operating expenses were RMB 564.6 million or $79.9 million compared with RMB 189.2 million for the same period last year. We continue to invest in technology, student acquisition, and acquiring talented teachers to support our growing business over the long term. In tandem with this investment, we are increasing our top line, structuring our model to become more efficient, and recognizing economies of scale. With that in mind, sales and marketing expenses for the second quarter were RMB 445.2 million compared with RMB 122.2 million in the second quarter of 2019. Research and development expenses for the second quarter were RMB 91.4 million compared with RMB 56.3 million in the second quarter of 2019. Our operating loss margin was 45.4% in the second quarter of 2020 compared with 25.7% for the same period of last year. For the second quarter of 2020, our net loss attributable to ordinary shareholders was RMB 257.8 million or $36.5 million compared with a loss of RMB 87.6 million for the same period last year. Non-GAAP net loss attributable to ordinary shareholders for the second quarter was RMB 250.5 million or $35.5 million compared with a loss of RMB 86.2 million for the comparable period last year. Basic and diluted net loss per ADS for the second quarter was RMB 2.3 or $0.33. Non-GAAP basic and diluted net loss per ADS for the second quarter was RMB 2.23 or $0.32. Our net cash generated from operating activities for the second quarter was RMB 93 million or $13.2 million. Looking at our balance sheet, as of June 30, 2020, our contract liability, which mainly consists of the deferred revenue for our online courses, was RMB 711.5 million or $100.7 million compared with RMB 456.8 million as of December 31, 2019. At the end of the period, our cash, cash equivalents, time deposits, and short-term investments totaled RMB 1.8 billion or $253.4 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 today comes from Brian Wong of Citigroup.

Unidentified Analyst, Analyst

Congratulations on the solid results. I have two questions. First, how is the new format of interactive beta classes progressing? And second, what are the details regarding the summer promotion, specifically student enrollment and the student acquisition cost?

Feng Zhou, CEO

Yes. For the first question about the features of the interactive big class model, this is a key project for us this year. We have a video presentation on our IR website, and I encourage you to check it out. After two quarters of releasing new features, we are pleased with the results. We have consistently seen a 20% to 30% increase in student participation in these interactions and classes, which is promising because higher participation leads to greater customer satisfaction and improved retention. Consequently, we have observed a significant rise in retention rates in certain classes. For example, in high school Chinese, we introduced a feature called Intelligent Memorization that helps students prepare for their exams. This has led to a double-digit increase in retention rates. In primary school math, we expanded the variety of questions to over 20 types, resulting in a conversion rate increase of more than 4%. If you have a moment, please watch the video. Thank you. Regarding the second question about the summer campaigns, in Q2, we allocated resources and budgets for the summer campaign based on data collected and trials conducted in Q1. The data supports our decision to proceed with the plan, as this is an excellent opportunity to enroll students in online courses, especially given the trend of students moving from offline tutoring centers to online options. This summer, we are primarily focusing on junior high school courses while also bringing in some primary school students, who have provided fantastic feedback.

Peng Su, VP of Strategy and Capital Markets

Thank you, Dr. Zhou. And Brian, this is Peng Su. We believe the summer enrollment business is already underway, as Dr. Zhou mentioned in the early call. We expect to significantly increase our paying customer base this year, especially in the K-12 segment. Summer is a key period for achieving these goals. We are refining our models, leveraging the quality of our courses, and we are ready for that. So far, the feedback from the market has been positive.

Operator, Operator

The next question comes from Sheng Zhong of Morgan Stanley.

Sheng Zhong, Analyst

My first question is about the gross billing. In Q2, we still see a very strong gross billing growth while the momentum compared to the last two quarters seems slightly slowed down. Can you share more color about this growth? And what is the outlook for growth momentum in the next two quarters this year? This is the first question. The second question, Dr. Zhou mentioned that the K-12 retention rate improved by double digits. Can you share with us what the actual range is now? Apart from the technology improvement, I believe the teacher system should be a very important part of this. Can you share something about your teacher assistance numbers now and what the further hiring plan is?

Feng Zhou, CEO

Yes. Thank you, Sheng Zhong. So regarding gross billing, if you look at our K-12 gross billing, it was RMB 307 million, up 229% year-over-year and up 60% quarter-over-quarter. We think this is healthy for Q2. Seasonally, Q2 is a little bit weak, but we believe this is good for Q2. For our adult segment, we had a very positive push from many white-collar customers staying at home in Q1, leading to a strong performance for our adult courses. In Q2, we still observed strong performance, with RMB 150 million, up 189% year-over-year. We added a new course, bringing the total to five quarters now. We expect our adult segment to continue to have healthy year-over-year growth in the coming quarters. One key focus for us is looking at our subjects or courses and deciding on their competitiveness. We have added new Class A subjects, so we expect to see growth here coming from a couple of those newly classified courses. For Q3, we are quite bullish, as demand during the summer is strong. We have observed positive movement towards online courses from parents. We are trying to capture this opportunity. Regarding tutors, the number has grown substantially, from 800 to over 2,500, representing about 200% growth. We have also added new operating centers in Hangzhou and Jinan, in addition to the existing four. We expect to continue growing that tutor team, training more personnel, and meeting the increased demand for services and conversion.

Peng Su, VP of Strategy and Capital Markets

Yes. For the retention rates among the grades, we have substantially increased the number of tutors from 865 to over 2,000. This year, we expect to improve our services to enhance our retention rates. In particular, we are focusing on the grade 6, grade 9, and grade 12 classes. For instance, our grade 6 to grade 7 retention is around 60% during this retention period, and we expect further improvements in the next retention season.

Feng Zhou, CEO

Yes. The grade 6 and grade 7 retention can be particularly challenging during the transition from primary to junior high school, so we believe our performance here is competitive. Additionally, our kids' programming course has achieved over 85% retention due to our enhanced collaboration between instructors and tutors along with our interactive large class model.

Operator, Operator

The next question comes from Alex Xie of Crédit Suisse.

Alex Xie, Analyst

Congratulations on a very strong growth momentum. I have two questions. My first question is about the enrollment and ASP. It appears that ASP in terms of gross billings divided by student enrollments decreased. Could you please share if there's any special reason for that? Did you change the definition for enrollments? What is your actual ASP after adjusting for such changes? Secondly, I would like to know more about your plans to further improve or maintain your margins in your online courses business. Do you have a target for the future or in the long term for your GP margin?

Peng Su, VP of Strategy and Capital Markets

The pickup in enrollment growth is very fast, over 300% growth in Q2, mostly driven by the number of students, especially in our junior high school segment. There were also impacts from two other reasons: the enrollment split due to new regulations on course duration, and the introduction of new Class A subjects, which have generated more cross-sell opportunities per student. Regarding ASP, our first half price increases were modest. We did not significantly raise prices for our courses this year. Therefore, the enrollment regulation and increased course offerings affected average ASP.

Feng Zhou, CEO

Yes. Additionally, our courses this spring included different types of shorter-term offerings, which are priced lower than our typical packages. This combination contributed to the decrease in average ASP compared to last year.

Yongwei Li, VP of Finance

In the second quarter, our gross margin for learning services was 52%, significantly improved from last quarter's 29%. Going forward, we expect further improvement in our learning service on an annual basis based on three main drivers: First, further access from economies of scale. We believe our large class teacher model will yield more benefits as we achieve more economies of scale. We expect larger class sizes due to increased paid student enrollment from our summer campaign. Secondly, there is more room to achieve a higher ASP. Our premium courses' ASP was around RMB 1,140 in the second quarter, up 30% year-over-year. However, our pricing remains lower compared to some of our peers. Finally, we believe there is a better compensation structure which aligns our sales team's incentives to achieve higher GP margins. Although modular courses may negatively impact GP margin in the short term, we believe our GP margin will rise to the industry average level in the longer term.

Operator, Operator

The next question comes from Thomas Chong of Jefferies.

Thomas Chong, Analyst

I have two questions. The first one is about our operating cash flow. Can management comment about the direction to consider for the cash flow as well as the timing of profitability? My second question is about our synergies with our existing product offerings. Given that Youdao Dictionary has shown good results, how should we think about our strategies in generating synergies with our K-12 offerings going forward?

Yongwei Li, VP of Finance

Regarding operating cash flow, we have achieved positive operating cash flow in both the first and second quarters, totaling over RMB 140 million in the first half of the year. This can be attributed to improvements in our business fundamentals, such as the higher GMV level and healthier unit economics. While we do not provide any quantitative guidance on operating cash flow, we expect our increased marketing expenditures to acquire more users during the summer promotion season will place pressure on our operating cash flow for the next one or two quarters. We believe this seasonal fluctuation is acceptable for the online learning market, as we expect healthier longer-term cash flow soon.

Peng Su, VP of Strategy and Capital Markets

For your second question regarding the synergy between our apps and hardware with our courses, if you open our Dictionary app, you will see that we're not just uploading a new page for our Dictionary tool; we are enhancing its usefulness as a learning resource. It will assist students in locating learning information and materials. We intend to hold more seminars online to provide students with learning and testing information, enhancing our ability to convert users from our apps to online courses. On the hardware side, our Dictionary Pen customers typically range from primary to high school, making them the same user pool for our online courses. We are developing more functions in our hardware devices to facilitate conversions from hardware to online courses. We will have more data to share in the second half of the year.

Operator, Operator

The next question comes from Binnie Wong of HSBC.

Binnie Wong, Analyst

Just a question for Dr. Zhou. Remember, last quarter, we talked about how Youdao is differentiated with technology using AI-driven interactions and providing more personalized exercises. Is that one of the reasons we have seen an improvement in conversion rate this quarter? How should we think about utilizing technology even more to drive our conversion rate, since it still has a lot of room to improve? My second question is about sales and marketing; it seems like our sales and marketing dollar per student is increasing. Is this due to a growing user base, or is the competition for users becoming more intense?

Feng Zhou, CEO

Yes, you are correct that technology is a key differentiating factor in our industry. Long-term competitiveness in online education hinges on technology. As we've discussed in previous calls, our smart pen project has evolved into an interactive large class model that enhances both students' and parents' experiences, improving retention and conversion. For instance, our programming course has achieved over 85% retention due to advancements in our hardware and improved collaboration between our students and instructors. We believe this direction is valuable and will yield results over time. Regarding sales and marketing, I'll let Su Peng add some details.

Peng Su, VP of Strategy and Capital Markets

Yes, for sales and marketing efficiency, it appears to be lower compared to the first quarter due to the increased number of tutors we hired in preparation for the summer campaign. We have also increased our marketing expenditure in June to attract new users. This upfront investment will show results in the coming months as students are attracted during the summer season.

Feng Zhou, CEO

Our approach to sales and marketing is disciplined and data-driven. Each team evaluates how long it will take to recoup investments and their profitability horizon. This year represents an excellent opportunity to acquire more users, so we've strategically increased spending in this area.

Peng Su, VP of Strategy and Capital Markets

Indeed, my team focuses on maintaining healthy unit economics, which we believe are fundamental for our business.

Binnie Wong, Analyst

Can you share if the industry seems to be more aggressive this year compared to last in terms of marketing spending, or is it stabilizing? In such a competitive environment, what ROI level do you see compared to industry benchmarks?

Feng Zhou, CEO

Every company must decide the strategy that fits them best when it comes to customer acquisition costs. For us, we analyze the data to gauge the value we can provide and the retention confidence we have. There is still a substantial market opportunity since over 90% of students in China are not engaged in online courses yet. We believe it’s crucial to seize the opportunity to attract more customers given the market dynamics.

Operator, Operator

The next question comes from Jessie Xu of Nomura.

Jessie Xu, Analyst

I understand that we rolled out stronger courses this year, enabling us to do more combo sales or cross-selling now. Can you share the average number of enrollments per student and your cross-selling strategy?

Peng Su, VP of Strategy and Capital Markets

Thank you, Jessie. Our retention, cross-selling, and subject enrollment rates are all improving trends. For instance, in high school, the number of subjects students enroll in has increased by over 20% quarter-over-quarter and 6% year-over-year. We expect to see continued growth in cross-sell opportunities for our middle school segments thanks to the introduction of more Class A subjects.

Jessie Xu, Analyst

We noticed that the revenue growth of smart devices was particularly strong in Q2. Can you provide more details?

Feng Zhou, CEO

Smart hardware sales reached RMB 86 million in Q2, up 50% year-over-year and 63% quarter-over-quarter. Our supply chain and sales channels were impacted by COVID-19 in Q1 but have returned to normal in Q2. We launched the Dictionary Pen 2.0 Pro, which has been well received due to the inclusion of Japanese and Korean language features. This has allowed us to charge a higher unit price, around RMB 1,200 compared to the original RMB 800 version. We have more new products coming in the second half of the year, particularly education-oriented and AI-enabled devices. The trend among students, who are digital natives, indicates a willingness to engage with these devices. We are optimistic about our product pipeline.

Operator, Operator

In the interest of time, this concludes our question-and-answer session. I would now like to turn the conference back over to management for any closing remarks.

Pei Du, Investor Relations Director

Thank you once again for joining us today. If you have any further questions, please feel free to contact Youdao directly or reach out to TPG. Good night.

Feng Zhou, CEO

Thank you.

Peng Su, VP of Strategy and Capital Markets

Thank you.

Feng Zhou, CEO

Check out our videos on the apps.

Operator, Operator

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