Earnings Call Transcript - DAO Q3 2021

Operator, Operator

Good day, and welcome to the Youdao 2021 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 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 the certain filings of the company with the 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 the non-GAAP to GAAP financial results, please see the 2021 third quarter financial results news release issued earlier today. As a reminder, the conference is being recorded. Additionally, 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. Wayne Li, our VP of Finance. I will now turn the call over to Dr. Zhou to review some of our recent highlights and strategic direction.

Feng Zhou, CEO

Thank you, Jeffrey, and thank you all for participating in today's call. Before we begin, I would like to remind everyone that all numbers are based on renminbi. The third quarter was a good quarter for us with some development of our non-tutoring business. With the announcement of sweeping industry changes in late July, we quickly evaluated our business and set out steps to better align with the PRC's latest regulations. On September 30, we anticipated to terminate and announced the plan to dispose of the after-school tutoring services for academic subjects included in China's compulsory education system and applied to the competent local governments to approve the proposed disposal. We expect the disposal to be completed by the end of 2021, subject to regulatory approval. There can be no assurance regarding the ultimate timing or that the transaction will be complete. Due to the execution of the double reduction policy, gross billings from academic subjects included in China's compulsory education system decreased by approximately 70% year-over-year in the third quarter. Gross billings, including adult courses decreased by 33.9% year-over-year to RMB631 million in the third quarter. Total net revenues for the third quarter were RMB1.4 billion, representing a 54% increase year-over-year, with approximately 25% of our total revenue derived from academic tutoring for compulsory education. Operating loss decreased significantly to RMB129 million, and the operating loss margin was 9.3%, a sharp narrowing compared with 99% for the same period of last year. As we mentioned in the last call, learning products, adult and vocational courses, STEAM courses, and education digitization solutions are the four core pillars for our future growth. Now let me walk you through the progress of each segment. First, our learning products segment maintained strong growth momentum. Q3 learning product revenue reached a record RMB254 million, a 56% increase year-over-year and a 23% increase quarter-over-quarter, led by our industry-leading Dictionary Pen. We continue to upgrade the Dictionary Pen and launched the people's education version in collaboration with People's Education. The product marks our first significant partnership with PE EAP, whose parent company publishes basic education textbooks directly under the Chinese Ministry of Education. Through the upgraded Dictionary Pen, we provide over 4,000 recordings of listening and speaking training textbook content. In Q3, we shipped approximately 400,000 Dictionary Pens. We also launched Youdao Dictionary Pod, powered by our new generation adaptive AI learning technology, featuring capabilities like AI subtitles, real-time speech scoring, and pronunciation correction to facilitate more effective learning for students. The first batch of Youdao Listening Pods sold out within one week, reflecting strong demand. We encourage you to view a related video on our IR website to get a more complete picture. Now let's look at the STEAM courses. Youdao Weiqi is becoming more and more popular each quarter. In Q3, revenue from Youdao Weiqi increased by more than 30% quarter-over-quarter. We upgraded our Weiqi AI system and launched a mini program, which supports assessments and interactive features so that students can check their learning progress at any time. As for our used programming product, ICOS, we launched a new pipeline course, which our users have asked for a lot. Additionally, a lot of middle school and high school students are learning coding to participate in programming contests like the CSP or NOIP, the most popular programming contests in China. Youdao provides a CSP assessment to allow students to better understand how well they are doing, and it has become quite popular, now used by more than one-third of all CSP contestants. Finally, the China Computer Federation, the organizing body of the CSP and NOIP contests, officially announced that Youdao has become a Programming Trainer Accreditation (PTA) member in the third quarter, combining efforts in promoting programming teacher training. Overall, STEAM is a very active area for us, and we are seeing good results. Moving on to adult and vocational courses. Gross billings were RMB182 million, with a slight decline of 9% year-over-year. The decrease is mainly due to relative weakness in English learning courses for reasons including COVID. The Memory Training course, 'Extraordinary Memory Feifán de jìyì,' is doing very well. It retains the leading position in the segment with gross billings approaching RMB100 million in Q3. Recently, NetEase Cloud Classroom officially launched about 100 digital training courses by Amazon Web Services in Chinese, created by Amazon Web Services experts. We promised to provide these courses complimentary to the whole society to help learners improve their cloud-related skills. On a more general level, there are increasing consumer needs for adult learning and vocational training courses. This is also an area supported by government policies going forward. Our teams have a lot of experience creating popular learning content like the Extraordinary Memory courses. We will release more self-developed courses in the coming quarters and drive growth in this area. As for education digitization solutions, the Ministry of Education and other departments jointly issued guidelines on this initiative called New Infrastructure for Education in Q3. The guidelines proposed constructing an intensive, efficient, safe, and reliable national new education infrastructure by 2025. The initiative requires the comprehensive application of new technologies, such as 5G, artificial intelligence, big data, cloud computing, and blockchain. We believe our products and expertise align very well with these recent policies. In Q3, we launched Youdao's Smart Learning Terminal-II, an AI-driven appliance that helps classrooms process homework and learning materials digitally. It supports high-speed scanning of paper-based homework and tests, automatic grading of student work, and generation of in-depth analytics for students, teachers, schools, and school districts. It is the first of its kind product that seamlessly bridges paper-based learning and digital intelligence, which we believe is easy to deploy and truly helps teaching. Since last year, the first generation of Youdao's Smart Learning Terminal has been deployed in many schools. We look forward to working with more schools and educators on the adoption of the second generation. Looking at other parts of our business, in Q3, Youdao Dictionary launched an academic search function in its mobile app, supporting searching for academic papers and one-click translation. We also extended its search functionality to content like learning videos. Youdao Dictionary reached a milestone of 900 million cumulative users in Q3. Moreover, as an intelligent learning company with a mission to help all learners achieve more efficient learning, Youdao Dictionary started to provide accessible services for digitally challenged users. This feature aims to support users with disabilities to enjoy the benefits of technological advancements and expand their learning equitably. We also help those in need when we can. In Q3, we helped the customers of some tutoring companies going out of business by exchanging course hours from these companies for Youdao's services. Youdao was commended by the China Association for Nongovernment Education for these industry mutual assistance efforts. So far, we have helped customers from over a dozen AST institutions. The last few months have been a period of introspection, planning, and implementation for us. In July, we started on a journey to transform our company toward a new growth trajectory. As we finish Q3, we have made good progress. As always, we are committed to running the business within the scope of laws and regulations and taking on corporate responsibilities for our community and society at large. We believe we have a solid growth plan and the right teams to execute it. We look forward to helping many more users learn better through all of our efforts and products. And with that, I will hand over to Su Peng to give you more updates on our financials. 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 our 2021 third quarter. We encourage you to read through our press release issued earlier today for further details. As for tutoring service, gross billing and paid student enrollments decreased due to the execution of the double reduction policy. Gross billing from academic subjects included in China’s compulsory education system decreased by approximately 70% year-over-year in the third quarter. Total gross billing, including adult courses, decreased by 33.9% year-over-year to RMB631.6 million in the third quarter. Paid student enrollments included in China’s compulsory education system decreased by approximately 70% year-over-year in the third quarter as well. Total paid enrollment, including adult courses for premium courses, decreased by 40.9% year-over-year. Paid student enrollments from our K-12 and adult segments account for 64% and 36% of the paid student enrollments for premium courses, respectively. For the third quarter, total net revenue reached a record RMB1.4 billion or USD 215.3 million. This represents an increase of 54.8% from the third quarter of 2020. Looking at this growth by segment: net revenue from our learning services was RMB995.7 million or USD 154.5 million, up 65.9% from the same period in 2020. We attribute this growth to the increased revenue generated from our tutoring services, further driven by the growth in paid student enrollments during the period in the second quarter of 2021. Net revenue from our learning products was RMB254.5 million or USD 39.5 million, up 56% from the same period in 2020, driven by the substantial increase in sales volume of Youdao Dictionary Pen. Net revenue from our online marketing services was RMB137 million, or USD 25.3 million, representing a 3.4% increase from the same period in 2020. For the third quarter, our total gross profit reached RMB785.6 million or USD 121.9 million, up 90.9% compared with the third quarter of 2020. Gross margin for learning services increased to 66.2% for the third quarter of 2021, up from 53.9% for the third quarter of 2020. The increase was driven by the improved economy of scale and ongoing optimization of Youdao's faculty compensation structure. Gross margin for learning products increased to 33.7% for the third quarter of 2021 from 29.8% for the same period in 2020. The improvement was mainly attributable to the substantial rise in the sales volume of Youdao Dictionary Pen version 3, which carries a higher gross margin than other learning products. Gross margin for online marketing services was 29.2% for the third quarter of 2021 compared with 29.5% for the same period in 2020. For the third quarter, total operating expense was RMB914.9 million or USD 142 million, down 29.9% from RMB1.3 billion for the same period last year. With that, for the third quarter, our sales and marketing expense was RMB650.2 million, significantly decreased from RMB1.1 billion in the third quarter of 2020. Research and development expenses were RMB193.3 million compared with RMB121 million in the third quarter of 2020. Our operating gross margin was 9.3% in the third quarter of 2021 compared with 99.8% for the same period of last year. For the third quarter of 2021, our net loss attributable to ordinary shareholders was RMB128.9 million or USD 20 million, compared with RMB877.8 million for the same period last year. Non-GAAP net loss attributable to ordinary shareholders for the third quarter was RMB101 million or USD 15.7 million compared with RMB865.7 million for the same period last year. Basic and diluted net loss per ADS for the third quarter was RMB1.05 or USD 0.06. Non-GAAP basic and diluted net loss per ADS for the third quarter was RMB0.82 or USD 0.13. Our net cash used in operating activity for the third quarter was RMB628.7 million or USD 97.6 million. Looking at our balance sheet as of September 30, 2021, our contract liability, which mainly consists of deferred revenue for our tutoring services was RMB1.1 billion or USD 175.8 million compared with RMB1.4 billion as of December 31, 2020. At the end of the period, our cash, cash equivalents, restricted shares, cash, term deposits, and short-term investments totaled RMB1.3 billion or USD 201.7 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

The first question comes from Zhong Sheng of Morgan Stanley.

Zhong Sheng, Analyst

And congratulations on the good result. As I said, after the double reduction, I think all the eyes are on the potential of the non-K-12 business. I would like to start my question from the learning devices. Can you please give more color on the learning devices sales momentum? And what's the product pipeline and any management target for the learning devices next year? Also, we see the gross margin of learning devices in Q3 is a bit lower than last quarter. Any particular reason for this? And what should the normalized margin be for the learning devices?

Feng Zhou, CEO

Thank you, Sheng, for the question. Yes, this is Feng Zhou. Yes, learning products revenue came in at RMB255 million. Yes, so it's 56% year-over-year growth. So we're happy with it. Yes, it is positively impacted by new product launches like the People's Education Dictionary Pen, in collaboration with People's Education. However, it is negatively impacted by COVID episodes in August and September. Within the quarter, September sales were the strongest, marking the start of the new school year when parents and students shop for new learning gear. Our lineup of products this year performed well despite increased competition. Last year, we had no competition, but this year we have more competition and faced COVID challenges. Recently, last Thursday was the conclusion of a significant shopping festival. Our learning device sales were up 57% compared to 2020. We have been the leading electronic dictionary seller for three consecutive years on the JD platform. Regarding new products, the People's Education Dictionary Pen was released on September 1, and it includes full text and audio materials for all official elementary school English textbooks. This is a key feature for the Dictionary Pen since its release. We also launched another new product, the Youdao Listening Pod, which focuses on enhancing students' English listening and speaking capabilities. It provides over 4,000 listening material examples in adaptive-driven learning technology and addresses key challenges students face in standardized tests. By providing these features without using a cellphone, students can enjoy a learning experience without distractions. The initial batch of several thousand listening pods sold out in a week, marking a great start. As we discussed in Q2, we are doubling down on learning products R&D and believe we now have the strongest product pipeline ever for the next few quarters. Yes, new products will come out in the coming quarters, and we'll share more information as we get closer to the release dates. Our team is very confident about these future products, so we are excited. Regarding the margins, gross margins for learning products actually increased compared to the same period last year from 29% to 33%. However, compared to Q2, it declined from 43%. This decline is mainly due to timing as we are approaching the end of the lifecycle of the second-generation Dictionary Pen. We are selling more third-generation Dictionary Pens than the second generation, and we have lowered prices to clear inventory. We expect this to be a temporary situation. Once the inventory of the second-generation Dictionary Pen is cleared, we anticipate gross margins to start increasing.

Operator, Operator

The next question is from Brian Gong of Citibank.

Yuzhong Gao, Analyst

Following the government's opinion, many other leading AST companies also plan to transform their businesses to STEM courses such as coding and other areas. What do you think about the competition in this sector? What is our competitive advantage?

Feng Zhou, CEO

Yes, this is Feng Zhou. Yes, many companies are focusing on this segment now. I can share several thoughts we have regarding the competition. Firstly, we always try to focus on large verticals where we believe we have a competitive advantage. STEM and STEAM are substantial areas. For example, many people ask us why we focus on Weiqi. When we started offering Weiqi courses, it was a small area with less attention. However, there are over 60 million Weiqi players in China, with 3 million new learners every year. We think it has great potential, and it is hard for individuals to learn Weiqi by themselves. In Q3, Weiqi revenue grew 30% sequentially, indicating we chose the right product strategy. Second, we believe quality and depth are key for long-lasting, highly satisfying products. The coding and Weiqi programs have been in development for over two years, leveraging our self-developed AI systems and interactive learning techniques, which have received positive feedback. Overall, we think product excellence trumps marketing, particularly considering the limitations on marketing due to the double reduction policy. Our teams excel at building excellent products that address users' needs. Lastly, we recognize that student needs are increasing. Many students now have more time to pursue their STEAM interests due to the double reduction policy. We plan to collaborate with schools and other institutions on these courses. We expect the market to be more organic and rational after the double reduction, without excessive promotional spending. We believe that high-quality products will ultimately prevail. Thank you.

Operator, Operator

The next question is from Thomas Chong of Jefferies.

Thomas Chong, Analyst

My first question pertains to our adult education. Can the management comment on our strategies regarding the competition and our competitive edge in this segment?

Peng Su, VP of Strategy and Capital Markets

I will address your questions and might start with your second question first regarding the competitive landscape. Yes, indeed, the regulatory changes have attracted more players into the adult education sector. However, we want to emphasize that we are not new entrants; our education business began back in 2016 with our China English Test Level 4 and Level 6 programs. We have accumulated extensive experience in delivering high-quality online content for adult education through various SKUs. We have successfully developed SKUs for English education and the Extraordinary Memory courses for adults. In the long run, we will leverage our experience in building content and services tailored to emerging adult educational needs. Furthermore, we plan to increase our investment in vocational training, especially in response to government support for resources in this area. The potential for adult education remains bright, and we expect growth in this segment. Now, regarding the progress of our courses, we are currently developing a rich pipeline for adult education, offering English courses and more vocational training, particularly in IT training and additional sectors over the next few quarters. We expect to share more details as we progress. I hope that answers your question.

Operator, Operator

The next question is from Candis Chan of Daiwa.

Candis Chan, Analyst

My question concerns education digitalization. Can you share the progress in this business? Will you further increase investments in this segment? Lastly, who are the key competitors in this area?

Lei Jin, VP of Operations

We believe there is significant potential in digitization solutions. The market size is projected to exceed RMB650 billion in 2023. We have established a new team focused on developing patient digitalization solutions. The current policy environment enables us to leverage our advanced technology to assist schools in establishing educational improvements. Youdao possesses AI capabilities, related technology, hardware design and integration experience, and the ability to create digital content. We have a profound understanding of education, which gives us an advantage in meeting the demand for educational transformation.

Peng Su, VP of Strategy and Capital Markets

To add a few more details related to education digitization solutions: this is a substantial market, estimated at $400 to $500 billion. Several established companies have been in this space longer, including and other traditional firms. Additionally, new entities like Bytedance and Tencent are entering this market. While numerous companies are interested in this field, we believe we have a unique position due to our long-standing experience with educational products and our ability to integrate hardware, artificial intelligence, and educational content effectively.

Operator, Operator

The next question is from an analyst at Macquarie.

Unidentified Analyst, Analyst

My question is about the spinning off of the academic tutoring business. What is the progress of it? What do you project the timeline will be for completion? Additionally, how is the business license application progressing?

Jeffrey Wang, Investor Relations Director

This is Jeffrey. I will take your questions. We are still in the process of disposing of our academic tutoring business. As mentioned, revenues from the academic business accounted for approximately 25% of our total revenues in the third quarter. Currently, the government authorities are actively assessing the materials related to our business license application for the nonprofit organization. However, there is no clear timetable for this process at the moment. We will continue working constructively with the government authorities regarding the proposed transaction and still expect the business to be disposed of or terminated by the end of this year. As disclosed in our official announcement on September 30 regarding the earnings release, I want to remind you that there is no assurance regarding the ultimate timing of the proposed deal or that the transaction will be completed. We will update the market on the status of the deal and the business license application when any material progress is made.

Operator, Operator

The next question is from Brian Gong of Citibank.

Brian Gong, Analyst

I apologize for the technical issues we experienced earlier. My question is about the new directions for the business, including the STEAM and smart devices segments. Can management provide an update on the latest progress, as well as any modifications to our new strategies?

Feng Zhou, CEO

Yes, your question concerns the changes to our new strategy post-double reduction. The short answer is that we believe we have the right strategy in place and are executing it while making substantial progress. Let me share a few insights into what we call our four-pillar strategy. The first point is that our business will always have a strong core, which is AI and learning content creation. Although we discuss four directions for our businesses, it centers around a single core, that is artificial intelligence and learning content. We have built four different products or services around this core and believe that all of them represent good growth opportunities. Every one of them has potential, and we are currently investing efforts in all of them. In the future, we may discover that one of them is more compelling, and we will possibly focus more on that area; however, for now, we see good opportunities in all four. The second point emphasizes the importance of good products. If we can build a differentiated product that solves a substantial number of user needs, we can establish a strong business. Product progress is crucial for the future growth of our business. During this critical time, when some of these four business segments are still relatively small, it’s essential to focus on product programs. For example, the Youdao Listening Pod sold out its first batch in a week, indicating strong product-market fit after many months of R&D. Another example is the Chess course launched in September, which utilizes innovative teaching methods that combine Chinese and English in a bilingual, AI-driven interactive format. We observed that this Chess course has performed significantly better in its first month compared to Youdao Weiqi's initial launch month. This suggests we are on the right track. Finally, the financial impact of this new strategy is essential moving forward. As the academic tutoring sector contracts, which is expected due to regulatory changes, we anticipate that the non-tutoring business will continue to grow and become a larger part of our overall revenue mix over time. In the short term, we expect some top-line growth deceleration followed by accelerated growth. Regarding our bottom line, we foresee a stable or slightly improving bottom line as overhead and sales costs decline. I would like to highlight that our operating loss for Q3 has significantly reduced to RMB130 million compared with RMB540 million last quarter.

Operator, Operator

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 TPG Investor Relations in China or the U.S. Have a great day.

Operator, Operator

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