Earnings Call Transcript - DAO Q2 2022

Operator, Operator

Good day, and welcome to the Youdao 2022 Second 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.

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. 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. 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 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 the Youdao 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. Wei Lee, 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 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. As you may have noticed, in Q2, regional COVID-19 resurgence significantly disturbed the macro economy, especially in April and May. By June, the economy began to recover, and our business followed suit. Despite the challenges, Q2 net revenue was largely stable year-over-year, at RMB 956 million. We narrowed our net loss to RMB 461 million in Q2, a 12.3% improvement year-over-year. Besides, operating cash flow reached positive RMB 104 million in Q2, the highest we have achieved in any second quarter period since our IPO, mainly due to the strong sales performance of our new services and smart devices. One metric we track is digital content services, defined as sales of new digital non-hardware services released after the double reduction policy. Sales of digital content services reached over RMB 200 million in Q2, with gross margins exceeding 50%. With persistent demand, we expect digital content services to keep growing for the next few quarters. Because of the quick ramp-up of our new products and services in the first half of the year and relatively strong demand from consumers across our business lines, we believe our prospects for the second half of the year are strong. With that overview, I would now like to share more color on our strategy and progress in the second quarter. Technology and innovation are the cornerstones of our business and directly deployed to our smart devices. Net revenues from smart devices reached RMB 239.9 million for the second quarter, up 16.3% year-over-year. Despite the pandemic's impact on the delivery of smart devices in Q2, this demonstrates the resilience of our business and popularity of our newly launched products, particularly those that have hit the market over the course of the last year. Youdao Dictionary Pen continues to lead its category. For the third consecutive year, it topped the charts on JD.com and Tmall during the June 18th shopping festival with the most sales volume and number of units sold in its category. Our Youdao Listening Pod, which we released last year, also grew quickly in Q2. During the festival, it led its category on JD.com with the highest sales volume and number of units sold. More recently after Q2, we had two significant product launches. One is Youdao Dictionary Pen X5, an all-new dictionary pen that brings more possibilities to the dictionary pen category. With support for more than 100 languages, double the word database size, note-taking features and a new design, it is again leading the market and helping even more language learners everywhere. We have a video about the new Youdao Dictionary Pen X5 on our IR website and I encourage you to view it. The other new product is Youdao Smart Learning Pad. This marks our entry into the learning tablet market. The learning tablet market is interesting because it is a growing market that is undergoing a fundamental technological change. The learning tablets are going from video content-based to AI adaptive learning technology-centered. And, of course, we are good at applying AI technologies to learning, which is exactly what has made Youdao dictionary pen and Youdao listening pods successful. With our experience in learning technology and device designing, our teams are bringing important innovations to this product form factor and making a lot of learners learn more efficiently. Turning to the learning services segment, our strategy is to create unique and comprehensive experiences for curious minds by using our sharp technology edge, applying our course offerings across more scenarios and creating more synergy between our proprietary courses and apps. Net revenue from learning services was RMB 564 million, down 7% year over year, mainly due to macro headwinds and different seasonality after double reduction. However, sales of learning services performed well in Q2 and total sales were up significantly year over year. So looking at the full year, we expect Q2 learning service revenue dip to be a one-time event. Moreover, we are making good progress on growing new learning services. Net revenues generated from STEAM courses grew to over 20% of our total net revenues. Since double reduction, the compound quarterly growth of gross billings from STEAM courses surpassed 70%. This bodes well for our future growth prospects. We continue to leverage our strong capabilities in AI functions to enhance our courses. By further integrating AI into Youdao Chess, for example, second quarter gross billings from the course rose over 60% quarter-over-quarter. Similarly, the compound monthly growth rate of DAUs from the Youdao Board Game Academy app rose over 130%. Gross billings from graduate school entrance exam courses grew by triple digits year-over-year in Q2, led by upgrades to our one-stop service. The unit economics for these courses improved as well. Demand also soared for vocational education. Our data analysis course was a standout for the period, with gross billings up over 1000% year-over-year in Q2. Demand for our English courses also began to go up, particularly in June with the market's return, along with our upgrades to enact a more immersive first-person scenario. Gross billings from our English courses rose by over 30% quarter-over-quarter, despite the pandemic's impact. Our other business lines progressed smoothly. Net revenues from online marketing services reached RMB 152.8 million, up 25.9% quarter-over-quarter, despite headwinds from the pandemic. We released a new campus sports education digital solution in Q2 and it had a good start. Q2 marks the completion of our product and service transformation since the introduction of the Double Reduction Policy. Looking at the year-over-year trend, it is clear that our diversified and technology-driven business model has allowed us to weather the storm more resiliently. Our revenue structure change also reflects the effectiveness of our strategy. Net revenues from the new services and devices initiated post the Double Reduction Policy already accounted for over 40% of our total net revenues in Q2. Looking ahead, our focus will be on upgrading products and services with the support of technology and innovation. While we navigate the short-term macro challenges, we will continue to build up and strengthen our long-term competitiveness. We are confident in our prospects for the second half of the year, bolstered by the support of our new products and services. We are on the right track, with the right technology and the right service offerings to advance technology-powered learning. With that, I will turn the call over to Su Peng to give you more details on our financial performance.

Su Peng, VP of Strategy and Capital Markets

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights for the second quarter of 2022. We encourage you to read through our press release issued earlier today for further details. For the second quarter, total net revenue was RMB 956.2 million or USD 142.8 million. This represents a decrease of 2.4% from the second quarter of 2021. Net revenue from our learning services was RMB 563.6 million or USD 84.1 million representing a 7.3% decrease from the same period in 2021. I attribute this decrease to the decline in revenue from the adult courses resulting from the decrease in demand due to the resurgence of COVID-19. Net revenue from our smart devices was RMB 239.9 million or USD 35.8 million, up 16.3% from the same period in 2021, driven by the popularity of the newly launched products since last year. Net revenue from our online marketing services was RMB 152.8 million or USD 22.8 million, representing an 8% decrease from the same period in 2021. The decrease was mainly attributable to the curtailed advertising budget of partially advertising customers. For the second quarter, our total gross profit was RMB 409.7 million or USD 61.2 million, representing an 18.1% decrease from the second quarter of 2021. Gross margin for learning services was 52.2% for the second quarter of 2022 compared with 58.8% for the same period in 2021. Gross margin for smart devices was 30.6% for the second quarter of 2022 compared with 43% for the same period in 2021. Gross margin for online marketing services was 27.7% for the same quarter of 2022 compared with 32.7% for the same period in 2021. For the same quarter, total operating expenses were RMB 864.9 million or USD 129.1 million compared with RMB 755.1 million for the same period of last year. With that, for the second quarter, our sales and marketing expenses were RMB 596 million, compared with RMB 555.1 million in the second quarter of 2021. Research and development expenses were RMB 208.4 million compared with RMB 145.8 million in the second quarter of 2021. Our operating loss margin was 27.6% in the second quarter of 2022 compared with 26% for the same period of last year. For the second quarter of 2022, our net loss from continuing operations attributable to ordinary shareholders was RMB 453.9 million or USD 67.8 million compared with RMB 234.9 million for the same period of last year. Non-GAAP net loss from our continuing operations attributable to ordinary shareholders for the second quarter was RMB 435.8 million or USD 65.1 million compared with RMB 215 million for the same period of last year. Basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for the second quarter of 2022 was RMB 3.67 or USD 0.55. Non-GAAP basic and diluted net loss from continuing operations per ADS for the second quarter was RMB 3.52 or USD 0.53. Net cash provided by the continuing operation activity was RMB 104.2 million or USD 15.6 million for the same quarter. Looking at our balance sheet, as of June 30, 2022, our contract liability, which mainly consists of the deferred revenue generated from our earning services, was RMB 1.1 billion or USD 168.1 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 deposit, and short-term investments totaled RMB 1.3 billion or USD 188.1 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions.

Operator, Operator

Our first question today will come from Elsie Sheng of Morgan Stanley.

Elsie Sheng, Analyst

Congratulations on the second quarter results. I have a question regarding your outlook for the second half. You mentioned having a strong perspective on it. Could you provide more details on what gives you confidence in this outlook? Also, in which areas do you anticipate substantial potential?

Dr. Feng Zhou, CEO

Thank you, Elsie. This is Feng Zhou. There are a number of factors that give us confidence in the second half. Firstly, we have mostly completed our products and offering transitions after the double reduction last year. So our revenue structure has changed very dramatically. Net revenue from new services and devices, as I just talked about, launched after the double reduction already accounted for over 40% of our total net revenue in Q2. So we basically went from 0% to over 40% in less than a year. The rest, 60% are pretty stable businesses, including some devices that we launched before double reduction, and also our online marketing business and everything else. So this quick ramp-up of new business gives us confidence that we can actually continue to grow new revenue going forward. We see this trend extending into the second half of the year. So that's one. Secondly, sales of our smart devices continue to grow. Q2 was actually a very challenging quarter for our device team because of COVID, because of the logistics difficulties and the surprising factors of the pandemic situation in April and May. Despite that, revenue for our smart devices was up 16% in the quarter to RMB 239 million. If you look at the monthly trend, April and May sales of devices were actually down multiple double-digit percentages. So a lot of challenges. However, June sales rebounded very quickly to achieve year-over-year growth for the whole quarter. We may still see challenges from COVID down the road, but as local governments get better at managing these situations, along with the growing demand for our devices and our new products launched after Q2 and Q3, we believe that we have already shown that the demand for our learning devices is strong. If you look at the whole learning device market, Frost & Sullivan estimates that the smart learning devices market was RMB 66 billion in 2021 and expect it to grow to RMB 145 billion in 2026. So we believe we have a pretty long path to grow here. Finally, our new digital content services are rapidly growing, and we expect to see continued fast growth in the second half of this year. As I said, the gross billings for digital content services reached over RMB 200 million in Q2, and gross margin was over 50%. So we expect this sector, which includes new services and products not including hardware, to keep momentum in the second half of this year. I hope that helps.

Operator, Operator

Our next question today will come from Brian Gong of Citigroup.

Brian Gong, Analyst

I noticed you just mentioned that you plan to introduce smart learning pads. Can management give some more elaboration on this product, like what's the reason we launched this product? And what's our expectation for this product over the long run?

Dr. Feng Zhou, CEO

Yes, Brian. The Youdao Smart Learning Pad was launched a couple of weeks ago. What's interesting here is that there's a clear generational transformation that is taking place in the learning tablet or education tablet market. So that's going from content-based or recorded video-based learning experience to a technology-centered experience with AI adaptive learning. This kind of generational change in technology or business model presents an opportunity for new players. The whole learning tablet segment is a very popular product category. So overall, we think it's a good opportunity for us. Talking about the product form factor a little bit, the AI adaptive learning technology can be very effective if it's done right. In the U.S. market, a lot of companies are offering adaptive learning products for school learning, including Google, Talent Academy, and PSC. In China, our view is that home learning is the most promising market for adaptive learning technology because of the tradition of parents buying home learning devices. With the Youdao Learning Pad, AI can diagnose a learner's weak points through quick quizzes or by mapping a picture of their school test papers. This allows for more personalized learning that enhances learning efficiency with targeted videos and exercises. This is a very attractive value proposition for learners, and we believe it's the key benefit of the new technology, enabling us to succeed with this product. We view learning tablets as a significant vehicle for delivering this technology because parents are already purchasing many tablets. Frost & Sullivan data estimates the Chinese education tablet market will be RMB 26 billion by 2026. So we think learning tablets present a significant opportunity for us, and we expect to launch more products in this line in the coming quarters. I want to add that adaptive learning technology is challenging. As I mentioned, it requires quizzes or the ability to scan school test papers to diagnose weaknesses, which was technically not feasible just ten years ago. Now we can do it, but it still requires a lot of research and engineering. We've leveraged the technologies and experience we've accumulated over the past ten years, including video-based text processing. I believe there are only a few companies in the market that can execute this well, and we believe we are one of them. Thus, we expect to be very competitive in this space.

Operator, Operator

The next question will come from Liping Zhao of CICC.

Liping Zhao, Analyst

I noticed the STEAM courses gross billing achieved a 7% compound quarterly growth rate post double reduction policy. Could you please share the growth strategy for your STEAM course sector? And what's Youdao’s competitive advantage in this business segment?

Su Peng, VP of Strategy and Capital Markets

This is Su Peng. I will take the questions. We think we achieved faster and sustainable growth of the STEAM courses, with gross billings increasing over 900% year-over-year in Q2. You can see we have built a strong momentum for our business growth. As Dr. Zhou discussed in his prepared remarks, we always strive to build high-quality content and provide unique experiences for our customers. For example, our Chinese core program is currently one of the biggest programs we operate in the STEAM courses. Almost two years ago, we released our products to the market and we were not the only players at the time, nor the first to offer those services to customers. However, now we have become one of the leading companies in this area, possibly the biggest in this sector. Our success here is due to not following conventional methods to build up our program and services. We leverage our technology edge into the products. We believe we have learned a lot from the market, assisting our students in achieving success. As Dr. Zhou mentioned, if you take a look at the Youdao Board Game Academy app, which provides free services for each customer playing Chinese board games online, you can see the daily active user count has increased dramatically, mainly due to the ongoing updates of our app features and better synergy between chess-related courses and apps. In the long run, the STEAM courses diversify our program and are not concentrated in some small area. I see great potential in this market for this business. We plan to offer more high-quality products in the long run, with several exciting programs in the pipeline for the next few quarters. That’s our growth strategy for the STEAM courses.

Operator, Operator

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

Thomas Chong, Analyst

Can you share about the progress for our education digitization solutions?

Lei Jin, President

Thank you, Thomas, this is Lei. For the education digitization solutions, the main product is Youdao Smart Linear Terminal. It targets a homework scenario with AI functionality. In the semester, over 30,000 students used it in schools and they collected more than 2 million pages of homework reports that helped teachers plan their targeted lessons more efficiently. With our personalized practice, students also enhanced their learning efficiency. Our homework digitalization solutions have been recognized with awards by the government in multiple areas including Haidian in Beijing, Zhejiang in Hangzhou, and several others in Shanghai. In Q2, we also introduced a new compact sports education digitization product utilizing our cutting-edge video analytics technology which automatically records, measures, and analyses student performance on the playground without any wearable device. This is significant since sports education is being promoted by policy, making it the third largest focus area in education. The demand for sports teachers has increased; traditionally, they had to manage dozens of students manually tracking their performances which took a lot of time to assess their improvement. With our products, teachers no longer need to repeatedly record measurements, allowing them to spend more time giving students strategic advice based on digital data and analytical reports derived from student exercises. Students also have more opportunities to access this technology freely and can use any device. Additionally, parents can better understand their children's physical condition and growth progress. Overall, despite governmental budget controls due to COVID-19, we are optimistic about achieving improved financial performance for education digitization solutions in the second half of the year.

Operator, Operator

And our next question today will come from Candis Chan of Daiwa.

Candis Chan, Analyst

I want to follow up on your earlier comments regarding the second half outlook, specifically for the vocational and adult courses given the current macro situation and COVID. How is the demand recovery, and what's the growth outlook for the second half?

Su Peng, VP of Strategy and Capital Markets

Su Peng here. There’s a variety in that sector, which, despite being labeled as vocational and adult courses, comprises several different product and service offerings. We currently focus on several different verticals. First, we believe graduate school entrance exam courses will maintain momentum in the second half. This is our top priority for adult courses this year. The number of students registered for the graduate school entrance exam reached over 4.5 million this year, marking an increase of about 800,000 compared to last year. This reflects strong demand from the market and shows why we prioritize this sector. Additionally, we can leverage our advantage in these areas. We operate the largest dictionary app in China, with roughly half of our registrants being above the age of 18, meaning they are potential college students. Moreover, we have the largest Chinese university MOOCs, with over 40% of university students registered for our products. We see immense potential to convert these users into our product users long-term. The experience we have accumulated since starting our adult business in 2016 also serves as a differentiation point from our peers in this area. In relation to intelligent learning, this is an area of significant interest since we see strong demand for these types of courses. For instance, gross billings for illustration courses grew over 700% year-over-year in Q2. We maintain a focus on the quality and content of our products while working to understand student needs through our services. Lastly, we anticipate that English courses will likely rebound further in the second half, subject to pandemic and macroeconomic conditions. As highlighted in our prepared remarks, we saw demand recover for English courses, rising over 30% quarter-over-quarter in Q2. This recovery has positively contributed to our performance with our immersive first-person scenarios, enhancing course completion rates up to about 50%. However, we expect interest-related courses to face challenges due to macro conditions. That overall provides an outlook for the vocational and adult courses in the second half of 2022.

Operator, Operator

Our next question will come from Linda Huang of Macquarie.

Linda Huang, Analyst

I have one question regarding the margin because we saw that certain headwinds impacted the second quarter. But looking into the longer term, how should we think about the normalized gross margin for the different business divisions? And in terms of operating profit margin, can you also give us an outlook on what the normalized level is for the longer term?

Wei Li, VP of Finance

Thank you, Linda. This is Wei. In respect to our gross margin, we saw a decline from 51% in the last quarter to 43% in this quarter. This change was mainly due to the seasonal fluctuations of revenue recognized for our learning services. On the revenue side, the new generation of the Dictionary Pen X5 and other launches will potentially improve our gross margin. On the cost side, we will continue to explore different ways to optimize our cost structure to improve our margin. Considering the factors mentioned above, we are very confident in our ability to improve our gross margin over the long term. Let's look at some details on the margins of our learning services and smart devices sector. For learning services, we expect a much higher revenue base in the second half of the year with the completion of our learning services transition. The economics are expected to return to normal levels, and we expect the annual gross margin for our learning services to remain stable or even better than last year. For smart devices, the lockdown policy caused significant uncertainty in the production and delivery. After a relatively slow start in April and May, we observed signs of recovery in this business in June. Ultimately, we achieved a 15% annual increase year-over-year, despite the challenges from the COVID resurgence and adverse macro environment. We continue to adapt and remain focused on creating long-term value for our customers. The release of our new product series, including the X5 and Learning Pad, should enable us to achieve higher skills and better profitability in our smart devices category. Regarding our operating margin, while we dedicate resources to improving sales and marketing efficiency and staff costs, we continually strengthen our technical and R&D investments to maintain our technology edge. As noted, our net loss narrowed by 12% to RMB 450 million this quarter. We are working on long-term solutions to improve our operating margin.

Operator, Operator

Our next question today will come from an unidentified analyst from Haiti Securities.

Unidentified Analyst, Analyst

Could you please update the proportion of sales channels for online and offline for smart devices? And we understand that there could be some impact in Q2. How do you see the momentum of sales of new services and new products in the second half?

Dr. Feng Zhou, CEO

Sure, regarding the different sales channels, currently, over 50% of our devices sales are through online channels. The major e-commerce platforms and live video channels are key online channels. Offline channels are also important; we have partnered with thousands of sales endpoints across the country. These are essential for reaching mid-income consumers, especially in Tier 2 and Tier 3 cities, where many customers prefer purchasing devices from local shops. In Q2, the impact from COVID-19 had several factors. When potential customers ordered online and saw the delivery taking several weeks, it affected their willingness to place orders. This slowdown impacted our overall sales processes. The COVID situation in places like Shanghai severely limited sales. Additionally, storage issues affected our delivery capabilities, as some warehouses were in areas heavily impacted by the pandemic. Looking ahead, local governments are becoming more effective in managing COVID situations without causing major logistics issues. We see this improvement as beneficial going forward. We have diversified our warehouse locations to mitigate issues, which should also help our sales momentum. We are optimistic about future sales trends, particularly for the new Dictionary Pen X5, which we believe is an excellent product. Check out our IR website to view the promotional video. In the long term, we believe we have significant opportunities ahead for both our learning tablets and other product categories.

Su Peng, VP of Strategy and Capital Markets

To add to the discussion about online and offline channels, the dynamics vary by city tier. In Tier 1 and Tier 2 cities, more devices are sold through online means and e-commerce platforms, while in Tier 3 and below, offline channels have seen stronger sales. However, the penetration of short video platforms has increased online sales in lower-tier cities as well, and we anticipate this will further shift the balance towards online channels in the future.

Operator, Operator

And that concludes the question-and-answer session. I would like to turn the conference back over to 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

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