Earnings Call Transcript - DAO Q1 2022

Operator, Operator

Good day, and welcome to the Youdao 2022 First 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 for Youdao. Please go ahead.

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 certain filings of the company with the Securities and Exchange Commission. The company does not undertake any obligation to update 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 reconciliations of GAAP to non-GAAP financial results, please see the 2022 first 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, 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. We're pleased to report solid performance in the first quarter of 2022 following the cessation of our K-9 academic AST business, with record-high revenues and overall gross margin as well as a significant improvement in operating loss. Q1 net revenue was RMB1.2 billion, up 26.6% year-over-year and 14.5% quarter-over-quarter, a new record high. We also achieved an overall gross margin of 53.5%, another record high. Given the disposal of the K-9 academic AST business, retrospective adjustments to the historical statements of operations have also been made for the previous periods, which provides a consistent basis of comparison for the financial results of the continuing operations. Furthermore, we narrowed the operating loss by 41.6% year-over-year to RMB125.1 million from a loss of RMB214.3 million in Q1 2021. These results amid a challenging macro environment clearly reflect our strengthening fundamentals as well as the effectiveness of our strategy. Liquidity-wise, we have adequate funding for long-term growth. First, as of March 31, 2022, Youdao's cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB1.2 billion. Secondly, our controlling shareholder NetEase Group has been supporting our long-term growth. Until the date of this release, Youdao has received various financial support from the NetEase school, including RMB878 million short-term loans and a US$300 million revolving loan facility. In support of Youdao's future business, NetEase Group has agreed to provide financial support for our continuing operations. Now, I'd like to share more details on our first quarter progress. First, let's look at smart learning devices. Our Q1 device revenue was RMB253.2 million, representing an increase of 25.4% year-over-year. This is remarkable growth given the COVID-related supply chain and sales channel challenges. In total, we sold 430,000 devices in Q1. As we discussed in past quarters, devices are a key growth area for us. An important priority this year is to drive growth and synergy by scaling up R&D, updating existing product lines, and shipping new products. We strictly followed our strategy in Q1. We added new dictionary databases to Youdao Dictionary Pen, while we already have the most comprehensive dictionary database. We added 11 new series of English textbooks to Youdao listening part, with the total reaching 19. In terms of new products, more recently, in early April, we launched Youdao's Smart Light. A product in development for over a year. Youdao Smart Light is a smart desk lamp with integrated AI learning features, powered by our advanced AI algorithms. It automatically analyzes users' hand and body movements while sitting at the desk, allowing the user to seamlessly access a host of AI learning functionalities while they are reading, writing, or doing homework. You can point to an English word to look up or tap a sentence to have it read to you or ask it to check your arithmetic worksheet for you. It even tracks the user’s sitting posture and will alert the user when detecting unhealthy postures. After we launched Youdao's Smart Light, the initial feedback was very positive. We plan to grow its popularity over the coming months as we did with other products. We are also looking forward to introducing additional smart devices this year as planned. Now let's talk about learning strategies. Our strategy here is to transition from an academic AST center business to STEAM and vocational courses center business at an accelerated pace. Since Q3 last year, Q1 is the third quarter in which our team scaled up our growth products like the Weiqi courses and graduate school entrance exam courses. While at the same time, closing down academic AST courses has been a challenging process, and we have continued to deliver steady progress in Q1. Our new courses are growing quickly, which partially offset loss of revenue from academic AST courses. Net revenue from learning services reached RMB826 million in Q1 2022, up 36.1% year-over-year. If we were to compare with the learning services net revenue including K-9 academic AST business in Q1 2021, it declined by 17.3% year-over-year. Note that we were positively impacted by seasonality because Q4 was a major renewal season, and a large part of gross billings generated in Q4 were recognized as net revenue in Q1. As for STEAM courses, Youdao Chess expanded particularly fast with its gross billings increasing 170% quarter-over-quarter. Besides, we established a strategic partnership with the Haidian Chess Association. In addition to courses, our Go and chess user community has been growing at a fast pace. Here, we have the Youdao Boardgame Academy app, where users can play against others or learn Go or chess with the help of our proprietary AI technology. Every day about 200,000 Go or chess games are played on the Youdao game economy app and our other assets. This approach of combining courses and the community and AI-based app experience is a major competitive advantage for us. The courses and the app drive each other's growth. In addition, Youdao has become an official online testing and certification site for which economies in Beijing and Anhui province. Through the test, users can receive certifications for their skill by the Chinese Weiqi Association or Beijing Weiqi Association. Let's turn to vocational and adult education courses. In Q1, we upgraded our graduate school entrance exam courses to offer a one-stop service for our customers. We also explored online-merge-offline courses to increase learning efficiency and effectiveness. With ongoing upgrades, the gross billings from the graduate school entrance exam courses grew by over 160% quarter-over-quarter. We also saw growing demand for other vocational courses, such as constructor certification courses and accounting courses with gross billings increasing over 7 times year-over-year in Q1. Our other endeavors, including education digitization business, dictionary and translation apps, and our charity initiatives are also progressing smoothly in Q1. Looking ahead, we continue to implement our strategy of four growth pillars, that is: smart devices; STEAM courses; vocational education; and education digitization. The first two devices and STEAM courses are at a larger scale and already a significant part of our business. The latter two are making good progress in product development and business model validation. We expect to see challenges, including this new wave of COVID in China. We intend to overcome them through our diversity of businesses, large user bases, and deep technical routes for innovation. With that, I will turn the call over to Su Peng to give you more details on our financial performance. Su Peng?

Peng Su, VP of Strategy and Capital Markets

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights for the first quarter of 2022. We encourage you to read through our press release, issued earlier today, for further details. For the first quarter, total net revenue was RMB1.2 billion or US$189.4 million. This represents an increase of 26.6% from the first quarter of 2021. Looking at this growth by segment. Net revenue from our learning services was RMB826 million or US$130.3 million, increased by 36.1% from the same period in 2021. We attribute this growth to the increased revenue generated from our learning services, which were further driven by the growth in active users compared with the same period of 2021. Net revenue from our smart devices was RMB253.2 million or US$39.9 million, increased by 25.4% from the same period in 2021, driven by the increase in sales volume of Youdao Dictionary Pen in the first quarter of 2022. Net revenue from our online marketing services was RMB121.4 million or US$19.1 million, representing a 12.7% decrease from the same period in 2021. For the fourth quarter, our total gross profit reached RMB641.8 million or US$101.2 million, increased by 29.3% compared with the first quarter of 2021. Gross margin for learning services was 63.9% for the first quarter of 2022 compared with 63.4% for the same period in 2021. Gross margin for smart devices was 33.7% for the first quarter of 2022 compared with 44.1% for the same period in 2021. Gross margin for online marketing services was 23.7% for the first quarter of 2022 compared with 16.4% for the same period in 2021. For the fourth quarter, total operating expenses were RMB766.9 million or US$121 million compared with RMB710.8 million for the same period of last year. With that, for the first quarter, our sales and marketing expenses were RMB506.4 million compared with RMB548.7 million in the first quarter of 2021. Research and development expenses were RMB203 million compared with RMB127.7 million in the first quarter of 2021. Our operating loss margin was 10.4% in the first quarter of 2022 compared with 22.6% for the same period of last year. For the first quarter of 2022, our net loss from our continuing operations attributable to ordinary shareholders was RMB95.4 million or US$15.1 million compared with RMB219.3 million for the same period of last year. Non-GAAP net loss from continuing operations attributable to ordinary shareholders for the first quarter was RMB70.9 million or US$11.2 million compared with RMB204.8 million for the same period of last year. Basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for the first quarter of 2022 was RMB0.77 or US$0.12. Non-GAAP basic and diluted net loss from continuing operations per ADS for the first quarter was RMB0.57 or US$0.09. Our net cash used in continuing operation activity was RMB425.6 million or US$67.1 million for the first quarter. Looking at our balance sheet, as of March 31, 2022, our contract liability, which mainly consists of the deferred revenue generated from our learning services, was RMB729.5 million or US$115.1 million compared with RMB1.1 billion as of December 31, 2021. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB1.2 billion or US$183 million. This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

Operator, Operator

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

Elsie Sheng, Analyst

I'd like to ask about the non-academic or the STEAM courses business. Could you give us more color in terms of the progress of this business and also the competitive landscape in this business?

Feng Zhou, CEO

Yes, this is Zhou Feng. I'll take your question. As I mentioned earlier, we're making good progress here. The STEAM courses saw significant growth again in Q1. Go and chess remain strong areas for us, and we have been running these courses for about two years. Our teams have gained valuable experience, and we have a unique product strategy that incorporates excellent teaching staff, well-designed interactive materials, AI tutoring, and an online community. In Q1, we have established ourselves as a market leader in this segment, continuously acquiring new customers each quarter. Chess was a standout area for us in Q1, with gross billings increasing by over 170% compared to the previous quarter. Although chess serves a smaller, more affluent audience than Go, both are promising businesses for us, and we will continue to emphasize these courses. Our offerings stand out from our competitors by providing an integrated experience. We've made significant strides in AI and our online community this quarter, enhancing the app experience so that AI effectively assists students in reviewing their chess and Go games. We've also improved player matching, allowing users to connect with others of similar skill levels, which enhances their learning and overall experience. Our strategy remains to focus on promising areas and patiently develop the best products within those categories. We have applied this approach to our devices, courses, and now to chess, which we believe will lead to our success. We do not plan to diversify into too many courses or products; rather, we aim to concentrate on a few areas. Beyond Go and chess, we intend to select one or two additional focus areas in the non-academic course space and will share more details about these new products when they are ready. Thank you.

Operator, Operator

The next question comes from Hongyi Cao with CICC.

Hongyi Cao, Analyst

Congratulations on the good performance. My question is, can you give us more color on the new product, Smart Light? And how is the sales performance? And what is the momentum for this new product compared to your Dictionary Pen?

Peng Su, VP of Strategy and Capital Markets

Thank you. This is Su Peng. I will address the questions. First, I want to highlight our Q1 numbers regarding the performance of our smart devices, which benefited from favorable conditions surrounding the new school season, generating revenue of RMB253.2 million. This marks an increase of over 25% year-over-year in the Smart Devices segment for the first quarter. Regarding the Youdao Smart Light, it has been well-received by customers. We are pleased to announce that the first batch of Smart Lights sold out within the first month of its launch in early April, indicating strong market demand. The positive feedback stems from our innovative product experiences, such as the subretinal ratio on JD.com, Fingertip World Search, and Sentence Intensive Reading, which customers have particularly praised. Our focus remains on delivering high-quality products that meet customer needs. We will continue to enhance our Smart Devices, anticipating positive market reactions. While we are in the early stages, we are optimistic about the long-term performance of these new products. We plan to share more detailed information in the second-quarter earnings report, and we have sufficient time to analyze customer feedback and introduce more products to the market.

Operator, Operator

The next question comes from Brian Gong of Citi.

Unidentified Analyst, Analyst

This is Katrina asking on behalf of Brian. So my question is how should we look at the margin trend for the second quarter of 2022 and the full year? Have we done any cost optimization measures? And how should we think about cost control going forward?

Yongwei Li, VP of Finance

Katrina, thank you for your question. This is Wayne. I will add some color for the margin for 2022. As you've seen this quarter, we achieved a new high record in overall gross margin at 53%. Therefore, we are very confident about the improvement in our gross margin in the long run. For Learning Service settlement, which is the largest segment from a revenue perspective, we are always seeking to optimize the cost structure and to achieve economic scale to get a better gross margin. On a full year basis, we expect the average gross margin of learning services for 2022 will remain stable when compared with last year. Meanwhile, we also noted that the seasonal fluctuation on a quarter-over-quarter basis in its gross margin is due to the seasonality of the recognized revenue. For the Smart Devices segment, which is another significant segment, we continue to invest in R&D and other resources, and we expect to achieve some growth on a year-over-year basis. However, the lockdown policy caused by the pandemic has been making a significant impact on the production and delivery of our smart devices, which further results in more uncertainties on both sales and the change of gross margin for this segment. We expect an improved gross margin of smart devices with realization of greater economic sales. However, we need to keep a close eye on the uncertainty around the margin of smart devices, considering the margin of smart devices is relatively lower than the learning services element at the current stage. If a higher revenue portion from smart devices is achieved, the overall gross margin level is expected to be lower. As for operating margin, on one hand, we are putting efforts into improving the efficiency of sales and marketing as well as staff costs. On the other hand, we continuously strengthen our technical and R&D investment to keep our technical advantages. As you see, improved operating margin was achieved in this quarter, and we have tried to seek better performance in operating margin in the long run, wish it is helpful.

Operator, Operator

Next question comes from Linda Huang of Macquarie.

Linda Huang, Analyst

My question is regarding the recent pandemic. We all know that this COVID situation remains unclear. So how is the impact from the recent pandemic outbreak like in Shanghai and Beijing? And if the city lockdown or the social distancing restrictions remains, do we have any contingency plan to mitigate the impact? It would be great if management could elaborate on learning devices and the learning services business?

Peng Su, VP of Strategy and Capital Markets

Linda, this is Su Peng. I will take these questions. And indeed, recently, COVID issues in some cities in China have actually had some impact on our business. Yes, we have come up with some contingency plans to mitigate the impact. And we will divide it into two parts because of the different impacts on these businesses. As for the Learning Services segment, that's where our major revenue is generated from. The process of our services is primarily delivered via the Internet. So we don't really need physical contact with our customers. Most of our services have been offered over online channels instead of offline learning centers. So we think we have very limited impact on the online learning services business. And so that's the first part. And secondly, as for the Smart Devices segment, there are indeed some impacts on our smart devices. It is because of the logistics and transportation issues for our products to our customers, regardless of whether they purchase these devices online or in retail stores. However, we believe that all of this will be a short-term impact. In the long run, we don't think there will be any decline in demand from our customers regarding the services provided by our smart devices from Youdao, because we see a very strong momentum and demand from customers for the last several quarters regarding the new products. You can see the growth rate and growth trend of our Smart Devices business in the last several quarters. So we think that in the long run, things will go back to normal. Indeed, we are taking steps to mitigate the short-term impact. For example, we are setting up new warehouses in Tianjin, Chengdu, Wuhan, and other areas in Mainland China to deliver our smart devices directly to the regional distributors. So we believe that this approach will help mitigate the short-term impact, and we expect to see the business return to normal right after the COVID impact settled down. We expect renewals in the middle of Q2 and we expect to provide more information after we finish the Q2 season. Thank you.

Linda Huang, Analyst

Just a very quick follow-up. Do you see the logistics disruptions improving, or do they remain similar in April and May?

Peng Su, VP of Strategy and Capital Markets

Yes, we think it's getting better and better with time. But that still depends on regions because in the different regions, they have different policies regarding the COVID impact. So in general, we see improvements. We expect that trend will continue, and we can deliver more products to our customers.

Operator, Operator

The next question comes from Thomas Chong of Jefferies.

Thomas Chong, Analyst

May I ask about the upgrade on education digitization strategies and the addressable market?

Lei Jin, VP of Operations

This is Lei Jin. I want to emphasize the education digitization initiatives supported by national market policies this year, which are part of the new infrastructure for education and the 5-year digital economy development plan outlined by the Ministry of Education. The national level has clearly indicated its commitment to investing in digitization, aiming to enhance the quality of its digital methods. Youdao plans to leverage our software, hardware, AI capabilities, and teaching expertise to assist public schools and our clients in achieving these objectives. While our digitization efforts mainly focus on localized services, the recent epidemic control measures have limited our access to schools, resulting in some delays in implementing solutions. However, I view this as a temporary setback and remain optimistic about the long-term prospects of this business. Moreover, we have received significant official recognition. A project centered around the smart education quality system and teaching plans was included in the inaugural batch of 5G smart education initiatives by both the Ministry of Industry and Information Technology and the Ministry of Education. Additionally, we were acknowledged as part of the new education base by the regional government, and our smart terminal was recognized as a recommended product by public educational institutions for its innovations and enhancements in teaching. According to the Ministry of Education's statistics, there are over 500,000 users of our services, which have reached more than 290 million students and 80 million full-time teachers. As for the potential market size for education digitization, it is projected to surpass RMB650 million in 2023.

Operator, Operator

The next question comes from Candis Chan of Daiwa.

Candis Chan, Analyst

I would like to ask about your adult education business. And how does the growth outlook look like this year? And also, can you share a little bit more color on our device pipeline for this year?

Feng Zhou, CEO

Thank you, Candis. This is Zhou Feng. Yes, first, regarding the vocational and adult courses. The current objectives for the teams are to basically upgrade our courses and focus on the growth products. As you probably know from the past few quarters, the other courses segment for us has seen some challenges. One of the key reasons is that demand for English courses, which were a large part of the business, was significantly impacted by COVID. So we are not out of the transitional period yet. Yes. So with that said, we have actually several bright spots in Q1. We saw good progress on graduate school and examination courses, with gross billings from graduate school entrance exam courses growing by over 160% quarter-over-quarter. Another bright spot is the constructor certification courses, which is a vocational course to help prepare for the exam to acquire a professional constructor certificate. The gross billings of this course increased over 10 times year-over-year in Q1, although from a low base. Given the current macro environment, the government is actively promoting vocational education and overall strong demand from the sector, we think that the outlook is quite bright. So we will be patient here and spend time growing new products and perfecting the courses. We believe vocational and adult courses have a big future. As for the device pipeline, we said we would have other new products this year. The Smart Light was launched in early April, and we expect to launch another new category of smart device in the second half of this year. That’s our current plan. Moreover, we will continue to upgrade the smart devices portfolios in preparation for the sales season of the new school year that's in September. Our lineup is basically like this: we have Dictionary Pen as our flagship product, and now we have the Smart Light taking its place alongside the Listening Pod as new upcoming products. These two products are becoming increasingly popular. If we compare this with last year, when we only had the Dictionary Pen as our main product, we achieved good growth with just one category last year, but this year we have a more comprehensive lineup. This allows for a larger addressable market and also internally allows for more sharing of technological expertise and personnel among the product lines. We believe this is a good strategy and lineup for us. The plan is to have another category of new products in the second half of the year. Yes, I hope that’s helpful. Thank you.

Operator, Operator

This concludes the question-and-answer session. I would like to turn the conference back over to Jeffrey Wang for any closing remarks.

Jeffrey Wang, Investor Relations Director

Thank you once again for joining us today. If you have any further questions, please feel free to contact us at Youdao directly or reach out to TPG Investor Relations in China or the U.S. Have a great day.

Operator, Operator

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