Earnings Call Transcript - ZEPP Q2 2022

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for Zepp Health Corporation's Second Quarter 2022 Earnings Conference Call. At this time, all participants are in listen-only mode. Today's conference is being recorded. I'd now like to turn the call over to your host, Ms. Grace Zhang, Director of Investor Relations for the company. Please go ahead, Grace.

Grace Zhang, Director of Investor Relations

Hello, everyone and welcome to Zepp Health Corporation's second quarter 2022 earnings conference call. The company's financial and operating results were issued in our press release via the News Wire Services earlier today and are posted online. You can also view the earnings press release and slides we refer to on this call by visiting the IR section of the company's website at ir.zepp.com. Participating in today's call are Mr. Huang Wang, our Chairman of the Board of Directors, and Chief Executive Officer; and Mr. Leon Cheng Deng, our Chief Financial Officer. The company's management will begin with prepared remarks and the call will conclude with a Q&A session. Mr. Mike Yeung, our Chief Operating Officer will join us for the Q&A session. Before we continue, please note that today's discussion will contain forward-looking statements under the Safe Harbor Provision of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the company's actual results may be materially different from the views expressed today. Further information regarding this and other risks and uncertainties is included in the company's Annual Report on Form 20-F for the fiscal year ended December 31, 2021, and other filings as filed with the U.S. Securities and Exchange Commission. The company does not assume any obligation to update any forward-looking statements, except as required under applicable law. Please also note that Zepp's earnings press release and this conference call include discussions of unaudited GAAP financial information, as well as unaudited non-GAAP financial information. Zepp's press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures. I will now turn the call over to our CEO, Mr. Wang Huang. Please go ahead.

Wang Huang, CEO

Hello, everyone. Thank you for joining our call. For the second quarter of 2022, we forged ahead countering the challenges brought about by the ongoing pandemic and a weakening consumer sentiment underscored by regional conflicts and microeconomic factors across a number of our markets globally. Our second quarter revenue was in line with our guidance at RMB1.1 billion, down 39.6% year-over-year compared with RMB1.84 billion in the second quarter of 2021. On a positive note, we presented an improvement of 46.4% quarter-over-quarter from RMB757 million of revenue in the first quarter of 2022. This year-over-year decline in revenue was primarily attributable to the later timing of our Mi-band launch this year. The new generation Mi-band contributed to just 1 month of sales in the second quarter of 2022 versus the full quarter sales in the second quarter of 2021. That said, we were pleased to see our top line improved from the first quarter. This occurred despite the subdued retail spending on discretionary items owing to the rising cost of living, worldwide geopolitical events, lockdowns and other pandemic control measures in China impacting our business. We expect further sequential improvement in sales going forward, particularly given the positive sales impact from the launch of several innovative, self-branded smartwatches, including Amazfit Trex 2, Amazfit Bip 3, and Amazfit Bip 3 Pro towards the end of the second quarter. Furthermore, in the third quarter, we will launch new products in our most popular line, the Amazfit GT series. Before we further elaborate on our new products and regional achievements. I'd like to share some updates on our business operations. Earlier this year, we optimized our organization structure to improve our operational effectiveness and enhance our customer-facing capability. We also formed an Information and Management Construction Committee to oversee the development of a new generation information management system which better serves the post-COVID era working style, including working from home and collaborating across time zones. This also strengthens our advantages in AI, chip technology, and cloud service in Europe and North America, built through R&D collaboration and our manufacturing and production capabilities in China. This approach of systematic automation makes our organization more flexible, effective, and better suited for the comprehensive operational needs of our business units. We continue strengthening and elaborating our brand identity on the global stage, accomplishing significant progress in multiple markets. For example, in North America, we enjoyed impressive results during the recent July Amazon Prime Day events with sales going over 100% compared with the same events in 2021. Our outdoor smartwatch product line is gaining increasing consumer recognition. For example, Amazfit Trex 2, our latest, largest outdoor GPS smartwatch designed with outdoor adventurers and sports enthusiasts in mind, is equipped with comprehensive outdoor exploration features, including high precision positioning, ultra-low temperature operating capability, military-grade toughness, and optimized route navigation. At well-known outdoor events taking place globally such as the Escape from Alcatraz Triathlon, Spartan Race, participants speak highly and share their enthusiasm for our products. At the same time, our Amazfit Bip product lines continue to be popular in Southeast Asia, Latin America, and Southern Europe, owing to its best value, best price product philosophy, despite a microeconomic downturn occurring in many of those markets. Recently, we launched our Zepp quality product in the North American market. This is an invisible-in-the-canal hearing aid for people who have mild to moderate hearing impairment. Our mission is to make hearing aids more accessible and normalize their use, empowering those with hearing limitations to take control of their own audio health. As some of you may have seen that this August, the U.S. FDA finalized a rule change that will create a class of over-the-counter hearing aids available for purchase without prescription or fitting from audiologists, many have viewed the news as a great relief for millions of hearing-impaired Americans who often find these expensive medical devices out of reach. The U.S. FDA has finally allowed Americans with mild to moderate hearing impairments to easily purchase hearing aids from community pharmacies or online retailers, potentially making hearing aids a new digital blockbuster. We also introduced a new AI-based sleep aid music subscription service. Our app utilizes real-time biometric data, particularly heart rate tracking from our wearable devices to automatically compose high-quality customized rhythms to help our users fall asleep faster and holistically improve their sleep quality. This is the first time that our products have pivoted from being data-checking devices to being healthcare solution providers. We have already launched this service in the North American region. Before I conclude, I must briefly mention our Zepp OS ecosystem, an important strategic asset, central to our open health management platform. We have a completely different design philosophy from Apple Watch IOS and Android. It prioritizes longer battery life from 10 to 30 days depending on the device, so that users can continuously monitor their health conditions, giving Zepp OS a focus on designing for continuous health monitoring. This OS will evolve into new forms in the future, such as supporting the invisible-in-the-canal hearing aid devices. We continue to encourage users worldwide to join our Zepp OS ecosystem, which would support and inspire them to manage their health and fitness and enjoy life. In addition, our inclusive and innovative Zepp OS ecosystem has attracted worldwide developers from around the globe to design apps and watch faces for our platform. In fact, surprisingly to me, some developers have even developed interactive game watch faces. Based on the API, which we have not yet officially opened, to help nurture this driving developer community further, we are hosting the first-ever Zepp OS global online HEXO from August 21 to August 31, 2022. In summary, our second quarter revenue improved from the first quarter, which highlights our execution capabilities, product strength, and Zepp business management approach even though the macro environment remains challenging with ongoing geographic conflicts and COVID lockdowns. In the face of all those challenges, we continue to strive to improve our R&D, marketing capabilities, and business operating effectiveness. With our recent product launches, I am optimistic that we can deliver even stronger results in the second half. Despite the significant headwinds, I remain as proud as ever of our team as we accomplish some major milestones. This includes launching our first medical-grade product in a new product category, our invisible-in-the-canal hearing aid, as well as introducing our first AI-empowered health management subscription service, our AI music sleep aid service. These innovations have not only expanded our product category, but also helped us transform our business model from a pure device sales company to a healthcare management subscription provider. We view this accomplishment as a strategic upgrade into a new blue ocean market. As mentioned earlier, our organizational restructuring strengthens the sharing of our hardware platform resources across different business units. The use of the Zepp OS operating system and AI technology, this restructuring not only reduces redundant R&D investment and human resource costs but also improves our overall operational effectiveness and the competitiveness of our technology. This laid the foundation for us to quickly launch our new invisible in-the-canal hearing aid product line and the AI subscription service. In the meantime, both this new structure and the layering help our senior management team stand closer to our users and facilitate faster and better decision-making. We now have a better view of the market as well as the capability to fulfill its needs by using our leading technology. Using our current integrated information system enables our R&D teams in the U.S. and China to launch more health-related products in distinct categories and distribute our products worldwide through diverse global channels. So assessing our over 40 million monthly active users to benefit from more opportunities to enjoy our subscription services. As our Amazfit branded smart wearables shipment is growing rapidly worldwide, we keep acquiring new users who pay significant attention to their health. We are forming a user community with increasing user engagement. Our years of continuous investment in applying AI technology to monitoring and solving health problems are yielding more fruits. Combining smartwatch technology and health data, we have gained unique advantages in hearing aids and sleep aid music subscription services as well as reduced user acquisition costs. From smart bands to smart watches, we are now expanding into more healthcare product categories and online services. This helps mark the beginning of a new stage for Zepp Health and ignites the process of forming a flywheel effect. With that, I will now turn the call over to Leon to go over the highlights of our second quarter financial results.

Leon Cheng Deng, CFO

Thank you, Wang. Hello, everyone. I would like to start by highlighting some of the key metrics driving Zepp's development for this quarter. Before providing further details on our financial performance, the global impact of the COVID-19 pandemic, which continued in the second quarter of 2022, especially the fresh lockdowns in China that affected retail store sales and posed challenges to our supply chain globally. Shortages of electronic components and chips for different industries persisted and consequently affected the company's supply and production cycle. Separately, escalating geopolitical strife among countries, notably the conflict between Russia and Ukraine is creating turbulence, dampening consumer confidence and causing inflation, leading to a slowdown in consumer discretionary spending. These adverse conditions weighed on our revenues generated and our overall gross margin. Together, these factors have affected our Q2 results and continue to impact our ongoing second half 2022 performance. Despite these headwinds, our Q2 revenue was RMB1.1 billion and in line with guidance, consisting of 42.9% self-branded product sales and 57.1% Xiaomi product sales versus 32.7% of self-branded product sales and 67.3% of Xiaomi products sales in the same period last year. However, our sales were affected by the timing of the new product launches compared with the same period last year. Mi-band 6 2021 launch generated sales throughout the second quarter of last year, whereas this year's launch of the Mi-band 7 only contributed sales revenues in June. Likewise, as the launches of the new Amazfit Trex 2, the Amazfit Bip 3, and Bip 3 Pro take place towards the end of the second quarter, hence, their boost to self-branded product revenue will only be visible in the second half of the year. On a sequential basis, second quarter 2022 revenue was better than first quarter 2022 and our operating profit also improved, reconfirming our solid execution capabilities. Now let's turn to the second quarter gross margin, which can be affected by product mix, product launch timing, and product life cycles, including model upgrades. Our Q2 gross margin was 17.9%, 2.2% lower than the first quarter of 2022 and 4.1% lower than the last year's same period. The lower gross margin in the second quarter of 2022 resulted from higher outbound freight costs globally, the adverse impact of currency depreciation, and the promotions for our previous-generation products to prepare for the new product launches. Turning now to costs, which has been a key focal point for the company both in terms of absolute amount as well as a percentage of sales. While we need to balance cost controls carefully with expenditures to fuel growth, we’ve already seen a decreasing trend in total operating expenses since Q3 2020. As a portion of operating expenses is fixed and it takes time and creativity to reduce them gradually, we expect to achieve further cost reduction in absolute terms for the remainder of the year. Going forward, we will continue to right-size our operating expenses from their current level in order to deliver profitability in the coming quarters. First, as mentioned by Wang, we also have streamlined our organization structure in the past quarters, aiming to bring down our fixed cost breakeven point and prepare for a recovery in the coming periods. Moreover, we started to apply a strict return on investment-based and modularized approach in our day-to-day operations to drive faster decision-making while becoming more service-oriented and customer-centric. Second quarter 2022 non-GAAP operating expenses were RMB296.4 million, with spending on non-GAAP R&D in Q2 2022 being RMB123.3 million, a decrease of 7.4% year-over-year as we reduced research and development costs by pursuing a smarter and leaner approach. Q2 non-GAAP selling and marketing expenses were RMB107 million, an increase of 4.7% compared with Q1 2022 and 9.3% year-over-year. The increase was due to e-commerce online advertisement promotions for our self-branded product. Q2 non-GAAP G&A expenses were RMB6.60 million, 27.2% higher compared with the first quarter of 2022 and 9.3% higher than the same period last year. It was largely attributable to the revaluation of operating working capital resulting from exchange rate fluctuations. If we exclude the impact of currency fluctuation, G&A expenses were relatively flat quarter-over-quarter. As our revenue improved sequentially and expenses remained largely flat, adjusted operating loss for the second quarter of 2022 improved to RMB98 million compared to the loss of RMB142.4 million in the first quarter 2022. Our adjusted net loss in the second quarter was RMB94.4 million compared with RMB75.7 million in the first quarter. Q1 net income included RMB66.3 million investment income generated by our investments, whereas our Q2 investment gain included income from fair value changes and profit from equity method investment at RMB52,000. We will continue applying a disciplined approach and strive to return to profitability in Q3 2022. Now turning to the balance sheet. Cash and cash equivalents and restricted cash as of June 30, 2022, were RMB997.1 million, reflecting our strict working capital control practices. Our inventory balance for the second quarter of 2022 was slightly better than the first quarter of 2022. We have introduced a more precise inventory management strategy to better serve the current business going forward. In November 2021, the Board approved the allocation of up to US$20 million towards a share repurchase program. In Q2 2022, we continued the repurchase program, reflecting our confidence in our growth strategy and financial performance. We have bought back US$8.8 million worth of shares until June 30, 2022, and intend to carry on with this buyback program. Lastly, I would like to discuss our outlook. In light of the ongoing challenges, our guidance for the third quarter of 2022 currently projects net revenue to be between RMB1.2 billion and RMB1.5 billion compared with RMB1.6 billion in the third quarter of 2021. Please note, this outlook reflects the continued uncertainty of the potential effects of the COVID-19 pandemic on sales as well as lower discretionary consumer spending, especially in our international market. Given this outlook, we will continue to apply strict cost control measures and disciplined working capital management through 2022. Please note that this guidance is based on existing market conditions and reflects management's current and preliminary estimates of market, operating conditions, and customer demand, which are all subject to change. This concludes our prepared remarks. We will now open the call to questions.

Operator, Operator

We will now open the call to questions. Operator, please go ahead. Nick? Hello?

Unidentified Analyst, Analyst

Okay, okay. Thank you. Hi, management. Congratulations on the second quarter, very good results. I have two questions. Firstly, it's about your Mi-band 7. We noticed it has launched at the end of June. So could you share some color about the shipment in the last 2 months and how can we expect the Mi-band 7 shipment this year? Thank you.

Leon Cheng Deng, CFO

Yes. As we mentioned earlier, the Mi-band 7 was launched in June, and we have seen promising results in the initial weeks since its release. However, the sales figures from June do not fully capture the potential of the Mi-band 7 because we are still somewhat limited by chip shortages, which is more of a supply challenge than a demand issue. Therefore, we anticipate that Mi-band 7 sales in the third and fourth quarters will surpass the sales of Mi-band 6 during the same period last year. It's important to note, though, that we've observed a decline in the overall global market for bands since the second quarter. While we haven't received the Q2 figures yet, various sources, including IDC and other market intelligence firms, indicate a decline of 30% to 40% in global band sales in the first quarter of this year. I believe this trend will continue into the second quarter and likely persist into the latter half of the year. This provides some insight into the Mi-band 7 situation.

Unidentified Analyst, Analyst

Okay, okay. Thank you. And I have another question about new market. We think the VR, AR market is very likely to boost in the near-term. So I wonder how you think about this market and will Zepp launch any VR, AR products in the future?

Leon Cheng Deng, CFO

No. I think it's quite early to talk about our future roadmap. But I think VR and AR is definitely a market whereby if you follow the news and the media a little bit, most companies see the watch or the band on the wrist as a prototype to play into the VR and AR market. So from that perspective, the wearable product categories have a better lead into this market from a hardware perspective compared with many others. So we are actually one of the biggest wearable companies in the world. So for sure, VR and AR are definitely on our roadmap. But with regard to the exact product timing, sorry, I couldn't say too much in today's call.

Unidentified Analyst, Analyst

Okay, okay. I understand. Thank you.

Operator, Operator

Our next question will be from Lisa Lee of Alpha Research. Please go ahead.

Unidentified Analyst, Analyst

Thank you. Thank you, management for taking my question. I have three questions. The first one is for your self-branded products. Can you please discuss your recent progress and strategy in the international market? And the second one, the new businesses that you discussed, such as the medical-grade hearing aid and this sleep aid service seems pretty exciting. Can you please share with us more about the market potential for these new products and services as well as how we plan to monetize? And lastly, I would be grateful if you can provide some guidance for the second half of the year in terms of both the top line and margin trends. Thank you.

Leon Cheng Deng, CFO

Thank you very much. I think I will try to take your question one by one, right? I will start with the self-branded products and how we are going to drive it internationally. I think as we mentioned in the script early on, we have launched a few new products, which are the blockbusters of our existing self-branded product lines. For example, the more value segment, the Bip 3 and Bip 3 Pro products together with the outdoor segment, which is a Trex 2 outdoor watch, which is actually a competitor to Garmin watches. As well as in September, we are going to launch our GT4, which is actually a yearly renewal of our flagship smartwatch line. So those three are more tailored towards international markets. And we have very good performance because of the apps which we have built on Zepp OS, these are also the software and the mini programs are tailored to the individual consumer needs in different markets, addressing different consumers. So with this, we think the new product introductions position us well to capture the rebound of consumer demand because as you see, most of the first half of the year is not a big sales season. But heading into Q3 and Q4, where you prepare for Black Friday as well as the Christmas shopping season, these are the times whereby you can make a success based on your new product introduction. I would say, number one is definitely the new product introductions on our smartwatches and bands. And number two, also heading into your second question on the new businesses. I think Wang just mentioned, there are two milestone achievements, which we made in this quarter. One is the in-the-canal hearing aid devices and the other one is the sleep AI algorithm, right, as an Internet type of service. The hearing aid devices, let me just elaborate a bit on that. It's really an innovative product because a lot of the consumer pain has been that once people have hearing problems, they are reluctant for others to see it. The traditional hearing aid devices are very bulky. At the moment you wear it, everybody on the street notices that you have some sort of hearing problem. Our product is actually trying to build out the TWS technology, which we’ve gained in making TWS devices in our company and then build on that a specific form factor that is very small, which you can place in the canal, making it discreet. In August, the FDA issued a new regulation to allow over-the-counter sales of hearing aid devices in the United States. The hearing aid market was previously dominated by five manufacturers and now this FDA ruling opens the door for innovative variable companies like us to get into this area and disrupt it. From a market potential perspective, we see this as a self-pay market, which probably will start more from affluent consumers in the United States and in Europe. Later on, maybe we will bring it back to China. I can also point you to a company which is also listed, called Eargo, which has been very successful in launching similar products and selling them in the United States. So we have high hopes for the hearing aid device sales. Additionally, the sleep AI algorithm can address the common sleeping problems many consumers face. Most existing apps or devices do not tailor their solutions toward specific consumer needs, but our solution utilizes wearables and an algorithm to create a feedback loop to improve users' sleep quality. We also think this will be an interesting exploration into Internet-type services, which we have always aimed for because we can monitor vitals through various devices. We are optimistic that this business will take off in developed markets, and later expand to China. That should answer your second question. Regarding our second half top line guidance, we don't provide guidance beyond a quarter, but based on our current information, we expect flat or better than last year’s sales for the second half of this year. I think that gives you some insight into what we are looking at.

Unidentified Analyst, Analyst

It's very helpful. Thank you, Leon.

Leon Cheng Deng, CFO

Operator, are there any other questions on the line?

Operator, Operator

No. At this time, there are no further questions. We are going to return to the company side for closing remarks.

Grace Zhang, Director of Investor Relations

Thank you once again for joining us today. If you have further questions, please feel free to contact Zepp's Investor Relations department through the contact information provided on our website. Thank you. You may now disconnect your lines. Thank you.

Operator, Operator

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