Earnings Call Transcript - ZEPP Q2 2020

Operator, Operator

Hello, everyone, and welcome to Huami Corporation's second quarter 2020 earnings conference call. The Company's financial and operating results were issued in a press release via newswire services earlier today and are posted online. You can also view the earnings press release and the slides to which we will refer on this call by visiting the IR section of the Company's website at www.huami.com/investor. Participating in today's call are Mr. Wang Huang, our Chairman of the Board of Directors and Chief Executive Officer, and Mr. David Cui, 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 made 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, 2019, 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 Huami's earnings press release and this conference call include discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial measures. Huami'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 earnings conference call today. I want to start by highlighting four key takeaways from the quarter’s financial and operating performance. First, it wasn’t a typical quarter for the industry. We delivered good revenue growth in the second quarter and first half, at or near the top of industry growth. Second, we are well positioned with our latest new product and others yet to come as we go into the full run up to the year-end holidays. Third, the consistent investment in R&D should continue our active development, pace, and innovation into 2021. Fourth, Voxforce, recent insurer announced his operations. Partnerships such as the one announced yesterday with Aspen Imaging Healthcare and progress with our university research partners give me confidence in the future for this institutional side of the business. Despite global disruptions caused by the COVID-19 pandemic, we delivered good growth on both revenue and product shipments. In particular, our main three brands smartwatch shipments grew 30% year-over-year in the second quarter. This result confirms our strong value proposition and recognition of our own amazing brands and expanding sales and marketing strategy. Another achievement in the second quarter was that we successfully shipped Xiaomi’s Mi-Band 5, the fifth generation in the popular product line. I hope everyone is aware of today’s launch of our new Zepp brand, which is our healthcare services brand. Today, we are kicking off this premium tier of smart devices, beginning with two new smartwatches. We are introducing the Zepp brand, which we acquired in 2018, with a broader smart ecosystem vision. As part of this, we are rebranding the consumer phone app to Zepp in the U.S. The first of the new Zepp models, the ‘E,’ will be available next week on zep.com and on Amazon. These new products are part of our continuous focus on our mission to connect health with technology, in order to build a comprehensive health and fitness ecosystem. Strong capability in hardware, big data analysis, algorithms and product certifications are all indispensable. To tackle these, many companies choose to fight solutions from outside. We chose a road that few took, developing the solutions ourselves. I firmly believe one cannot excel in software without expertise in hardware, and vice versa. People who are really serious about big data made their own sensors. We developed not only smart devices, but also AI chip sensors, healthcare-related data and algorithms, and now have a comprehensive AI-driven health management pathway. During our first AI innovation convention in June, we launched Realbeat 2, an upgraded cardio health monitoring algorithm, which significantly improves the effective detection of atrial fibrillation at night and during the day, by 87% and 564% respectively, compared to its predecessor. We also launched Amazfit, which enables near medical-grade blood oxygen level measurement for our smart devices. Furthermore, in the second quarter, we launched the new generation of our biosensor tool as well as completed the design phase for our self-developed AI chip Huangshan-2. Huangshan-2 has more processing capability than its predecessor and enables more healthcare-related functionalities that will further differentiate our future smartwatch products. We plan to start volume production of Huangshan-2 in the fourth quarter of this year, and by the first half of 2021, making it available to our users through our smartwatches. In July, our wholly-owned subsidiary PAI Health announced an agreement with Prudential Corporation Asia to incorporate PAI Health's science-backed activity metric into Prudential's digital health app. Later this week, we will be announcing a follow-on expansion of our relationship with Prudential to co-develop new consumer solutions that may be made available to their users, as well as Huami. As you know, Huami’s 'Connect Health with Technology' strategy is broad. While we have already achieved significant market change on the consumer side of health technology, we have a national industrial side of the business, focusing on the insurance and medical institutional side of the industry can help us make devices smaller, portable, less expensive, and allow us and care providers to aggregate more medical data for analysis services. PAI Health’s recent success is one example. Yesterday, we announced a new venture with Aspen Imaging Healthcare, which is pioneering new X-Ray technology. We expect to leverage and combine the engineering expertise of both companies in cooperative product development. We expect to leverage our broader international distribution capabilities for assets, and we explore potential investment in the company. Aspen, which is based in Plano, Texas, is creating some disruptive technology for medical imaging, which can open or expand new applications. Additionally, we are very pleased to have partnered with International Guangdong respiratory expert and a fellow of the Chinese Academy of Engineering, Dr. Zhong Nanshan to establish research laboratory facilities. The purpose of this lab is for the ongoing study of respiratory disease, the habits, and the patient management using risk valuable devices that leverage our expertise in wearable technology, AI algorithms, and big data biometric analysis. While the first half of 2020 was a challenging period for all of us, we are proud of our performance in smart, wearable products shipments, and the strong execution of our health service strategy. We are confident that our device shipment volume will continue to climb in the second half of the year, and we look forward to delivering value to all of our stakeholders. Thank you again for joining today. I will now turn the call over to our CFO, David Cui.

David Cui, CFO

Thank you, Wang. In terms of our brand products and global sales and marketing strategies, they served us well in the second quarter, despite global uncertain times. The unit sales of both self-branded products and an event closed to 8.9 million increased by 7.2% from the same period last year, leading to 9.5% revenue growth. I am especially pleased that we remain profitable despite the lower gross margin affected by our product mix. The second quarter saw the continued prioritization of investment in R&D, as well as sales and marketing infrastructure, as product development and sales channel expansion remain critical components of revenue growth. While these costs impacted short-term profitability, we are confident that continued strategic spending in these areas, coupled with prudent cost control in other general operating expense categories will lead us to stronger profitability in the long term. Mindful of the length of this call, I will highlight the key financial measures for the second quarter of 2020, and I encourage you to refer to our earnings press release for further details regarding our financial performance. Now, here are some of the highlights of our second quarter. All amounts are expressed in RMB unless otherwise stated. As previously mentioned, revenues in the second quarter of 2020 increased by 9.5% to RMB1.137 billion from RMB1.039 billion for the second quarter of 2019. Unit growth in the quarter was 7.2% and for the first quarter of 2020 was 18.7%. Gross Profit decreased by 8.6% to RMB253.4 million from RMB277.3 million in the second quarter of 2019. Our gross margin was 22.3% compared with 26.7% a year ago. Gross margin can be affected by product mix, as different products have different margin contributions, and this can change over the life of a product. In the second quarter of 2020, total gross margin was positively affected by a higher mix percentage of Huami branded products, offset by a higher mix of a lower margin product shifted to Xiaomi and by discount promotions for some older products in the transition to the new Mi-Band 5. Next, I want to discuss the impacts of COVID-19 on our business. The Coronavirus continued to have a significant negative effect on retail sales in all areas of the world and in most product categories through the second quarter. For example, although China recovered and opened many retail establishments midway through the second quarter, a number of initial retailers reported that shoppers were slow to return, affecting second quarter results. In the Americas and Europe, continued or resurging Covid infection rates kept many stores closed and also kept many shoppers out of the stores. Many retailers reduced inventories and orders during the second quarter. These all affected our second quarter results. Product delays due to the pandemic that slowed the manufacture of products in the first quarter have been resolved, with minimal lingering impacts in the second quarter. Looking forward, Huami is working with its channel partners flexibly as they reevaluate or change their market strategies, such as shifting focus to online sales and on-demand retail models. While Huami has several direct online sales channels, the vast majority of our revenue flows through these retail partner channels. Before the pandemic hit, industry expectations were for strong demand and continued growth for smart health technology for many years. Aside from the disruption and resetting of consumer purchasing method choices, we see no evidence to indicate that megatrend has been materially changed. Whether by personal choice or by encouragement from those who pay for our care, the world is increasingly focused on improving health. In the nearer term, with all the reports of people gaining weight during lockdowns, we think there may be upticks in demand for smart health technology in different geographies as people refocus on their health. Additionally, the company is engaged in research and development related to the detection of COVID-19 infection signals through its internal R&D team, as well as with some of its university research partnerships. Now, moving to expenses, research and development expenses increased 25% to RMB117.2 million from RMB93.8 million for the second quarter last year. As a percentage of sales, R&D expense only increased 130 basis points to 10.3% in the second quarter. We are striving to build up a top-tier R&D team for our future growth. The increase was primarily due to an increase in the number of R&D staff and a rise in investment in healthcare-related features, algorithms, cloud services, and new product development as we carry out our mission. R&D expenses were also up as we aim to launch a series of new products in the second half of 2020 to expand our customer base as we target different geographies and price points. Our sales and marketing expenses increased by 76.6% to RMB71.3 million from RMB14.4 million for the second quarter last year. On a percentage of sales basis, sales and marketing expenses rose to 6.3% of revenue versus 3.9% in the year-ago quarter. The increase was primarily due to expanding international markets outside of China for our Amazfit branded products, including increases in advertising and promotional expenses during holiday sales, and promotional events and growth in personnel-related expenses. In June, we organized our first AI Innovation Convention to present our current research results to the public and opened our first Amazfit offline retail store in Beijing to offer domestic consumers the opportunity to have a first-hand in-person experience with our products and build our brands. We have a strategy to open a number of these locations globally; a number of these are independent authorized dealers. The second quarter of 2020 general and administrative expenses increased by 9% to RMB55.4 million from RMB51 million for the second quarter last year, reflecting primarily an increase in exchange rate fluctuations, professional fees for business management, and depreciation and amortization expenses, offset by the decrease of share-based compensation. Our total operating expenses increased by 32% to RMB244 million from RMB185.2 million for the second quarter of 2019. Total operating expenses represented 21.5% of revenue in the second quarter of 2020, compared to 17.8% in the year-ago quarter and 20.6% in Q1 2020, reflecting our strategy of consistent investment in R&D with an emphasis on healthcare-related product development and testing, talent acquisition, and branding and marketing to enhance our company's long-term returns. Operating income for the second quarter of 2020 was RMB9.4 million, down from RMB22.1 million in the year-ago quarter, driven primarily by the year-over-year increase of RMB31 million in sales and marketing expenses, and RMB23 million in R&D. Relating to cash, as of June 30, 2020, the company had cash and cash equivalents of RMB2.6 billion, compared with RMB1.8 billion as of December 31, 2019. Now, let's turn to our outlook. For the third quarter of 2020, management currently expects net revenues to be between RMB2.1 billion and RMB2.15 billion, which would represent an increase of approximately 13% to 16% from the third quarter of 2019. The outlook is based on the current market conditions and reflects the company management's current and preliminary estimates of market and operating conditions and consumer demand, all of which are subject to change. This concludes our prepared remarks. We will now open the call to questions. Operator, please go ahead.

Operator, Operator

Thank you. We'll now begin the question and answer session. For the benefit of all participants on today's call, if you are asking your question to the company's management in Chinese, please immediately repeat your question in English. Our first question comes from Clive Cheung from Credit Suisse. Please go ahead.

Clive Cheung, Analyst

Hi, management. Thank you for taking my questions. I have three small questions. The first is about the sales and marketing expenses in the second quarter. You spoke about the expansion in channels. Can you speak a little bit about where these expenses have gone into the channel expansion? And is there any specific updates on that? My second question is on R&D. What kind of expectations should we have regarding R&D in the second half of 2020 and in 2021? And lastly, what is the current status of the contract renewal with Xiaomi? Thank you very much.

Wang Huang, CEO

So, thank you for your questions, Clive. With respect to our sales and marketing expenses, we launched multiple products in the first half of 2020. We attended CES at the beginning of this year. We also hired multiple personnel in sales and marketing to help us build a channel in Europe and Southeast Asia, and we also added a few new staff in the U.S. Our strategy is to sell our products and, in the future, hopefully, expand into healthcare services in global markets. So, even as the pandemic continues in those regions, we are sending our staff out and setting up new companies in those countries. So that’s how we have expanded our sales and marketing dollars. Regarding our R&D expense, again, we are investing in adding new qualified R&D staff. We added new staff quite rapidly in the latter part of last year and the first half of this year. We anticipate that R&D expenses will remain relatively moderate in the second half of this year and into early 2021. Despite an increase in revenue, we will not see a significant increase in our R&D expense. As for Xiaomi's contract, our relationship with Xiaomi is deeper than just a vendor relationship. This is well known. Xiaomi also has a significant ownership interest in Huami. It’s important to understand that the general contract we’re discussing with Xiaomi is about the blanket terms and conditions associated with being a preferred vendor. We negotiate specific contracts for each product we develop for them, such as the new Mi Band 5. That’s how we’ve done business with Xiaomi in the past and expect that to continue. While I have no additional updates, we are optimistic about negotiating a similar framework contract with Xiaomi and maintaining our relationship moving forward. Thank you.

Clive Cheung, Analyst

Thank you very much.

Operator, Operator

The next question comes from Xudong Chen from CICC. Please go ahead.

Xudong Chen, Analyst

Hi, management. Thank you for taking my questions. I think you just started a new brand named Zepp, which focuses on smart equipment for sport use. I wonder what your strategy for this product line is? And my second question is, I think you also cooperate with Prudential Insurance in PAI Health. Could you give me more information about this cooperation? Thanks.

David Cui, CFO

Sure. I will try to answer the first question regarding the Zepp brand. Zepp is a brand new brand we introduced to the market. It is our digital health solution brand with variable technology in it. We launched this new brand in Zepp to speak to a different audience compared to Amazfit, which aims more at everyday use. Zepp is aimed to be a little dressier with a focus on product features and materials. As you know, our mission is to connect health with technology. Currently, we are launching new products under the Zepp brand. In the future, we hope to build a line that provides not just hardware but also health solutions globally. Mike?

Mike Yeung, COO

Yes. Thank you, David. Regarding the partnership with Prudential, you probably saw the announcement earlier between Prudential Asia and PAI Health, which is our wholly-owned subsidiary. Essentially, it's an extensive partnership. The press release mentioned incorporating Prudential's digital health app, Pulse, which currently has over 6 million downloads in the 12 major regions across Asia. This was the first press release about our partnership, but we will also be working with Prudential to expand our partnership, which will be announced in a second press release very soon. Basically, we aim to leverage each other's products and services to cross-sell, upsell to each other’s customers, focusing on both health and wealth products and services for our joint users. You will hear more news about this extensive partnership soon in the second press release later this week.

Xudong Chen, Analyst

Thanks.

Operator, Operator

The next question comes from Tony Zhang from Haitong. Please go ahead.

Tony Zhang, Analyst

Hello, management. Thanks for taking my call. I have two questions. The first question is, your management is expecting quite strong sales in the third quarter. Can you provide a little more context on where this strong growth will come from, from China or overseas market? And how about the sales recovery in overseas markets in such a pandemic situation recently? My second question is, what is the gross margin outlook for the third quarter? Thank you.

Wang Huang, CEO

Okay. We provided a strong forecast for Q3 because we do anticipate strong sales recovery in overseas markets as well as in the domestic market. We will see more shipments of Mi Band products, but we see an even stronger recovery for our own branded products. That’s why you can see we doubled our forecast for Q3. Similarly, we anticipate that Q4 should also be strong, resulting in a robust second half of 2020. Regarding our gross margin, as you can see, in Q2, our margin was not great because we launched the Mi Band 5 and provided deeper discounts on Mi Band 4, which dragged down our gross margin. In Q3 and Q4, we expect the product mix to change, meaning that we will sell more Mi Band 5 compared to Mi Band 4, which will help improve margins. With our own branded products, we expect them to remain strong. My estimate is that we will see a slight increase in gross margin in Q3. Thank you.

Operator, Operator

The next question comes from Michelle Zhang from China Renaissance. Please go ahead.

Michelle Zhang, Analyst

Thank you management for taking my questions. I have two questions. The first one is could you please give me more context on the net income guidance for the third quarter? And the second question is, could you please share more regarding the geographic sales distribution of Amazfit products, and also an update on the current situation in Europe and India? Thank you.

Wang Huang, CEO

At this moment, I may not be able to provide an accurate net income guidance, but I can say that we will take extreme measures to control our operating expenses in the second half, so you will not see the same growth in operating expenses compared to our revenue growth. The net margin for the second half will significantly improve compared to the first half. Regarding geographic distribution for Xiaomi products, we don’t have the exact number, but a large portion of the Mi Band was shipped overseas, while we shipped even more of our Amazfit-branded products internationally. The geographic distribution will primarily be to European markets, followed by Southeast Asia. We sell to many countries, including North America. These primary markets are European and Southeast Asia, and we see improvements in sales as the pandemic situation improves. Remember, we do have roughly half our products sold online in those markets, so we expect to see significant sales improvements globally.

Michelle Zhang, Analyst

Thank you.

Operator, Operator

The next question comes from Robert Cowell from 86 Research. Please go ahead.

Robert Cowell, Analyst

Hey, management, thanks for taking my questions. I'd like to ask about pricing. So, in the second quarter, I guess the blended average selling price was down a little bit year-on-year. You’ve mentioned some discounting related to Mi Band 4 in anticipation of the launch. How is the pricing on the Mi Band 5 relative to the previous generation? And what kind of trend do you expect in pricing going forward?

Wang Huang, CEO

In Q2, we shipped more Mi Band 4 than Mi Band 5, and we provided deeper discounts on Mi Band 4, which is why the ASP was dragged down in Q2. For Mi Band 5, we expect to ship more than Mi Band 4. The retail price for Mi Band 5 is higher than Mi Band 4, and as it’s a new product, we are not providing discounts on Mi Band 5. I’m confident the ASP will climb.

Operator, Operator

The next question comes from Andrea Lin from Citi. Please go ahead.

Andrea Lin, Analyst

Hi, management. Thank you for taking my question. I have one question. Regarding the next quarter's guidance, can you share a bit about the product mix? How much contribution will come from the Mi Band? And I have a follow-up. Thank you.

Wang Huang, CEO

I expect a similar product mix as before, given that sales for both Xiaomi and self-branded products are strong. I would expect a 70-30 split.

Andrea Lin, Analyst

Thank you. And could you share a bit about the life cycle pattern for the new generation of the product? Usually, the product sells peak during the first few quarters after launch and then declines. What are your expectations for this generation?

Wang Huang, CEO

Regarding the Mi Band, we have much shorter product cycles for launching new products. Between Mi Band 3 to Mi Band 4, and Mi Band 4 to Mi Band 5, we have about a year's gap for launches. For Amazfit and Zepp products, we will have quicker upgrades and a variety of older and new products, aiming to launch new products at least once a year. If not, we will introduce entirely new products. So, it is a faster cycle, and you will see a pipeline of new products under our new brands coming out.

Operator, Operator

As there are no further questions now, I'd like to turn the call back over to the company for closing remarks.

Operator, Operator

Thank you once again for joining us today. If you have further questions, please feel free to contact Huami's Investor Relations department. This concludes this conference call. You may now disconnect your lines. Thank you.