Earnings Call Transcript - ZEPP Q2 2023

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for Zepp Health Corporation's Second Quarter 2023 Earnings Conference Call. Today's conference call is being recorded. I will now 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 2023 earnings conference call. The company's financial and operating results were issued in our press release via the newswire services earlier today and are posted online. You can also view the earnings press release and slides referred to on this call by visiting the IR section of the company's website. Participating in today's call are Mr. Wang Huang 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 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 are included in the company's annual report on Form 20-F for the fiscal year ended December 31, 2022, and other filings as filed with 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 GAAP earnings press release and this conference call includes discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial information that press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures. I'll now turn the call over to our CEO, Mr. Wang Huang. Please go ahead.

Wang Huang, CEO

Hello, everyone. Welcome to Zepp Health's second quarter 2023 earnings conference call. In the second quarter, we maintained our momentum through the successful execution of our strategic transformation. This shift in work moves away from a business model heavily reliant on a single customer for the majority of our revenues and in fact establishing ourselves as a self-reliant global smart wearable and health care solution provider. While Mi Band sales were heavily affected by the overall smart band market decline, our self-branded products continue to gain traction during the quarter generating 12.7% higher revenues quarter-over-quarter and contributing to approximately 70% of our top line. In this transformative phase, we have come to recognize that enhancing the quality of our revenue streams is paramount. Our strategy has undergone refinement, centering around the utilization of our self-branded product sales to effectively offset the company's fixed costs. This transition marks a shift from the pursuit of sheer growth to the steadfast commitment to attaining profitability. Notably, this shift in approach has been particularly successful in the Chinese and Indian markets, where we have converted our early investments into sources of profit. This strategic focus aims to improve our gross margin and ultimately steer us back towards sustained profitability. We have refined our product mix and strategically streamlined our sales channels. As a result, our overall gross margin has surged to 22% compared to 17.9% at the same period last year. This achievement marks the highest level we have attained since the second quarter of 2021 even in the face of several challenges, including revenue year-over-year declines and margin pressure from Xiaomi products. Our ROI-driven strategies involving supply chain, R&D, product development, and marketing have significantly improved our brand image within the premium smart wearable device market. These initiatives have not only elevated our brand influence and garnered increased consumer recognition but have also optimized our cost efficiencies. As a result, our products and services have experienced heightened adoption across various global regions. This growth is particularly evidenced in the high-end product segment, where we offer a compelling value proposition delivering premium features at a more accessible price point than our competitors' premium offerings. This is especially true in the North American market, where we have secured a market position within the top 5 for smartwatches according to industry reports with an increased gross margin. We continue to enrich our offerings to align with the preferences of our customers. On June 21, we unveiled the Amazfit Cheetah, our first smartwatch series dedicated to runners featuring a lightweight design. It can optimize users' running experience with industry-leading GPS technologies to deliver enhanced positioning, accuracy and upgraded AI-powered coaching to generate personalized training plans. Leveraging large language models and generative AI technologies, we also rolled out an AI chat feature in the Amazfit Cheetah to facilitate interactive coaching for users. Additionally, we have also been striving to refresh user experiences and better meet their fitness and lifestyle needs through firmware updates. On July 10, we released a major update for our popular Amazfit T-Rex 2, which added support for cadence sensors, upgraded waterproof activities such as surfing and kitesurfing, and the newly added wake surfing, as well as the long-awaited Zepp Coach feature allowing users to enjoy their favorite summertime activities with our AI-powered training guidance. We have enhanced our entry-level product line by introducing the new Bid Fast, featuring an expansive 1.91 inch ultra-large display. With the inclusion of a cutting-edge satellite positioning system, this device empowers users with accurate location tracking. The Bid Fast supports over 120 sports modes complemented by intelligent recognition technology. Moreover, it comes with monitoring capabilities for 24-hour heart rate, blood oxygen levels, and stress levels, ensuring a holistic view of our users' well-being. Additionally, we are planning to build several new products in the second half and are excited about how their advanced features can help more users better manage their health. We will save the details for their upcoming product launches, so please stay tuned. Our commitment to enhancing our offerings through the application of cutting-edge technologies across our products, services, and business is ingrained in our DNA. As our AI-powered Zepp Coach is providing a more interactive, informative, and customized training experience to our users through products like Amazfit Falcon, Amazfit T-Rex, Amazfit T-Rex 2, and now Amazfit Cheetah, we are also integrating GPT technology into our various development processes to enhance our R&D efficiency. We believe these innovations will benefit users as they will enjoy premium products and services at a low cost while also contributing to our bottom line gains. Lastly, I would like to highlight our participation in the renowned San Francisco Marathon from July 21 to 23, where we demonstrated the exceptional functionalities of our premium running smartwatch. This partnership has introduced Amazfit to more running enthusiasts and showcased our ability to craft leading products, helping amplify our reputation as a premium smartwatch manufacturer across the international sports community. Looking ahead, we remain optimistic about our company's prospects as the market continues to present enormous post-pandemic opportunities. According to IDC, global smartwatch shipments are forecast to increase from 157.3 million in 2023 to 206.2 million in 2027. This compound annual growth rate of 6.8% stands despite the challenging macroeconomic conditions. As we hone our value proposition with AI-powered products and services, we expect our self-branded products to continue to grow. We will continue to optimize our inventory levels and control costs while maintaining our competitive edge and building a long-term product pipeline through targeted investments in R&D and marketing. Supported by our vertically integrated supply chain and efficient platform-based R&D, we are confident that these efforts will stimulate margin expansion and a prompt return to profitability, ultimately fueling our growth and business success. Thank you again for joining us today. 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. Greetings, everyone, and thank you for joining our earnings call today. I would like to review some of the key metrics from our financial results for the second quarter of 2023. In the second quarter, the consumer electronics categories that we participate in remain challenged by factors such as foreign exchange headwinds and persistently subdued consumer spending power, among others. The conditions have not yet returned to what we could consider normal and we continue to see unprecedented levels of discounting by our competitors. We saw a reduction in channel inventory in the first half of the year, consistent with our expectation for activations to outpace selling; we expect this trend to continue through the third quarter, particularly in Europe and Asia Pacific, where retailers continue to tighten their inventories. As for underlying demand, strength in the Americas helped offset the impact of the tough economic climate in Europe and Asia Pacific. Despite this, our brand and product portfolio continued to perform well. Our second quarter revenue amounted to RMB 648.3 million, within the expected guidance range for a decline of 41.5% year-over-year, primarily attributed to lower Xiaomi sales. During the quarter, our revenue generated from Xiaomi-branded products declined by 67.2%, largely influenced by market deterioration in the smartbands category, while our self-branded products experienced a 7% decrease, mainly due to limited new product introductions during the quarter. Moving on to our gross margin, which can be influenced by various factors such as product mix, product launch timing, and product life cycles, including model upgrades. As we continue to pursue our ROI-oriented approach to optimize our product and sales channels, the gross margin for our self-branded products remained healthy. Despite a slight decrease in revenue for our Amazfit brand, we are delighted to report a remarkable 51% year-over-year expansion in our Amazfit brand gross margin. This significant growth has played a crucial role in driving our overall Q2 gross margin to an impressive 22%. Notably, this is the highest level we have achieved since Q2 2021, even withstanding a year-over-year decline of 42% in Xiaomi products gross margin during the quarter. This outstanding performance speaks volumes about the strength and resilience of our Amazfit brand. Despite the market challenges we faced, our dedication to delivering high-quality products and optimizing our operations yielded exceptional results. We're confident that with this positive momentum, alongside new product introductions planned for the second half of the year, as well as the moderated level of clearance activity, we should be able to expand the gross margin of our company even further. Now let's look at costs; as we have always mentioned in our past earnings calls, controlling costs remains a top priority for the company both in terms of their absolute amount and as a percentage of sales. Since Q3 2020, we have been pleased to see a downward trend in total operating expenses while we're still making strategic investments in new products, technologies, and footprint expansions to fuel our long-term growth. In Q2 2023, we delivered on our quarterly run rate target and successfully managed to reduce our adjusted operating costs to RMB 204 million, the lowest level since Q2 2019. Our second quarter R&D expenses were RMB 84.7 million, lowered by 31.4% year-over-year driven by our platform-based R&D strategy. However, as a percentage of sales, R&D costs still remain at a relatively high level, demonstrating our commitment to further building our product strength, and our long-term competitive edge. As we continue to prune our retail channels to maximize returns on every penny we spend, our selling and marketing expenses declined by 33.9% year-over-year, reaching RMB 70.7 million. However, as a percentage of sales, we were at 10.9% versus 9.7% in the second quarter of last year. We'll continue to invest strategically in our brand, adopting a ROI-based marketing strategy to ensure our ongoing growth and success. Second quarter G&A expenses were RMB 48.9 million, down by 25.9% year-over-year, benefiting from our effective cost control measures. Looking ahead, we will persist with our prudent stance towards costs and expect cost levels to maintain at current levels or lower in the upcoming quarters, while investing responsibly and with great discipline to fuel our business growth. With our enhanced gross margin and carefully managed costs, our non-GAAP net loss has narrowed to RMB 59.2 million in Q2. Despite facing a cost coverage issue in Q2, I'm delighted to share that we're optimistic about returning to profitability in Q3 2023. Now turning to the balance sheet, cash and cash equivalents, restricted cash, and term deposits as of June 30, 2023, totaled RMB 10 billion, providing ample runway for us to invest and capitalize on potential marketing opportunities. Efficient working capital management remains a priority for us. In Q2, we reduced our inventory to RMB 743 million, nearly at the lowest level in several quarters. We'll persist in carefully managing inventory levels in order to optimize our operations. Despite a modest P&L loss in Q2, we sustained positive operating cash flow for the fourth consecutive quarter. We utilized this to reduce our debt levels, and we will continue to do so in the coming quarters. Now turning to our share repurchase program. To recap, in November 2021, the Board authorized the allocation of up to US$20 million towards our buyback program. By the end of June 30, 2023, we had repurchased shares worth US$11.7 million and we intend to continue with this buyback program in Q3 reflecting our confidence in the company's future, and underscoring our commitment to delivering long-term value to our shareholders. Regarding our outlook for Q3, we expect our net revenue to range from RMB 600 million to RMB 800 million. We anticipate that the trend of quarter-over-quarter growth in self-branded product sales revenue will continue, positioning us to achieve higher overall gross margin and return to profitability. Please note that this outlook reflects ongoing uncertainties around lower discretionary consumer spending, especially in our key markets, and global macroeconomic weakness. In conclusion, despite the challenges, we faced during the second quarter, we're proud of the significant strides we made in enhancing our self-branded product sales, improving gross margin, and implementing efficient cost management efforts. With our continued focus on expanding our product margin, carefully managing our inventory levels and operating costs, as well as upcoming new product launches, we remain confident that we're on the right track to continue to deliver value for customers and investors over the long term. There's no doubt in my mind that we will emerge from this challenging period as a stronger company that creates substantial shareholder value. With that, I will now open the call for any questions you may have. Operator, please go ahead. Thank you.

Operator, Operator

Thank you. The first question comes from Nicolette Jones with Investments. Please go ahead.

Unidentified Analyst, Analyst

Hi. And thank you, management for taking my questions. I had three questions. Firstly, could you give some more details on the expected profitability in Q3 and Q4? And then, secondly, what do you see as the margin trend in Q3 and Q4? And then finally, could you provide some more details on the new products in the second half of the year? Thank you.

Leon Cheng Deng, CFO

Thank you. I'll start with the easier questions on the new product launches, and I will go into the gross margin and profitability questions in a bit. So, if you look at the new product launches, as Wang mentioned in his script, we launched quite a few new products around July and August timeframe, such as the Bid Fast watch, which is actually our value segment mainstream product line. We are also going to launch our latest flagship products, our famous GT series and we're set to unveil their names in the coming days during an event in Berlin. Additionally, we will launch a few new products which are the new versions of our famous Mini and GT Sports range in the second half of the year. So we have many new product launches planned for September and October, which is exciting for us. Related to that, this naturally brings me to the margin trend for Q3 and Q4. As you can see from our Q2 numbers, we see a clear jump in our self-branded product margins increasing in Q2, and we expect this trend to continue into Q3 and Q4. I have mentioned in previous calls a general expectation for our gross margin for our self-branded products to be around 30%. Given the new product launches on the way, we anticipate this number will further improve in Q3 and Q4. Now coming back to the profitability questions, despite still reporting a loss in Q2 this year, we can see we are clearly making progress. Notably, we've returned to the highest level in the past three years for gross margin percentage, which is 22%. It's not insignificant. We expect this number to continue improving in upcoming quarters, moving towards the 30% range. Moreover, we have reduced our operating costs from a run rate of RMB 300 million per quarter to RMB 200 million. We will be very prudent in managing these costs while leveraging AI tools, like ChatGPT models, to enhance our productivity. With a higher overall gross margin and lower operational costs, we're heading toward breakeven, and we are confident that we will achieve profitability in Q3. The transformation journey from reliance on a single large customer to a self-reliant company with a majority of self-branded products is happening now, particularly in Q3. Given the seasonal trends in Q4, we feel confident we should be able to return to profitability in this coming quarter.

Unidentified Analyst, Analyst

Thank you.

Operator, Operator

The next question comes from Lisa Lee with Research. Please go ahead.

Unidentified Analyst, Analyst

Hi. Thank you, management for taking my questions. I also have three questions. The first one is on the overseas market. Can you share more details about the situation in overseas? What are you seeing in July and August? What do you think about the trend for the remainder of the year? The second question is on potential new partnerships for Zepp Health. Any specific directions you're considering? And last one is your relationship with Xiaomi and what's your forecast for Xiaomi's products going forward? Thank you.

Leon Cheng Deng, CFO

Thank you, Lisa. Very good questions. Let me start with your third question about the Xiaomi relationship. I think Xiaomi stands in a unique position—we started as part of the so-called Xiaomi ecosystem company, but over time, this term has evolved for various companies, including ours. However, we still have a strong relationship with Xiaomi. Firstly, Xiaomi continues to be one of the largest shareholders of our company. Secondly, we still maintain wearables cooperation with Xiaomi across various product categories, and that is not changing for us. However, it’s important to note that we have embarked on a transformation journey, shifting from a dependence on a single significant customer. We aim to transition towards self-reliance with our own Amazfit self-branded products being the cornerstone of our sales. This transition has been a response to reporting six consecutive quarters of losses. We are evolving from a primarily OEM/ODM supplier approach, focusing instead on self-branded product sales that will cover our fixed costs over time. I want to reassure you that our relationship with Xiaomi is strong and will remain so. We will conduct thorough ROI analysis on product categories we work on with Xiaomi, setting clear profitability thresholds for cooperation that must benefit both parties and our stakeholders. Regarding new partnerships beyond Xiaomi, we continuously explore options, but I will refrain from commenting further until we have tangible developments to announce through our investor relations channels. Now, for your first question on the overseas market performance: apart from Xiaomi revenues, which have become a smaller portion of our overall sales, we see that the majority of our self-branded products are sold in international markets, primarily in Europe, followed by Asia Pacific and then the United States, with minimal sales from China. In Q2, we observed growth across all regions, aside from China and India, where our focus shifted from scaling to profitability. We aim to manage for profitability before considering whether we can pursue further growth in those markets. In our overseas markets, we find the U.S. to be particularly lucrative with great growth potential as we compete with brands like Garmin, Samsung, and Fitbit. Our unique positioning allows us to cater to the demand for value segments while also competing in the high-end premium segment against Garmin. Over the past year or so, we have reportedly increased our market share in the U.S. from 0% to around 10% or 11%, according to third-party reports from NPD. Overall, I hope this contextualizes our performance in international markets.

Unidentified Analyst, Analyst

Yes. That's very helpful. Thank you, Leon.

Operator, Operator

As there are no further questions now, I'd like to turn the call back over to Grace Zhang 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 IR website. This concludes this conference call. Thank you.

Operator, Operator

Again, this concludes the conference call. You may now disconnect your line. Thank you.