Earnings Call Transcript - ZEPP Q3 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by for Huami Corporation's Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. 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 Huami Corporation's third 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. Huang Wang, our Chairman of the Board of Directors and Chief Executive Officer; and Ms. 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 these 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'll now turn the call over to our CEO, Mr. Huang Wang. Please, go ahead.

Huang Wang, CEO

Hello, everyone. Thank you for joining our earnings conference call today. We are pleased to report another quarter of solid financial results, highlighted by revenue growth of 20% year-over-year that exceeded our expectations, despite supply issues due to COVID-19, which partially dampened results. Our top line results were complemented by bottom line visibility; together, this testifies to the resilience of our portfolio of smart health products and services, as well as our efficient product development capability. We have launched five new smartwatch products in the third quarter, and I am pleased with our development pace. Through agile development processes, our teams executed according to plan. Our product portfolio is well-positioned for the global holiday season this year. Innovation has always been the core of our DNA. It drives our R&D development and supports our comprehensive health and fitness ecosystem. Reflecting this, we recorded several new product upgrades and launches in the third quarter. In September, we upgraded our most popular product line, the GTS and GTR smartwatches, with numerous technology-enriched functionalities. Now, the upgraded versions are fully equipped with features that support blood oxygen monitoring, among other important applications. Blood oxygen saturation data is an essential metric used to monitor breathing quality. Our classic and sports variants of the Amazfit GTR 2, as well as other select smart wearables, are also upgraded with our newly launched BioTracker 2 PPG 24/7 heart rate sensor. This sensor supports five biological data engines and is the most versatile and precise biosensor we have ever developed. We also launched our new app market, Zepp brand, as previously announced in August. The Zepp line brings a more comprehensive and professional health and fitness management experience to users, leveraging our expertise in smart wearable technology. In the third quarter, we also extended our cooperation agreement with our strategic partner Xiaomi. The Mi Band is an important product line to us and to the global value-focused market, and we are pleased to continue to work with Xiaomi on that product line. Now turning to our global expansion efforts. Our Amazfit product achieved a strong market position in many of the international markets we serve. According to the IDC report, we have been positioned as number one in market share in Spain and Indonesia for several quarters. In IDC's second quarter report, we experienced a 323.7% growth in the Indian market and 241.6% in the Western European market, driven by our growing brand recognition, strengthened sales and market strategies, as well as distribution channels. Our international shipments as a percentage of total were 49.5% in the third quarter. Even our largest markets like Europe and FEA are still under the impact of COVID-19. Huami and Xiaomi device activation data further illustrates our globalization, with a noteworthy increase in the number of countries with sizable activations in the third quarter this year versus last year. Starting in September, two of our most popular smartwatch lines, the Amazfit Bip S and the Amazfit GTS, became available for purchase in America at over 2,800 Walmart retail stores. This is the first time that consumers can buy them at Walmart stores. We believe there's a strong fit between these value-priced lines and Walmart's target shoppers. We are pleased to have expanded our retail channel distribution with this large partner and will keep exploring opportunities with other global large channels. It's worth remembering that the global mega-trend of personal health awareness was well in place before the pandemic, and the last 10 months have brought awareness to a compelling level. We also note that leading industry analysts are unified in their forecast for continued strong demand for smart wearables well into the future. The variety of form factors keeps expanding, and we are expanding right along with this. The global opportunity remains robust for Huami, especially with our product market positions all representing exceptional value and feature sets at every price point. These new products and services development, as well as geographic expansion, are all part of our continuous execution on our connected health with technology strategy. In addition, we are now conducting academic research projects with more than 20 different hospitals, research institutes, and pharmaceutical companies in both China and overseas to help monitor users' health conditions by using our smart wearable devices. To name a few, we are now working with the first affiliated hospital of Guangzhou Medical College and Dr. Zhong Nanshan's team on an asthma early warning project. We identified sleep as a key area of interest for our users and are collaborating with the Sample Sleep Medicine Center in the U.S. and others to collect more data and perform analysis. The ultimate objective of these academic research projects will be to offer our users more dimensions of healthcare services, including pre-disease warning and more comprehensive health condition analysis in the future, leveraging our devices' ability to gather high-quality data consistently from every model regardless of price. On a final topic, I want to note two key Huami team additions. At our Board meeting last Friday, we added a new independent director to the Huami Board. I'm very pleased that Mr. Bing Xie, who recently retired from leading worldwide sales at Texas Instruments, has agreed to join our board. As an independent director, Bing will serve on the Audit, Compensation, and Nominating and Corporate Governance Committees. Next, I want to formally introduce our new Chief Financial Officer, Mr. Leon Cheng Deng. Leon comes to Huami from Royal Philips, where he was most recently Global Head of Finance for Philips Domestic Appliances Division. He brings to us 17 years of extensive experience in accounting, financial management, and a manufacturing perspective on Europe and many other key international markets, as well as strategic transaction experience that I believe will help Huami accelerate in our next phase of growth. Leon, welcome to your first Huami earnings call. We are glad to have you as part of our team and look forward to your leadership as we continue to execute and grow the business. The floor is yours.

Leon Cheng Deng, CFO

Thank you, Wang. I'm excited to join the Huami family. I believe that with my global consumer health experience, I can help the company focus on managing its sustainable growth. Huami has grown very fast and has many opportunities in both the health and fitness sector and the consumer industrial side of healthcare. Building off my 17 years of strategic operational financial and accounting management experience at Philips, I will be focusing on improving management processes, planning, and financial controls. I anticipate looking at areas such as working capital management, cash flow, and return on invested capital. I also look forward to leveraging my experience to help manage the company's global expansion in the future. So let's begin talking about third-quarter results with sales. The COVID-19 virus continued to challenge companies and their business planning around the world. It both helped and hurt Huami in the third quarter. During the summer quarter, COVID cases abated in many regions and allowed local economies to open up more. People got outside to exercise and to live their lives. That was good for the industry, and Huami shipped 15.9 million units in the quarter, up 16.1% from the year-ago third quarter, driving a revenue increase of 20%. The largest portion of that increase was driven by the Xiaomi Mi Band 5, and we also began shipping several of our own brand new products, as Wang just described. Where the virus hurt us was in some supply chain challenges, which left us short of new Huami product inventory in several locations and forced the delay of some of our new product launches from the beginning to the end of the third quarter. I will have more to say on the impact of the virus when I talk about the outlook and guidance. But first, I want to focus on a few key numbers, including gross margin and operating expenses, which I think are the most important for understanding what happened in the quarter and that shape our outlook. Gross margin can be affected by product mix, product launch timing, and product life cycles, including model upgrades. The 460 basis point decrease in gross margin from the year-ago quarter was predominantly driven by those effects. In our specific case, gross margin can be impacted by the proportional split between the products we make and sell to Xiaomi and also by the products we bring to market under our own brands. The split of products between Xiaomi and Huami was the same as in the year-ago quarter, reflecting nearly identical patterns of old model winding down and new model quantity shipments for Xiaomi. In this year's quarter, that was the new Xiaomi Mi Band 5. Gross margin on Xiaomi products in the third quarter of 2020 was 400 basis points lower than the year-ago quarter. This much larger volume of Xiaomi products versus our own branded products in the quarter was the primary driver of the overall lower gross margin. Let me next highlight operating expenses. As has been true all year, sales and marketing, R&D, and G&A expenses have been up year-over-year quite significantly in some areas. As you saw in today's press release, R&D was up 38.8% year-over-year and comprised 7.7% of revenue compared to 6.7% a year ago. Sales and marketing expenses were up 104.2% year-over-year and comprised 5.2% of revenue compared to 3% a year ago. G&A increased 30.8% year-over-year, comprising 4.1% of revenue compared to 3.7% a year ago. R&D has achieved a scale which we believe can continue to drive strong new product development going forward. Sales and marketing expenses vary with seasonality, and obviously it is important to support key selling seasons such as the year-end holidays and as we expand geographically. But we expect to apply some additional processes to prioritize sales and marketing investments with the highest sales impact and return on investment through the fourth quarter and into next year. Total operating expenses in the third quarter of 2020 were up 51.3% year-over-year, comprising 17% of revenue compared to 13.5% in the year-ago quarter. Given the uncertainties of the pandemic for the foreseeable future, we're going to manage operating expenses to a percentage of sales target at about where they are now in order to maintain profitability. The company's cash position continued to be strong, finishing the third quarter with cash and cash equivalents of RMB 2,556 million, up 42% from December 31, 2019. As I said, the new resurgence of cases in our key markets of Europe, Russia, and the U.S., and increasingly other areas, caused us to temper our outlook for fourth-quarter sales. How the impact of the virus will play out through the holidays is very uncertain. Retailers in several key geographies after reopening during the summer are facing new lockdowns, according to many recent media reports. Our guidance reflects this uncertainty. For fourth-quarter 2020, management currently expects net revenues to be between RMB 1.95 billion and RMB 2.15 billion. That outlook is based on the current market conditions and reflects the company management's current and preliminary estimates of market and 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, please go ahead.

Operator, Operator

Thank you. We will now start the question-and-answer session. The first question today comes from Kyna Wong of Credit Suisse. Please go ahead.

Kyna Wong, Analyst

Thanks for taking my questions. I have a couple of inquiries. First, I wanted to discuss the gross margin. I've heard that the overall product mix is a significant factor, but do you believe this will be a long-term issue as we approach the fourth quarter and the first half of next year? Additionally, we see some companies in the industry intensifying their promotional efforts and launching products in the IoT sector, aiming to boost recovery in that area for the latter half of this year and next year. Will the product mix issue with Xiaomi persist in the coming quarters? Also, I would like to know if there has been any impact from currency fluctuations, particularly with the recent appreciation of the RMB, on the margin, and if we should expect this to affect us moving forward. That covers my question about gross margin. For my second question, I'm noticing that sales and marketing expenses, as well as R&D costs, continue to rise. However, trading has been slow to rebound, partly due to COVID-19. How can we anticipate that our investments in R&D and marketing will yield benefits in the future? Thank you.

Leon Cheng Deng, CFO

Okay. Thank you very much. Those are good questions. So let me try to answer the first question first, right? On the gross margin, I think you're right that it is always Xiaomi's goal to provide high-quality cost-effective products to the end customers, and we continue to also integrate cutting-edge functionalities and sensors into our products, right? That's also why we keep on selling our products better than the previous generation, right? So, it is true that the gross margin from the Xiaomi Band 5 is actually lower than the previous generation last year. However, we're actually looking for scale and operating leverage from the Xiaomi products. Right? On the other hand, you also noticed that our own brand sales are also picking up, right? And our own brand sales carry a relatively high gross margin compared to the Xiaomi product, right? So in the end, with the effort of the product shipments of our own brands and also the continued growth of the Xiaomi product in the next year, we at least expect the gross margin to stay at the current level or maybe in the second half of next year to expand a little bit. I think that answers the gross margin part. On the currency part, I think we're more looking at a natural hedge situation because in the end, we sell quite a bit of the products overseas and we receive dollars. And also most of our purchases are also paid in dollars. So in this case, aside from the Chinese market, because that is not subject to currency fluctuations, the foreign exchange impact, I think, is relatively minimal to us. So I don't see any big adverse currency impact coming out of dollars. So I guess that concludes on the gross margin part. Coming back to your question on operating expenses, right? I think we are always a long-term kind of thinking and we apply that to our management and how we manage our business going forward, right? So there's a saying that says never waste a crisis, right? So in this time, we're trying to invest ahead of time and try to build the foundation for our product launches for next year and also to build a network of our distributions and channels overseas for next year. We believe that when the coronavirus calms down, and that probably is going to be in the second half of next year, that will be the time when we will see a rebound in our performance.

Operator, Operator

Thank you. The next question comes from Joe Hui of Industrial Securities. Please go ahead.

Joe Hui, Analyst

Okay. Thanks for taking my question. My first question is, could the health monitor function turn smartwatches and smart bands into a more widely used device like TWS earphones? And what are the core barriers of these two kinds of products? Do we have any medical certification that differentiates our products from others? And that is my first question. Thank you.

Leon Cheng Deng, CFO

I think I will be the person to answer your question again. Yes, we see consumers adopting more and more the usage of health monitoring functionalities of a smartwatch during the pandemic, right? So that's why you see also our competitors and all the usage of the data from the wrist are picking up, right? Whether or not they will become a TWS market, I think it's too early to tell. But as you see, both Apple and other big brands are actually integrating more functionalities like ECG and SpO2 metrics into their watches. I think it's a good sign and also a trend on where the industry is moving. Yes, there's definitely a barrier to it because you have the difference between health and fitness devices and medical devices, right? I think, on the medical device side, we're on par, if not better than our key competitors. With regard to core barriers to the usage of such data, I think FDA approval and medical device approval will set us apart between a health and fitness player and a serious health player, which we want to be in the future.

Joe Hui, Analyst

Okay. Thank you. My second question is that, as the last analyst mentioned, the R&D investments are relatively high in the past nine months this year. Could management give more color on what we invest in and how we can improve the property of our device?

Leon Cheng Deng, CFO

On the R&D side, actually, there's a lot of information which we could disclose a little bit more. I would definitely refer you to the press releases we issued at the beginning of this year around the April-May timeframe on what we have invested in. We have invested in AI, and we have invested in a lot of new functionalities, which will be used in our next-generation products. Not to mention, that we have refreshed nearly all our product lines for our own brands by the end of this year. We have launched many products during this quarter, which should set us apart and also lay a great foundation for next year. I think that's just because of the few R&D investments we made. If you need to know more, please feel free to send a question to our IR contact, and then we'll get back to you.

Joe Hui, Analyst

Okay, thank you. And then, I have one last question. We've heard that, Huami has some cooperation with maybe an insurance company to promote our healthcare solution. Could the management share more details on that?

Leon Cheng Deng, CFO

I think we update…

Mike Yeung, CFO

Hi. This is Mike Yeung, COO. So, yes, regarding the insurance companies, as you may have heard, we are currently partnering in Asia with Prudential Asia, where they have contributed our Pie technology algorithm into their Pulse app, which is their consumer app, that will be launched in over 11 countries in Asia. And that's just the beginning of our partnership with them. We will also partner with them on data analysis and also cross-selling of products. We are also working on similar types of deals not only in Asia, but in the U.S. and North America as well as Europe. And you will see announcements soon that we have signed those deals.

Joe Hui, Analyst

Okay, thank you. And that’s all my questions.

Operator, Operator

The next question comes from Kyna Wong of Crédit Suisse. Please go ahead.

Kyna Wong, Analyst

Hi. Thank you for allowing me to ask a follow-up question. I've noticed a significant increase in EBITDA related to stock-based compensation in the third quarter. I would like to understand the trend moving forward. We anticipate that there will be substantial stock-based compensation expenses, although they won't impact the adjusted earnings. I'm curious about what we should expect in the future regarding this. Will similar levels be expected in the fourth quarter as well?

Leon Cheng Deng, CFO

I think the increase of this quarter is as what we mentioned in the press release, it's primarily due to the increase in share-based compensation which we give to a few key employees. Whether or not, the same level is going to continue into Q4, at this moment, my answer is no because the previous one which you saw is pretty much a one-off, which tied back to some incentive scheme which we had. At this moment, to the best of my knowledge, I don't see anything in Q4 popping up.

Kyna Wong, Analyst

Okay. Thanks.

Operator, Operator

Next question comes from Michelle Zhang of China Renaissance. Please go ahead.

Michelle Zhang, Analyst

Hi. Thank you, management for taking my questions. I have two questions. The first one is, I want to know about the current development progress of the distribution channel expansion for the Amazfit product?

Leon Cheng Deng, CFO

Excuse me, can you repeat your first question?

Michelle Zhang, Analyst

Yes. Sure. My first question is about the current status of the distribution channel expansion for the Amazfit product?

Leon Cheng Deng, CFO

Okay, now I get it. So, we have made very meaningful progress in building channels for the Amazfit product in the third quarter. As we mentioned, our star products Bip S and GTS entered more than 2,800 Walmart stores in the third quarter. We're also now serving more than 70 countries and our sales team is covering different regions. We have a strong presence on major platforms like Amazon, Flipkart, and AliExpress, where we also cooperated with many local partners like Reliance in India and Svyaznoy in Russia. These are only a few examples of our strong overseas channels, and we'll continue to strengthen our global distribution in the coming quarters.

Michelle Zhang, Analyst

Okay, thank you. And my second question is about the management outlook for the shipment growth of the Xiaomi Band and also Amazfit products for next year? Thank you.

Leon Cheng Deng, CFO

Normally, we don't guide for the next year. But I can give you some flavor on what it is, right? I think, on a higher level, the global band market is becoming a relatively mature market. So we would anticipate the Mi Band product, the Xiaomi Band product shipment and ASP to stabilize a little bit with moderate growth going forward. On the other hand, you know the ASP of our own products is much higher than those of the Xiaomi's. So, I would expect that our own product shipment will continue to grow, alongside with gross margin expansion. However, I need to caution you that the COVID-19 virus still has impacts on the global market and we don't know when that is going to stop. Therefore, there are still quite some uncertainties around that topic. I hope that answers your question. I'll give you at least some flavor of what it is.

Michelle Zhang, Analyst

Yes, yes sure. Thank you so much.

Operator, Operator

As there are no further questions, now I'd like to turn the call back over to the company 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 Huami's Investor Relations department. This concludes this conference call. You may now disconnect your lines. Thank you.