Earnings Call Transcript - ZEPP Q3 2021

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for Zepp Health Corporation Third Quarter 2021 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 Zepp Health Corporation's Third Quarter 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, which we will refer to in this call by visiting the IR section of the company's website at ir.zepp.com. 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 under the Safe Harbor provision of the US 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, 2020, and other filings as filed with the US 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. The third quarter was marked by continued strong performance from our Amazfit and Zepp branded smartwatches, while Mi Band Series sales weakened due to an earlier launch of the new generation Mi Band this year compared with last year. These factors drove our total net revenues to RMB1.6 billion in the third quarter, 28.1% lower year-over-year. We should highlight that our self-branded products have quickly emerged as a powerful engine propelling our growth. Shipments of our self-branded products grew by 88.9%, compared with the same period last year and accounted for 38.6% of our total net revenues. Clearly, the strategic initiatives we have put in place to actively expand our portfolio of self-branded Amazfit products, enhance our sales channels, and grow the influence of our brand are delivering concrete results and extending our reach. Product traction in international markets is strong and growing. Over 80% of the self-branded products are overseas, and our overseas expansion momentum is growing. I will highlight some of our recent progress. In Southeast Asia, Amazfit now ranks number two among our best-selling smart wearable brands. In the US, our self-branded products shipment volume more than doubled in the third quarter, as we continue to expand our reach through large retail channels like Walmart, Target, QVC, and others. We have also made significant achievements in Europe. According to our internal sales data, our shipments in Germany increased 150% in the third quarter as we newly partnered with Euronics and added more than 150 offline stores. In Italy, our brand ranked number one in the adult smartwatch market, according to the September Italy GfK report. To further heighten our brand awareness in China, we formally introduced a Chinese name for Amazfit under the brand's sixth anniversary on October 12. It is called Yuewo, which means rise up and surpass ourselves. It came with a redesigned logo and a new brand tagline, 'up your game,' reflecting our vision for the brand to become a partner with our users in their life explorations. Consumers are increasingly calling for smart wearable devices with improved fundamentals such as ease of use, better user experience, and longer battery life. We have heeded this call by launching new universally popular attractive products and an advanced OS that meets growing market demand. Most recently, in early October, we launched two brand-new Amazfit GTR 3 and GTS 3 series, fully equipped with our newest internally developed smartwatch operating system, Zepp OS. Both series bring next-generation capabilities to our smartwatches with an industry-leading BioTracker 3 PPG sensor that monitors blood oxygen level, heart rate, stress level, and sleep quality providing users with easy-to-use, enhanced health and sports experiences. Initial adoption of both our new product series has been strong, showing increasing momentum in multiple geographies. We are also extremely proud of our new Zepp OS and its enriched capabilities including exciting energy efficiency and an open architecture for developers to work seamlessly with our OS. We believe Zepp OS will become the cornerstone of our comprehensive health management platform. Along with the increasing sales volume of GTR 3 and GTS 3, Zepp OS will bring more enriched displays and apps. We continue to enrich our pipeline to offer customers new products that complement our current offerings. Before the year's end, we will also be introducing a new sleeveless blood pressure measurement algorithm called PumpBeats. Working with our Amazfit GTR 3 Pro, this algorithm can measure blood pressure in 30 seconds, providing users with easy, convenient, accurate readings anytime and anywhere throughout their busy day. Separately, we received broad market enthusiasm for our newly-launched earbuds, Amazfit PowerBuds Pro, and we are extremely honored to be named a CES 2022 Innovation Awards Honoree. These earbuds are not only a wireless active noise cancellation headset but also a biosensor device users can wear that supports smart running, recognition, ear canal, heart rate monitoring, hearing protection, and cervical spine protection. Adding to our accomplishments in growing our own capabilities, we believe in the power of collaboration to amplify various strengths. Our strategic partnership with Xiaomi continues to be important for both parties and we hold our collaboration in high esteem. As the Mi Band Series designed and manufactured by us delivers steady performance, we are continuing to actively grow our own brand, namely Amazfit and Zepp, to deepen our portfolio of self-developed offerings. Furthering our mission to connect technology and health is a driving force behind our innovation, which we hope can bring potential advancement for society at large. By steadily growing our portfolio of Amazfit products and services, we continue to make progress towards this goal. We are dedicated to creating quality products that make people's lives easier in their pursuit of healthy living and advance their health and fitness goals. By leveraging rich technology to create wearable products and services, we are pursuing global health, one step at a time. Lastly, I'm pleased to announce that today, our Board approved a 20 million share repurchase program. The share repurchase program demonstrates our confidence in achieving substantial long-term growth as we execute our strategy supported by our strong balance sheet and cash-generation capability. We are confident such a program will benefit the growth of the company and create value for all of our shareholders. I will now turn the call over to Leon to go over the highlights of our third-quarter financial results.

Leon Deng, CFO

Thank you, Wang. As I did last quarter, I want to focus on highlighting what I think are the handful of the most important metrics. Starting with sales, we're especially pleased with the continuing growth of our Amazfit and Zepp-branded products in the third quarter. For each of the first three quarters this year, we have driven year-over-year revenue growth in self-branded products of 84%, 81%, and now 38% in the third quarter, which was a quarter in which we launched no new products and had preannounced the GT3 coming in the fourth quarter. This presents a strong demonstration that we're continuing to expand our brands globally. The timing of new product launches often impacts year-over-year quarterly sales comparisons. Last quarter, the pull forward of Xiaomi's new Mi Band 6 gave an extra boost to Q2 because the new Mi Band 5 shipped in Q3 last year. So for Q3 this year, we had the opposite effect. Like many other companies, supply chain issues dampened our third-quarter results in a number of ways. For example, we had some name branded chip suppliers surprise us with last-minute supply cuts. At the same time, like everyone else, we have experienced higher shipping costs and uncertain deliveries both inbound and out. Moreover, how the effects of the Delta and other variants will play out globally in Q4, it's very unclear. These challenges have continued into the first part of the fourth quarter and factored into our guidance. While Xiaomi remains a valuable partner, we're pleased to be growing our way into less reliance on products from their channel. This year's flow of Xiaomi's business has been significantly different from 2020, which boosted our second quarter year-over-year numbers and was a drag on third-quarter results. Third-quarter 2021 revenue from Xiaomi products was down 45% year-over-year or RMB799 million driving the 28% overall decline in total revenue. As Wang noted before, we are optimistic about the fourth quarter, given the new technology and products we're bringing to the market. Now moving to gross margin. Gross margin can be affected by product mix, product launch timing, and product life cycles including model upgrades. The third-quarter 2021 gross margin of 20.2% was essentially flat, with only a 40 basis point difference from the third quarter last year. Operating expenses have been a key focus of mine since joining the company in the third quarter last year, both in absolute amounts and as a percentage of sales. A portion of these expenses are fixed, so it takes time to continue to gradually reduce expenses. While we have to balance cost controls with fueling growth, we have decreased total operating expenses sequentially since last year's third quarter. That continues to be my focus. The third-quarter 2021 operating expenses also showed the effect of our cost control and balancing efforts, both in absolute amounts and as a percentage of sales. In absolute currency, sales and marketing expenses were down 22%, R&D was down 37% and G&A was down 32%. Balancing these costs drove a 30 basis point improvement in operating income as a percentage of sales. As mentioned before, we are continuing to invest in R&D sales and marketing and G&A costs to support growth but in a more balanced way since Q3 of last year, when I came on board. We'll be maintaining this balanced approach to expense growth and control in Q4 for a similar run rate. Net income as a percentage of sales declined slightly year-over-year, with lower interest income and higher interest expenses, and a gain in fair value of the investment in the third quarter last year. Our balance of cash and cash equivalents continued to be strong in the third quarter at RMB1.2 billion. Our working capital ratio continued to strengthen. In the quarter, we retired RMB230 million short-term loan. We're confident in our strategy and financial trajectory as we finish 2021 and look ahead to 2022. The Board has approved up to US$20 million to repurchase shares. This is primarily to supply the employee incentive stock plan. Looking forward to guidance, let me outline key factors we're taking into consideration. On the positive side, we have just launched our new GT three products in the fourth quarter, which features our compelling new technologies and capabilities that we are seeing our consumers respond favorably to. Supply chain challenges, including chip shortages and higher freight costs and delivery uncertainties remain significant questions and caused us to guide conservatively. For the fourth quarter 2021, management currently expects net revenues to be between RMB1.75 billion and RMB2.0 billion compared to RMB1.97 billion in the fourth quarter 2020. We'll continue to exercise good cost control and expect to continue to report a profit in the fourth quarter this year. That outlook is based on current market conditions and reflects the company management's current and preliminary estimates of market and operating conditions and customer demand, which are also 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 begin the question-and-answer session. And today's first question comes from Clive Cheung with Credit Suisse. Please go ahead.

Clive Cheung, Analyst

Hi, management. Thank you for taking my question. I have a couple. I'll ask one by one. First of all, I think given the continued improvement from Amazfit in terms of revenue contribution, I want to check why the margin declined particularly significantly quarter-on-quarter against seasonality? Thank you. That's my first question.

Leon Deng, CFO

Clive, I mean, actually the margin didn't move too much quarter-on-quarter, but I think it's more of a product mix issue. So as I mentioned in the previous remarks, this quarter the Xiaomi products actually stand for around 60% of our overall revenue and our self-branded products stand for around 40%, 38% to be exact. And the margin differentiation between the Xiaomi and self-branded products is actually a value of 1.7 times to 2.0 times. I think you can do the math and that actually results in the gross margin number of this quarter.

Clive Cheung, Analyst

Okay. Thank you. And I think, I was wondering if there's more color for the below kind of seasonality shipment. I think we already expected that, I think 9.1 million was a little bit further below the expectation. I was wondering if this is from a demand perspective or from kind of supply bottlenecks given the reasons you mentioned in the prepared remarks. Thank you.

Leon Deng, CFO

Thank you, Clive, for your question. There are several factors that influenced the numbers we reported today. One of the main issues is the chip shortages and unexpected last-minute supply cuts from some well-known chip manufacturers. A few quarters ago, I mentioned that we accounted for potential risks with long lead times for these critical components. However, since chipmakers are prioritizing their supply for automakers toward the end of the quarter, it had a significant and unexpected impact on us. We are working on second sourcing for our key components, but these last-minute changes still require time for the supply chain to stabilize. Additionally, freight costs for sea and air shipments were very tight in the third quarter and are continuing into the fourth quarter. These factors contributed significantly to the lower sales figures we reported this quarter. To answer your question, this situation is primarily due to supply challenges rather than demand issues. In fact, our products have been performing well in the global market.

Clive Cheung, Analyst

Okay. Thank you very much. And that's it for me. Thank you.

Operator, Operator

Today's next question comes from Kevin Chen from China Renaissance. Please go ahead.

Kevin Chen, Analyst

Hi. Thank you for taking my question. I have two questions. First, the company mentioned that our own brand's revenue contribution has reached an impressive 38%. I'm curious if we have an internal target for how high this percentage might be by the end of this year or next year. Additionally, what is our strategy to achieve this goal? Thank you.

Leon Deng, CFO

Thank you, Kevin. That's a good question. Yes, as you've noted, the weight of our self-branded products in Q3 is already close to 40%. To answer your question, this year we're targeting a split of around 40% for self-branded products and 60% for Xiaomi, possibly even a bit better. It's still early to discuss next year, but we hope to improve this ratio further, aiming for a half-and-half split. Achieving this will require us to execute well on a few key areas. First is our product offerings, as we are a product and innovation-driven company. We're proud of our products, especially the recently launched GT 3 Series, which I highly recommend trying. The second area is our distribution network; we're expanding rapidly overseas and have seen success in Europe, the United States, and Southeast Asia, where we lead in market share in the smartwatch sector. Lastly, our strong team in innovation and supply chain, operating both within China and internationally, plays a crucial role. These three factors give us confidence that we can execute even better next year.

Kevin Chen, Analyst

Thank you, Leon. I would like to follow up with another question regarding gross margin. As you noted, the hardware industry is currently facing component shortages and logistical challenges. I'm curious if we have an estimate for the normalized gross margin of our Zepp brand in the future. What do we still need to achieve this? Is it about normalizing the supply chain or reaching a critical scale? What scale do you think we need to reach to obtain that normalized margin?

Leon Deng, CFO

Yes. So let me try to answer the first part of your question. I think for our self-branded products, we're looking at somewhere in a range between 25% to 35% of gross margin on our self-branded products, right. So that is the range we're looking at. Sometimes, I mean, it depends on the seasonality. This number may fluctuate, but this is actually the range we're aiming for. If you are looking at the things that are going to impact that number, I think seasonal patterns play a role because if you look at the promotional period, for example, the Double 11 in China and then the Christmas sales, etc., then obviously you want to get rid of those products at a much cheaper price. So it may have an impact on the ASP, right. But on the other hand, it also couples with the new product launch, and in the consumer electronics industry when you launch a new product, that specific SKU or product will carry definitely higher than the normalized gross margin number, right. So it's a mix problem and it's also a seasonal pattern, which we're working towards. But obviously, it depends on the new product launch and depends on the normalization of the supply chain pattern as what we mentioned we experienced a lot of last-minute surprises, although we're actually prepared for it to some extent. And thirdly, it's really also the uncertainty that lies on COVID. I don't want to downplay this issue because in Q3 when we thought the situation was really getting improved, all of a sudden you saw the cases spike in China as well as in Europe. And I think the Netherlands recently went into a partial lockdown. So all that issues play into the gross margin outlook for next year.

Kevin Chen, Analyst

Great. Thank you, Leon. Very clear. I'll get back to the question queue. Thank you.

Leon Deng, CFO

Thank you.

Operator, Operator

And our next question today comes from Marcel Muench with DONGXii. Please go ahead.

Marcel Muench, Analyst

Yes. Thank you for taking my question. My first question would be around the hardware, particularly the new Zepp premium products like the GT 3 Pro. And what would you say is the competitive advantage against, let's say, the Huawei Watch 3, which seems to have a similar offering?

Leon Deng, CFO

That's a good question, Marcel. Yes, I'm not a product person per se, but I will try my best to answer. I think the most differentiating factor of our GT 3 Pro is the Zepp OS, right. As Wang mentioned in his script, Zepp OS is really a cutting-edge operating system, which allows a lot of third-party apps to be built on it and also from a size perspective it's really, really small compared with the other mainstream operating systems that you can find in the watch market, right. And that in turn translates into a longer battery life which you know that we're pretty good at with the low-power Bluetooth connection and also the power consumption is actually prolonged in the GT 3 Series. And lastly, but not the least, the important thing was the design, right. We have a beautifully designed GT 3 Pro with a curved screen and it attracts a lot of consumers. It received very, very good reviews from the Chinese consumers who are very critical on JD.com and as well as in Tmall, which is the Alibaba platform. So I think those are the key things that I would like to highlight. But also we have the PumpBeats functionality, which our CEO just mentioned as well. So that all plays into the product mix.

Marcel Muench, Analyst

Okay. Thank you. And my second question would be are there any updates on the value-added services like the insurance part or something related to other B2B services?

Mike Yeung, COO

Yes. So we are still continuing our pilots with large insurance companies. And at the same time, while these pilots are going we're discussing with them about the long-term contracts and the business — the revenue model so that the pilots will need to be finished before we will really truly engage in the long-term contract. But the pilots are going very well right now according to the criteria.

Marcel Muench, Analyst

Thank you.

Operator, Operator

And ladies and gentlemen, 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 Zepp's Investor Relations department. This concludes this conference call. Thank you.

Operator, Operator

And ladies and gentlemen, this concludes today's conference call. You may now disconnect your lines and have a wonderful day.