Earnings Call Transcript - ZEPP Q2 2021

Operator, Operator

Hello, ladies and gentlemen, thank you for standing by for Zepp Health Corporation Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. Today's conference call is being recorded. I would now like to turn the call over to your host Ms. Grace Zhang, Director of Investor Relations for the company. Please go ahead, Grace.

Grace Zhang, Director of Investor Relations

Hello, everyone, and welcome to Zepp Health Corporation's second quarter earnings conference call. The company's financial and operating results were released in our press release via Newswire services earlier today and are available online. You can also view the earnings press release and the slides we will refer to during this call by visiting the Investor Relations section of the company's website at ir.zepp.com. Participating in today's call are Mr. Huang Wang, our Chairman and Chief Executive Officer; and Mr. Leon Deng, our Chief Financial Officer. The management team will start with prepared remarks, followed by a Q&A session. Mr. Mike Yeung, our Chief Operating Officer, will also join us for the Q&A. Before we proceed, please be aware that today's discussion will include forward-looking statements made under the Safe Harbor provisions of the US Private Securities Litigation Reform Act of 1995. These statements carry inherent risks and uncertainties, meaning the company's actual results may significantly differ from those expressed today. Information on potential risks and uncertainties is included in the company's Annual Report on Form 20-F for the fiscal year ended December 31, 2020, as well as other filings with the US Securities and Exchange Commission. The company does not take on any obligation to update forward-looking statements, except as required by law. Additionally, Zepp's earnings press release and this conference call will include discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial data. The press release contains a reconciliation of the unaudited non-GAAP metrics to the unaudited most comparable GAAP measures. I will now turn the call over to our CEO, Mr. Huang Wang.

Huang Wang, CEO

Hello, everyone. Thank you for joining our call. Second quarter results demonstrated strong continued progress on Zepp Health's mission of connecting health with technology and in our strategic plan to build a company driven predominantly by its own brands and powered by our own proprietary technology. Let me highlight some key examples from the quarter. In the second quarter, we modestly topped our guidance range. Our own Amazfit and Zepp-branded product revenue continued to grow at 81% versus the same period last year. In June, in the IDC Worldwide Quarterly Wearable Device Tracker, Zepp Health's self-branded Amazfit and Zepp watches were recognized as being among the leading shippers of smartwatches in the first quarter of this year. This is a tremendous proof point for the progress of our own brand. It is my strong conviction that the key to that success lies in our proprietary smart device technology, a faster pace of innovation, and a broadening line of products and future sets and price points that are attractive to many different customers around the world. We have not gotten to this point by being a me-too company, assembling devices with special parts. I know that being a relentless technology leader is the key path to success. Two weeks after the end of the quarter in July, we held our Annual Developer’s Conference, Next Beat 2021. I view this as the most important event of the year. As we demonstrate and discuss our new proprietary technology and future courses of development, it also serves as a key engineering recruiting event. This year, we announced the next generation of our proprietary smart device AI chip, the Huangshan 2S, which offers substantial performance increases such as reducing operating power consumption by 56%, reducing normal power consumption by 93%, and improving graphic performance by 67%. We believe this provides many significant competitive advantages. We also made the much-anticipated announcement of our new operating system for our devices, Zepp OS, which serves at the core of an open health management platform. To avoid the limitation of many other mobile or smart operating systems, such as battery and memory usage, we developed a completely different super-efficient and lightweight system that emphasizes health, user experience, and privacy protection. At 35 megabytes, the new Zepp OS is one-tenth the size of the company's previous Amazfit OS and is 1/28 the size of Apple watchOS 8. The new Zepp OS creates a strong platform for third-party developers and partners to create engaging and useful apps for our devices while retaining the exceptional battery life for which our products are known. We expect to launch this new operating system in devices later this year. At the Developer’s Conference, we also previewed PumpBeats, a squeeze-less blood pressure measurement system for our Amazfit products. The new blood pressure capability is a significant differentiator for our products, and I expect it will create much interest in our offerings. Clinical testing at the First Hospital of Peking University demonstrated excellent accuracy in both systolic and diastolic measurements. The timeframe for accepting applications for clinical trials from external customers of our smartwatch is the fourth quarter of this year. This is particularly gratifying for me personally. Three years ago, on the IPO roadshow, an investor asked me when a smartwatch would be able to measure blood pressure. I told him it would take three years. I am very proud that we have now achieved that. If you know Zepp Health, you know that another key part of our strategy is to expand our range of smart products beyond watches. Recent announcements reinforce our progress on these fronts also. In July 2021, we launched Amazfit PowerBuds Pro, earbuds featuring true wireless stereo with powerful multi-scenario active noise cancellation and advanced health monitoring functions, including cervical vertebrae and hearing protection. We recently launched our brand-new children's smartwatch product line, which allows us to enter a niche market we have not addressed before. Beyond providing basic children's smartwatch functionalities, our products focus on motivating children to go outdoors and participate in activities, which will also help prevent myopia for the next generation. This product will be showcased in China, combined with the policy guidance of Chinese education regulatory agencies. I believe this product focuses on health and sports characteristics, liberating primary school children from a large number of on-site tutoring classes, and it will be supported by users and government agencies. We do not pre-announce products, but I want to say that we have many exciting things in store for later this year, and everyone at the company looks forward to surprising and delighting our users. Recent announcements also demonstrated continuing progress in our data analytics business. While these recent announcements are primarily developmental pilots toward creating future revenue systems, recently announced agreements with Zurich, Brazil, suggest we are continuing our progress on this front. With this second quarter of developments, Zepp is also a company moving quickly in building its own brands that drive its financial performance. When we started the company, we leveraged partnerships to develop and build products for others while working toward being less reliant on those products for Xiaomi and others. The progress of this quarter should instill confidence in our path to having our own products driving our financial results. I am incredibly proud of what we have accomplished in just a few short years and equally proud of my team. I have shown confidence in our future, as we continue to be leaders in key technology, the pace of innovation, and creativity in designing products and personalities that customers find compelling. I will now turn the call over to Leon, to go over highlights of our second quarter financial results.

Leon Deng, CFO

Thank you, Huang. 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 with the continuing growth of our own Amazfit and Zepp-branded products globally. The pandemic slowed that growth in 2020, but the year-over-year results for the first two quarters of 2021 showed year-over-year growth rates of 84% and 81% in the last two quarters for self-branded products. As Huang noted, the best is yet to come this year with new products and functionalities that we believe will continue to drive our growth in this side of our business. The launch of the Mi Band 6 in the quarter provided strong growth in our Xiaomi product sales, as we are working with Xiaomi on the exciting next-generation products as we speak. In fairness, I do also want to point out the timing impact of the launch of the new Xiaomi Mi Band 6 in the second quarter this year instead of the third quarter, as it did last year. Xiaomi sales fluctuations over the quarters create some fluctuations in the company's overall sales and that, to some extent, overshadows the self-branded product sales performance, which also affects our guidance for the third quarter. Overall, the trend we are seeing speaks to our long-term strategy to grow our self-branded products faster and shift the balance to our own products, lessening the reliance on products developed for others. On the pandemic, resignations and lifting of the COVID restrictions in some markets helped our second quarter. How the effects of the Delta and other variants will play out globally in the second half of this year is still very uncertain, and that reflects in our guidance as well. Product trends we discussed on last quarter's call continued in the second quarter. The GT Series and the Bip Pop basic smartwatches series, representing different ends of our product line, together comprised approximately 78% of the company's self-branded product revenue. Now moving to gross margin. Gross margin can be affected by product mix, product launch timing, and product life cycles, including model upgrades. Second quarter 2021 gross margin of 22% was essentially flat, with only a 30 basis points difference from the second quarter last year. Second quarter total gross margin was primarily kept in check by the larger increase in Xiaomi unit volume compared to our company-branded products. 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 will take 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, and that continues to be my focus. Second quarter 2021 operating expenses, including R&D, sales and marketing, and G&A expenses and total OpEx, were all down on a percentage of sales basis. But on an absolute amount basis, we're up to meet the demands of the business and some additional long-term incentives for retaining key talent as the Chinese market has become incredibly competitive. I view this as a good and reasonable partnership between finance operations to strive for efficiency but to be flexible where it is in the best long-term interest of the business. Excluding those stock-based incentives, OpEx declined year-over-year. Net income attributed to Zepp Health Corporation for the second quarter was RMB92.6 million compared to RMB13.3 million in the year-ago second quarter. This benefited from a year-over-year increase of RMB13.5 million of investment income and RMB24.8 million of net income from equity method investments. Our balance of cash and cash equivalents continued to be strong in the second quarter, and we expect this trend to continue into the second half of this year. Looking forward to the guidance, let me outline key factors we are taking into consideration. There remains much uncertainty globally about the pandemic, as we mentioned earlier, and we expect most of our new self-branded product introductions to occur in the fourth quarter. As already noted, the timing of the new Mi Band 6 product launched this year versus last year, we're also expecting somewhat lower Mi Band volumes for the year compared to 2020. IDC has been predicting lowering demand for band products as entry-level smartwatch prices come close to Band prices. But this transition was anticipated and for the funding of the company, we have focused on developing our own products and brands globally. The quarterly path may not always be smooth, but we have confidence in the longer-term vision of the company, in which we're driving the company and its financial performance on the strength of our own branded products. For the third quarter 2021, management currently expects net revenues to be between RMB1.6 billion and RMB1.8 billion compared to RMB2.2 billion in the third quarter 2020. We'll continue to exercise good cost control and expect to continue to report a profit in the third and fourth quarter this year. The higher profitability of our self-branded products helps our cost coverage, and long-term helps us in this transition. That outlook is based on the current market conditions and reflects the company's 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 the questions. Operator, please go ahead.

Operator, Operator

We will now begin the question-and-answer session. The first question today comes from Clive Cheung with Credit Suisse. Please go ahead.

Clive Cheung, Analyst

Hi. Good evening, management, and congratulations on the strong second quarter results. My first question is on the guidance. I think this came a little bit lower than expectation. I guess, Leon already outlined some of the key reasons, but could you elaborate more on the second half plans in terms of products? Because it is always, I guess, my expectation that the product launches are more second half heavy. And how does that play out now versus, I guess, macro conditions? My second question is on the investment income. I guess, there is RMB 13 million on investment income and then RMB 24 million on equity method investments. Could you give us the background of these and then how we should expect these going forward, particularly in the second half of 2021? Thank you.

Leon Deng, CFO

Hi, Clive. Thank you for your questions. Let me address the simpler ones first. I'll start with your second question. The net investment income you mentioned comes primarily from the toothbrush investments we made back in 2017, if I recall correctly. We still hold a significant stake in this company, and as it continues to progress, we plan to gradually reduce our stake. You can expect to see some returns from this in the upcoming quarters. Now, regarding the guidance for Q3, the value may appear lower compared to the same time last year. As I noted earlier, this is largely due to the new product sales that took place last year with the Xiaomi Band 5. Additionally, this year's new product launch for Xiaomi has been moved up by a quarter to Q2. On the flip side, our self-branded products are more concentrated in Q4 this year compared to last year, when we had activities in both Q3 and Q4. So, the first part of your question is mainly influenced by seasonality. The other reason I mentioned is the uncertainty surrounding the COVID Delta variant. We can't predict how much it will affect us in the latter half of this year. However, we still anticipate overall growth in full-year revenue compared to last year. I hope that addresses your questions.

Clive Cheung, Analyst

Yes. Okay. Very clear. Thank you, Leon.

Operator, Operator

The next question comes from Andre Lin with Citi. Please go ahead.

Andre Lin, Analyst

Hi. Thank you for taking my question. I have a few questions regarding the non-GAAP adjustment. I have noticed that there is RMB 24 million adjustment in a non-GAAP basis. And how should we estimate that number in the next few quarters to a net level to be a recurring number going forward? And I also have a question regarding the third quarter breakdown. So given you have CNY 1.6 billion to CNY 1.8 billion revenue guidance, how should we think about the breakdown between self-branded product and some effect? Thank you.

Leon Deng, CFO

Okay. Thank you. So, on the R&D adjustment, I think you are referring to the share-based compensation amount, correct?

Andre Lin, Analyst

Yes.

Leon Deng, CFO

Okay. Yes. So the share-based compensation amount actually happens in every single quarter. Some in certain quarters, it was a little bit lower; in other quarters, it was a little bit higher. But I think on average, you can plug in a number between RMB 15 million to RMB 20 million per quarter on the SBC expenses. But, however, as I said, this is very much linked to the bonus cycle for the employees, so in certain quarters, probably we won't have any. And in certain quarters, we'll have a significant amount. That's why we're discussing the non-GAAP adjustments in our financials as well.

Andre Lin, Analyst

Okay. Thank you.

Leon Deng, CFO

Does that answer your question? Okay. And then on the third quarter split between our self-branded and Xiaomi products, I think what I can say at this moment is that our self-branded products will continue the growth rate, which we observed in the past quarters. I think from last year's Q3, you saw the trend that our self-branded products started to accelerate. I think last year Q3, the base was around RMB 400 million to RMB 500 million, if I remember correctly. In Q3, we will continue a high double-digit percentage growth of our self-branded products. So that speed and trend will continue on in the second half of this year. On the other hand, the Xiaomi volume and revenue is still subject to certain market conditions. As I have mentioned a few times, the fitness band product category is becoming a mature category. Also, if you look at the IDC report, the overall market size for the fitness band market is showing a decline rather than an increase quarter-on-quarter. So there's going to be some limitations on how much we can grow our Xiaomi Band revenue. However, we are seeing growth in our self-branded products, which should provide good cost coverage for our profitability going forward.

Andre Lin, Analyst

Thank you. Very clear. Thank you very much.

Operator, Operator

The next question comes from Robert McKay with Blue Lotus. Please go ahead.