Earnings Call Transcript - ZEPP Q1 2023

Operator, Operator

Hello, ladies and gentlemen, thank you for standing by for ZEPP Health Corporation's First Quarter 2023 Earnings Conference Call. At this time, all participants are in 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 First Quarter 2023 Earnings Conference Call. The company's financial and operating results were issued in a press release via the News Wire 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 at ir.zepp.com. Participating in today's call are Mr. Huang Wang, our Chairman of the Board of Directors and Chief Executive Officer; and Mr. Leon Cheng Deng, our CFO. 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 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 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’ll 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. In the first quarter, we recorded revenue of RMB645.2 million, with RMB391 million from our self-branded products and RMB254 million from the Xiaomi ODM business. Our total revenue declined as cautious consumers limited discretionary spending due to volatile geopolitical and macroeconomic conditions in Europe and in the U.S. As we mentioned in earlier quarters, we anticipate that the Xiaomi ODM business will diminish further and thus our self-branded product line will become the main growth driver in the future. In the quarter, we made progress globally by strengthening our go-to-market capabilities and increasing brand awareness. This, along with the value of our products, drove higher shipments and market share gains with a 20% increase in the Southeast Asia and East Asia region. Despite experiencing a decline in the consumer electronic device market, during the first quarter of 2023, we maintained our optimism that macro headwinds will subside and we expect to see a market recovery during the second half of the year. Furthermore, another cause for optimism is that, recent forecasts suggest an increase in the smartwatch market in 2023. We strongly believe in Amazfit’s long-term potential in the smartwatch markets, presenting a significant opportunity to build sales by enhancing our product competitiveness, leveraging our vertically integrated RISC-V based chip and Zepp OS in all product lines. We can reduce product costs and improve product gross profit margins. Our high-end products offer similar performance to premium competitors but at a fraction of the cost, with longer battery life. This will help us generate higher revenue and profit margins along with our integrated supply chain and efficient R&D. We will secure our position in the $100 to $200 market segments while expanding into premium segments and enhancing our sales channels and supply chain management for increased profitability. With these enhancements now implemented, I am thrilled to share that our new products have achieved a remarkable 34.6% margin in the current quarter. We remain confident that the overall margin will improve in the future as we work towards achieving a more optimal inventory level. Moreover, the rapid implementation of OpenAI LLM technology sets us apart from our competitors in the industry. By utilizing smartwatches powered by generative AI, we position ourselves as trailblazers in the market, emphasizing our advanced technology rather than traditional sports watches. For example, as we mentioned last quarter, we have been the industry pioneer in integrating GPT technology into our products and services such as Zepp Coach and Zepp Aura. On March 29, we launched an enhanced version of the AI-powered Zepp Coach chat function for Amazfit Falcon users. Powered by its constantly learning and evolving AI chat capability, Zepp Coach chat can provide users with personalized and updated exercise recommendations. In the recent quarter, we have implemented refreshed marketing and product strategies that include creating communities for sports and outdoor activities. By leveraging generative AI technology, we have not only supported the growth and development of athletes, both in indoor and outdoor sectors but also built a thriving user community. This has resulted in the organic spread of positive word-of-mouth and distribution, further boosting our brand reputation in the mid to high-end market. As a result, we have also gained brand premium in the mid to low-end market, driving higher profit margins in the future. Alongside our efforts to equip our products with cutting-edge technologies, we have also been striving to expand our product portfolio aiming to offer more diverse products to address different cohorts, fitness, health, and lifestyle needs. In Q1, we launched the Amazfit T-Rex Ultra, our ultimate outdoor GPS smartwatch on March 20. It received positive feedback from outdoor sports enthusiasts for its rugged design, premium materials, and 160+ sports modes. We have other exciting products planned for the year ahead, aiming to bring innovative features to more users. For example, on May 4, we released a significant firmware update for the Amazfit T-Rex 2 smartwatch. It includes heart rate recovery information, altitude, water temperature, slope, and automatic slope analysis. These enhancements improve the user experience, making our smartwatches reliable fitness companions for indoor and outdoor activities. For the past few months in 2023, we have seen some signs of economic recovery in certain markets. That said, the fragile economic environment in many other markets remains an uncertain factor, potentially impacting our sales performance in the coming quarters. Nevertheless, we remain confident in our strategy described above and believe this is the right path leading to the company's sustainable growth as we aspire to become a leading global healthcare solution provider, which will enable us to deliver incremental value to our users and shareholders. Thank you again for joining us today. I will now turn the call over to Leon to go over the highlights of our first-quarter financial results.

Leon Cheng Deng, CFO

Thank you, Wang. Greetings, everyone. Let me walk you through some key metrics of our first-quarter 2023 financial results. In the first quarter, we recorded revenue of RMB645.2 million within our guidance range and down 14.8% year-over-year. The decrease was mainly due to global macroeconomic uncertainties that dampened discretionary consumption in the first quarter. According to recent reports, the value of the global wearable market, including basic bands, basic watches, and smartwatches, decreased by 8% in the first quarter. More specifically, the basic band subcategory lost more than 30%. Also, as I mentioned a few times before, Q1 is typically the lowest seasonal quarter of our financial year. Before diving into our financial performance, I would like to provide a brief overview of the macro environment. In the first quarter, we experienced a shift in China's COVID-Zero Policy, which disrupted our new product launch schedule due to factory closures. As a result, we had to postpone the release of some of our new product lines to subsequent quarters, which negatively impacted our Q1 sales. At the same time, consumer spending was rather weak, especially as spending shifted away from goods toward travel and services as consumers enjoyed activities that they were deprived of during the pandemic. The consumer electronics space, in particular, continues to experience softness, which, together with geopolitical risks in Europe, has pressured our top line in North America and Europe. Despite the challenging start of the consumer electronics market during the first quarter of 2023, we remain optimistic about the smart wearable market's recovery in the second half of the year. Despite these headwinds mentioned above, as Wang just mentioned, in some of our global markets, our self-branded products achieved encouraging year-over-year sales growth during the quarter. Thanks to our enhanced brand value and product features, we remain confident in our ability to drive our self-branded products to grow further in the coming quarters. 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 took an ROI-oriented approach to optimizing our product and sales channel portfolio, the gross margin for our self-branded products remained relatively healthy. Meanwhile, the gross margin for Xiaomi products declined significantly in the quarter as a result of its multi-year pricing strategy. These factors combined drove our overall gross margin to 15.9% in the first quarter, down 4.2% year-over-year and 4.8% versus the previous quarter. We believe that with the launch of our new higher-margin products and continued streamlining of our low ROI products and channels, the gross margin of our self-branded products will expand further for the remainder of the year. Now let's look at our costs. As we have always mentioned in our past earnings calls, costs remain a main focus for the company, both in terms of their absolute amount and as a percentage of sales. Since Q3 2020, we have seen a trend toward a decrease in total operating expenses while still making strategic investments in new products, technologies, and footprint expansions to fuel our long-term growth. In Q1, we made good progress in cutting our expenses, successfully reducing our quarterly operating expenses to RMB253.8 million, reflecting a year-over-year decrease of 17.5% and a quarter-over-quarter decrease of 13.3%. Non-GAAP operating expense decreased to RMB129.8 million, which is the lowest level in the past two years. As a percentage of revenue, our first-quarter adjusted operating expenses rate decreased by 3.3 percentage points year-over-year. Going forward, we'll continue to manage our expenses in a disciplined manner and enhance our operating efficiencies, targeting to cut our expenses run rates to approximately non-GAAP RMB200 million or lower in the coming quarters, representing a significant decrease of around 33% or more from the average of RMB300 million per quarter in 2022, as we aim for a turnaround in profitability in the coming quarters. Spending on R&D in Q1 2023 was RMB117.9 million, decreasing by 19.5% year-over-year. Benefiting from our enhanced R&D efficiency, it is also worth mentioning that R&D expenses now account for nearly half of our total operating expenses as we remain committed to investing in our future by focusing on new technologies to enhance offerings for our users. Selling and marketing expenses were RMB86 million, declined by 16.6% year-over-year as we carefully review our sales channel strategy while still investing in opportunities with higher ROIs to fuel growth. Q1 G&A expenses were RMB49.9 million, lowered by 14.2% versus RMB58.2 million in Q1 2022 and down by 6.5% compared with RMB53.4 million in Q4 2022, due to organization delayering and strong cost control measures. We believe that our progress in cost optimization is a strong testament to our execution capability and will benefit our long-term growth. Thanks to decreased operating expenses, our adjusted operating loss narrowed by 10.9% year-over-year. However, our reduced costs did not fully offset the impact of a smaller revenue scale and lower gross margin for Xiaomi products during the quarter. Our adjusted net loss in the first quarter was RMB112.7 million versus a loss of RMB75.7 million in the first quarter of 2022. While our Q1 2022 loss included investment income generated by our investments, we will continue to enhance our cost control policies by implementing more comprehensive measures, specifically targeting areas such as travel expenses, personnel-related costs, and other expenditures incurred by the company. Simultaneously, we're dedicated to refining our product pricing strategy to optimize both our gross margin and sales revenue, ultimately leading to an improvement in our bottom line performance. Despite a bottom line loss, our cash flow remains strong, thanks to our working capital management efficiency. We have sustained positive operating cash flow for three consecutive quarters since Q3 2022. Now turning to the balance sheet, cash and cash equivalent, restricted cash, and term deposits as of March 31, 2023, were RMB1 billion, an improvement from RMB973 million as of December 31, 2022. As we continue to execute our precise inventory management strategy, we further reduced our inventory balance to RMB800 million by the end of the quarter from RMB1 billion at the end of the year 2022, and it is the lowest level in the past six quarters. In November 2021, the Board approved the allocation of up to $20 million towards a share repurchase program. In Q1 2023, we continued our repurchase program as we remain confident in our business prospects in the longer term. We have bought back $11.1 million of shares by the end of March 31, 2023, and we intend to carry on with this buyback program. Now let's discuss our outlook. In light of the ongoing geopolitical and macroeconomic challenges, our guidance for the second quarter of 2023 currently projects net revenue to be between RMB650 million and RMB850 million, compared to RMB1.1 billion for the second quarter of 2022. We expect roughly 65% to 75% of the revenue will be contributed by our self-branded products in the second quarter. Please note that this outlook reflects continued uncertainty around lower discretionary consumer spending, especially in our international markets and global macroeconomic weakness. That said, we have seen some positive signs, and much of the year lies ahead of us. Furthermore, as we mentioned last quarter, the year may be somewhat back-end loaded as we gradually release our new products. And with that, I would open it up for questions. Operator, please go ahead.

Operator, Operator

Thank you. We'll now begin the question-and-answer session. The first question comes from Nicolette Jones with Investments. Please go ahead.

Unidentified Participant, Analyst

Thank you for taking my questions. So I have three questions. Firstly, can you please provide some color on the revenue trend of self-branded products in the second quarter and beyond? And then secondly, I'd like to ask if you can discuss factors that impacted your margins in the first quarter and margin outlook in the remainder of the year? And lastly, I'd like to understand a bit more about the revenue breakdown by region? Thank you.

Leon Cheng Deng, CFO

Yes, there are many questions. Let me begin with the first one, which is regarding the revenue outlook for self-branded products in the second quarter and the future quarters. Is that correct?

Unidentified Participant, Analyst

Yes. Thank you.

Leon Cheng Deng, CFO

Okay. Now I think as we just guided, we are looking at roughly RMB650 million to RMB850 million for Q2 as our revenue range. And then we expect around 65% to 75% of that revenue will be contributed by our self-branded products. So if you take the mid-point over there, in essence, we're looking at the second quarter revenue to be around RMB750 million. And out of that, 70% would be our self-branded products. If that number is correct, I believe that indicates our self-branded products' revenue is likely to grow compared to the same period last year. Looking ahead, we have mentioned several times that we're transforming more into a self-branded driven revenue company rather than primarily relying on the ODM Xiaomi product. You will begin to see this trend more solidly take shape in Q2, Q3, and Q4 this year. You'll see a solid trend where the majority of our sales revenue will be generated by self-branded products. We will still have a small portion of revenue from the Xiaomi and ODM products, but this sales mix change will help us deliver a higher gross margin. So this naturally leads into your second question, regarding the margin outlook. I believe we have seen consecutive quarters where our self-branded product gross margin is starting to recover, and we see this trend progressing into Q1 this year. As noted in our prepared remarks, our new product sales gross margin is around 35%, which is significantly higher than the past. However, our overall gross margin for self-branded products in Q1 was still flat year-over-year due to some old inventories from previous generation products that carried over. We are coming to the end of this. You’ve also seen our inventory balance decrease dramatically in the past six quarters, now sitting at RMB800 million worth of inventory. If you put this into perspective, it's equivalent to the sales outlook of a quarter for us. Coupled with clearing out old inventory nearly ending now, plus the newly launched products, we expect both the gross margin of our self-branded products and overall gross margin to continue improving in Q2 and eventually in Q3 and Q4. This should address your second question. Regarding your third question about the revenue breakdown by region, we have mentioned that our biggest sales region for self-branded products is Europe, which accounts for roughly 60% of our overall self-branded revenue. In many large European countries, such as Spain and Italy, we hold a very dominant market share position. We will continue to expand in Europe, especially in Eastern Europe and countries with strong brand awareness like Germany and the U.K. Additionally, we see the United States as a significant growth opportunity. We have been operating in the North American market for roughly two years and have grown our market share from zero to approximately 11%. This positions us among the top five players in the U.S. The ASEAN countries, including Japan, Korea, Malaysia, Singapore, and India, are also critical for our self-branded revenue. Finally, in China, we aim to sell selectively our premium products while focusing on profitability rather than scale, as competition in the smartwatch domain is intense. In particular premium price segments, we believe we have a unique position to compete. All together, this should provide you with insight into our revenue driving strategies for self-branded products this year.

Unidentified Participant, Analyst

Thank you. That's very helpful. Thank you.

Operator, Operator

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

Unidentified Participant, Analyst

Thank you for taking my question. I have two questions. The first one is on the very strong margin that you just mentioned for your new products. You said it was around 35% in the first quarter. I'm just wondering what are the drivers behind this performance? And are there any further upside to this number? And secondly, the second question is on the run rate of your operating expenses. You mentioned a target of RMB200 million on the adjusted basis in the coming quarters, but I noticed in the first quarter, your total operating expenses have reached around RMB225 million on an adjusted basis. Are you being a little conservative on this target? What is your current run rate? Thank you.

Leon Cheng Deng, CFO

Yes. Let me start with the easier question regarding our expenses. We have been focused on managing them closely on a daily basis. If you review our quarterly expenses for 2022 and 2021, they've averaged around RMB300 million per quarter, which covers R&D, general and administrative, and sales and marketing expenses. We have implemented several measures to manage this effectively. First, we optimized our workforce to match revenue levels. Second, we take a return on investment approach to assess discretionary expenses and encourage our teams to be careful with spending on items like travel and marketing campaigns, ensuring they are justifiable based on expected returns. Lastly, we implemented a platforming strategy for R&D. By integrating our vertically-aligned chips and operating system, we have reduced overall delivery costs while enhancing user experience and functionality compared to our previous disparate software and hardware configurations. Consequently, we achieved an adjusted operating expense run rate of approximately RMB229 million in Q1, which is slightly above our target of RMB200 million. However, we expect this figure to decrease in the upcoming quarters as we continue to improve our practices. As for the factors driving the impressive 35% margin for our new products in the first quarter, several elements contributed. Firstly, we have diversified our product lines to reach different consumer segments. Our outdoor sports products, including models like T-Rex and the Qualcomm series, provide competitive features at lower prices than our competitors. We aim to increase our average selling price for our overall product portfolio through greater market recognition. Additionally, utilizing our vertically-integrated supply chains and R&D for more efficient product delivery significantly contributes to enhancing our margins. The overall outlook for our gross margin is positive, reflecting our strategies to capture market share across various price points.

Unidentified Participant, Analyst

Yes, it did. Thank you.

Operator, Operator

As there are no further questions now, I'd like to turn the call back over to Grace Zhang for any 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 website. This concludes this conference call. You may now disconnect your lines. Thank you.

Operator, Operator

Again, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.