Earnings Call Transcript - ZEPP Q1 2022

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for Zepp Health Corp's First Quarter 2022 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 2022 earnings conference call. The company's financial and operating results were issued in our press release earlier today and are posted online. You can also view the earnings press release and the slides we will refer 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 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 the call 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 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 is included in the company's Annual Report on Form 20-F for the fiscal year ended December 31, 2021, and other filings 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 reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures. I'll now turn the call over to our Zepp CEO, Mr. Wang Huang. Please go ahead.

Wang Huang, CEO

Hello, everyone. Thank you for joining our call. The last several months have been challenging, given the ongoing COVID-19 pandemic, compounded by geopolitical alerts. Against these challenges, we are pleased that our first quarter revenue came in aligned with our guidance. We achieved RMB0.8 billion in revenue, representing a decrease of 34% year-over-year. Our revenue was affected by the decrease in Mi Band 6 shipments, as consumers are waiting for the new generation Mi Band launch, as well as reduced discretionary spending as consumers cut back amidst the inflationary environment. Supply chain and logistic interruptions due to lockdowns and other restrictions as part of the pandemic prevention and control measures in China also impacted our first quarter. We should highlight, however, that the first quarter has typically been a slow quarter for sales due to seasonality. Besides all these headwinds, we were also pleased to see that our revenue mix continues to shift towards our self-branded products, which now contribute more than 65% of our total revenue. This demonstrates once again the broad appeal of our products as we focus on connecting health with technology to enhance user lifestyles and help them effectively manage their health conditions. To further build out our sales channels, we continue to expand and deepen our partnerships with retail outlets in overseas markets. As a result, we saw particularly strong performance in the North American region, where our self-branded products revenue surged by more than 110% year-over-year. These achievements are a testament not only to our successful operations, despite challenges and uncertainties, but also to the lifestyle evolution we are part of with healthcare services supported by smart wearable devices that are transforming people's daily lives. We expect the undeniable benefits of smart wearable devices, coupled with innovations in software, sensors, and other hardware, to provide continued tailwinds to our future growth. As we strive to be a leader in this mega trend, we have been working relentlessly to harness technology to enhance our product and have established a comprehensive AI algorithm system, incorporating sensors and health Big Data, which we incorporate into our product designs to help our users realize their health and fitness goals. To that end, we are preparing to unveil our next generation smartwatches. Today, we launched our upgraded outdoor watch, T-Rex 2, which has enhanced GPS capabilities. Later this year, we will also upgrade our most popular GTS, GTR, and BIP series as newcomers to our basic and sport product lines. These devices boast meaningful market enhancements in functionalities, style, and algorithms, among others. Additionally, we continuously upgrade and add new features to our existing products to enhance user experience. For example, we rolled out a firmware update for Amazfit GTR 3 and GTS 3 series devices in late April, adding text-based phone capabilities for incoming calls, as well as automation for alarms, music downloads, and system stability. We have also recently made meaningful inroads in our exploration of the medical-grade healthcare industry and launched the first product in our smart hearing aid product line, Zepp Clarity One, an adjustable, comfortable, invisible, and discreet device for those with hearing loss, especially for those who don't want others to notice. Notably, Zepp Clarity One offers more than just hearing support. It also comes with a best-in-class customer support, guided by audiology professionals to ensure the best possible experience for users. Our collaboration with Xiaomi continues to be fruitful. Just today, we launched Mi Band 7, and we look forward to building on the previous successes of past generations of this powerful product line and taking its journey one step further. As we remain committed to connecting health with technology, we continue to drive technological innovation through collaboration with universities and by engaging our user community. Together with the University of Science and Technology of China, we launched our first Zepp OS technology and health campus innovation contest, inspiring students to develop apps for smart wearable devices that can improve people's health management habits. We also collaborate with UC Berkeley on their Caltech event to encourage users worldwide to join our Zepp OS ecosystem. The core values that we hold here at Zepp will continue to help our users better manage their health and wellness and design their lives with healthy choices. Our inclusive and innovative Zepp OS ecosystem has drawn globally to design apps and watch faces on our platform, contributing to our flourishing user community, which is more vibrant than ever. To conclude, we are making progress amidst macroeconomic uncertainties. Going forward, we will continue to invest in and capture enormous opportunities in the healthcare services industry by focusing on technological innovation in AI chips, health Big Data, and our product portfolio expansion. Despite the short-term impact from geopolitical conflicts, pandemic resurgence, and associated supply chain and logistic challenges, we are very excited about Zepp’s long-term prospects as we remain dedicated to shaping the technologies of tomorrow while meeting the needs of our users today. With that, I will now turn the call over to Leon to go over highlights of our first quarter financial results.

Leon Deng, CFO

Thank you, Wang. I would like to start by highlighting some of the key metrics driving Zepp’s development. Before providing further details on our financial performance, I would like to briefly elaborate on the macro environment issues we have faced so far in 2022, which is shaping up to be a year packed with challenges. The Q1 2022 lockdowns in China's Tianjin and Shenzhen, in addition to significant disruptions in March 2022 to our export routes through Shenzhen into Hong Kong, vital to our global supply chain and product availability, have interrupted our deliveries and sales worldwide. Furthermore, the pandemic-related restrictions in the Yangtze River Delta since March have also impacted our supply chain in early Q2. Moreover, the global semiconductor shortage continues to constrain our supply chain, albeit our supply chain team has been working hard to seek alternative solutions to resolve the ongoing situation. Separately, escalating geopolitical strife among countries, notably the conflict between Russia and Ukraine, is creating turbulence that is impacting consumer confidence and leading to cost inflation, which has led to a slowdown in consumer discretionary spending. These adverse conditions weighed down our revenues generated and our overall gross margin. Together, these factors have affected our Q1 results and continue to impact our ongoing Q2 2022 performance. Despite these ongoing headwinds in 2022, we reported revenue of RMB0.8 billion in Q1, within our guidance range against a very difficult macro environment. Our revenue was down 34% compared with Q1 2021, with the decrease mostly driven by the decline in Mi Band sales. In the meantime, COVID-19 and chip shortages also constrained the growth of our self-branded products. I have to say that we are very proud of our self-branded products' performance, especially in light of all these headwinds. Our self-branded products contributed over 65% of the total revenue this quarter. We believe our self-branded products will continue to gain momentum as we develop our product capabilities and enhance our brand's market recognition globally. Now let's look at gross margin, which can be affected by product mix, product launch timing, and product lifecycles, including model upgrades. Our first quarter 2022 gross margin was 20.1% compared with 22.5% for the first quarter of 2021 and 19.3% for the fourth quarter of 2021. The lower gross margin versus last year was mostly affected by the increase in freight costs and the pandemic, while the improvement versus Q4 2021 was supported by refinements to our product mix, including an increased proportion of self-branded products. Turning now to costs, which have been a key focal point of our operations, in both terms of absolute amount as well as a percentage of sales. A portion of operating expenses are fixed, so it takes time and creativity to gradually reduce these expenses. While we have to carefully balance our cost controls with the expenditures to fuel growth, I'm pleased to report that we have already seen a decreasing trend in total operating expenses since Q3 2020. Going forward, we'll continue to right-size our operating expenses from their current level in order to deliver profitable growth in the following quarters. First quarter 2022 operating expenses decreased slightly in absolute terms compared with the same period in 2021. However, at 40.6% of sales, they represented a percentage increase compared with the first quarter of 2021, during which operating expenses were 26.9% of sales. This was mostly driven by the lower topline. Given the headwinds, I just explained above, we’re consistently streamlining costs to protect future profitability. Hence, spending on research and development in Q1 2022 was RMB146.4 million, a decrease of 30.9% year-over-year, though given the low revenue levels comprised 19.3% of revenue versus 13.3% for the same period last year. The lower spending in absolute terms reflects our effective R&D expense controls. Q1 2022 selling and marketing expenses were RMB103.1 million, an increase of 13.6% year-over-year, comprising 13.6% of revenue compared with 7.9% of the revenue for the same period in 2021, mainly due to higher advertising and promotions for our self-branded products and the increase in overseas sales personnel needed to serve the local markets. General and administrative expenses were RMB58.2 million in the first quarter of 2022, representing a decrease of 10.9% year-over-year, largely due to effective cost controls. It accounted for 7.7% of revenue compared with 5.7% in the same period in 2021. Regarding net income, the first quarter of 2022 saw an adjusted net loss of RMB75.7 million compared with an adjusted net loss of RMB29.0 million for the first quarter of 2021. Now turning to the balance sheet. As the Shenzhen lockdown in March impeded key component supply, our production was affected, and thus our inventories grew in Q1 2022 by RMB281.3 million compared with December 31, 2021. We are optimistic that the chip shortage and oversupply chain issues will start to ease in the second half of this year. Despite the challenging circumstances, our balance sheet remains robust. Cash and cash equivalents as of March 31, 2022, were RMB1.02 billion compared with RMB1.09 billion as of March 31, 2021, as we continue to implement disciplined working capital management practices. In November 2021, the Board approved the allocation of up to $20 million toward a share repurchase program. In Q1 2022, we continued the repurchase program, reflecting our confidence in our growth strategy and financial performance. By March 31, 2022, we had bought back $6.9 million worth of shares and intend to carry on with this buyback program. In addition, the company paid out the special dividends for 2021 to ADS holders on April 15, 2022. Lastly, moving to our outlook. Due to ongoing challenges, our outlook for the second quarter of 2022 currently projects net revenue to be between RMB1.08 billion and RMB1.3 billion compared with RMB1.84 billion in the second quarter of 2021. The second quarter performance is very much driven by new product launch timing, as the Mi Band 6 was launched in March 2021, while Mi Band 7 launched on May 24, 2022. This outlook also reflects the continued uncertainty of the potential effects of the COVID-19 pandemic on sales and electric component delays as well as lower discretionary consumer spending. Given this outlook, we'll continue to apply strict cost control measures and disciplined working capital management through 2022. Please note that our outlook is based on existing market conditions and reflects management's current and preliminary estimates of the market and operating conditions, as well as customer demand, which are all subject to change. This concludes our prepared remarks. We'll now open the call to questions. Operator, please go ahead.

Operator, Operator

We will now begin the question-and-answer session. Our first question will come from Jan Luo with PF Securities. You may now go ahead.

Jan Luo, Analyst

Thank you for taking my question, and congratulations on the first quarter. First of all, can you share some views about the impact that COVID in Shanghai to clarify? I found that COVID is very serious at this time. I mean, how is that impacting your operations, supply chain, and customers? Thank you.

Leon Deng, CFO

Thank you very much. The impact of Shanghai is relatively small for us compared to the impact on Shenzhen, because most of our supply chain and factories are based out of those in China, rather than the Yangtze Delta River area, which I just mentioned. However, we do have one of our factories in Suzhou, which is actually creating some new products for our company as well. Since the lockdown was constrained within Shanghai, the impact is relatively limited for us in Shanghai as a region. However, Shanghai was among the top cities in China where there are a lot of consumers purchasing our watches, and the two months lockdown obviously dampens the sales outlook for our Q1 as well as our Q2 sales in China. However, we will try to promote our products across different regions in China to compensate for the shortfall in Shanghai.

Jan Luo, Analyst

Okay. Thank you. And the second question is about the market trend. So I see that global political developments change day by day, and we see that food prices are even rising in some emerging markets. So how do you forecast the consumer electronics market and the smartwatch market in the next part of the year?

Leon Deng, CFO

It's a good question. We do notice that there are a few issues, which I mentioned in the script. We see some slowdown in Russia and Ukraine as specific markets, and we see the slowdown in consumer discretionary income in markets like Europe and the United States. We see that people's discretionary income is being squeezed to some extent by inflation. So overall, there is a certain degree of decrease in discretionary spending from consumers. However, we also see some interesting signs: our brand is actually taking over other brands, for example, in the United States and parts of Europe. We’re performing better than others. The future is still a very fluid picture; as you can see in our guidance, our Q2 number is already much better than our Q1 number, and we have high hopes that in Q3 and Q4, together with our new product launches, we should still achieve at least a similar level of revenue as 2021 or even with single-digit growth. But this is still very early for us to predict. And if we look at the growth of the smartwatch market, at least from the IDC report, which we have at this moment in time, it still points to growth in the overall market in the years to come. So we're still relatively optimistic about the wearables market in which we operate.

Jan Luo, Analyst

Okay. Thank you.

Leon Deng, CFO

Thank you.

Operator, Operator

Our next question will come from Kevin Chen with China Renaissance. You may now go ahead.

Kevin Chen, Analyst

Hi. Thank you, management, for taking my question, and congratulations on the good results. I have a question regarding your upcoming outlook. Since your guidance for Q2 is pointing to very strong quarter-on-quarter rebound growth, would you characterize this as mostly driven by the new Mi Band product or also by your own brand products as well? And how do we see the Xiaomi-related revenue contribution? I think this past quarter, it was only down to about 35%, and how do you see this trend going forward for the rest of the year? Thank you.

Leon Deng, CFO

Kevin, good question. So on the outlook, as I said, Q2 is already pointing towards a strong quarter-on-quarter rebound, and our quarterly number is very much linked to the new product launch timing. As I mentioned just now, Mi Band 6's launch time was in March last year. In Q2, you can account for a full quarter, which was the case last year, but this year, the new Mi Band 7 was only launched now, and we will start selling it as of June 1. So we can only account for the new product sales for a few months instead of the whole quarter. This actually explains the difference between Q2 last year’s sales and Q2 this year’s sales. On your question regarding the Xiaomi mix in our revenue, I believe that our self-branded products will continue to grow alongside Xiaomi. So in the upcoming quarters, we would expect the proportion of Xiaomi revenue to increase versus the current level, and that increase would also go into July and August. So basically, it's going to be very much in Q3 and Q4. Our self-branded products will also see growth, because, as Wang mentioned in his script, we also launched our new T-Rex product today, and we are going to launch our new BIP and POP watches in June, not to mention the new GTS series scheduled for Q3. Our self-branded product launch time is skewed towards June and Q3 and Q4 rather than earlier last year. This creates a mismatch in revenue outlook for our sales this year. What I'm saying is that, on a full year basis, I think, as I mentioned in previous questions, full-year revenue for the company should be at least similar in absoluteamount to 2021 or showing single-digit growth. On the mix between Xiaomi and our self-branded products, our self-branded products will certainly take a larger share in this overall number. But of course, in the coming quarters, in Q2, Q3, and Q4, you will see a proportional increase in Xiaomi’s weight in the overall revenue mix.

Kevin Chen, Analyst

Right. Very clear. Also, I have a second question regarding our own brand products. What kind of functional upgrades are we focusing on this year, and how would you expect this to change our product pricing or margin profitability due to these upgrades? Thank you.

Leon Deng, CFO

Let me try to answer the easy one. Obviously, the product average selling price (ASP) is something we definitely want to see increase for our self-branded products. We do see an increase from Q4 last year to Q1 this year, and that trend should continue. Regarding our self-branded products, we have different lineups to cater to different consumer needs. For example, the newly launched T-Rex 2 product focuses heavily on outdoor and hardcore sports and outdoor activities. Our GTR series, which is one of our biggest launches scheduled for Q3, will create a competitive product for the Apple Watch and Samsung watch. We also have low-end models, such as the BIP and POP series, which cater to entry-level watch users and are price-sensitive to compete with potentially white-labeled products. Therefore, the different product lineups we have will appeal to different consumers. The upgrades you will see this year from us will definitely come from specification and feature upgrades of the watches, including screens, battery life, and standby time, among others. Additionally, there will be enhancements to our Zepp OS, which we launched last year, as we're working on creating our ecosystem using Zepp OS and trying to make more appealing apps for consumers. Lastly, there will be health functions integrated, including SpO2 and blood pressure measurements, as well as other updates for our watches. These three upgrades should help to lift our ASP for our self-branded products.

Kevin Chen, Analyst

Okay. Thank you, Leon.

Operator, Operator

Our next question will come from Clive Cheung with Credit Suisse. You may now go ahead.

Clive Cheung, Analyst

Hi. Good evening, and thank you for taking my question. The first question is a follow-up to Leon’s comment just now on the expansion of Zepp OS. Given the challenging macro environment, could we see a decline in shipments or a slowdown in shipment growth? I was looking to accelerate the monetization of Zepp OS in terms of new application offerings. That's my first question.

Leon Deng, CFO

Thank you, Clive. Those are very good questions. So let me first comment on Zepp OS monetization. Yes, for sure, we are trying to make Zepp OS one of the differentiating factors for our products compared with others. You probably noticed that we have announced that we have different third-party applications working within Zepp OS, for example, Spotify and GoPro, and we are going to add more popular apps that our users appreciate. We're not going for mere quantity; we're focusing on quality. We have certain services that went online in a small handful of countries by Q4 last year, such as our sleep and focus-type services that are connecting the hardware with AI-powered music to help users sleep better and focus more. We are rolling that out to more geographies as we speak. We will definitely work on widening the use of Zepp OS and link more popular third-party apps to it. So I hope that answers your first question. Moving to operating expenses, our OpEx in the past quarters has been around RMB300 million, give or take, per quarter. In certain quarters, when the topline exceeds our threshold, we may allow the team to spend a little more, but if you take our average, we’ve been below the RMB300 million line for the previous year, and the same applies to this year. We're signaling a right-sizing of our costs and trying to step down on this cost level, but you might realize that a lot of this is linked to personnel. Even if you want to right-size the people, you will incur costs first before you see a step change. We're doing that as we speak. So in Q2, you might still see a similar kind of RMB300 million mark for our costs, but you should see a step down from Q3 onwards. You can expect a reduction of about 10% to 15% compared to the current level, which we reported in Q1.

Clive Cheung, Analyst

Okay. Thank you very much. Very clear. Thanks, Leon.

Operator, Operator

Our next question will come from Abhishek Sahoo with Templeton. You may now go ahead.

Abhishek Sahoo, Analyst

Hi. Thanks for taking my question. My first question is on the mix in the current quarter. What growth are you seeing in Amazfit? Going forward in the coming quarters, what kind of growth would you expect to sustain in the Amazfit products?

Leon Deng, CFO

So Abhishek, that's a very good question. The Q1 number is kind of a slow quarter because, from a seasonality perspective, Q1 is traditionally the lowest demand quarter for consumers. This year, Q1, as I mentioned in the script, faced a perfect storm with the Ukraine and Russia conflict and the lockdown of our factory in Shenzhen impacting revenue for Q1, which affected not just the Xiaomi products but our self-branded products too. If we strip out all those effects, I would say our self-branded products should continue to grow, maybe not at the double-digit growth rate we reported last year, but at least it should grow versus the decline we have seen this year. Looking at our Q2 outlook, we already see supply chain and lockdown issues easing in China, which positively impacts us. The self-branded product sales will surely exceed Q1 levels, but whether or not they will match last year's figures is something we are working towards. For the full-year numbers, we want to change the overall mix. From an absolute amount perspective, we believe overall company revenue will be at least flat versus 2021 or show a small single-digit growth for the year. From a seasonality perspective, Q1 will be the lowest quarter, Q2 will gradually improve, and Q3 and Q4 will be the key quarters driving the year, traditionally benefiting from Prime Day sales, the Double 11, and Christmas sales.

Abhishek Sahoo, Analyst

Got it. Thanks. Also, while the mix continues to shift in favor of the self-branded products, shouldn't that lead to a significantly higher margin than the 20% that we are currently reporting? I thought that self-branded products typically come at a much higher margin rate?

Leon Deng, CFO

That should, Abhishek, that's a good question. What you saw here is already an increase of 1% in overall margin versus Q4. Even in Q4, our self-branded products accounted for more than 60% of the mix. In Q1, there were certain one-offs; for example, freight costs were extremely high as compared to our run rate in 2021 due to lockdown and macro issues. However, those factors are gradually improving in Q2 and as we enter the second half of the year. You will definitely see a gradual increase in gross margin for self-branded products as we approach Q3 and Q4 due to seasonality and new product launches. Yes, to answer your question, you should see the bottom gross margin now and it should rise as we go into the second half of the year.

Abhishek Sahoo, Analyst

Understood. Thanks. Regarding the quantum of the buyback we have done so far, should we accelerate the pace of buybacks if we believe that the business is undervalued?

Leon Deng, CFO

Regarding the buybacks, we are indeed continuing our buyback program. As of March 31, we had bought back $6.9 million; we continue to buy back shares as we speak. I believe by the end of Q2, we will publish the results showing the buyback number going up. We are committed to continuing with buybacks as we progress through the second half of the year. As for the delisting risk you mentioned, that's a systematic risk that hangs over all Chinese tech companies. We closely monitor the situation and are considering different options, including a second listing in Hong Kong and working closely with our audit firm to obtain PCAOB clearance. We are working on this and will update when we have more information. In the short to mid-term, we do not see any risk or negative impact, and we believe our company is undervalued, which is why we will continue with the buybacks as planned.

Abhishek Sahoo, Analyst

Got it. Thank you so much, Leon, and all the very best.

Leon Deng, CFO

Thank you.

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 Zepp’s Investor Relations Department through the contact information provided on our website. This concludes the conference call. You may now disconnect your line. Thank you.