Earnings Call Transcript - ZEPP Q3 2022

Operator, Operator

Hello, ladies and gentlemen. Thank you for standing by for Zepp Health Corporation's Third Quarter 2022 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 2022 earnings conference call. The company's financial and operating results were issued in our press release via the News Wire Services earlier today and are posted online. You can also view the earnings press release and slides we 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 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 is included in the company's Annual Report on Form 20-F of the fiscal year ended December 31, 2021, 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 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 contain 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. First, I would like to provide some context by adjusting the macro environment, which continued to worsen during Q3 and impacted our operations amid heightened geopolitical uncertainties and COVID-19 containment measures in China. Against this backdrop, our third quarter revenues came in within our expectation at RMB1.2 billion, down 24.9% year-over-year, primarily due to decreased sales of Mi Band products. Despite these challenges, we continue to grow during the quarter, with the top line up 8.8% quarter-over-quarter, a significant reflection of the resilience of our business. I would like to highlight that despite the macro headwinds we faced during the quarter, our self-branded products have returned to their growth trajectory, with this 4.2% year-over-year and 35.6% quarter-over-quarter increase in revenue. This growth was underpinned by increased recognition from global consumers as we made progress in enhancing our product value and expanding our sales channels. In the North American market, as we have expanded into more retail channels, our revenue grew by 23% year-over-year and 54% quarter-over-quarter. In Europe, we also had several bright spots. In Poland, for example, our revenue growth rate was 222% year-over-year. We were also the official partner of the 44th Warsaw Marathon, which has further raised our brand value and recognition. In France and Spain, we enjoyed 36.4% and 26.2% revenue growth, respectively, against macro challenges. In September, we launched our brand new Amazfit GTR 4 and GTS 4 at our event. The Amazfit GT 4 series is packed with premium features for both sections and functions. Over 119 million outlets in the EMEA region reported our launch event, and our GT 4 series was recognized by three media sources as the best product. Our new GTR 4 and GTS 4 are equipped with the industry's first dual-band circularly-polarized GPS antenna technology, enabling movement tracking and positioning up to 99% accurate as handheld GPS in open air scenarios. This generation also features our new BioTracker 4.0 with a high precision PDG optical sensor and heart rate checking performance, which enhances our ability to match the heart rate stress accurately. We believe these upgraded product features will be attractive to users worldwide, enabling more people to reach their business goals and better manage their health in their daily lives. Furthermore, we are excited to team up with Adidas, a well-established digital platform that serves 182 million athletes to empower users to synchronize workout data to Adidas running via the Zepp app. This function became available on our newly released Amazfit GT 4 series in October and we gradually plan to implement it on our other smartwatches going forward by partnering with global brands that share our passion for helping users achieve their business goals. We hope to further expand our user community and achieve continued growth. In October, we introduced our premium multi-sport GPS watch, the Amazfit Falcon. It features the new AI-powered Zepp Coach, providing users with scientific and tailored business guidance through our self-developed smart coaching algorithm. Crafted with a top aircraft-grade titanium unibody and 20 ATM water-resistance, a first for Amazfit smartwatches, as well as 150 billion sports modes, dual-band GPS checking, and six satellite positioning systems. Amazfit Falcon is a companion built to break limits. The young smart wearables we forged ahead with the expansion of our new healthcare solutions product lineup, which features discrete invisible technology with up to 18 hours of battery life and 12 unique settings for optimized effect. Apart from physical health, we believe it's crucial to mental health and overall well-being. As an innovative AI-generated product that adapts to users' biological phases, our newly developed Zepp Aura solution can help users fall asleep faster and sleep more deeply. We are confident that these new innovations represent an important milestone in our expansion into the healthcare sector and will usher in a new growth stage for us. Additionally, we have always been passionate about technology innovation and fostering a more vibrant developer community while striving to reinforce our brand identity on the global stage. Accordingly, we were proud to join past sponsors such as Microsoft and Google Cloud in sponsoring the world's largest tech event held in October. During the event, we talked to over 5,000 attendees and successfully attracted more than 1,500 top talent students to visit our booth and learn more about who we are. We also awarded prizes and our Amazfit smartwatches to women in their watch faces and apps categories to recognize their ingenuity and encourage their use of technology to create solutions that improve our work. As we anticipate continuing microeconomic headwinds in Q4 and potentially begin increasing organizational efficiency has also been a key focus of our management team this year. Our measures have delivered concrete results in cost efficiency in R&D and G&A expenses, as we will take additional measures as needed to manage the fixed costs. All in all, a fruitful third quarter results, including new product launches and encouraging performance from our self-branded products highlight our organization's resilience in the face of multiple external challenges. We will further expand our products and services offering while improving organizational efficiency to maximize the value for our shareholders, as well as help users live a healthy life. Thank you again for joining us today. 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 all. Hello, everyone. I would like to start by highlighting some of the key metrics of our third quarter financial results. As mentioned by Wang, in the third quarter, we saw persistent challenges associated with high input and freight costs, the evolving geopolitical situations, and ongoing COVID-19 containment and control measures in China. These adverse conditions weighed on our revenue generation and our overall gross margin. Amid the macro volatilities and uncertainties, our Q3 revenue came in line with our guidance at RMB1.2 billion, down 24.9% year-over-year, which consists of 53.5% from self-branded product sales and 46.5% from Xiaomi product sales, versus 38% self-branded product sales and 61.4% Xiaomi product sales in the same period last year. The decline in revenue at large is mainly driven by the lower-than-expected Mi Band sales in the third quarter. However, our self-branded products restored their growth with a 4.2% year-over-year increase in revenue despite the headwinds. We have seen bright spots in many parts of our business, for example, in North America markets, our revenue grew by 23% year-over-year and 54% quarter-over-quarter. Quarter-over-quarter, we continue to improve on both our top line and bottom line with 8.8% revenue growth and a narrowed loss during the quarter. Our adjusted net income for the quarter is a loss of RMB8.8 million, which included a one-off severance cost of RMB10 million. This almost breakeven result demonstrated our organization's resilience and the effectiveness of our continued measures to streamline our cost base. On a sequential basis, third quarter 2022 revenue was better than the second quarter 2022 revenue and our operating profit also improved, reconfirming our solid execution capabilities. Notably, our self-branded product revenue in the third quarter grew 35.6% sequentially, boosted by our newly launched products, including the Amazfit GT4 series, Amazfit Bip 3, Amazfit Bip 3 Pro, and Amazfit Trex 2. Now, let's turn to our third quarter gross margin, which can be affected by product mix, product launch timing, and product life cycles, including model upgrades. Our Q3 gross margin was 19.1%, 1.1 percentage points lower year-over-year, affected by higher freight costs compared with the same period last year and clearance of our previous generation products, partially offset by higher gross margin from our new product introductions. However, given the 1.2 percentage points increase quarter-over-quarter, we can see a positive gross margin development trend now. It's also worth mentioning that given the new product launches, our gross margin for self-branded products exhibited continuous growth month-over-month in the third quarter. Turning now to costs, which have been a key focal point for the company, both in terms of absolute amount as well as the percentage term. While we have to balance cost controls carefully with expenditures to fuel growth, we have already seen a decreasing trend in total operating expenses since Q3 2020. As a portion of the operating expenses is fixed and takes time and creativity to reduce them gradually, we expect to achieve further cost reductions in absolute terms for the remainder of the year. Going forward, we'll continue to right size our operating expenses to deliver profitability in the coming quarters. Our third quarter 2022 operating expenses were RMB303.9 million, representing a 1.6% quarter-over-quarter decline. R&D in Q3 2022 was RMB127.4 million, an increase of 17.2% year-over-year, driven primarily by a lower government subsidy received. Excluding the above factors, R&D expenses remained slightly down versus the third quarter of 2021, due to strict productivity measures applied. Selling and marketing expenses were RMB123.9 million, 36% higher year-over-year, mainly due to our increased investments in various international markets and sales channel expansion through digital marketing initiatives and partnerships with leading global sales platforms. These actions are critical to drive our long-term organic growth. Q3 G&A expenses reduced 14.8% compared with the third quarter of 2021 and 26.5% compared with the second quarter of 2022. This decrease illustrates the effectiveness of our expense control strategy. As we look ahead, cost structure optimization will continue to be our primary focus, especially aimed at the complex and high volatile macro environment. With higher productivity, ROI-based operations, and more disciplined cost reduction measures, we expect to reduce our operating expenses further. As our revenue improved and expenses declined sequentially, the adjusted operating loss for the third quarter of 2022 improved further to RMB65 million, compared with the adjusted loss of RMB98 million in the second quarter and the adjusted loss of RMB142 million in the first quarter of 2022. We also paid close attention to foreign exchange fluctuations and recorded a positive FX contribution year to date, thanks to our proactive management of FX risks. Our adjusted net loss in the third quarter was RMB8.8 million, which includes the RMB10 million severance payment, narrowed compared with the loss of RMB90.4 million in the second quarter and the loss of RMB75.7 million in the first quarter of 2022. Now turning to the balance sheet. Our cash flow remains strong with cash flow from operations in Q3 standing positive at RMB115.3 million. As of September 30, 2022, cash and cash equivalents were RMB1.01 billion, compared with RMB997 million as of June 30, 2022. During the quarter, we continued to manage our working capital and inventory more efficiently and realized lower inventory levels quarter-over-quarter. We're targeting to reduce our inventories by year-end to be on par or lower than the levels we exited 2021. In November 2021, the Board approved the allocation of up to US$20 million toward a share repurchase program. In Q3 2022, we continued the repurchase program reflecting our confidence in our growth strategy and financial performance. We have bought back US$9.2 million worth of shares until September 30, 2022, and intend to carry on with this buyback program. Moving on to our outlook. In light of the ongoing challenges, our guidance for the fourth quarter of 2022 currently projects net revenue to be between RMB1.1 billion and RMB1.35 billion, compared with RMB1.66 billion for the fourth quarter of 2021. Please note that this outlook reflects the continued uncertainty of the potential effects of the China COVID-19 pandemic policy on ourselves and the lower discretionary consumer spending, especially in our overseas markets, amid global macroeconomic weakness. Please also note that this guidance 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

Thank you. The first question today comes from Clive Cheung with Credit Suisse. Please proceed.

Clive Cheung, Analyst

Thank you management for taking my question. This is Clive from Credit Suisse. I have three questions. I'll ask them all at once. So, number one, I saw the sales and marketing expenses disproportionately grew this quarter. I noticed in the prepared remarks, Leon already mentioned it was going to channel expansion in specific markets; could you share a little bit more color on where geographically this has gone into? And what kind of digital channels are we targeting at the moment? That's number one. Number two, with regards to our staff force right now and with reduced capacity, how does that impact our R&D assets and product delivery intensity? And lastly, number three, I think there was a mention on supply chain constraints, and my question is, what components in particular are we facing the most delays and impacting our fourth quarter shipments or for next year as well? Thank you.

Leon Deng, CFO

Thank you, Clive. Let me answer the easiest question first on the supply chain constraints. In Q3, all the supply constraints we have seen at the beginning of the year have been elevated. So, basically, the supply constraints issue no longer applies to us starting from the second half of Q3. We don't see any of that will impact us in Q4 anymore. Similarly, regarding freight costs, we also see a trend that they are going down, especially on sea freight. So, that additional freight cost situation versus last year, which we experienced for the first three quarters of this year, should also be resolved to a certain extent in Q4. I hope that answers your third question. Then let me turn to the first question, which is on the marketing and sales expenses. Yes, we have invested quite a bit in the international marketing and sales expansion, i.e., investing in digital platforms, for example, Amazon and some local online platforms, the big ones regionally, such as Kuplu in the Netherlands and MediaMarkt.com in many European countries. We will continue to invest in those online platforms as we see the shopping pattern from most of our international clients turning towards the big online channels. Also, given our D&A, we believe that investing in digital campaigns and digital marketing on online platforms will yield a bigger return for ourselves. Additionally, we've increased our investments in offline channels. For example, in the United States, we have seen quite a growth year-over-year, driven largely by our offline channel investments, including listings in major offline channels like Best Buy and Target. We are also deepening our presence in offline channels in Europe as well. Furthermore, we have expanded our efforts in Asian countries, such as India and the rest of the Asian countries. To give you an approximation, we invested around 10% of our sales and marketing expenses relative to our self-branded sales value in this quarter, and we will continue with that run rate in the upcoming quarters as well. As for your second question on the reduced capacity in relation to R&D resources, we have mentioned in our prepared remarks that we are looking at how to optimize our R&D efforts. In the past, since we didn't have Zepp OS, we needed to engineer separate software platforms for each product. Now with Zepp OS, we can apply a more platforming approach with fewer people to deliver a high-quality product. We are also streamlining our operations to generate more efficiencies in our R&D projects and our new smartwatches. So, I believe that at a reduced R&D spending level, we will be able to turn out the same quality of R&D efforts or even more with a reduced workforce. That summarizes what we're trying to achieve.

Clive Cheung, Analyst

Yes, very clear. Thank you, Leon.

Operator, Operator

The next question comes from Lisa Lee. Please go ahead.

Unidentified Analyst, Analyst

Hi, management. Thank you for taking my question. I just have one question. You mentioned further cost reductions going forward; can you please elaborate on your measures? And how should we think about quantifying further cost reductions in the fourth quarter and next year? Thank you.

Leon Deng, CFO

Thank you, Lisa. We have identified a few areas to streamline our costs. Number one is what I just mentioned regarding R&D; we are trying to apply a platforming approach to realize similar goals with a reduced workforce. Number two is on the sales and marketing expenses part. We are assessing the return on investments for our marketing investments. For example, if we sponsor a sports activity, like a marathon, we want to evaluate the return on investment closely to ensure that we're not investing in initiatives just for the sake of it. We are also examining the performance across different offline channels to determine which products to sell in each channel to achieve the best return. Lastly, we are looking into our G&A expenses, identifying where we can save or streamline services and prioritize certain requests. To answer your question, our current operating expenses are roughly RMB300 million per quarter, which includes a RMB10 million severance cost. If we exclude that, we're essentially at around RMB290 million for Q3. For Q4, we expect to streamline costs towards the RMB250 million level, serving as a first step, and we will proactively monitor the cost base into next year to see if further reductions are needed depending on the macro environment.

Unidentified Analyst, Analyst

That's very helpful. Thank you. I actually have another question. Can you also give us some guidance on your gross margin going forward?

Leon Deng, CFO

Yes. Our gross margin is picking up, although it hasn't returned to the 2021 level yet. There are two main reasons for this. First, we understand that inventory levels have created challenges, as we exited the year with high ambition but were hit by the Russian-Ukraine war and lower consumer spending in most international markets in Q1. Therefore, we have invested resources in clearing older generation products. This impacts the mix of our Q2 and Q3 gross margin, contributing to lower gross margins from clearing previous generation products. We're nearing the conclusion of this process, so we expect self-branded products' gross margins to improve as we approach the high season in Q4. Secondly, our revenue mix has shifted. Previously, Xiaomi products comprised the majority, but this year, self-branded products account for around 55% of our overall revenue mix year to date. We intend to continue this trend and anticipate that self-branded products will contribute even more to revenue growth in Q4 and next year, which should enhance our gross margin further. I hope this provides clarity on what you can expect in the upcoming quarters.

Unidentified Analyst, Analyst

Yes. That's great color. Thank you, Leon.

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 this conference call. You may now disconnect your lines. Thank you.