Youdao Inc. (DAO) Q3 2022 Earnings Call

Youdao Inc. (NYSE:DAO) Q3 2022 Results Conference Call November 17, 2022 5:00 AM ET

Company Participants

Jeffrey Wang - IR Director

Dr. Feng Zhou - CEO and Director

Peng Su - VP of Strategies & Capital Markets

Lei Jin - President

Wayne Li - VP of Finance

Conference Call Participants

Brian Gong - Citigroup

Hongyi Cao - CICC

Thomas Chong - Jefferies

Linda Huang - Macquarie

Lian Duan - Huatai Securities

Candis Chan - Daiwa

Operator

Good day and welcome to the Youdao 2022 Third Quarter Earnings Conference Call. [Operator Instructions] Today’s conference is being recorded.

At this time, I would like to turn the conference over to Mr. Jeffrey Wang, investor relations Director of Investor Relations of Youdao. Please go ahead.

Jeffrey Wang

Thank you, operator. Please note the discussion today will contain forward-looking statements, related to future performance of the Company, which are intended to qualify for the Safe Harbor from liability, as established by the U.S. Private Securities Litigation Reform Act. Such statements are not guarantees of the future performance and are subject to certain risks and uncertainties, assumptions and other factors. Some of these risks are beyond the Company’s control, and could cause actual results to differ materially from those mentioned in today’s press release and this discussion.

A general discussion of the risk factors that could affect Youdao’s business and financial results is included in certain filings of the Company with the U.S. Securities and Exchange Commission. The Company does not undertake any obligation to update this forward-looking information, except as required by law.

During today’s call, management will also discuss certain non-GAAP financial measures, for comparison purposes only. For the definitions of non-GAAP financial measures, and reconciliations of GAAP to non-GAAP financial results, please see the 2022 third quarter financial results news release issued earlier today.

As a reminder, the conference is being recorded. Besides, a webcast replay of this conference call will be available on Youdao’s corporate website at ir.youdao.com.

Joining us today on the call from Youdao’s senior management is Dr. Feng Zhou, our Chief Executive Officer, Mr. Lei Jin, our President, Mr. Peng Su, our VP of Strategy and Capital Markets and Mr. Wayne Li, our VP of Finance.

I will now turn the call over to Dr. Zhou to review some of our recent highlights and strategic direction.

Dr. Feng Zhou

Thank you, Jeffrey. And thank you all for participating in today’s call. Before we begin, I would like to remind everyone that the financial information and non-GAAP financial information mentioned in this release is presented on a continuing operations basis, and all numbers are based on Renminbi, unless otherwise specifically stated.

We had a strong third quarter with solid financial and operating results. Our net revenues reached a record-high of RMB 1.4 billion, up 35.0% year-over-year. Total gross margin climbed to a record-high of 54.2%, improving 1.6% year-over-year. These results were attributable to the strong performances of our new services and smart devices.

Sales of digital content services reached over RMB 400 million with gross margin ratio exceeding 60%. For smart devices, the first 100,000 units of the newly launched Youdao Dictionary Pen X5 have been sold out, propelling net revenues from smart devices to RMB 356.5 million in Q3, a new record. In fact, net revenues from Youdao Dictionary Pen series in Q3 this year have grown tenfold compared with Q3 2019 after Youdao Dictionary Pen 2 was launched. The first 10,000 units of Youdao Smart Learning Pad Y10 released in August have also been sold out, reflecting strong demand for this new category.

In terms of our operating loss, it narrowed to RMB 219 million with operating loss margin narrowing by 6.1% year-over-year to 15.6%. We have improved the margin structures of our business lines while growing their top line at the same time. For example in Q3, for digital content services, Youdao Dictionary Pen and Youdao Listening Pod, their net revenues could cover their costs and operating expenses, respectively.

Today we announced that the board of directors has authorized the Company to adopt a share repurchase program in the near future in accordance with applicable laws and regulations for up to USA 20 million of its Class A ordinary shares including in the form of ADS during a period of up to 36 months. We are bullish about the future growth of the business.

With that overview, I would like to share more color on our business lines in Q3. Smart devices revenue reached RMB 356.5 million in Q3, a new record for the sector and up 40.1% year-over-year. Gross margin of smart devices reached 40.4%, up 6.7% year-over-year, mainly due to the launch of new products. The application of advanced AI technology and unique learning content make us confident that the gross margin of smart devices will be around 40% in the long run.

Our new flagship Dictionary Pen, Youdao Dictionary Pen X5, is a great showcase of our strength in R&D and product innovation. In fact, in September we cannot make enough X5s due to strong demand. Not only did X5 feature even better translation precision, support for over 100 languages and a whole-new design, it also includes the world's first smart dictionary pen operating system. It allows users to download apps to customize the dictionary pen to their liking with endless possibilities.

Many top content providers were already on-board, including Ximalaya FM, RAZ English, NetEase Cloud Music and Kaishu Storytelling. They all created apps using our easy-to-use Software Development Kit and offered them on Youdao Dictionary Pens, creating a unique ecosystem that will grow stronger when more consumers and developers join in.

Recently, we launched Youdao Smart Learning Pad X10, our 2nd learning pad product, with significantly improved AI precision learning, larger screen, more storage and other improvements. In the long-term, the learning pad has significant market potential. According to Frost & Sullivan, expected volume of education tablets are likely to reach 7.26 million units in 2025, with total sales of RMB 25.4 billion. Our AI adaptive learning feature provides high-quality personalized learning for students and has received very positive feedback from consumers. Over time, we expect the Youdao Smart Learning Pad to become as popular as our Youdao Dictionary Pen.

Then let’s turn to learning services. Net revenues from learning services reached a record-high of RMB 888.5 million in Q3, up 37.2% year-over-year, with a relatively flat gross margin of 64.5%. Breaking this down a bit further, net revenues from STEAM courses increased by more than 200% year-over-year and accounted for over 25% of the net revenues of this segment.

We continued to make progress on the Youdao Go course. In collaboration with the Chinese Weiqi Association and the Jiangsu Chess Sports Association, we held the National Children’s Weiqi Open Championship in Q3, which was highly recognized by the General Administration of Sport of China.

As for adult courses, we see a downward trend in gross margins year-over-year, mainly due to the macro environment. We are actively realigning our resources to focus on growth areas in this segment. Graduate school entrance exams and vocational courses are two bright spots. Their gross billings increased by over 150% and over 200% year-over-year respectively.

Looking forward, we are confident in our operations in Q4. The transition from regulatory changes last year is mostly finished. For the last four quarters, we have maintained our investment level for our business, kept innovating in challenging times, and this allowed us to gain share in the market. It was made possible by the long-term investment in AI technology and a diversified product portfolio, and also by firm support from our parent NetEase group.

Going forward, we believe we are in a good position today to achieve sustainable growth and drive towards profitability with a portfolio of strong products and businesses. Our team continues to capitalize on tailwinds including the quick adoption of smart learning devices, digital content services and STEAM courses. We look forward to bringing our products and services to more and more consumers.

With that, I will turn the call over to Su Peng to give you more details on our financial performance. Su Peng?

Peng Su

Thank you, Dr. Zhou, and hello everyone. Today I will be presenting some financial highlights for the third quarter of 2022. We encourage you to read through our press release issued earlier today for further details.

For the third quarter, total net revenues were RMB 1.4 billion, or USA 197.2 million. This represents an increase of 35% from the third quarter of 2021.

Net revenues from our learning services were RMB 888.5 million, or USA 124.9 million, representing a 37.2% increase from the same period in 2021. We attribute this growth to the strong sales performance from the new services initiated after the implementation of the “Double Reduction” Policy.

Net revenues from our smart devices were RMB 356.5 million, or USA 50.1 million, up 40.1% from the same period in 2021, driven by the popularity of the newly launched products in 2022.

Net revenues from our online marketing services were RMB 157.5 million, or USA 22.1 million, representing a 14.9% increase from the same period in 2021. The increase was mainly attributable to the increase in performance-based advertisements through third parties’ internet properties.

For the third quarter, our total gross profit was RMB 760.2 million, or USA 106.9 million, representing a 39% increase from the third quarter of 2021.

Gross margin for learning services was 64.5% for the third quarter of 2022, compared with 65% for the same period in 2021. Gross margin for smart devices was 40.4% for the third quarter of 2022, compared with 33.7% for the same period in 2021. Gross margin for online marketing services was 27.1% for the third quarter of 2022, compared with 29.2% for the same period in 2021.

For the third quarter, total operating expenses were RMB 979.2 million, or USA 137.7 million, compared with RMB 772.6 million for the same period of last year.

With that, for the third quarter, our sales and marketing expenses were RMB 709.8 million, compared with RMB 553.4 million in the third quarter of 2021. Research and development expenses were RMB 212.9 million, compared with RMB 163.6 million in the third quarter of 2021.

Our operating loss margin was 15.6% in the third quarter of 2022, compared with 21.7% for the same period of last year. For the third quarter of 2022, our net loss from continuing operations attributable to ordinary shareholders was RMB 183.9 million, or USA 25.9 million, compared with RMB 225.3 million for the same period of last year.

Non-GAAP net loss from our continuing operations attributable to ordinary shareholders for the third quarter was RMB 164.4 million, or USA 23.1 million, compared with RMB 200.2 million for the same period of last year.

Basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for the third quarter of 2022 was RMB 1.49, or USA 0.21. Non-GAAP basic and diluted net loss from continuing operations per ADS for the third quarter was RMB 1.33, or USA 0.19. Our net cash used in continuing operating activities was RMB 294.1 million, or USA 41.3 million, for the third quarter.

Looking at our balance sheet, as of September 30, 2022, our contract liabilities, which mainly consist of deferred revenue generated from our learning services, were RMB 996.5 million, or USA 140.1 million, compared with RMB 1.1 billion as of December 31, 2021. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB 953.1 million, or USA 134 million.

This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Brian Gong with Citigroup.

Brian Gong

Congratulations on the solid results. So I saw the revenue increased roughly in the third quarter and may I know what's the main contributors to our rapid transition? And how should we look at the growth trend in the future?

Dr. Feng Zhou

So as for Q3 growth, so data content services and smart devices are 2 main drivers for this quarter for our growth. And both are -- based on our strength in technology R&D, as you know. So digital content service are doing well. So compared with the online services that we offer before, they -- the difference is they are mostly -- they're mostly contains prerecorded video content or interactive learning or STEAM content STEAM courses. As with our courses before, they are live courses mainly. So the form is different.

So it's a new product after last year. So in Q3, digital content services have maintained strong momentum. So sales reached over RMB 400 million compared with over RMB 200 million in Q2. So basically doubled quarter-to-quarter. So while gross margin also rose from over 50% in Q2 to over 60% in Q3. So more over net revenues from digital on services can cover their costs and operating expenses in Q3. So this supports our bottom line improvements in this quarter.

So second, Smart Devices revenues are at, as you can see, a record high of RMB M356 million, up 40% year-over-year in Q3. Moreover, this growth also comes with a healthy operating metrics. So net revenue from Youdao Dictionary Pen and Youdao Listening Pod, for these 2 products, they can also cover their own costs and expenses in Q3. So one product that's pretty important is Dictionary Pen X5 launched in August.

So this new generation of Dictionary Pen supports online translation of over 100 languages and is equipped with the world's first Dictionary Pen operating system, smart operating system. So after its release, it's already the top seller of Dictionary Pens or electronic dictionaries on both JD.com and Tmall, selling out the first batch of 100,000 units quickly. So the launch of another product is the launch of Youdao Smart Learning Pad Y10 and also more recently, X10.

So this marked our entry into the learning tablet market and also the first batch of 10,000 Y10 units sold out in about 2 months. So that gives our teams more confident in this category. So our plan is to have a steady flow of new product -- new learning smart devices products to drive sustainable growth in this category. So recently after Q3. So we launched 3 more new products. That is Youdao Dictionary Pen P5 for more advanced learners and professionals.

And also, Youdao Smart Learning Pad X10, I just mentioned. So with the learning dashboard that further improves the AI precision learning experience and lastly, an upgraded version of Youdao Listening Pod with new English and Chinese content in line with textbooks. Also with more advanced AI technology helps users improve listening and speaking skills in both English and Chinese. So given the strong pipelines we sold more than 100,000 units of Youdao Dictionary Pens in the Singles Day on November 11 shopping festival this year, so over 100,000 is Youdao Dictionary Pens. Yes. So that's an overview of drivers of growth for Q3.

Operator

Our next question comes from Hongyi Cao with CICC.

Hongyi Cao

Congratulations on the good performance. We can see the strong growth of net revenue, but Youdao still face the operating loss. So my question is, what are our strategies for improving the loss-making factors?

Dr. Feng Zhou

That's a very natural question. So first, I would say that driving towards profitability is a priority for us. The operating loss in Q3 mainly came from our early-stage products and businesses. These include STEAM courses, Youdao Smart Learning Pad of the new device and education digitization solutions. These are the 3 significant loss makers. Yes, we have plans for profitability for each product area here.

So let me break that down a little bit. So our STEAM courses, they are growing fast, and we believe they have a bright feature. For this segment, what we are doing is to optimize our product offerings and marketing tactics. And we're seeing continuous improvements in return of investments every month. The Go courses are more mature over all the STEAM courses. Our other STEAM courses such as chess programming, science music and Chinese painting, they are mostly still in their early days.

So the investments we made in these areas, they are paying off. So Youdao Go and it's compelling app has accumulated over 1.6 million users and it's already the leader in online Go learning in China. That's for the Steam courses. For Smart Learning Pad, it is a strategic product for us and it is in the early stages. The opportunity here is that the learning pad market is going through a generational transformation from a hardware and content-based business to a technology-centered AI adaptive learning based business.

We are taking advantage of this transformational opportunity, and it is a very good investment for us. And very importantly, the first 2 products, Y10 and X10, they are off to a good start, and we believe they have a bright future. As for the third category, the education digitization solutions, we recently reduced our resources here. There are progress in our products and services here.

So our campus board education digitalization solution with Vision analytics was released and started to enter schools and schools like them. However, due to macroeconomic challenges, the landscape has been different from our projections 1 or 2 years ago. Yes, spending on digitalization solutions has been slower than we expected. So our goal here is to find better product positions in this challenging environment with less resources and achieve profitable growth.

So all in all, if we add all our business that's operating profitably and also the -- these 3 loss makers together, we've been able to narrow our net operating cash outflow to RMB 294 million in Q3. Operating loss also improved to RMB 219 million with operating loss margin improving 6.1% year-over-year. Going forward, the plan is to operate prudently growing the business while, at the same time, drive towards profitability. I hope that answers the question.

Operator

Our next question comes from Thomas Chong with Jefferies.

Thomas Chong

In Q2, I think we mentioned that we are confident in the prospect of second half of this year. Would you please share your Q4 expectations?

Dr. Feng Zhou

Yes, I think yes, you have seen our Q3 numbers. And the solid Q3 financials and operating results, they give us confidence in Q4. So net revenue reached RMB 1.4 billion in Q3, so up 35% year-over-year. So one thing is even if you compare the net revenue in Q3 to Q3 last year and Q3 2020, without giving effect to the recent disposal of our academic AST business, revenues still increased by 1.1% and 56.5%, respectively. So in Q4, we will keep focusing on the healthiness of our key financials and operating indicators. That's for sure.

As for learning services, Q3 -- Q4 is the retention season for STEAM courses, which is expected to have a positive effect on the cash flow and other financial metrics. Besides digital content services released in Q2 have performed well in sales and gross margin over the past 2 quarters. In terms of smart devices, Q4 is typically the season with the November 11 and December 12 shopping festivals. Our smart devices sales performed well during the November 11 shopping festival with the aggregated sales of RMB 100 million in Tmall, JD.com and Douyin up over 80% year-over-year.

So in terms of Youdao Dictionary Pen, has retained the leading position in sales in its category for 3 consecutive years in both Tmall and JD.com. Youdao Listening Pod also ranked number one in sales in this category in JD.com. I think this all bodes well for Q4. Today, we announced that the Board of Directors have authorized us to adopt the share repurchase program in the near future for up to USA 20 million. It basically reflects management's confidence in the business, both in the short term and in the long-term. Yes, I think that's all for me. Su Peng, do you have anything to add?

Peng Su

This is Su Peng. Just one more comment added after the Dr. Zhou we think about our expectation for the Q4. If you -- the business, we expect to maintain the momentum of the business growth and whatever in the digital conserves but also in the smart devices and the rest of the sector we are you might see in. And we feel confident about this growth and we see we find the great potential of the market from the customers' demand. And that's why we think about the confidence.

And also, we still have enough capabilities we invest with our new categories in the learning products as well as the new server initiatives, new services after the policy change. If you look at our balance sheet, we still have almost RMB 1 billion cash in our balance sheet as well as we do have about USD 230 million revolving the flow in from the net school that gives us the more capabilities to invest and waiting for -- and see the feedback from the market and that we will feel about the promising about the market in the long run. I hope that answers your question.

Operator

Our next question comes from Linda Huang with Macquarie.

Linda Huang

My question is regarding for the learning devices because we launched a very successful the learning tablets in the second quarter. So can you share with us how do you think about the future for this product, especially management, you just mentioned about the very -- the sizable addressable market. So what kind of the market size we can capture in the long-term? And we also hope that the management can share with us what is the product strategy? Maybe you can explain with us regarding for your products back and the pricing strategy?

Peng Su

This is Su Peng. And first of all, we are still confident about our products of Youdao learning pad and -- because we see about great demand in smart market. And we expect -- if you -- according to the Sullivan, and -- Frost & Sullivan expected volume of education tablets is likely to reach about 7 million units in 2025 and with total sales above RMB 25 million, as we mentioned. And as we mentioned in the last call, we actually remember, we said we feel confident of our products. And last time we just released in August, we released our new products of Youdao, AI Smart Learning Pad and it's Y10, it's released in August and have been -- right now, I think, has been sold out for the first batch of the 10,000 units. And that's, I think, reflecting the strong demand from this new category.

And more recently, we just released about our next-generation Youdao Learning Pad, it's called X10 and we think that we have upgraded about definitely in the features and functions and there will be more precession on AI diagnostics, and we think about that will be more expected more suitable for the student learning road maps, and we think we try to build up kind of that road map for the individual student to provide highly customer services for the different students based on our technology. So that's why we think about the -- feel confident about our products.

And even right now, we see -- still see production, a lot of demand from the market and right now it's at a very early stage to see about finally, how much market we will account for the smart tablets market. But right now, we see the fast growth of our product sales week by week. So we think that shows our product -- part of our successful product strategy, and we will keep investing in this market and whatever we will upgrade our products and upgrade the features and provide more diversified services to the -- to our customers. That's the way I think about that's our strategy and what's the expectation for this market.

Dr. Feng Zhou

Yes. So let me add a few points. So first, the addressable market of learning tablets are larger than probably larger than Dictionary Pen. So if you look at different numbers, it's either 5x, 6x or maybe 10x larger. So that's -- so that's a very good market to be in if we can actually take shares from it. And the reason we think we are at a very good position to get our tablets into the hands of a lot of consumers is that, as I said, it's an AI-driven product.

And from our experience for the last few years, so we -- whenever we can come up with really useful AI experiences like for the Dictionary Pen, the very quick translation look up of its -- Dictionary Pen. And also, for example, for our recent Dictionary Pen P5, you can scan multiple lines with a single swipe of the pen. Whenever we can come up with experiences like this, we will be at a good position in the market. So the product will have good reputation, and we will have lower marketing costs and everything. Things work in our favor.

And we are going to just do that for the learning pad. And there are first 2 products have already bring new experiences to our users. That's one. And the other point I want to make is that is that we will be using a pretty quick product patents, as you have seen. So we have already released 5 different SKUs this year already, and that's faster than last year. And that's because our teams have been gaining more and more experienced. We have gaining more know-how in the supply chain of learning hardware.

And we are also getting more intellectual properties, more patents and everything. We have more of that already in place, so we can innovate faster. And we are also building an ecosystem of content providers as we have seen in the Dictionary Pen OS initiative. So that's also going well. Yes. So with that, I think we can -- we are at a good position to with a lot of effort from the team, of course, to be able to achieve a leading position in the learning tablet market.

Peng Su

Yes, Linda, so just one more point to add here. And just if you go back to see our strategy of our Dictionary Pens, and you can see that and we spent almost 2 years to increase about 10x in terms of the number of sales of units. So I think we expect -- we also think for the AI tablets market is for us is a long-term strategic investment. We are not -- we will be patient.

And we -- that's -- we expect to copy our successful strategy in our Dictionary Pen in our smart tablets. So that's what we exactly expect for this special category. And so we have to -- right now, we're at in the investment stage and just at various stage, it's just beginning, and we expect we can receive a lot of very strong demand and positive feedback from the markets. That's our expectations from this new categories. Thank you.

Operator

The next question comes from Lian Duan with Huatai Securities.

Lian Duan

In recent quarters, we saw adult courses face some challenges. What is our strategy for improving the business?

Lei Jin

This is Lei Jin. Yes, your question is, yes, the adult courses face challenges. And given the macroeconomic factors and the pandemic, we adjust our strategy from the interest-related courses to the segment that students have better chance to get their job. There are graduate school entrance exam preparation and vocational education, such as digital skill improvement. We have been seeing a booming demand from the graduate school entrance exam. There is a record high number of registers of 4.5 million this year and 21% growth year-over-year and double the number from 2017, it is likely to grow further in the coming years because the higher education means higher profitability for better.

As our Youdao campus recruitment post-graduate resumes have accounted for over 70% of total candidates for the 5 years. Our graduate school entrance exam course is focused on personalized service, as we know choosing a suitable college and subject is a key factor. So our AI assistant application consulting service offer a tailor-made device to students based on their own academic performance and the big data of the [regular desk] college recruitment. We are OMO services, especially in the pandemic conditions create a comprehensive experience in the online learning and offline summer camp.

In terms of user acquisition, we have the most popular study APPs for college students in China, including Youdao Dictionary and China University MOOC. In Q3, over 50 of the gross billings came from this organic traffic and increased over 150% year-over-year. Vocational education especially digital skill improvement is the other focus. It is consistent with the government's policy direction of boosting employment.

Our digital skill process, mainly include data analysis and youth driven design provide a virtual training system where learners could easily log in and practice with web browser on a PC. With the virtual system, the training environment has already been set up and other operations by the learners can be recorded and replayed. Tutor could also have guidance and feedback in the online system convenience. With the easy-to-use system, we can see approaching 100% year-over-year growth of the gross billings from this case in Q3.

Operator

Your next question comes from Candis Chan with Daiwa.

Candis Chan

Great. Good evening management, congrats on the solid set of results. We actually see that for this quarter, the gross margin of Learning Services indeed has been very strong at close to about 65%. So I wonder whether this margin level will be sustainable in the following quarters? And any colors on the margin trend of learning services for the next year? That would be great.

Wayne Li

Thank you for your question, Candis. This is Wayne. You're seeing our gross margin for quarter 3 arrived at around 55%, up 13% quarter-over-quarter, which mainly contributed to the benefit from economic skill from the higher revenue base and improved margin for the digital content services. We are pleased to see the gross margin return to the similar level as last year after we experienced a transitional period since the release of double reduction policy last year.

In last quarter, we got a relatively low revenue base for our learning services due to the service transition, which directly resulted in decreased gross margin performance during the last quarter. With the launch of our new services with digital content services since quarter 2 and the relevant sales increased very quickly and reached over RMB 400 million in this quarter, along with over 60% gross margin increased from 50% in Q2. With the further expansion of our new services, we expect to enjoy good benefit on the economic skills and higher gross margin whatever for Q4 or next year.

Although business fluctuation will expect it. But in the long run, we are very confident in our revenue growth of learning services as well as its gross margin. Just for the learning services gross margin, Actually, I'd like to add some other color to our Smart Devices gross margin performance as well. In this quarter, the gross margin of smart devices increased to around 40% from 34% for the same period of last year, which mainly contributed from the sales of X5 which carry with a higher gross margin.

Youdao has the advanced AI technology has reached learning content and good at technology innovation, which brings us the advantage in product and more premium price. But note, we also believe a higher gross margin will be achieved for our smart devices. So that's all. Thank you for your questions.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to the management for any closing comments.

Jeffrey Wang

Thank you once again for joining us today. If you have any further questions, please feel free to contact us at Youdao directly, or reach out to TPG Investor Relations in China or the U.S. Have a great day.

Operator

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