Youdao - Q1 2023

Transcript

Operator (participant)

Good day, welcome to the Youdao 2023 first quarter earnings conference call. 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 Youdao. Please go ahead.

Jeffrey Wang (Director of Investor Relations)

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 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 2023 Q1 financial results news release issued earlier today. As a reminder, this conference is being recorded. The 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.

Feng Zhou (CEO)

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 RMB, unless otherwise specifically stated. Q1 net revenue was RMB 1.2 billion, a decrease of 3.1% year-over-year. Loss from operations was RMB 195.8 million, up 56.5% year-over-year. Net cash used in continuing operating activities was RMB 437 million, an increase of 2.7% year-over-year. During the first half of the quarter, our main learning services and smart devices businesses faced significant challenges due to the pandemic.

The challenges gradually eased in the second half, and our business returned to growth. Despite the headwinds, our digital content services maintained a strong trajectory. In fact, its gross margin approached 70%, and net revenues covered the cost and operating expenses for three consecutive quarters. Gross billings from learning services, excluding adult courses, increased over 40% year-over-year in Q1, rising by over 70% in February and March, after falling by over 20% in January. In Q1, our advertisement business was a bright spot, with net revenues of RMB 218.1 million, representing a 79% year-over-year growth. This was mainly attributed to the expansion of customers, led by the significant upgrade of advertising technology since Q4. We foresee continued positive momentum in this sector.

In Q1, we also made notable progress with generative AI and large language model technologies that offer breakthrough abilities in knowledge reasoning, language tutoring, and other applications. This marks a significant inflection point in our six-year journey of applying modern artificial intelligence to education, which began with the release of Youdao Neural Machine Translation technology in 2017. As one of the first companies to release generative AI-powered education products, we recently launched Youdao AI Speaking in Youdao Dictionary Pen. Leveraging our proprietary generative model, we also unveiled AI Box for Youdao Desktop Translation, which utilizes our generative AI technology. The AI Box feature received an overwhelmingly positive response and contributed to a nearly 200% year-over-year increase in translation subscription fees.

Looking ahead to the full year of 2023, I am confident in the growth and improved overall health of our business, and also fruitful applications of generative AI in our products. Our controlling shareholder, NetEase Group, will continue to support our long-term development. I would like to provide more details on our business segments in Q1. We generated RMB 732.4 million in net revenues from learning services, which represented an 11.3% year-over-year decrease, primarily due to the pandemic. Nonetheless, as we just mentioned, gross billings from learning services, excluding adult courses, increased over 40% year-over-year in Q1, indicating positive momentum.

Our STEAM courses continued to see notable achievements, contributing to the overall gross billings growth. In Q1, our flagship, Youdao Literature, Youdao Guowen product, gained even more popularity, while the Minecraft collaboration project, Youdao Literature Creative Writing, Youdao Guowen Miaobi Shijie received positive feedback from more users. Additionally, the champion class of Youdao Go, released in Q4 of last year, had already coached an award-winning student who secured the top spot in a youth group championship at the British Youth Go Championship. Our child-oriented digital online reading service, Youdao Fun Reading, demonstrated promising growth in Q1 by utilizing AI algorithms to recommend books to readers of diverse ages and interests. The gross billings of Youdao Fun Reading rose by almost 40% year-over-year.

Furthermore, we were recently designated as a GESP certification service center of the China Computer Federation, signifying our recognition and leadership in competitive programming education. In terms of adult courses, our postgraduate entrance exam courses sustained a healthy momentum in Q1, posting mid-double-digit % growth in the gross billings of professional courses for postgraduates entrance exam year-over-year. Regarding smart devices, net revenue were RMB 212.7 million in Q1, representing a 16% year-over-year decline due to the pandemic. The sector saw a rebound of more than 20% year-over-year in the activation of dictionary pens in March. The rapid recovery indicates that both the education needs of our customers and our distinctive product design and features allows the device business to demonstrate resilience against the macro headwinds and the challenging consumer electronics market.

We continue to improve Dictionary Pen experience with over-the-air updates to Youdao Dictionary Pen OS. In addition to the Youdao AI Speaking feature we just mentioned earlier, our users can now access other new applications, such as Baidu Netdisk, Baidu Wangpan, and Chinese Children's Encyclopedia, Zhongguo Shaonian Ertong Baike Chuanshu. Furthermore, Youdao Dictionary Pen X5 and P5 ranked highest among a number of dictionary pens based on tests conducted by the China Academy of Information and Communications Technology, underscoring our product leadership. In addition, we recently upgraded our smart learning pad by launching a comprehensive data-based learning dashboard and other significant updates. This dashboard enables parents to conveniently monitor their children's study plans and daily learning progress.

Looking ahead to the remainder of 2023, assuming no unexpected macro events, we anticipate a continuation of the recovery in education, consumer demand, and a robust market demand for digital learning products, including both our online learning services and smart learning devices. Moreover, generative AI technology will play a significant role in driving more consumer demand for digital learning products. We also expect continued growth from our long-standing advertising business, which will contribute to our overall expansion and profitability. At Youdao, we will continue to leverage our technological leadership and innovation capabilities to deliver industry-leading experiences that serve our users, consumers, and stakeholders, while driving sustainable growth. We will continue to provide high-quality education services and deliver pioneering solutions that have a positive impact on society. With that, I will turn the call over to Su Peng to give you more details on our financial performance. Su Peng?

Peng Su (VP of Strategy and Capital Markets)

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from our Q1 of 2023. We encourage you to read through our press release issued earlier today for further details. For the Q1, total net revenue were RMB 1.2 billion, or $169.4 million, remaining stable compared with the RMB 1.2 billion for the same period of 2022. Net revenue from our learning services were RMB 732.4 million, or $106.6 million, representing an 11.3% decrease from the same period in 2022, primarily due to the decreased revenue derived from the adult and the vocational courses and other courses compared to the same period of 2022.

Net revenue from our smart devices was RMB 212.7 million, or $31 million, down 16% from the same period in 2022, primarily due to the decreased demand for the learning products in the Q1 of 2023. Net revenue from our online marketing services was RMB 218.1 million, or $31.8 million, representing a 79.7% increase from the same period in 2022. The increase was mainly attributable to the increased demands for the performance-based advertisements through the third party's internet properties. For the Q1, our total gross profit was RMB 601.9 million, or $87.6 million, representing a 6.2% decrease from the Q1 of 2022.

Gross margin for learning services was 62% for the Q1 of 2023, compared with 33.9% for the same period in 2022. Gross margin for smart devices was 39.6% for the Q1 of 2023, compared with 33.7% for the same period in 2022. Gross margin for online marketing services was 29.1% for the Q1 of 2023, compared with 23.7% for the same period in 2022. For the Q1, total operating expenses were RMB 797.6 million, or $116.1 million, compared with RMB 766.9 million for the same period of last year.

With that, for the Q1, our sales and marketing expenses were RMB 565.2 million, compared with RMB 506.4 million in the Q1 of 2022. The research and the development expense were RMB 182.8 million, compared with RMB 203 million in the Q1 of 2022. Our operating loss margin was 16.8% in the Q1 of 2023, compared with 10.4% for the same period of last year. For the Q1 of 2023, our net loss from continuing operation attributable to ordinary shareholders was RMB 204.4 million, or $29.8 million. Compared with RMB 95.4 million for the same period of last year.

Non-GAAP net loss from continuing operations attributable to ordinary shareholders for the Q1 was RMB 193.9 million, or $28.2 million, compared with RMB 70.9 million for the same period of last year. Basic and diluted net loss per ADS from continuing operations attributable to the ordinary shareholders for the Q1 of 2023 was RMB 1.67, or $0.24. Non-GAAP basic and diluted net loss from continuing operation per ADS attributable to the ordinary shareholders for the Q1 was RMB 1.59, or $0.23. Our net cash used in continuing operating activities was RMB 437 million, or $63.6 million for the Q1.

Looking at our balance sheet, as of March 31, 2023, our contract liabilities, which mainly consists of the deferred revenue generated from our learning services, were RMB 832.2 million, or $121.2 million, compared with RMB 1.1 billion as of December 31, 2022. At the end of the period, our cash equivalent, restricted cash, term deposit, and short-term investment, total RMB 601 million, or $87.5 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.

Operator (participant)

Thank you. We will now begin the question and answer session. To ask a question, you may press star, then one on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star, then two. Once again, it is star and then one to ask a question. Our first question today will come from Brian Gong of Citigroup. Please go ahead.

Brian Gong (VP and Equity Research Analyst)

Thanks, management, for taking my question. Just a very simple question. You know, this year the macro is quite weak. What are the reasons that management is quite all confident in Youdao's development for this year? What are the key drivers for the growth ahead? Thank you.

Feng Zhou (CEO)

Thank you. Thank you, Brian. In Q1, we faced a few short-term challenges due to the pandemic's impact on our primary businesses, that is, learning services and devices. However, strong advertising results partially offsets that decline. Both learning services and devices rapidly recovered in the second half of Q1. We expected a negative impact of Q1 to be a one-time event. Our confidence for the full year 2023 comes from several reasons. First, for learning services, we actually see strong demand, and we have a strong and growing product lineup. As we mentioned earlier, learning services in gross billings, excluding adult courses, grew by over 40% in Q1. That's actually quite strong growth. The growth is driven by both strong demand and the rollout of new and updated devices.

... digital content services. Including updates to Youdao Literature, digital content for high school, and also Youdao Fun Reading, as we mentioned. We have more new learning services in the pipeline for later this year, so we are confident about learning services growth. Secondly, for devices, we are also seeing good recovery and Dictionary Pen activations. That's for new devices. In March, we're up 20% year-over-year. We plan to release new devices in Q3.

We believe updates to existing devices through software and also new devices this year will also drive growth given the high market share in Dictionary Pen market and also the other products that we have. Thirdly, for ads, back in Q4, we reported accelerated growth from ads at 58%, almost 60% year-over-year. In Q1, that growth is even higher at 80%. We believe we are in an advertisement growth cycle due to two factors. One is, our significant algorithm updates to the platform in Q4 proves to be very effective, allowing us to attract more customers and more budget.

Also, in the current macro environment, businesses are actually leaning to performance ads, which is our main form of advertisement service that we render to our customers. Performance ads are what businesses are actually relying on to accelerate their recovery. We expect the advertisements growth cycle to continue. Although we had a kind of a hiccup in Q1, as I just shown, we think the overall business is in a healthy state. We are executing towards our goals this year, so we are quite confident about our development for the full year 2023. I hope that answers your question. Thank you.

Peng Su (VP of Strategy and Capital Markets)

Yeah. Yeah. Okay, Brian, just only one more point at it after those comments. We just mentioned in our in the call, and if you go to back to see the difference, the performance in the different months in the Q1 and the gross billings from... I think that gross billings, number of gross billings is kind of the indicator about the trend of our business. In January, the gross billings from our learning services, excluding the adult courses, just down about over 20% in January. Right after that period, in February and March, the gross billings from the same sectors just rising by over 70%.

You can see the different change, different performance, totally different performance in January with compared with the February and March. That's the reason why we expect contest kind of impact, this short-term impact, we'll be well event for the, for this year. Thank you.

Brian Gong (VP and Equity Research Analyst)

Thank you. That's very helpful.

Operator (participant)

Our next question today will come from Thomas Chong of CICC. Please go ahead.

Thomas Chong (Managing Director)

Thanks for taking my question. Just a quick question regarding the AI. Would you please introduce our latest progresses on artificial intelligence? As it is the most promising and eye-catching field for the investors now. Thank you.

Feng Zhou (CEO)

There's a lot of attention on the Generative AI. People say that education is one of the first areas that it'll have a big impact. We agree with that. We think Generative AI is that we see like every 10, 20 years or maybe more. We plan to leverage Generative AI as a competitive advantage. The impact of Generative AI on education and learning cannot be understated, and we are committed to driving innovation in this space. To this end, we announced the educational Large Language Model project. The aim is to develop and apply Large Language Model technology to enable personalized learning and tutoring.

Tutor that has a deep understanding of the learning materials, can quickly grasp the student's learning style and needs and provide effective teaching. This kind of tutor, AI tutor, I would say it is the holy grail of education technology. Products that harness the power of this kind of generative AI will be in high demand in the market. We are already making some rapid progress. We recognize that speed and fast iteration are essential in developing any kind of new groundbreaking technology. We have already released several generative AI-powered new products and features.

ned earlier, there is the AI Box feature in Youdao Desktop Translation, Youdao AI Speaking in Youdao Dictionary Pen, and there is a generative AI-based Go game review and suggestions in our Go course. We already have several of these products released since the launch of AI Box less than a month ago. It has been used almost a million times. That is promising early momentum. I also want to add that at Youdao, applying AI to education has already been a six year journey. We are good at it, and now the progress will be accelerated. It began in 2017 with the release of the Youdao Neural Machine Translation technology.

In 2018, we applied Transformers, the current most popular generative AI, kind of underlying technology, Transformers, to the translation engine in back in 2018. In 2019, we embedded the Transformers into the Dictionary Pen. In 2020, we developed a Transformer-based high-quality voice recognition engine. In 2022, we moved that voice translation, voice recognition engine to the device side in Dictionary Pen P5. We think we already have a head start in this area. Because of the fact that we already have a lot of investment into our technology, in particular Transformer technology, we don't expect to need to increase overall R&D expenses to deploy generative AI.

We will be leveraging our existing investments and redeploy and optimize our R&D resources in the process to do that. Finally, I would like to reiterate that we remain committed to abiding by related laws and regulations related to AI, and ensure that our technology is developed and utilized in an ethical and responsible manner. Yeah, thank you.

Thomas Chong (Managing Director)

Thank you very-.

Operator (participant)

Our next question will come from Howard Ton of Macquarie. Please go ahead.

Howard Tan (Executive and Group Treasury)

Hi, I'm Howard from Macquarie. Thanks for taking my question. I just wanted to know what is the main reason for the decline in revenue in smart devices in Q1? You have talked about it a bit. Could you elaborate a bit more? Thank you.

Feng Zhou (CEO)

Thank you. This is Feng Zhou. As we mentioned earlier, smart devices revenue was down 16% in Q1, mostly due to the pandemic. In January and early February, consumer demand was very weak, and many offline channels, many electronic stores were not open for business. However, demand quickly recovered, and channels started operating normally close to the start of the spring school semester. Therefore, in March, business rebounded with over 20% year-over-year growth in new activations of dictionary pens. That's how the quarter looks like, if you look at it month-by-month, so it's already recovering.

Right now, we think consumer demand and channels are where we want them to be since March. Our teams are working hard to drive growth with product innovations. We receive very positive feedback on the newly launched AI Speaking and Baidu Netdisk features we added to the Dictionary Pen. Because of all the publicity about generative AI, users are really eager to try features like AI Speaking. Baidu Netdisk have been the most asked for feature because a lot of users already use the Baidu Netdisk to store learning materials. The ecosystem is growing nicely.

If you look at the growth of the overall dictionary pen user base, we have nearly 40% year-over-year growth of monthly active users of active dictionary pen users in Q1. This means more customers bought the device, and more importantly, they are actively enjoying the product, and they are satisfied with the experience. This is great, and this is what brings more business for us down the road. Compare with the other consumer electronics, smart educational devices demonstrates resilience under hard macro economic circumstances. Our new smart devices are expected to be released in Q3, so we look forward to new products bringing even more better, even better experiences to our users. In terms of sales channels, we have expanded our reach by utilizing more live streaming channels. Our partnership with Li Jiaqi, Austin Li, has led to nearly 20 live streaming sessions featuring our Dictionary Pens.

The collaboration has helped to boost our sales and strengthen our brand's influence at the same time. We will be doing more of that. We expect the device revenue growth to gradually recover. We are confident in the long-term prospects of smart learning devices. I hope that answers your question. Yeah, thank you.

Howard Tan (Executive and Group Treasury)

Yeah, thank you very much for the answer.

Operator (participant)

Our next question today will come from Candis Chan of Daiwa. Please go ahead.

Candis Chan (Equity Research Analyst)

Great. Thank you, management, for taking my question. Congratulations on the very strong revenue growth of the online marketing services. Can management give us more granularity of the growth behind? For instance, maybe is it more driven by the macro recovery or the advertiser sentiment, or it is something more related to the devices or app that we are seeing greater traffic? Thank you.

Lei Jin (President)

Thank you. This is Lei Jin. As for advertising business, customer value is the first priority. We have been make a big effort to create an added value for the customers. 8% year-over-year increase from the revenue side in Q1 shows we are on the right track. There are maybe three reasons for the growth. The first is macro economy recovery spurs the demand, especially for the fast-moving consumer group. It's resulting in the revenue growth from the performance-based advertisement. Secondly, performance-based advertisement was further improved in Q1. The system was upgraded in last Q4 last year. It has provided more timely and accurate conversion data from our customers.

They give us the positive feedback on the greater precision of the marketing capabilities by AI technology. Thirdly, our AI algorithm upgrades have increased our ability to better match advertisers with the users. Our audience is mainly made up of the colleges, the graduates, young professionals and young couples. With the help of our teams, our customers have recently been very successful marketing to their audience in sectors like fast-moving consumer goods, cosmetics and food. By leveraging the power of AI, we can make more accurate predictions and recommendations, which tends to lead to better matching from our user and the customer. The positive momentum for this sector is expected to continue in Q2. Thank you.

Candis Chan (Equity Research Analyst)

Great. Thank you very much.

Operator (participant)

That concludes the question and answer session. I would like to turn the conference back over to management for any additional or closing comments.

Lei Jin (President)

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 The Piacente Group, Inc. in China or the U.S. Have a great day.

Operator (participant)

The conference has now concluded. We thank you for attending today's presentation. You may now disconnect your lines.