Youdao - Earnings Call - Q1 2025

Transcript

Operator (participant)

Good day, and welcome to Youdao's first quarter 2025 earnings conference call. All participants are in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star then two. Please note this event is being recorded. I will now leave the conference over to Jeffrey Wang, Investor Relations Director. Please go ahead.

Jeffrey Wang (Director of Investor Relations)

Thank you, Operator. Please note the discussion today will contain forward-looking statements related to the 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 future performance and are subject to certain risks and uncertainties, inceptions, 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 company filings 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 2025 first quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. A web coverage 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 are Dr. Feng Zhou, our Chief Executive Officer, Mr. Lei Jin, our President, Mr. Peng Su, our Senior President, and Mr. Wei 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. Thank you all for participating in today's call. Before we begin, I would like to remind everyone that all numbers are based on RMB unless otherwise specifically stated. In the first quarter, we significantly boosted profitability while executing our AI-native strategy through product development. Operating income reached a Q1 record of RMB 104.0 million, a surge of 247.7% year-over-year. Net revenues were RMB 1.3 billion, declining 6.7%, primarily due to decreased learning services revenue. Operating cash outflow narrowed by 34.7% to RMB 255.5 million, reflecting stronger financial efficiency. Product R&D accelerated in Q1. We launched Confucius 01, our first open-source reasoning model. We trialed with key clients Youdao Magic Box, an AI-powered app creator suite. We also introduced Space One, our first large-screen tutoring pen.

These advances reinforce our AI-native strategy that is applying large language model technology to critical learning and advertisement scenarios, solving real-world challenges, driving user satisfaction, and business growth. Now, let's look at our business lines. In the first quarter, although net revenues from the learning services segment declined by 16.1% year-over-year, the rate of decline narrowed by approximately 5 percentage points compared to the previous quarter. Net revenues covered the segment's costs and operating expenses, and they yielded meaningful profits. Within the learning services segment, net revenues from digital content services were RMB 410.8 million in Q1. The product team enhanced Youdao Ling Shi's college planning solutions using our proprietary Confucius LRM.

The upgraded AI college admission advisers now feature six integrated components: 24x7 online Q&A services, comprehensive university and program databases, specialized proprietary courses and materials, professional assessment tools, and AI-powered recommendation system for school selection and predictive admission analytics. This comprehensive ecosystem has significantly improved our differentiated user experience, contributing to over 25% year-over-year growth, gross billing growth in Q1, and recently improved retention rates. In STEAM courses, our programming courses saw strong gross billing growth of over 40% year-over-year, fueled primarily by strong demand for GESP, that is, grade examination of software programming preparation courses and more efficient customer acquisition channels. Our AI-driven subscription services generated nearly RMB 70 million in Q1 sales, growing over 40% year-over-year.

On the model development front, we open-sourced Confucius 01 in Q1, a lightweight 14-billion-parameter reasoning model that delivers competitive K-12 performance while being significantly more cost-effective and easier to deploy than larger alternatives. We also enhanced our flagship translation model through multimodal fusion and online direct preference optimization, DPO training, achieving quality improvements, cost reductions, and increased adoption. The translation model now processes over 1.5 billion tokens daily as of April, representing 100% growth since Q1. Additionally, we recently started self-hosting full-size DeepSeek R1 inference for our products instead of relying on third-party DeepSeek model services, improving latency and stability while reducing costs at the same time. Moving on to our applications, the upgraded Mr. P AI Tutor now features a multimodal visual system with over 92% accuracy for K-12 problem-solving, up from 85% last year, and is available across both the Mr. P app and our hardware devices.

We recently launched Youdao AI Podcast Assistant, Youdao Wendao, an innovative audio synthesis platform that instantly converts text documents like PDF, Word files, and web pages into studio-quality podcasts, earning a featured recommendation on the Apple App Store. We also introduced our AI-powered academic paper plagiarism detection system, which detects AI-generated content in academic writing while providing actionable suggestions to enhance originality and quality. Turning to online marketing services, Q1 net revenues rose 2.6% year-over-year to RMB 505.4 million. Our performance-based advertising client base grew by 20% year-over-year in Q1, reflecting the successful scaling of our client acquisition efforts, a key driver for future performance app growth. In overseas advertising, we have recently secured official Google Partner certification, complementing our existing TikTok partnership. These collaborations provide access to premium ad inventory and optimization tools, enabling more impactful international campaigns.

Technology remains at the heart of our advertising strategy. Leveraging our Confucius LRM, we launched Youdao Magic Box, an AI-powered creative suite that automatically produces high-quality ad assets, including images, videos, and dynamic templates. This innovative solution is poised to play a pivotal role in transforming content creation workflows. In addition, we have deepened the collaboration with NetEase Group through two operational initiatives. First, we strengthened our partnership with NetEase Games, driving over 50% year-over-year growth in advertising revenue from gaming industry clients. Second, we enhanced the collaboration with NetEase Cloud Music, expanding the range of advertising scenarios available to advertisers. Gross margin from online marketing services moderated to 30.5% in Q1, an approximately 4 percentage point decline year-over-year. This primarily reflects our strategic emphasis on client acquisition, as newer clients typically impact margins during initial onboarding.

Looking ahead, we anticipate the segment's gross margin to stabilize between 25%-35% in the medium to long term. Our smart devices segment delivered RMB 190.5 million in Q1 revenues, representing a 5.1% year-over-year growth. In February, we introduced Youdao Space One, an AI-powered large-screen tutoring pen featuring our Confucius multimodal LLM. This innovative device offers precise image recognition, photo to speech conversion, and voice dictation capabilities, significantly broadening application scenarios while improving the learning experience. The product's strong market perception was evident as the initial inventory sold out within 10 days, contributing to over 20% year-over-year growth in our dictionary pen revenue during the quarter. Moving forward, we will accelerate the integration of our Confucius large language model across both learning and advertising verticals, executing our AI-native strategy to elevate user experiences while driving greater growth.

Having achieved our first full-year operating profits in 2024, we are now strategically positioned to maintain this positive trajectory, targeting accelerated profit growth and achieving operating cash flow break-even for full year 2025. With that, I'll pass the call to Su Peng for a detailed review of our financial performance. Thank you.

Peng Su (Senior President)

Thank you, Dr. Zhou, and hello everyone. Today, I will be presenting some financial highlights from the first quarter of 2025. We encourage you to visit our press release issued earlier today for further details. For the first quarter, total net revenue was RMB 1.3 billion, or $178.9 million, representing a 6.7% decrease from the same period of 2024. Net revenue from our learning services was RMB 602.4 million, or $83 million, representing a 16.1% decrease from the same period of 2024. The year-over-year decrease was mainly because we continue to take a strategic approach to customer acquisition, which places greater emphasis on high ROI, return on investment engagement. We believe despite the short-term revenue decline, this strategy has enhanced the overall resilience and operational efficiency of our business.

Net revenue from our smart devices was RMB 190.5 million, or $26.3 million, up 5.1% from the same period of 2024, which was primarily driven by the continued increase in sales of Youdao Dictionary Pen in the first quarter of 2025. Net revenue from our online marketing services was RMB 505.4 million, or $69.6 million, representing a 2.6% increase from the same period of 2024. For the fourth quarter, our total gross profit was RMB 614.2 million, or $84.6 million, representing a 9.9% decrease from the same period of 2024. Gross margin for learning services was 59.8% for the first quarter of 2025, compared with 63.1% for the same period of 2024. Gross margin for smart devices was 52.3% for the first quarter of 2025, compared with 32.6% for the same period of 2024.

Gross margin for online marketing services was 3.5% for the first quarter of 2025, compared with 34.3% for the same period of 2024. For the first quarter, we reduced our total operating expense to RMB 510.2 million, or $70.3 million, compared with RMB 651.6 million for the same period of the last year. Looking at our expense in more detail, sales and marketing expense declined to RMB 357.6 million, compared with RMB 455.4 million in the first quarter of 2024. Research and development expense was decreased to RMB 115.5 million, compared with RMB 146.7 million in the first quarter of 2024. Our operating income margin was 8% in the first quarter of 2025, compared with 2.1% for the same period of last year.

For the first quarter of 2025, our net income attributable to ordinary shareholders was RMB 76.7 million, or $10.6 million, an increase of over six times from the RMB 12.4 million for the same period of last year. Non-GAAP net income attributable to the ordinary shareholders for the first quarter was RMB 81.7 million, or $11.3 million, significantly increased from the RMB 20.3 million for the same period of last year. Basic and diluted net income per ADS attributable to the ordinary shareholders for the first quarter of 2025 were RMB 0.65, or $0.09, and RMB 0.64, or $0.09, respectively. Non-GAAP basic and diluted net income per ADS attributable to ordinary shareholders for the first quarter was RMB 0.69, or $0.10, and RMB 0.68, or $0.09, respectively.

Our net cash used in operating activities was RMB 255.5 million, or $35.2 million for the first quarter. Looking at our balance sheet as of March 31st, 2025, our contract liabilities, which mainly consist of the different revenue generated from our learning services, were RMB 711.2 million, or $98 million, compared with RMB 961 million as of December 31st, 2024. At the end of the period, our cash, cash equivalents, current and non-currently received cash, and short-term investment totaled RMB 424.5 million, or $58.5 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)

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 the handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. Your first question comes from Brian Gong with Citigroup.

Brian Gong (Internet and Media Research)

Yeah, thanks for taking the question. A very good question on AI. I noticed our AI tutor integrated DeepSeek ahead of our peers in the first quarter. From a medium to long-term perspective, how does management view the differentiation between Youdao's large language model conclusions and other large language models in educational scenarios? Thank you.

Feng Zhou (CEO)

Hi, Brian. Yeah, so let me take the question. From day one of large language model development back in early 2023, we've emphasized the importance of embracing open technologies. This year, the release of DeepSeek R1 provided the perfect opportunity for us to exercise that strategy. That is why we are the first in the edtech industry to integrate it into our LLM stack and Mr. P AI Tutor in Q1, giving users options of models to solve K-12 problems. At the same time, our proprietary model, Confucius, has been evolving since 2023. In January, we released a major leap with Confucius 01, actually before the DeepSeek R1 release. Confucius 01 was the first open-source educational reasoning model capable of step-by-step exposition while being far more GPU efficient than general-purpose models.

This next-generation Confucius is now also deeply integrated across our learning services, so AI-driven subscriptions and also smart devices, solidifying our leadership in deploying large language models for education in China. Let me highlight three key advantages of combining open and proprietary technologies for you. The first, we believe, is this dual approach enhances user experiences. Confucius delivers faster responses while DeepSeek R1 often provides more comprehensive answers. We've observed that users very naturally adopt the Confucius for quick checks and the DeepSeek for in-depth explanation. Currently, actual usage is split roughly evenly. Second, we believe open technologies accelerate our teams and technology growth. Just as Google Android leverages the Linux kernel, we benefit from the broader ecosystem while contributing back. This dynamic environment pushes our teams to iterate faster, keep us at the forefront of innovation. Thirdly, Confucius excels in education-specific scenarios.

Thanks to the continuous refinements, it outperforms general-purpose models in a few very important areas. First is translation quality. Confucius leads the industry in translation accuracy, a core capability for our platforms, while operating at a fraction of the cost of general-purpose models. As noted earlier, we've completed our year-long transition from NMT to LLM translation, now processing over 1.5 billion tokens every day. The second strength of the Confucius model is Q&A accuracy. With recent multimodal upgrades, Mr. P AI Tutor achieves over 92% accuracy in K-12 problem-solving. That is a seven-point year-over-year improvement over last year, significantly surpassing standalone DeepSeek performance in these scenarios. We are also optimizing our use of DeepSeek by migrating DeepSeek R1 inference to our fully internal deployment. We've achieved 99.9% availability, lower latency, and also greater cost efficiency with further optimization still ongoing.

Our progress has gained a lot of recognition. Actually, Time Magazine recently ranked Youdao as the world's number two edtech company among over 7,000 firms, underscoring our leadership in LLM deployment and operational excellence. Moving forward, we'll deepen our focus on educational verticals, enhancing Mr. P's accuracy while also expanding Confucius into more areas, including lesson planning, grading, and assessments. Exciting products and model updates are coming this summer, and we look forward to sharing them soon. Thank you.

Brian Gong (Internet and Media Research)

Thank you.

Operator (participant)

Your next question comes from Liping Zhao with CICC.

Liping Zhao (VP)

Good evening, Dr. Zhou, Mr. Su, and Ms. Li. My question is about your learning service. I noticed that the net revenue from learning service segments remained year-over-year declined during the first quarter. When does you project the segment's revenue to return to growth? Thank you.

Peng Su (Senior President)

Thank you, Brenda. This is Peng Su. I will handle the question first. I think our adjustment for the learning service segment initiated last year remains ongoing right now. We have intensified our focus on service with the robust demands and significant growth potentials, such as the Youdao Group while scaling back non-essential offering. As we mentioned in the last two quarters, it will be accomplished in this year. Although the net revenue from the learning service segment still declined from year-over-year basis in Q1, the rate of decline narrowed by roughly 5% compared to the previous quarters. This improvement was primarily driven by the resilient performance of the Youdao Ling Shi during this quarter. We believe there are several points to support the sustainable growth of the Youdao Ling Shi business.

The first is about China's paid college entrance exam advisory service market has been demonstrating significant growth potentials in recent years, driven by the evolving college and school selection rules under the new Gaokao policies, and at the same time, the family's urgent needs to bridge the information gaps. In Q1, we launched an upgraded AI college admission advisers powered by our large language models, offering the user professional, efficient, and tailor-made one-stop services. This service gained the immediate users' recognition and driving the Youdao Ling Shi Q1's gross billing to grow by over 25% year-over-year. Looking forward, we expect a sustained rapid growth for our AI college admission advisers. Our Confucius modeling continuous advancements will further refine the recommendation accuracy while our pricing, which at least adds less than 10% of the traditional advisory fee, makes quality guidance accessible to more families.

At the same time, we just noticed about the recent education construction plan online has been released, which emphasizes cultivating the top tier's innovative talents and including the outstanding talent program for exceptional high school students. We will definitely actively monitor the policy development and leverage our premium resources and product expertise to capitalize on these emerging opportunities. In summary, we anticipate completing our segment restructuring in the second half of this year, with revenue stabilizations expected thereafter. For our flagship Youdao Ling Shi services, we project both revenue and profit to achieve year-over-year growth in this year. Thank you, Brenda.

Operator (participant)

Thank you. To our next question comes from Thomas Chong with Jefferies.

Thomas Chong (Managing Director)

Hi, good evening. Thanks, Management, for taking my question. My question is about online marketing services. As we see revenue from online marketing services has remained at around RMB 500 million for six consecutive quarters, when does Management anticipate a reacceleration in revenue growth? Thank you.

Lei Jin (President)

Hi, this is Lei Jin. Assuming the stable market conditions and the execution of our business plan, they expect online marketing services revenue will show stronger growth momentum in the second half of this year compared to the first half, driven by three key factors. First, accelerated overseas advertising expansion. After obtaining Google's official partnership status in Q1 and completing certification, we are now implementing collaborative initiatives that should contribute meaningfully to H2 revenue. Additionally, our TikTok advertising revenue maintains strong growth in Q1, a trend we expect to continue through the year-end. Second, updated AI-powered advertising solutions. Our Q1 launch of Youdao Magic Box and AI-driven One-Click AD Creator two marked the first step to our enhanced capabilities. We are currently developing our AI advertising optimizer with a beta version launching in Q2 and a full release planned for H2.

This system will automatically generate compliance strategies, including targeting scenarios and budget allocation, aligned with advertiser objectives while continuously optimizing through real-time LLM insights and adaptive recommendation models. Third, deepened collaboration with NetEase Group. In Q1, they leveraged our aggregation and data analytics expertise to enhance the efficiency of NetEase gaming promotions. In particular, for global promotions, our oversea influencer network now encompasses 15 million creators across 75 countries, reaching over 2 billion users directly. NetEase advertising bandwidth with us grew steadily in Q1. With this positive trajectory, it is expected to continue. Regarding tariff impacts, now the uncertainty duties may present challenges for acquiring oversea e-commerce clients. This segment currently represents a minor portion of total ad revenue, making the overall effect negatively stable. We should note that H2 performance remains subject to macroeconomic conditions in domestic and international markets, which could introduce operational variabilities. Thank you.

Operator (participant)

Your next question comes from Bo Zong with Huatai Securities.

Yu Zhang (Research Analyst)

Hello. Thanks for taking my question. This is Zhang Yu of Huatai. My question is, last year was Youdao's first full year of profitability. Among the four quarters, only the second quarter reported a downward drop. Is there a possibility of profitability in the second quarter this year?

Wayne Li (VP of Finance)

Thank you, Zhang Yu. This is Wayne Li. I will take your question. Our financial performance throughout 2024 and Q1 2025 demonstrates significant and sustained possibility improvements. This program validates the success of our strategic initiative across three critical areas. First, sharpen focus on high-margin digital content advertising and AI-powered subscriptions. Second, comprehensive AI-native transformation boosting operational efficiency. The last one is to simplify the cost optimization. By concentrating resources on Youdao Ling Shi, online marketing services, and other key initiatives, we've successfully contained the losses from non-core operations. Our AI integration has revolutionized multiple business functions, from cost operations to ad production and R&D, delivering higher efficiency and profitability levels compared to our historical performance. Historically, Q2 has remained unprofitable mainly due to two seasonality reasons. First, Q2 is traditionally the weakest quarter for revenue generation from learning services and smart devices.

Second, substantial sales and marketing campaigns for summer enrollment, which typically begin in June. For Q2 this year, we will maintain our strategic priorities like large language model deployment and cost development by further optimizing our cost structure in line with our full-year profitability goals. Our ongoing investments in core offerings like Youdao Ling Shi may temporarily wait to present. This program is designed to stand in a competitive position and drive full fiscal profitability. In summary, we expect to significantly reduce Q2's operation losses year-over-year while acknowledging potential macroeconomic uncertainty that may affect results, which is helpful. Thank you. Thank you.

Operator (participant)

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

Jeffrey Wang (Director of Investor Relations)

Thank you once again for joining us today. If you have any further questions, please feel free to contact us now at Youdao directly or reach out to Pearson Financial Communications in China or the U.S. Have a nice day.

Operator (participant)

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