Youdao - Q2 2024

Transcript

Operator (participant)

Good day, and welcome to the Youdao two thousand and twenty-four second 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 (Investor Relations Director)

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 the future performance and are subject to certain risks and uncertainties, intervening 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 2024 second quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. 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 senior management are Dr. Feng Zhou, our Chief Executive Officer, Mr. Lei Jin, our President, Mr. Peng Su, our VP of Strategy and Capital Markets, 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, and thank you all for participating in today's call. Before we begin, I would like to remind everyone that all numbers are based on renminbi, unless otherwise specifically stated. In the second quarter of 2024, net revenues reached RMB 1.3 billion, growing 9.5% year-over-year. Operating cash inflow reached a record level of RMB 250.2 million, an increase of 80.2% year-over-year. Loss from operations was RMB 72.6 million, as Q2 is typically seasonally weak in the bottom line, and it narrowed by 74.9% year-over-year. In the first half of 2024, net revenues reached RMB 2.7 billion, marking an increase of 14.5% year-over-year.

Loss from operations was RMB 42.6million, narrowing 91.2% year-over-year. Operating cash outflow was reduced to RMB 103.8 million, reflecting an improvement of 53.7% year-over-year. The financial performance was in line with our in. Now, let's review the major developments across our business lines in the second quarter. Net revenues from learning services were RMB 643.8 million, slightly down by 5.5% compared with the same period of last year. Digital content services maintained a healthy growth trajectory, achieving net revenues of RMB 403.3 million, up 6.8% year-over-year. Operating cash inflows generated by digital content services exceeded RMB 200 million. Youdao Lingxi continued to drive product upgrades and customer satisfaction.

Firstly, in Q2, we released over 400 newly carefully calibrated tiered learning videos for students of different levels. We also significantly upgraded the class-based study experience for better motivation and context. As we discussed before, Lingxi pioneered the approach of personalized pre-recorded video learning. Building upon this vast library of thousands of high quality videos, we offer a set of important services, including automatic diagnosis of students' current learning levels, class-based digital learning, personalized quiz generation, and weekend live consultation with our experienced staff members. These are all key to the high effectiveness of our products, and we keep improving them every year. Second, in terms of applications of AI and growth initiatives, we upgraded our college admission consultation service to the all-new AI college admission advisors, AI in Q2.

Using large language models, the AI advisor effectively discusses and guides students in their college application process, helping them in choosing universities and majors. Since the new release, the service saw nearly three million page views, rising by 30% year-over-year, making it a key asset in attracting new students and parents. Continuous product and service upgrades significantly boosted the retention ratio of Youdao Lingxi, reaching over 70% in the second quarter, a record high, and an increase of more than 10 percentage points year-over-year. In addition, as for Youdao Literature, we offered nearly 40,000 high-quality AI writing refinements in the second quarter, improving our retention rate by approximately 10 percentage points on a year-over-year basis. Next is Learning Services segment, is our AI-driven subscription services.

In the second quarter, our AI-driven subscription services maintained rapid growth, with total sales surpassing RMB 60 million, marking a nearly 200% year-over-year increase, and over 30% quarter-over-quarter growth. Moreover, this represents the sixth consecutive quarters of over 50% year-over-year growth. Product-wise, in June, we launched a major new mobile app, Mr. P AI Tutor, the first all-subject AI tutor in China, and it received positive feedback from users after its initial integration into Youdao Dictionary Pen earlier this year. Second, AI translation in Youdao Dictionary, Youdao Desktop Translation now supports languages other than English and Chinese. There is also new support for term databases and multi-model document input. These upgrades pushed AI translation usage to exceed 30 million times in Q2.

Third, in collaboration with NetEase Cloud Music, Youdao Dictionary introduced a music sentence feature in the second quarter, helping users learn vocabulary while listening to music. Last but not Hi Echo introduced the children mode, offering tailored topics for children, child-friendly digital avatars, and generating exclusive post-conversation reports to aid children in improving their English speaking skills. We are also delighted to observe that the average usage time of children mode is nearly twice that of other modes, highlighting its effectiveness in engaging and retaining users, as well as enhancing their English proficiency. Our online marketing service segment maintained a strong growth trajectory in Q2, with net revenues reaching RMB 511.2 million, hitting a record high and representing an increase of 68.4% year-over-year.

This marks the seventh consecutive quarter of over 50% year-over-year growth, driven primarily by RTA, real-time API, and domestic KOL's ongoing robust performance, with RTA revenue more than doubling year-over-year in Q2. Furthermore, as large language models rapidly advance in the market, the demand for promoting these models and their applications among tech companies has surged. Our team seized this opportunity and is helping leading players like ByteDance, Douban, Zhipu, and Baidu in this area to grow their products. In Q2, net revenues from AI tools and advertisement grew by more than 100% quarter over quarter. Additionally, our advertising collaboration with NetEase Group has been advancing smoothly and demonstrating synergy. On one hand, Youdao's data applications significantly enhances the traffic monetization rates on a number of NetEase assets by over 100% in Q2.

On the other hand, our improved advertising performance has attracted more NetEase product teams to use our service. In the second quarter, the percentage of our total advertising revenue from NetEase as our clients increased around three percentage points quarter over quarter. It is still less than 10% of our total ad revenue, indicating significant future growth potential. Regarding the smart devices segment, the net revenues were RMB 166.7 million in Q2, down 25% year-over-year. The decline was in large part due to unfavorable product mix. In Q1, we updated our entry-level Dictionary Pen, so these reached record unit sales in Q2. In the meantime, our high-end products were from last year and reached the latter part of their life cycle in Q2. So high-end products had relatively lower sales.

These factors negatively impacted total device revenue and also average unit price for Q2. We expect Q2 to be the low point operationally for the device business this year, as we are currently ramping up high-end products for the new school year. In fact, Youdao Dictionary Pen was again the category top seller on JD.com during the June sixteen-June eighteenth shopping festival for the fifth consecutive year. In Q2, unit sales show a year-over-year increase of over 50%, broadening our brand's reach. More recently, we launched the new high-end Youdao Dictionary Pen X7. Large language model functions like AI translation and Mr. P AI Tutor has already been widely welcomed by users. First month sales units double those of X6 Pro, the high-end product released last time.

This week, we just released our top-of-the-line X7 Pro with a premium screen and a more advanced AI features. It is gaining a lot of interest. Looking at our business as a whole, in the first half of this year, we executed on our overall strategy of AI plus education and made a significant progress in our journey. We focused our resources on three core businesses: digital content services, online marketing services, and AI-driven subscription services. All three areas show good growth, healthy economics, our unique competitiveness, and long future runways. And more importantly, they are key assets in our mission of helping every person learn more effectively. In the meantime, financially, we worked hard to drive towards sustainable profitability, which we believe is the foundation for our next phase of growth.

I am pleased with the team's progress and solid execution. Our operational and financial metrics showed increased competitiveness of our business. For example, in addition to the numbers I shared at the beginning, the ratio of sales and marketing expenses to net revenues was 35.8% in the first half of this year, down by approximately 13 percentage points year-over-year. A very good improvement. Looking ahead, barring the unexpected market changes, we expect the business to achieve full-year positive operating income in the near future. Youdao's strength lies in our unique ability to advance AI empowerments across business lines, combining technical strengths with operational excellence. The rapid development of our online marketing and AI subscription services prove this, and will continue to drive our growth.

Our online courses, underpinned by high quality content, differentiated services, and unique ways of leveraging AI, are another pillar of our future growth. In the long term, the future of AI plus education looks incredibly bright, and we will strive to lead the charge. With that, I will turn the call over to Peng Su to provide you with more detailed insights into our financial performance. Thank you.

Peng Su (VP for Strategies & Capital Markets)

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from the second quarter of 2024. We encourage you to read through our press release issued earlier today for further details. The second quarter total net revenue was RMB 1.3 billion, or $181.9 million, representing a 9.5% increase from the same period of 2023. Net revenue from our learning services was RMB 643.8 million or $88.6 million, representing a 5.5% decrease from the same period of 2023. Net revenue from our smart devices was RMB 166.7 million or $22.9 million, down 25% from the same period of 2023, which was mainly attributable to the decreased unit price due to the change of the product mix.

Net revenue from our online marketing services was RMB 511.2 million, or $70.3 million, representing a 68.4% increase from the same period of 2023. The increase was primarily due to the increased sales of the performance-based advertisements through the third party's internet properties, which were driven by our continuing investment in the cutting-edge AI technology. For the second quarter, our total gross profit was RMB 636.8 million, or $87.6 million, representing a 12.3% increase from the second quarter of 2023, whereas the gross margin for learning services was 60% for the second quarter of 2024, compared with 57.4% for the same period of 2023.

Gross margin for smart devices was 30.3% for the same quarter of 2024, compared with 35.8% for the same period of 2023. Gross margin for online marketing services was 39.1% for the second quarter of 2024, compared with 31.9% for the same period of 2023. For the second quarter, we reduced our total operating expense to RMB 609.3 million, or $97.6 million, compared with RMB 856.3 million for the same period of last year. Looking at our expense in more detail, sales and marketing expense declined to RMB 515.7 million, compared with RMB 587.7 million in the second quarter of 2023.

Research and development expense were decreased to RMB 153 million, or compared with RMB 205.1 million in the same quarter of 2023. Our operating loss margin also significantly narrowed to 5.5% in the second quarter of 2024, compared with 24% for the same period of last year. For the same quarter of 2024, we narrow our net loss attributable to ordinary shareholders to RMB 99.5 million, or $13.7 million, compared with RMB 299.2 million for the same period of last year. Non-GAAP net loss attributable to the ordinary shareholders for the second quarter was RMB 96 million, or $13.2 million, compared with RMB 283.6 million for the same period of last year.

Basic and dilutive net loss per ADS attributable to the ordinary shareholders for the second quarter of 2024 was RMB 0.85 or $0.12. Non-GAAP basic and diluted net loss per ADS attributable to the ordinary shareholders for the same quarter was RMB 0.82 or $0.11. Our net cash provided by operating activities was RMB 250.2 million, or $34.4 million for the second quarter. Looking at our balance sheet, as of June 30, 2024, our contract liabilities, which mainly consist of the deferred revenue generated from our learning services, were RMB 1 billion, $142.9 million, compared with RMB 1.1 billion as of December 31, 2023.

At the end of the period, our cash, cash equivalents, current and non-current restricted cash, time deposit, and short-term investment totaled RMB 568.5 million, or $78.2 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 touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we will pause for a moment to assemble our roster. Our first question today will come from Brian Gong of Citi. Please go ahead.

Brian Gong (Vice President and Equity Research Analyst)

Thanks, management, for taking that question. I have a question regarding our strategy on education sector. So, as we observed, competitors are ramping up their investments in the whole sector, right, education sector. Given the intensified competition, what is our strategy? Thank you.

Peng Su (VP for Strategies & Capital Markets)

Thank you, Brian. This is Peng. I will handle the question first. Before answer your question, I will give a very quick background regarding on the education scenario in China. If you see the numbers of the candidates registered for the college entrance exam has been increased from roughly 10 million in 2019 to over 30 million in this year. It's likely to keep increasing in the next decades as well. Also, the exam is getting more competitive. The overall college entrance exam score line has been shown as the upward trend. Taking the example as in Tianjin, it has been increased by more than seventy points compared to 2019. So we think the demand for the college entrance exam preparations will continue to rise. Go...

If you go back to your questions, we do see the competition intensify moderately for the pre-college learning services in this year. That's understandable, given the current market conditions. I believe we have the necessary means to continue to invest to be still the leading player here and benefit from the more dynamic markets. The first thing we do is we will still continue to drive the customer satisfaction and retentions. We already have the industry-leading satisfaction and retention rates. During the first half of this year, our retention rates reached our historical high in Q2, exceeding about 70% and representing a year-over-year increase of over 10%. I think that metric is a testament to the users' recognitions of our products and services.

Secondly, we think we will continue to produce outstanding learning results as long as we had already helped the students get good results and get into their dream university and school. Most students will come to us, and if you look at our results from the last year and this year, we almost more than double the number of the students getting to the top school and universities in this year. I think that is an important thing that can help us to build up our reputation in the market. I think that that's the this is possible because I think our innovative format of our classes, the AI plus content and the comprehensive services models. I think that's pretty innovative and creative, and improves the problems and learning methodologies for the college entrance exam preparations and the others.

Third, we think we are applying more AI technology in our business, such as the segment that have been mentioned previously, like the AI quiz recommendation and the AI-based college admissions advice services. In Q2, our AI college application advisors generated nearly 60,000 application form, roughly 30% increase year-over-year. Positioning, I think we believe that is we will be the leading one in the market in this year. I think that shows what kind the AI can bring us the privilege over the market. The first one, we think we will keep innovating and investing in the market as well.

We will continue to strengthen our market channels and branding development, providing a better integrated experience for the users through our online and offline coordinations.

This year, through the methods such as the WeChat video accounts, the Weixin Ship Hao, we have enhanced the localized live broadcast and operations to provide the users with a range of the localization services and the highly customer services in the different cities. We will fully leverage our teaching strengths and IT operational experience to enhance our online customer acquisition, competition, and reduce customer acquisition cost. I think as well, we will persist in exploring the offline service and the opportunities, and looking for the better chance to invest into that market. I think above all, we think that we are confident about future growth of the Youdao Business and Service. We think in the long run, definitely the high quality products always will be the answer for the competitive market. I think.

Brian Gong (Vice President and Equity Research Analyst)

Thank you.

Feng Zhou (CEO)

Yeah, let me add a point. So I think what's the most important thing is the product. In the end, it's about how well you understand the customers and how to best satisfy the customer's needs. So we think we are—our teams are very good at this, because Lingxi and its previous, its predecessor have been a long-running business at Youdao, have been doing it for eight years already. Yeah, so and within the process, we actually innovated several times. So the current AI plus pre-recorded video, plus comprehensive service model, it was introduced in 2021, so it was a big change.

But if you think about it, it really makes a lot of sense, because for students preparing for college entrance exam, what they really lack is they lack a lot of free time. So the traditional live course format is not such a good fit. So the team had actually been preparing for the change for a year at that time. And the market condition in 2021 pushed the team to make the leap, and that's why we've been able to grow the business several times since then. So I think that proves the innovation capability of our teams, and we...

I expect the Lingxi team to keep innovating and keep loving what they do. That is what the harmony and unity culture is and what makes us good at making high-quality content. Yeah, so I think that's the most important thing. We'll keep improving the product and serve the customer better. Thank you.

Jeffrey Wang (Investor Relations Director)

Thank you, [you both].

Operator (participant)

The next question will come from Liping Zhao of CICC. Please go ahead.

Liping Zhao (Equity Analyst)

Good evening, Dr. Zhou. Thanks for taking my questions. Your online marketing business saw very strong revenue growth in the first half of the year. Can we ask, could you please tell what's the outlook of this business in second half of the year? Thank you.

Lei Jin (President)

Hi, this is Lei Jin. For the second half of the year, our outlook for online marketing services remains positive. We have seen a net revenue growth significantly from around RMB 200 million per quarter to over RMB 500 million in Q2 of this year. This marks 7 consecutive quarters of year-over-year net revenue growth, exceeding 50%, alongside continuous improvement in profitability. We expect year-over-year revenue growth to continue through the second half of this year. Several key factors are driving this sustainable growth. First, our robust data accumulation, advanced AI algorithms, and deeper understanding of customer demand forms the cornerstones of our long-term competitive advantages. As we continuously collect and feed data into our Data Management Platform, DMP, we achieved more accurate prediction, better decision-making, and more refined online marketing services tailored to user needs.

Second, our expansion to overseas advertising has been a significant growth driver. We offer to clients comprehensive and personalized international advertising services, including brand communication, global KOL marketing, overseas ad placement, and live streaming commerce. Leveraging our deep understanding of client needs, we have a very accelerated development of international advertising infrastructure. By the end of the Q2, our international KOL database has exceeded seven million, a year-over-year increase of over 200%. This drove Q2 net revenue from international performance-based advertising to nearly RMB 100 million, a growth rate about-

... three, thirty percentage points higher than in Q1. In this second half, we will continue to capitalize on the growing demand from Chinese companies looking to expand internationally, fostering the sustainable development of our international advertising efforts. Third, our collaboration with NetEase has been mutually beneficial. In Q2, Youdao's data applications significantly improved the monetization rate by over 100% of NetEase's traffic. In return, NetEase provides us with more controllable and predictable traffic resources. Moving forward, we will keep upgrading our algorithm and the DMP platform to enhance our AI-driven data capabilities, improve advertising efficiency, and boost revenues. We are mindful of the increasing risk of traffic competition. We are committed to seizing opportunities to assist Chinese companies in their global expansion, at the same time, leveraging our strengths in customer relations, AI, and data.

We are gradually establishing our own exclusive ad network. This will be helpful to the sustainable and healthy development of our ad business. Thank you.

Operator (participant)

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

Thomas Chong (Regional Head of Internet & Media)

Hi, good evening. Thanks, management, for taking my question. May I ask about AI-driven subscription services? We are actually seeing the subscription services continue to expand. What is the commercialization path for Mr. P AI Tutor? Thank you.

Feng Zhou (CEO)

Hi, Thomas. Yeah, this is Feng. The key thing here is the user scenario. At Youdao, we focus a lot on the user scenarios. And Mr. P serves the home learning scenario, which we believe is the number one or number two of all consumer learning scenarios for students. So it is very important and not served well by current products. So we think Mr. P fits this scenario very well. In terms of the product and our learnings and also the commercialization path, as you asked, I have several points to share. The first one is the initial feedback for the app is very positive. The recent release of Mr.

P is our what we call a broad release for us. So in the app form factor and in the X7 and X7 Pro dictionary pens. In its first month on the market, users engaged with Mr. P AI Tutor for nearly two million times, ranking it actually as the second most used feature of the X7 dictionary pen. Only after word lookup and translation, which is kind of the basic function of the device. So it is already number two. So it's surpassed the previous favorite features like Waiyan Wen Jingjiang. So I think that proves its popularity. The second point I want to share is Mr.

Mr. P is quite unique and a leading product in the market in terms of functionality. It is the first all-subject that's nine in total K-12 AI learning companion app with high-quality results. Some of our peer companies focused on one or two subjects. Others, their product doesn't yet deliver high-quality results. So our engineering and the research team has developed a key set of technologies that make Mr. P possible and are now working hard to keep on improving it. So obviously, we're still in the early days. So we expect the experience to become much better over time, and we believe this technology holds a lot of promise.

So I think, yeah, I would think every family in China with students needs this AI companion. So yeah, think about it. So either in apps form or in hardware devices or other forms. Actually, not only in China, but in other countries as well. So that's how we look at it. Yeah. Third point is that regarding monetization and commercialization, we think subscription fees are a very scalable way of monetizing generative AI technology. And obviously, we also look at other ways like smart devices, B2B licensing and also international markets.

So I do not want to talk too much about our concrete plans, but you can look at our existing products to get some ideas. For Hi Echo is already a significant contributor to our overall AI subscription sales, which in total we just shared, reached over RMB 60 million in Q2, and it grew nearly 200% year-over-year. The growth Hi Echo comes from several things. Our continuous product improvements, positive word of mouth, and a lot of user-to-user referrals. So we expect Mr. P to follow a similar path. So we also did some projects Hi Echo on the B2B Hi Echo has entered over 100 schools nationwide. We also focused on partnerships.

Hi Echo became an official partner of the British Council's IELTS test. So I believe this is also our strength. NetEase has a long history of working effectively with international companies and Hi Echo was also recently featured on the App Store, Apple App Store homepage, which is a testimony of its quality and popularity. So overall, we find that AI apps are popular among users, and we have a lot of ideas. Our team has a lot of ideas to how to commercialize them, and we expect this year and next year to be a very good time period, time window, to grow and monetize these AI apps. Yeah, so we will focus on them. Yeah, thank you.

Thomas Chong (Regional Head of Internet & Media)

Thank you.

Operator (participant)

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

Howard Tung (Analyst)

Hi, good evening, and thank you for taking my question. My question is about the non-academic tutoring market. So I'd like to know more about your company's progress in STEAM courses, and whether you will accelerate investments in the future. Thank you.

Peng Su (VP for Strategies & Capital Markets)

Thank you. This is Peng Su. I will handle the questions. In the second quarter, we made some progress in our non-academic courses, although our language training and logic thinking courses are in their early stage. But in terms of the course billings, both have experienced a year-over-year growth over 100%. As for English oral communication and the other skill-based training has always been the strength of Youdao, as you know. Empowered by the AI, we can now provide the users with very comprehensive services and highly customized services in the during, before, and after classes. On the other hand, we already have this very strong faculty and high quality content to provide excellent in-class services to the users.

There's a rapid development of our AI-driven subscription services, and we can also assist the users in personalizations and the post-classes scenario to improve their listening and speaking capabilities. For example, as we mentioned in the last several quarters, Hi Echo app allows users to engage in oral communication anytime and anywhere, and generate personalized analysis reports to correct the issues related to speech and grammar during the conversations. For logic thinking courses, it is highly demanded by the users. Parents always hope that through the courses, I think, their children's thinking abilities will continuously improved. Our products meets the needs of the parents, and additionally, when the students encounters a problem after classes, as Dr. Zhou mentioned, Mr. P AI Tutor assistants or AI tutors can help them to answer the questions and with...

I think with a different way, and we didn't, just like Dr. Zhou mentioned, the method is not directly give them the answers, but just try to leading them to think about all the path. We think that will be the kind of innovation, and that will be really need from family education scenarios. Looking ahead, we will continue to emphasize the high quality development of the non-academic courses. If we identify the clear opportunities, we are ensuring the health and of our business. We will consider increasing the investment in the non-academic courses. Thank you.

Feng Zhou (CEO)

I think you need to choose which courses to provide very carefully to be successful. So it is particularly important for non-academic learning, because they can be very wide in terms of topic. So you can choose from a very wide set of topics. But you have to choose very, very carefully. Because parents they may initially be interested in different topics. They may want to try it, but in the end they are they choose the courses that's really helpful for their kids in the long term. Only those courses will become popular for the long term. So you need to choose carefully.

So that's what we focus on for non-academic courses. Yeah, for example, we believe Chinese literature abilities are very, very important for kids. Being able to grasp the power of language is one of the key abilities that benefits a person's whole life. Yeah, so that course has proven successful, yeah, so in the last several years. We will keep improving. And also one other thing we think that's really important is computing skills. Everyone knows that it's key for future careers. Our competitive programming course has been running for six years now. We had our first national NOI gold medalist for this year.

Yeah, so the key thing is that if we start some academic course, we will make sure that we choose carefully, and we want it to be successful for many years to come. Yeah, so I think that's important.

Operator (participant)

Our next question today will come from Bo Zhang of Haitong Securities. Please go ahead.

Hello, Bo Zhang, your line is open.

Bo Zhang (Equity Analyst)

Hello. Can you hear me?

Operator (participant)

Your line is live. Yes, thank you.

Bo Zhang (Equity Analyst)

Thank you, operator, for taking my question, and congratulations on the strong performance this quarter. I have a question regarding smart device. We saw the revenue from the smart device is still decreasing. Could you share some color on strategy for your dictionary pen for the second half of the year and the average upwards? Thank you.

Feng Zhou (CEO)

For the last few quarters, we've reorganized our device sales channels, as we communicated in the last several quarters. We also focused our products to be, again, around our core dictionary pen category. This year we've released four dictionary pens, from the mid-tier A6 Pro, X6 Pro, to flagships X7 and X7 Pro. So, the good thing is, users have told us that they really like these new products. So, they are. Youdao Dictionary Pen is ranked the number one seller in the category during the June eighteenth shopping festival on JD.com for five years, you know, consecutively. So reflecting their users' preference for our brand.

X7, in its first month on the market, generated twice the revenue of last year's flagship, X6 Pro, as I just talked about, during the prepared remarks. These good news tell us that our overall strategy of focusing on core products and channel efficiency are correct. You know, so what we need to do now is we need to continue to focus on our key products, mainly dictionary pens, and build strong sales capability and efficient channels. At the same time, another good thing is that the device business and the financial performance has improved after the refocusing. So, that set up a good foundation for the business to build on.

So here are a few, a few more kind of points about the dictionary pens. The first one is about high-end products. These are our strengths, and our first large language model application were on our high-end products. In July, we launched the dictionary pen X7, and last week, X7 Pro. Both of them carry large language model features, including Mr. P and AI translation. As we just shared, Mr. P is the number two most popular function, and AI translation is also very popular. That's really encouraging for us because only our products have these features right now. Second point I want to share is regarding price point.

So, last year, we expanded into the mid-range market, with the launch of the X and A series, aiming to serve a broader audience, and meet diverse user needs. In Q2, one of the results is dictionary pen unit sales grew by over 50% year-over-year. And, in addition, net revenue from dictionary pens increased nearly 10% year-over-year. So, unit growth 50%, revenue growth 10%. So that means the strategy of not going for a very low price is correct. We didn't go for a price war, so our cheapest product, A6 Pro, is still RMB 50 or 100 higher, more expensive than our peers.

So we believe that's a good balance to strike. So achieving allowed us to achieve both unit growth and revenue growth. I think that's a good trend. Yeah. The third point is regarding gross margin ratio, because this is something that people look at carefully. So in Q2 our gross margin ratio for smart devices was a bit low at 30%. Again, that was mostly due to the product mix, as we just discussed. So more mid-tier products, fewer high-end products. However, as we ramp up on the higher-end product in Q3 and Q4, so we are still targeting 40% gross margin ratio as before.

So we have a good feature differentiation, a lot of AI features, and the hardware is much stronger, with AI cameras, the first time this year, and with much better screens that users really like. So and we also improved our supply chain a lot over the last year. So that lowered our supply cost. Yeah, so we think 40% gross margin ratio is a reasonable and feasible growth target to shoot for. Yeah, so I think overall, as we said, we expect Q2 to be the low point operationally for the hardware business. Yeah, so we're looking forward to its future performance. Yeah.

Bo Zhang (Equity Analyst)

Thank you.

Operator (participant)

Our next question today will come from Yifan Zhang of CITIC Securities. Please go ahead with your question.

Yifan Zhang (Analyst)

Good evening, management. Thank you for taking my question. My question is about the profits. Will we achieve profitability this year? And if so, will we be able to sustain profitability in the future? Thank you.

Wei Li (VP of Finance)

Thank you for your question. This is Wayne. I will take your question. We are fully committed to improving the overall health and achieving full-year positive operating income in the near future. Over the past year, we have successfully reduced operating loss on a year-over-year basis, especially in the first half of this year, where operating losses were reduced by over 90% year-over-year to approximately RMB 40 million. Historical data indicates that due to seasonal factors, typically higher operating income in the second half year compared to the first half year, giving us confidence in achieving positive operating income for the full year of 2024, despite intense competition and various uncertainties. We believe that this profitability is expected to be sustainable on a full year basis in the future due to the following reasons. First, strong profitability in three core areas.

Digital content services, online marketing services, and AI-driven subscription services have been identified as our key strategic focus area. We allocate more resources to these areas, which has resulted in profitability, and we will continue to do so. Our online marketing services, fueled by our RTA technology, data capability, and precise understanding of user needs, have achieved over 50% year-over-year net revenue growth for seven consecutive quarters, driving profitability. Through leveraging AI technology and high quality content, our digital content services, especially Lingxi, have improved learning efficiency and effectiveness for our users. Lingxi's leading products and services have been pivotal in driving revenue and profit growth. AI-driven subscription services, a key aspect of our AI commercialization efforts, have experienced strong sales growth, and we have confidence in their future profitability. Second, enhance the financial performance in non-core business.

For non-core business, such as smart devices and non-digital content services, we have implemented the stricter health requirements, focusing on higher ROI metrics and labor efficiency. This has resulted in a temporary decline in overall business scale, but has significantly improved the health of this business and reduced the losses. Third, operational efficiency improvement through AI technology and content innovation. To achieve profitability, we are continuously striving to improve marketing efficiency through innovation and enhance the user experience through the creation of premium learning content. We explore various innovations, such as diversifying marketing channels and leveraging advanced AI technology to optimize marketing efficiency, and to mitigate challenges like rising acquisition costs due to intense competition.

By innovating premium content, such as our transition from traditional live stream online classes to pre-recorded content embedded with AI technology, like adaptive question bank, we address user concerns such as inflexible schedules, and provide a personalized learning experience. This premium content has exhibited strong user engagement, with over 70% retention rate in Q2. In summary, our strategic focus and innovative approaches have resulted in a continued improvement in our operating margins, giving us confidence in sustained profitability of our business in the future. Thank you.

Operator (participant)

Our next question today will come from Crystal Li of China Merchants Securities. Please go ahead.

Crystal Li (Equity Research Analyst)

Thanks, management, for taking my question, and congratulations on the strong results. I just want to know, how should we interpret the recent opinions on promoting the high quality development of service consumption, and particularly regarding the education and training consumption? Thank you.

Peng Su (VP for Strategies & Capital Markets)

Thank you. Yeah, we have noted that earlier this month, the State Council issued the opinions on promoting the high-quality development of service consumption, which emphasize meeting the diverse and personalized learning needs of the general public, and promoting the social training institutions to enhance service quality in response to the public demands. First, I think I'll just make it clear that Youdao is always consistently to embrace the policy and adhere to operating within the scope of the permission by policies. By now, it's still in the very early stage, and we don't know any further information and the detailed information like scope and the category of the policy. But first, definitely, we will wait for the following information released to the public regarding the detailed information.

What we can say now is about the strategy of Youdao is to consistently invest into the education sectors within the AI features. If you see the dynamic of our products, they always be innovative and creative to create a new format of our products following the policies. We think we will keep the updates and the existing product, and provide the new services following the instruction of the existing policy and upcoming ones. We think that will be the consistency to be delivered to deliver the message regarding on the policies. We can discuss more in details right after we receive the more information regarding on this detailed policy. Thank you.

Crystal Li (Equity Research Analyst)

Thank you.

Operator (participant)

At this time, we will conclude the question and answer session. I'd like to turn the conference back over to management for any closing remarks.

Wei Li (VP of Finance)

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 in China or the US. Have a great day.

Operator (participant)

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