Youdao - Q3 2023

Transcript

Operator (participant)

Good day, and welcome to the Youdao 2023 third 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 (Head of Investor Relations Director)

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 future performance and are subject to certain risks and uncertainties, assumptions, and other factors. Some of these risks are beyond company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. A general discussion of the risk factors that could affect Youdao's business and financial results is included in certain filings of the company with the U.S. Securities and Exchange Commission. The company does not undertake any obligation to update this forward-looking information, except as required by law. During today's call, management will also discuss certain non-GAAP financial measures for comparison purpose only.

For the definitions of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2023 third quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. Besides, a webcast replay of this conference call will be available on Youdao's corporate website at ir.youdao.com. Joining us today on the call from Youdao 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. In Q3, we achieved a record high net revenues of CNY 1.5 billion, marking a year-over-year increase of 9.7%. Loss from operations narrowed by 73.7% year-over-year to CNY 57.7 million. Net cash used in continuing operating activities amounted to CNY 294.7 million, largely stable with the same period of last year. We are clearly making steady progress towards achieving profitability.

In Q3, excluding the current loss-making smart devices segment, net revenues of our business lines could cover their combined cost and operating expenses. Before looking at results from our various business lines, let us first discuss our progress on artificial intelligence. AI technology, specifically large language models, represents an unprecedented opportunity for education technology. It is becoming clear that this technology has fundamentally revolutionized access to many formerly highly valuable but cost-prohibitive services for learners, schools, and families. We are already witnessing accelerated changes in this domain. We're very excited about the opportunities presented by large language models. I'm delighted to share that Youdao is playing a leading role in the rapid advancement of LLMs and their applications in education. Recently, we achieved a notable milestone with the receipt of relevant filings for our proprietary LLM, Ziyue, this month.

This underscores the acknowledgment of our technological capabilities by regulatory authorities. On the product front, we introduced the world's first digital human language coach, named Hi Echo. It was launched on Youdao Dictionary Pen X6 Pro in August and made its way to mobile app stores in October. I'm happy to share that Hi Echo has already accumulated more than 100,000 registered users. A quick update. Additionally, we continue to enhance AI Box in Youdao Translation and introduce the AI writing alongside other features, driving over 160% year-over-year growth in translation subscription fees in Q3. Moreover, I am thrilled to share that we will host an event in Beijing next month to introduce more LLM products and features. Next, I will quickly outline key business developments in Q3.

As for the learning services segment, revenue comes in at CNY 960.8 million, representing a 7% year-over-year growth. We continue to focus on user satisfaction and healthy growth in line with our goal to achieve profitability. Sales of the digital content services exceeded CNY 400 million in Q3, with gross margin ratio exceeding 70%. That hit the record high. During Q3, we released an AI quiz recommendation feature, which presents personalized quiz questions after students watch instructional videos to help improve learning and assess results. Students finished over 7.6 million quiz questions in Q3. Additionally, we launched AI writing refinement in Q3, effectively reducing the time required for detailed assessment and refinement of student writings by 50%.

Regarding our STEAM courses, the gross billings of programming courses grew by over 30% year-over-year in Q3. Our programming and informatics courses have high user satisfaction, mainly due to our one-stop services that provide comprehensive learning, competition preparation, and post-competition score estimations. Furthermore, we once again collaborated with the Chinese Weiqi Association to successfully hold the second National Children's Weiqi Open Championship. Turning to online marketing services, we continued to see strong growth momentum in Q3. Net revenues of online marketing services reached a historic high of RMB 336.1 million, marking a 113.5% year-over-year increase, and four quarters of over 50% growth. We continue to deploy enhancements to both AI and matching technology, and more industry-specific data.

The continued growth of the business also provided our technical teams access to more data to do more precise audience targeting and real-time traffic filtering. These upgrades have, in turn, improved conversion rates, customer satisfaction, and our revenue. As for the smart devices segments, net revenues were CNY 251.9 million in Q3, down by 29.3% year-over-year. The decline was mainly due to our continued efforts to reduce low return on investment sales channels, leading to a reduction in overall channel inventory that impacted Q3 revenue. Our channel optimization efforts will continue in Q4. We expect a continued short-term negative impact in this segment before the optimization is likely to conclude by the end of the year. I would like to stress that these channel optimizations improve the business's long-term growth and profitability potential.

On the product front, users embrace our new products, including the Youdao Dictionary Pen X6 Pro and Youdao Listening Pod Pro, leading to a year-over-year increase of over 10% in smart devices sellout, RMB amount. Youdao Dictionary Pen X6 Pro, our flagship with LLM features, exhibited over 50% higher usage frequency than Youdao Dictionary Pen S6 in Q3, reflecting the popularity of its new features among customers. Our other efforts are also progressing well. For educational digitalization solutions, we successfully secured project bids in Jiangsu, Gansu, and other regions in the third quarter. Education digitalization is a big focus for the overall public education sector, and we aim to build this line as a growth segment steadily. Looking ahead, we are committed to delivering top-quality education content, products, and services to our customers.

Moreover, our leading proprietary large language model, Ziyue, unlocks various opportunities for many novel applications, which is crucial in revolutionizing learning on a wider scale. We are very excited about the opportunities and cannot wait to serve our customers with more innovative products. Thank you. And now it's Peng Su to give you an update on our financials.

Peng Su (VP of Strategy and Capital Markets)

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from the third quarter of 2023. We encourage you to read through our press release issued earlier today for further details. For the third quarter, total net revenue were CNY 1.5 billion, or $210.9 million, representing a 9.7% increase from the same period of 2022. Net revenue from our learning services were CNY 950.8 million, or $130.3 million, representing a 7% increase from the same period of 2022, primarily driven by the strong sales performance of the digital content services compared with the same period of 2022.

Net revenue from our smart devices was RMB 251.9 million, or $34.5 million, down 29.3% from the same period of 2022, primarily due to our continuous efforts to streamline marketing channel with low return on investment for the intelligent learning products in the third quarter of 2023. Net revenue from our online marketing services was RMB 336.1 million, or $36.1 million, representing a 113.5% increase from the same period of 2022. The increase was mainly attributable to the increased revenue from the performance-based advertisements through the third party's internet properties. For the third quarter, our total gross profit was RMB 859.6 million, or $117.8 million, representing a 13.1% increase from the third quarter of 2022.

Gross margin for learning services was 67.8% for the third quarter of 2023, compared with 64.5% for the same period of the last year.

Wayne Li (VP of Finance)

... Gross margin for smart devices was 42.6% for the third quarter of 2023, compared with 40.4% for the same period of 2022. Gross margin for online marketing service was 31.9% for the third quarter of 2023, compared with 27.1% for the same period of 2022. For the third quarter, total operating expense were RMB 917.3 million, or $125.7 million, compared with RMB 979.2 million for the same period of last year. With that, for the first third quarter, our sales and marketing expense were RMB 674.2 million, compared with RMB 709.8 million in the third quarter of 2022.

Research and development expense were CNY 187.3 million, compared with CNY 212.9 million in the second quarter of 2022. Our operating gross margin was 3.7% in the third quarter of 2023, compared with 15.6% for the same period of last year. For the third quarter of 2023, our net loss from continuing operation attributable to the ordinary shareholders was CNY 102.9 million, or $14.1 million, compared with CNY 183.9 million for the same period of last year.

Non-GAAP net loss from continuing operation attributable to ordinary shareholders for the third quarter was RMB 67.3 million, or $9.2 million, compared with RMB 164.4 million for the same period of last year. Basic and dilutive net loss from continuing operation per ADS, attributable to the ordinary shareholder for the third quarter of 2023, was RMB 0.85 or $0.12. Non-GAAP basic and dilutive net loss from continuing operation per ADS attributable to ordinary shareholder for the third quarter was RMB 0.55, or $0.08. Our cash provided by the continuing operating activities were RMB 294.7 million, or $40.4 million for the third quarter.

Looking at our balance sheet, as of September 30, 2023, our contract liabilities, which consists of the deferred revenue generated from our learning services, were RMB 931.6 million, or $137.7 million, compared with RMB 1.1 billion as of December 31st, 2022. At the end of the period, our cash, cash equivalents, restricted cash, term deposit and short-term investment totaled RMB 360.1 million, or $49.4 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)

Ladies and gentlemen, we will now begin the question and answer session. If you wish to register for a question, you may press star and one on your touchtone telephone. If you want to withdraw from the queue, you can press star and two. The first question come from the line of Brian Gong with Citigroup. Please go ahead.

Brian Gong (VP, Equity Research Analyst)

Yeah, good evening, and thanks for taking my question. I have a very quick question on our, our AI product. We have launched, you know, our, AI product, Hi Echo, for a while. So what is the user feedback you have received so far? And, are there any plans for future updates? Thank you.

Wayne Li (VP of Finance)

Thank you. Thank you. So Hi Echo, the mobile app, launched in October, and so far we are very happy with its performance. Our user feedback has been very positive. As we discussed in prepared remarks, the app already has over 100,000 registered users in a month. Yeah, so it's only for a month and almost all of the 100,000 registered users come through organic channels. And from this, we can see that users are really attracted to this app. Users really like the freeform conversation, so they told us through the feedback.

As well as, they also like the eight categories, eight scenarios, and 68 different topics that they can choose from, if they already have a topic they want to discuss in mind. And another feedback we receive is that users tell us that the end of conversation reports that the app provides about the language the user uses during the conversation, and also how to improve them, are really helpful for them to improve their pronunciation and also grammar and the language skills. Yeah, so basically based on the feedback, we can see that the product, the idea behind the Hi Echo, is a pretty sound one. Yeah.

The idea is that for a lot of users, the biggest, largest obstacle in learning their language is the lack of a really high quality language environment. The idea of Hi Echo is that we are finally able to leverage the ability of large language models to create this high quality language environment in a very cost-efficient way. And so it is a breakthrough and very useful in language learning.

Feng Zhou (CEO)

And another point is that now that we have received the regulatory approval for Ziyue, and it's raised the underlying language model behind Hi Echo, it's. We would well be able to increase distribution of the product and drive more user growth. So this is a great opportunity for Hi Echo, Hi Echo, because users' interests in language model kind of based products are really high. And there are not many kind of high quality competitive education language model-based apps on the market currently. So we kind of have a time window that we can try to do distribution to a larger much larger audience. So we will try to do that.

We are also on track to release the next major version of Hi Echo by the end of this year. We don't want to talk too much about it in advance. What I want to share is that it'll be a significant update. The benefits of actually being first to market, which is the case for Hi Echo, is that you gain a deeper understanding of the users' true needs. What they like, what they don't like, what makes them come back, and what helps them learn better, and what leads them to pay. So we will update the product according to these understandings, and these will go into the major version I just mentioned.

And we will also have some pleasant surprises for our users that the Hi Echo team has been working on for quite some time. So we look forward to sharing the new version with you soon. I hope that answers your question. Thank you.

Operator (participant)

Yeah, that's very helpful. Thank you. The next question is from Kelly Wang with CICC. Please go ahead.

Kelly Wang (Equity Research Analyst)

Good evening, management. Thanks for taking my questions. My question is related to our learning services. Would you mind provide some color on the overview of our learning services segment performance in the next quarter? Thank you.

Peng Su (VP of Strategy and Capital Markets)

Thank you. This is Peng Su. I will take this question first. And, in this Q3, we believe it's a little bit different quarters compared with the last three years. And, first of all, the students have a very little bit different summer plans in this summer, and, like, they are doing the traveling domestically and or the international trips in this summer. So I think at sometimes, the more a lot of students has very less time or the less flexibility to take courses as usual. So we think that's the first difference. And secondly, it's about our companies, just like Dr. mentioned, we have been approved by our large language models.

We think we believe our product and content, like Echo, is in the transition of the current period from the pure the we call the traditional courses format, and to upgrade to the new format supported by the large language models. We have already deployed the large language model scales to our teaching assistant as well as the others. Right now, it's a very limited scenario to deploy the technology. We have seen a very great performance of the large language of the technology, and also received a very positive feedback from students. We expect they can help us to decrease the cost in the long run and increase the margin of our product and business.

I think that's the sometimes we think because we are in that transition period, that we just limited about and take a little bit less investment in our traditional courses and content investment in the summer, like the customer, as well as customer acquisitions cost. So we think that's kind of the overview and the trend we believe of our learning services. We feel confident about our business performance of the learning services and courses, and that's because we think we can provide more interactive and content and more different formats of our services to student in the next few quarters. That's my comments about the question. Thank you.

I think that my colleague will add her comments for discussion as well.

Feng Zhou (CEO)

Yeah, this is Ming. I'd like to add two more points in financial aspects here. The first one is, we will continue to seek profitability and a positive cash flow from the learning services in the long run. As emphasized before, we are more focused on the health of the business than the size. In the first quarter, we have reached a new high record on cost margin of learning services to around 58% and achieved profit from this segment. Another point is we are having the great opportunity to continue lower our costs and improve the efficiency via AI technology, as mentioned by Dr. Su and Peng Su.

Although we still have faced competition from peers and faced challenges from uncertainty of our operating environment, but, we are playing a leading role in the rapid advancement of large language models and the application in education, which give us great advantages. So we are very confident in our learning services on a going forward basis, which is helpful. Thank you.

Kelly Wang (Equity Research Analyst)

Yeah, thank you for the comments. That's very clear. Thank you.

Operator (participant)

The next question is from Thomas Chong with Jefferies. Please go ahead.

Thomas Chong (Managing Director and Head of China Internet)

Hi, good evening. Thanks, management, for taking my questions. My question is about online marketing. Can management comment about the key driver behind the substantial growth of online marketing services in the third quarter? Thank you.

Lei Jin (President)

Hi, Thomas, this is Lei Jin. Thank you for your question. As for our online marketing services, the net revenue has grown over 50% year-over-year for the past four quarters, since the Q4 last year. Moreover, the growth rate has jumped to around 100% for the last two quarters. The primary driver behind this growth is the growth of our AI technology. A key contributor in Q3 was the upgrading of real-time API, that's RTA capabilities. We began to use RTA in our advertising business at the end of the last year. After ongoing improvements, it received the recognition from our clients and partners. The proportion of RTA application keeps increasing, and in Q3, the overall conversation rate of RTA improved by three or four times.

The online entertainment and the gaming industry also played an important role for our growth. There's a huge increase in demand for advertisers in this field. The RTA upgrade leads to over 100% year-over-year increase of net revenues from the entertainment industry in this Q3. On top of that, the summer season was an important promotion period this time, further boosting our advertising performance. We have been trying out various methods to further enhance the advertising effectiveness for our clients with our data and AI technology. I believe it will help us provide better ad services to our client and achieve a sustainable growth of our advertising business. Thank you.

Operator (participant)

The next question is from Yukin Zhang with Citi. Please go ahead.

Brian Gong (VP, Equity Research Analyst)

Hi, management. Thank you for taking my question. My question is about the learning devices. So what is the user feedback on the Dictionary Pen X6 Pro? Are there any plans to introduce new SKUs before the end of the year? Thank you.

Feng Zhou (CEO)

Thank you for the question. So let me first talk a little bit about the business operations and then user feedback. So as I discussed in the prepared remarks, Q3 smart devices sellout RMB amount actually increased by over 10% year-over-year. So sellout is a key sales metric we focus on internally because when we gauge our business progress and healthiness. So basically it is the value of goods sold to end users through our channels, all of our sales channels. I mention this because we are currently experiencing a kind of adjusting period of our sales channels.

So the sellout amount and also the final revenue amount, they are a little bit different when you look at the trend. The revenue is actually down for this quarter. So through the sellout metric, we can see that our devices are selling well to the end users, despite the current headwinds displayed by the financial metrics. So this is because we, again, cut back on some sales channels that are providing a not very good return of investment for us, and this will have the effect of reducing sales channel inventory.

So that's kind of a fuller picture of the device business operations. And now let's talk about user feedback. So X6 Pro was a hit among users owing to standout features like English grammar instruction, digital human language coach, and an impressive 100-day standby time. The first two features I just mentioned are based on large language models. The most important metric we look at is engagement. So the introduction of these large language model features significantly boosted user engagement with the X6 Pro. It actually exhibits over 50% higher usage frequency than the other product, S6, which doesn't have large language model features in Q3.

So notably, both the English grammar instruction and digital language coach are powered by our Ziyue language model. And, you know, just to explain the feature a little bit, when a user scans a multiple-choice question with X6 Pro, our large language model will analyze the question and generate step-by-step audio explanations. So these explanations cover key points, Chinese translations, and choice analysis of the question, and pauses between these different stages, just as a teacher would explain the question in a classroom setting. Yeah, so because of the much higher engagement level, we see that users really like these new features. So we think these are working great.

You also asked about upcoming products. So regarding our upcoming smart devices releases, we are focusing on harnessing capabilities of the language model to provide more high-value learning services, as you can imagine. Our goal here is to make the product experience as close as possible to what the students encounter when learning kinda in person with a teacher. This will make these devices kind of in different form factors vastly more useful compared to traditional learning devices, boosting learning efficiency and effectiveness and raising satisfaction. So we have exciting plans to launch multiple SKUs before the end of this year.

So, please stay tuned, and we will give you updates shortly. Yeah. Thank you.

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.

Feng Zhou (CEO)

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 U.S. Have a great day!

Operator (participant)

Ladies and gentlemen, the conference is now concluded, and you may now disconnect your lines. Thank you for joining, and have a nice day. Bye-bye.