Youdao - Q4 2022

Transcript

Operator (participant)

Good day, welcome to the Youdao 2022 fourth quarter and full year earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Jeffrey Wang, Investor Relations Director of Youdao. Please go ahead.

Jeffrey Wang (Director of Investor Relations)

Thank you, operator. Please note the discussion today will contain forward-looking statements related to 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, assumptions, and other factors. Some of these risks are beyond the company's control and could cause actual results to differ materially from those mentioned in today's press release and this discussion. A general discussion of risk factors that could affect Youdao's business and financial results is included in certain filings of the company with the U.S. Securities and Exchange Commission. The company does not undertake any obligation to update this forward-looking information except as required by law.

During today's call, management will also discuss certain non-GAAP financial measures for comparison purpose only. For the definitions of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2022 fourth quarter and full year 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's senior management is Dr. Feng Zhou, our Chief Executive Officer, Mr. Lei Jin, our President, Mr. Peng Su, our VP of Strategy and Capital Markets, and Mr. Wayne Li, our VP of Finance. I will now turn the call over to Dr. Zhou to review some of our recent highlights and strategic direction.

Feng Zhou (CEO)

Thank you, Jeffrey. Before we begin, I would like to remind everyone that the financial information and non-GAAP financial information mentioned in this release is presented on a continuing operations basis, and all numbers are based on renminbi, unless otherwise specifically stated. Our financial performance in Q4 was strong, producing record high net revenues and achieving our first-ever income from operations. Net revenues soared to a record RMB 1.5 billion in Q4, up 38.6% year-over-year. Income from operations reached RMB 24.6 million, compared with the loss from operations of RMB 248.3 million in the same period of 2021. Total gross margin climbed to 53.3%, rising by 11% year-over-year. In terms of cash flow, we achieved an operating cash inflow of RMB 84.1 million.

These results were primarily driven by the solid performance of our new services and smart devices. Sales of digital content services reached over RMB 600 million. Besides, the gross margin has been above 60%, and net revenues have covered the cost and operating expenses for two consecutive quarters. As for smart devices, strong new product sales drove approaching 100% year-over-year growth on November 11 Shopping Festival, and facilitated the growth of net revenues from this segment to the best level of RMB 407 million in Q4. Let me walk through the key financial metrics for second half 2022. Net revenues reached RMB 2.9 billion in second half of 2022, increasing 36.8% year-over-year. Gross margin was 53.7%, improving 6 percentage points year-over-year.

Loss from operations reached RMB 194.4 million, narrowing by 59% year-over-year. Operating cash outflow improved to RMB 210 million, a decline of 63.8% from the second half of 2021, which included discontinued operations. For the fiscal year of 2022, our key financial indicators improved significantly. Net revenues reached RMB 5 billion, up 24.8% year-over-year. Gross margin was 51.6%, improving 2 percentage points year-over-year. Loss from operations was RMB 774.7 million, narrowed by 17.9% year-over-year. Operating cash outflow improved to RMB 603.1 million, a decline of 55.2% from 2021, which included discontinued operations.

I would like to add more color to our business progress in Q4. Net revenues from smart devices hit RMB 407 million, up 28.1% year-over-year. Dictionary pen sales exceeded 400,000 units, the majority of which were the new products launched in 2022. Product-wise, we launched the Youdao Dictionary Pen P5 in Q4, especially specifically designed for professionals. Updated with 5 million professional terms in 16 professional fields. It provides translation into over 100 languages and enhances recognition accuracy by more advanced natural language processing. We also launched Youdao Smart Learning Pad X10 in Q4 with an upgraded AI-supported learning dashboard for better personalized learning experiences. As we enter the field of education tablets in Q3, the compound monthly growth rate of sales units exceeded 100%.

Moreover, for the first three months after we launched the Learning Pad X10, its compound monthly growth rates of sales units was nearly twice that of the Y10 for the same period. As for learning services, net revenues reached RMB 806.3 million in Q4, up 39.2% year-over-year. Gross margin of learning services climbed to 64.1%, improving 13 percentage points year-over-year. We have been exploring digitization of our learning services and have made significant progress. In Q4, we upgraded Youdao Literature Creative Writing, which was co-developed by Youdao and Minecraft Education Edition. The digitized content effectively enhances learners' interaction and engagement, making learning materials easier to understand and more attractive. I encourage you to view the video on our IR website.

In addition, the champion class of Youdao Go was released in Q4 with a teaching team led by world champion Ke Jie. The Youdao Go courses create a learning path starting from entry level to advanced level, followed by champion-level classes. The successful adaptation of these progressive courses drove the gross margins up by over 50% year-over-year in Q4. Besides, the retention rate of the advanced level class reached over 70%. In terms of adult courses, we released upgraded solutions to the post-graduate entrance exams. It offers comprehensive solutions from target consultation to hybrid tutoring by AI and humans. Students are thrilled with these new features, leading to gross margins up by nearly triple digits year-over-year in Q4. Meanwhile, gross billings from vocational courses such as IT and internet and constructor courses increased over 100% year-over-year in Q4.

Looking back, we stuck to customer-oriented philosophy and enhanced the customer experiences with upgraded services and smart devices facilitated by technology and innovation in 2022. We released the world's first Dictionary Pen OS and launched digital content services that enhanced learning efficiency and effectiveness, which was quoted by customers and ultimately reflected in our financials. Moreover, the share repurchase program demonstrated management's confidence in future growth of the business. Looking ahead, we will continue to leverage our cutting-edge technology and innovation to promote the sustainable development of smart devices, digital content services, and STEAM courses, further improving our business healthiness and financial performance. With that, I will turn the call over to Su, Peng to give you more details in our financials. Su, Peng.

Peng Su (VP of Strategy and Capital Markets)

Thank you, Dr. Zhou, and hello, everyone. Today I will be presenting some financial highlights from our 2022 first quarter and full year. We encourage you to read through our press release issued earlier today for further details. For the first quarter, total net revenue RMB 1.5 billion or $210.8 million. This will represent an increase of 38.6% from the first quarter of 2021. Net revenue from our learning services were RMB 806.3 million or $116.9 million, representing a 39.2% increase from the same period in 2021. We attribute this growth to the strong sales performance from the new services initiated after the implementation of the double reduction policy.

Net revenue from our smart devices were RMB 407 million, or $59 million, up 28.1% from the same period in 2021, driven by the popularity of the Youdao newly launched products such as the Youdao Dictionary Pen X5. Net revenue from our online marketing services were RMB 240.8 million or $34.9 million, representing a 58.6% increase from the same period in 2021. The increase was mainly attributable to the increase in performance-based advertisement through third-party internet property. For the first quarter, our total gross profit was RMB 774.7 million or $112.3 million, representing a 74% increase from the first quarter of 2021.

Gross margin for learning services was 64.1% for the first quarter of 2022, compared with 51.4% for the same period in 2021. Gross margin for smart devices was 46.2% for the first quarter of 2022, compared with 30.8% for the same period in 2021. Gross margin for online marketing services was 29.2% for the first quarter of 2022, compared with 32.6% for the same period in 2021. For the first quarter, total operating expense were RMB 750 million, or $108.7 million, compared with RMB 693.6 million for the same period of last year.

For the first quarter, our sales and marketing expense were RMB 515.9 million, compared with RMB 420.4 million in the first quarter of 2021. Research and development expense were RMB 179.5 million, compared with RMB 170.2 million in the first quarter of 2021. Our operating income margin was 1.7% in the first quarter of 2022, compared with operating loss margin of 23.7% for the first same period of the last year.

For the first quarter of 2022, our net income from continuing operations attributable to ordinary shareholder was RMB 12.3 million, or $1.8 million, compared with net loss from continuing operations attributable to ordinary shareholders of RMB 215.9 million for the same period of last year. Non-GAAP net income from continuing operations attributable to ordinary shareholder for the first quarter was RMB 31.1 million, or $4.5 million, compared with non-GAAP net loss from continuing operations attributable to ordinary shareholder of RMB 168.2 million for the same period of last year. Basic and diluted net income per ADS from continuing operations attributable to ordinary shareholders for the first quarter of 2022 was RMB 0.1 or $0.01.

Non-GAAP basic and diluted net income from continuing operations per ADS attributable to ordinary shareholders for the first quarter was RMB 0.25 or $0.04. Our net cash provided by the continuing operating activity was RMB 34.1 million or $12.2 million for the first quarter. Turning to our full year results. Our total revenue for 2022 increased by 24.8% to RMB 5 billion or $726.8 million. Net revenue from our learning services for 2022 were RMB 3.1 billion or $447.2 million, up 26.3% from 2021.

Net revenue from our smart devices for 2022 grow by 28.2% year-over-year to RMB 1.3 billion or $182.2 million. Net revenue from our online marketing services for 2022 were up 13.2% year-over-year to RMB 672.4 million or $97.5 million. Total gross profit for 2022 was RMB 2.6 billion or $375 million, compared with RMB 2 billion in 2021. Total operating expense for 2022 increased to RMB 3.4 billion or $487.63 million, compared with RMB 2.9 billion in 2021.

Net loss from continuing operations attributable to your ordinary shareholder for 2022 was RMB 770.9 million or $104.5 million. The basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for 2022 was RMB 5.83 or $0.85. Looking at our balance sheet, as of December 31st, 2022, our contract liabilities, which mainly consists of the deferred revenue generated from our learning services were RMB 1.1 billion or $154.7 million, compared with RMB 1.1 billion as of December 31st, 2021.

At the end of the period, our cash equivalents, restricted cash, time deposits, and the short-term investment totaled RMB 1 billion or $147.4 million. This conclude our prepared remarks. Thank you for your attention. We would now like to open the call to your questions. Operator, please go ahead.

Operator (participant)

Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your telephone keypad. If you are using a speaker phone, 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 Citigroup. Please go ahead.

Brian Gong (Internet & Media Research Analyst)

Good evening, management. Thanks for taking my question. Congratulations on the solid results. My question is about the outlook for this year. What's management's expectation for the revenue for 2023? What are the key drivers of learning services this year? Thank you.

Peng Su (VP of Strategy and Capital Markets)

Hello. Hello, Brian. Yeah. Our mission is to make learning happen, and we are doing that with the other business that we do, including our devices, our artificial intelligence-based

Feng Zhou (CEO)

Our learning services and also our teaching staff. We believe at this particular time, at this moment, we're in a good position to both grow the impact of our business and also improve our financial metrics, including top and bottom line and cash flow. For this year. You ask about the drivers for learning services. This is our largest sector. Yeah. I see several things that works in our favor, but I'll talk about two major drivers. One is digital content services. We've talked about this form of a product for several quarters. Yeah. Popular.

We have popular products in this form, including Youdao literature, Youdao Bowen. In 2022, it has proven that interactive content instead of live classes, live courses based learning, are a great way of delivering learning services. These services have consistently expanded for us in 2022. The customers really like them. We expect it to be the preferred way for us to offer new learning services in 2023.

Our teams are constantly looking for new content opportunities, and also using AI assisted ways to do digital content and also use things like immersive learning ways of offering this new content, whatever works for the particular area and also for the particular user need. We will continue to scale our digital content services by both adding new content and iterating on existing ones. We're bullish on this area. It's already proven and we have, our teams have many ideas and we will do a lot of work in this area. The second driver I see is is STEAM. Engineering, math and arts, so extracurricular kind of content.

We've talked about this trend before. As children's learning in China evolve, families are more and more willing to invest in STEAM learning like art engineering and other extracurricular activities. We offer very good computer programming courses, and that's, that'll be a focus area for us in 2023. We already have a leading and healthy Go game and chess course business. It grew by over 50% in Q4. Yeah. It is also a very special service. It's a very, I would say, a Youdao type of service, as it employs an excellent teaching staff, leading AI learning technology and has a thriving learning community.

The kids can actually play each other on our platform. You can imagine that we provide a very good user experience during the process because that's what we are good at. Because users are satisfied. We were able to basically double the size of the business in 2022. It is a testimony of a family's preference and need for this kind of extracurricular content. We will continue to look for opportunities in this area. I believe it is our unique ability to combine technology and great content and great teachers to for us to be able to be leading in this area.

In Q4, we were able to achieve profitability. This speaks to the results of our focus on the kind of the healthy operation of our business. This will also be, continue to be a focus for us for this year. We focused on not on kind of absolute growth numbers. We focused on unit economics of our various services. We also focused on user satisfaction. We put a lot of focus on that and because That's how we operate. At NetEase and Youdao, we've always been doing this, and we believe this will lead to we have a bright future for us in this year and beyond. I hope that answered your question.

Peng Su (VP of Strategy and Capital Markets)

Yeah. Yes, Brian.

Brian Gong (Internet & Media Research Analyst)

Yeah. That's very helpful.

Peng Su (VP of Strategy and Capital Markets)

Yes. If you I think you asked about the trend of the business growth as, in the 2023. If you, yeah, I think Dr. Zhou has already explained about the drivers as well as the key numbers we have reviewed in our earnings.

Feng Zhou (CEO)

There's, I think there's one more point I just want to add it here. It's just if you go back to look the first half or second half of 2022, the number is a little bit different. You can see about the If you look at the revenue in the first half of 2022, it grow about 12% compared with the first half of 2021. In the second half, the revenue growth rate reached almost, it's over almost 40%. It's 37% in the second half of 2022 compared with the second half of 2021.

the numbers, including the revenue from learning services, smart devices, or the online marketing service, it's also grow much faster, much higher than the second half over the first half. Also the net loss, if you go back to the net loss numbers, the first half we almost lost about RMB 600 million. But if you look at the second half, it's narrowed down to even below RMB 200 million. We also decreased cash outflow over RMB 100 million in the second half compared with the first half

I think we've built a more strong trends or strong momentum in the second half, and we expect to keep that momentum in 2023. I think that can show how we build up. Like Dr. in the last mention about how can we focus. How did we focus on a healthy operation and a healthy financial performance. Thank you. That's only, that's the point I added. Hope that answer your question, Brian. Thank you.

Brian Gong (Internet & Media Research Analyst)

Yes. Thank you. That's very helpful.

Operator (participant)

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

Liping Zhao (VP)

Good evening, Dr. Zhou and Su, Peng. Thanks for taking my questions. My question is about your AI R&D. According to recent media reports, your company has invested in AIGC in education scenario. Could you please share more color on that topic? Thank you.

Feng Zhou (CEO)

Thanks for that. It's a hot topic. Yeah. Everybody's talking about it. You know, I believe AIGC and large language models are going to have a significant impact on education technology and maybe a lot of kinda technology and product areas, business areas. It's a very long-term thing. This year we will see new products. Next year, we will see some company come up with a lot of new ideas. It's also gonna take it I would say a pretty long time to mature. We are looking carefully at this area.

What I can say is that we are prepared and we have the related technology foundations. Not the specific technologies, but the technology foundations, and we will pay a lot of attention to it. It's a very diverse and wide area of technology. If you really look at the details, there are several important pillar technologies in this wave of the what I would call modern language model technology innovation. There are several ones. One is what we call a transformer model, transformer models. Yeah. Another is a huge language data sets.

Also faster training and inference of these large models, a lot of technologies in that front. To name a few of these kind of pillar technology. Our teams actually have experience and have done work in most of these, these areas, through our work in translation, in AI learning devices and other areas like grammar correction, things like that. It's not mature yet. It's not like that as a lot of media talked about, it's gonna change everything overnight. I don't think so. Yeah, so, but, it's very promising. We will keep a close eye on it.

It's the fundamental difference about this wave of technology is, I would say, the versatility and generality. Basically, you can use one or several models to tackle dozens or even hundreds of different usage scenarios, different problems before. Before we need to build separate models for one of, each one of them. Now, maybe one or a few models will be enough. That's very promising. Yeah. That's what we can share right now. We believe that this will have a big impact on education technology related businesses in the coming years.

Yeah, when the opportunity, when the kind of very concrete opportunity actually comes, we will be prepared. We will be in the very good position. Yeah. Thank you.

Liping Zhao (VP)

Thank you.

Operator (participant)

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

Thomas Chong (Managing Director)

Hi. Good evening. Thanks management, for taking my questions. My question is that, will there be any new smart devices introduced in 2023? Which SKU will be the key contributor in the smart device segment for this year? Thank you.

Feng Zhou (CEO)

Thomas, let me take this question. As you can see, our dictionary pen, learning pads, and listening pods were doing quite well in Q4. We reached record revenue for the devices sector. Given the kind of challenging macro environment we're in, I believe that speaks to the effectiveness of our strategy. Basically, we focused on a few key products. We didn't receive like a sea of different devices. We didn't do that. We focused on a few key products, we tried our best to deliver meaningful innovation in each new product iteration. That works because parents don't need kinda white label, low quality learning devices.

They want the best products for their kids. We intend to offer that. If we can do that, then our product will do best in the market. Our key strength continues to be the unique ability to combine hardware, AI software abilities, and also great learning content. In the Chinese learning devices market, we believe we are the only one truly capable of doing all three really well. Of course you mentioned... You talked about new products. New products will always contribute to our growth. Will, but yeah. I wanna first talk about something else.

That is our new generation hardware and software platform. Our latest X5 and P5 Dictionary Pen are based on a new generation hardware platform. A lot of work went into the platform. We used different chips. We made sure the platform had features, had the capabilities that we need for not only the last year's products, but also kinda this year, maybe more products. We made sure that we can achieve the competitiveness that we want to achieve in this platform.

For example, we cooperated very deeply with our chip partner, with our computer chip partner, SOC partner, Rockchip, to enhance the NPU, the neural processing unit, for better efficiency in running the AI computation models that we are making a lot of improvements on. We want the chip to be able to execute larger models, to be able to execute them with better energy efficiency. We want kinda specifically design the models that only we have to be able to run well on those chips. The, maybe, the net result is that we are able to reduce already low translation error rates further by over 60%, while improving the speed of the device by 50%.

I believe this new platform is very important for us. Allows a lot of innovation to happen. Also allows kind of the sharing of work between our products. Runs our Youdao OS operating system. Shares common apps, and also brings in apps from high quality content providers like Himalaya, like Raz-Kids, and like NetEase Cloud Music. Our dictionary pen users will be able to enjoy these great content on devices, while these contents are not available on our peers' devices. Lastly, and not important. It's probably very important.

The new platform has a very good cost structure. You can already see the results of the cost structure in Q4's results as X5 and P5 helped Q4's device gross margin ratio. The gross margin ratio in Q4 was 46%. A record high for us.

Lei Jin (President)

Applying these new hardware platforms to more products is a priority for us in 2023. Maybe also talk a little bit about the Learning Pads. We expect the Learning Pad to be an important growth contributor in 2023. Our key advantage here is that we have both the product and also the selling expertise and more importantly, we have our teaching staff, the very experienced teaching staff that we have contributed a lot to the development of these Learning Pads and our X10 and the Y10 SKUs, they currently cover the mid-market price points. We are planning to cover other price points with new products this year.

That will make a lot of customers more happy, we believe. Lastly, we are also looking at a new category opportunity. We will share more information when we have them. Yeah. Thank you.

Peng Su (VP of Strategy and Capital Markets)

Thomas, this is Peng Su. Just [inaudible] talks about. If you go back to see our learning products development process, and we released our Youdao Dictionary Pen 2 in the middle of September 19th. You know, for the language learning, there are always four capabilities, including listening, reading and writing and speaking. We start from the dictionary pen, which helps the students and users to reading and writings. Right after it, we released about listening part to cover the listening and speaking to the users, including the potential users as well as the existing users. Right now we just moved to the Learning Pad and beyond the language learnings.

We start from I think you can understood our strategy of our develop the new products or learning products of Youdao through the above, through the process of the from dictionary pen to the Learning Pad. We're starting from the language learning. It's because we can leverage the strength of our dictionary pen, dictionary app. Right now we are we think we do more than the learning, English language learning. It's because right now we have already existing branding and existing users for the learning products sectors. We think about in the future, we will always leverage our strength of our products and brandings to release more categories in the long run. I think that's. I hope that can help you answer your questions.

Thank you.

Thomas Chong (Managing Director)

Thank you.

Operator (participant)

Our next question today will come from Linda Huang of Macquarie. Please go ahead.

Linda Huang (Head of Asia Consumer Research)

Thank you very much for the opportunity to ask the question. Mine is regarding for online marketing business, because we see that the Q4 number is quite impressive, especially for the year-over-year revenue growth. Can the management help us to walk through what is the key reason behind that? How sustainable is the business we're going to the 2023? It would be great if you can give us some more color for this year. Thank you very much.

Lei Jin (President)

Thank you, Linda. This is Lei Jin. The our advertisement is segment is the modest segment for us. It is relatively smaller than our learning service and micro devices segment. We still like it because it is stable and constantly growing. This quarter, the AD business is doing very well. The net revenue from this segment increased almost 60% year-over-year. It has reached RMB 240 million in Q4. We have always been focused on the customer value and technology-driven approach to the digital marketing. It's paying off when more and more customers pay more attention to the return of the investment of their marketing.

For the internal perspective, we upgraded our advertising system with more timely and accurate commercial data. The result to our performance-based advertisement was improved, and we brought better ROI to our clients. From the external perspective, we saw marketing demand from the online entertainment industry increased in the fourth quarter, which is major driven by our AD revenue. The number of clients increased around 20%, they spend more money on the advertisement. In terms of outlook for the online marketing service this year, I'm cautiously optimistic. We expect the revenue from the online marketing services to continue to increase on a year-over-year basis this year. With the macro environment, it is still very challenging.

The good news is that our many several economic policy has been rolled out since the Chinese New Year. Besides online entertainment clients, we are also seeing more AD budgets in the financial and transportation industry with the performance

Based advertisement. This is a very good start. Thank you. Hopefully it's helpful to you. Thank you.

Linda Huang (Head of Asia Consumer Research)

Thank you very much. Yeah, thank you.

Operator (participant)

Our next question will come from Candice Chung of Daiwa. Please go ahead.

Candice Chung (Analyst)

Great. Hi, management. Thank you for taking my question, and also congratulations on the strong set of results. My question is related to the gross margin trend for each segment for 2023. We have seen that for learning services and also smart devices, they've seen a great improvement in terms of the gross margin this year. Can you share about the trend going forward? Thank you.

Wayne Li (VP of Finance)

Thank you for your question. We achieved excellent performance on our overall gross margin in 2022, reaching around 52% this year, up from 50% last year. The increase in our gross margin was mainly driven both from our learning service and smart devices. As you mentioned, I'd like to add some color on this on going forward basis. To begin with our learning services, we achieved healthy sales in our digital content service in 2022. We expect even high revenue base to be achieved in 2023, which will bring us added benefits from economics of scale from our learning services.

For example, decreasing trend in the percentage of revenue shared with our instructors was noted on a year-over-year basis, which lead us to believe our gross margin for learning services will also slightly increase over the long run. Furthermore, for our smart devices segment, the average gross margin in 2022 was 39%, slightly up from 37% in 2021. We are pleased to note that in this quarter, gross margin for our smart devices reached 46% after we launched X5, updated generation of Dictionary Pen. We regularly update our smart devices, and the new version is usually with a higher gross margin level during its launch stage due to a higher price, better platform, and well, popularity. This is the reason why we could achieve a better performance of gross margin in this quarter.

We expect the gross margin will gradually reach a stable level. In the long run, we believe the gross margin of smart devices will keep at or above 40%, which is very healthy and make us more competitive. In conclusion, going forward on the annual basis, we still expect a reasonable improvement on our margin of learning services and the smart devices, while our entire business margin will be flat compared with last year. That's all. Wish it is helpful. Thank you.

Operator (participant)

Ladies and gentlemen, this will conclude our question and answer session. At this time, I would like to turn the conference back over to management for any closing remarks.

Wayne 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 Financial Communications in China or the U.S. Have a great day.

Operator (participant)

The conference has now concluded. We thank you for attending.