Youdao, Inc. (NYSE:DAO) Q3 2024 Results Conference Call November 14, 2024 5:00 AM ET

Company Participants

Jeffrey Wang - Investor Relations Director
Dr. Feng Zhou - Chief Executive Officer
Lei Jin - President
Peng Su - Vice President, Strategy and Capital Markets
Wayne Li - Vice President, Finance

Conference Call Participants

Brian Gong - Citigroup
Thomas Chong - Jefferies
Brenda Zhao - CICC

Operator

Good day, and welcome to the Youdao 2024 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, sir.

Jeffrey Wang

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 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 purpose only. For the definitions of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2024 third 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 also available on Youdao's corporate website at ir.youdao.com.

Joining us today on the call from Youdao's senior management are Dr. Feng Zhou, our Chief Executive Officer; Mr. Lei Jin, our President; Mr. Peng Su, our 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.

Dr. Feng Zhou

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.

We are thrilled to announce an outstanding third quarter. Net revenues for the quarter reached RMB1.57 billion, marking a 2.2% increase year-over-year. Our profitability improved remarkably. Income from operations reached RMB107.3 million compared with a loss of RMB57.7 million in the same period last year. This represents our first profitable third quarter and sets a new quarterly record for income from operations. We are on track to achieve our first full year operational profitability this year. Additionally, operating cash outflow narrowed to RMB85.4 million, an improvement of 71% compared to the same period last year.

Now let's review the major developments across our business lines. Net revenues from learning services were RMB767.9 million, down 19.2% year-over-year, primarily due to our proactive focus on high-demand services and a reduction in low return of investment customer acquisition operations during the summer. Notably, customer retention continued to improve. Therefore, the overall financial health of our Learning Services segment significantly improved in Q3.

Within this segment, net revenues generated by digital content services, that is online courses, were RMB513.7 million. These revenues covered the costs and operating expenses and yielded meaningful profit. Our team focused on improving the products of Youdao Lingshi. We expanded our knowledge video library to nearly 40,000 targeting students of different learning levels. Additionally, we doubled the question bank to around 100,000 questions. Leveraging our advanced large language model, our AI can now automatically collect and categorize users' mistakes, adding new questions to enhance personalized learning experience. We also released new small class study experiences, including personalized monthly learning plans developed by our experienced learning counselors and AI recommended quizzes. This provides students with a welcoming and motivating learning experience that delivers great results and high retention rates. In the meantime, Youdao Literature continued to expand the use of AI writing refinements in Q3, leading to a 7 percentage point increase in conversion rates.

We expect a sustained strong demand for online learning services in the coming years. The key to success lies in our ability to deliver high-quality service and learning outcomes at scale. While we have made significant progress in online learning innovations as evidenced by quickly improving retention rates and positive customer feedback, there is still substantial room for further innovation. Fortunately, we now have new AI tools at our disposal and customer demand remain robust. We look forward to serving learners and families in innovative online learning solutions in the years ahead.

Sales of our AI-driven subscription services in the Learning Services segment continued to grow rapidly, approaching RMB70 million in Q3, representing over 150% year-over-year growth. This marks the seventh consecutive quarter of more than 50% year-over-year growth. On the product front, we released new AI translation upgrades in Youdao Dictionary and Youdao Translation. These updates includes multilingual translation support, customized glossaries and multi-model input capabilities for images and documents.

To date, our AI document translation service has processed over 100 million documents. Youdao Dictionary introduced an AI-powered voice simultaneous interpretation feature powered by our large language model Ziyue. This feature has seen over 4 million users in its first quarter and has become the most popular paid feature in Youdao Dictionary. Hi Echo also gained prestigious recognition this quarter and was prominently featured on the Apple App Store homepage. It also ranked in the top 10 for next-day retention on a renowned AI application ranking chart by aicpb.com. Following this launch, Mr. P AI Tutor received an enthusiastic reception, with nearly 20 million users in the third quarter and a monthly compound growth rate exceeding 100%.

For online marketing services, net revenues reached RMB489.4 million in Q3, representing an increase of 45.6% year-over-year. Gross margin increased to 36.3%, up 4.4 percentage points year-over-year. This growth was mainly driven by our expansion into new sectors and leveraging data applications and AI to optimize ad performance, pushing RTA revenues to a historical high and an over 100% increase year-over-year.

Additionally, we observed positive developments in overseas advertising, which accounted for approximately 20% of the ad revenue in the third quarter. Robust demand in games and related industries fueled growth, driving overseas KOL ad revenue up by over 50% year-over-year. We also upgraded our anti-fraud system for advertising in Q3, integrating real-time monitoring across multiple dimensions, optimizing quality control and identifying potential audiences. We expect ongoing algorithm upgrades and enhanced service quality to support the long-term growth of our online marketing services.

In the Smart Devices segment, net revenues reached RMB315.3 million in Q3, up 25.2% year-over-year and marking the highest revenue since 2023. Alongside this growth, this segment's overall health has significantly improved with gross margin rose to 42.8%, also reaching its highest level since 2023.

In terms of product upgrades, we launched the latest generation of our flagship dictionary pen, the X7 Pro. This high-end device featured a comprehensive 78 million word database and an AI camera that supports advanced LLM functions such as Mr. P AI tutor and AI translation. Notably, the X7 series has become the first learning device in the industry to support offline large language model translation with accuracy surpassing online neural machine translation.

The strong performance of our new products drove over 50% year-over-year net income growth for Dictionary Pens in Q3. Building on this success, I'm pleased to announce that we will launch a new product in the fourth quarter. Please stay tuned for further details.

So that is the summary of our progress in Q3. As discussed on this call earlier this year, we have two key objectives for 2024. rapidly integrating generative AI technology across our businesses to enhance competitiveness, both now and in the future and operational focus on streamlining our business lines to achieve full year operating profitability.

With robust results from Q3, we are making significant strides towards meeting these goals. By the end of the third quarter, cumulative income from operations had reached RMB64.6 million, a significant improvement compared with RMB542.6 million loss from operations in the same period last year. I'm confident that we will achieve full year operational profitability this year.

Looking ahead, we are committed to the continued implementation of our large language models, Ziyue, to enhance user experience and create greater value through digital content services, AI-driven subscription services and smart devices. In our online marketing services, we aim to explore new domestic opportunities while also expanding internationally to better support client success. Lastly, financially, we remain dedicated to prudent operations and strengthening our profitability.

With that, I will turn the call over to Su Peng to provide you with more detailed insights into our financial performance. Thank you.

Peng Su

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from the third quarter of 2024. We encourage you to read through our press release issued earlier today for further details.

For the third quarter, total net revenue were RMB1.6 billion or $224.1 million, representing a 2.2% increase from the same period of 2023.

Net revenue from our learning services were RMB767.9 million or $109.4 million, representing a 19.2% decrease from the same period of 2023. The year-over-year decrease reflects our commitment to a more selective customer acquisition approach, prioritizing higher ROI return on investment engagements. This strategy has helped enhance our overall resilience and efficiency of our business.

Net revenue from our smart devices were RMB315.3 million or $44.9 million, up 25.2% from the same period of 2023, which was primarily driven by the popularity of the Youdao newly launched products in 2024.

Net revenue from our online marketing services were RMB489.4 million or $69.7 million, representing a 45.6% increase from the same period of 2023. The increase was mainly attributable to the increased demand for performance-based advertisements through third-party internet properties, which was driven by our continued investment in cutting-edge AI technology.

For the third quarter, our total gross profit was RMB789.5 million or $112.5 million, representing an 8.2% decrease from the third quarter of 2023. Gross margin for learning services was 62.1% for the third quarter of 2024 compared with 67.8% for the same period of 2023. Gross margin for smart devices was 42.8% for the quarter of 2024 compared with 42.6% for the same period of 2023. Gross margin for online marketing services was 36.3% for the third quarter of 2024 compared with 31.9% for the same period of 2023.

For the third quarter, we reduced our total operating expense to RMB682.2 million or $97.2 million compared with RMB917.3 million for the same period of last year. Looking at our expense in more detail, sales and marketing expense declined to RMB519.6 million compared with RMB674.2 million in the third quarter of 2023. Research and development expense were decreased to RMB119.6 million compared with RMB187.3 million in the third quarter of 2023. Our operating income margin was 6.8% in the third quarter of 2024 compared with operating loss margin of 3.7% for the same period of last year.

For the third quarter of 2024, our net income attributable to ordinary shareholders was RMB86.3 million or $12.3 million compared with net loss attributable to the ordinary shareholders of RMB102.9 million for the same period of last year. Non-GAAP net income attributable to the ordinary shareholders for the third quarter was RMB88.7 million or $12.6 million compared with non-GAAP net loss attributable to the ordinary shareholders of RMB67.3 million for the same period of last year.

Basic and diluted net income per ADS attributable to the ordinary shareholders for the third quarter of 2024 were RMB0.74 or $0.11. Non-GAAP basic and diluted net income per ADS attributable to the ordinary shareholders for the third quarter was RMB0.76 or $0.11. Our net cash used in operating activities was RMB85.4 million or $12.2 million for the third quarter.

Looking at our balance sheet. As of September 30, 2024, our contract liabilities, which mainly consists of the deferred revenue generated from our learning services, were RMB839.7 million or $119.7 million compared with RMB1.1 billion as of December 31, 2023. At the end of the period, our cash, cash equivalents, current and non-current restricted cash, time deposits and short-term investments totaled RMB489.4 million or $69.7 million.

This concludes our prepared remarks. Thank you for your attention. We would now like to open the call to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] The first question that we have comes from Brian Gong of Citigroup.

Brian Gong

I have a very quick question. We have noticed that many of our peers have been increasing investments in the cost-related business, right? So can management share our strategies on this? And are we planning to increase our investment in the learning service sector in the future?

Peng Su

Thank you, Brian. This is Su Peng. I will handle the question first. I think aligned with our strategy of achieving the positive full year operating profit in the near future, we focus on strong demand services, which are scaling back on the low return customer acquisition efforts during the last summer -- during this summer, and we believe that the healthy and sustainable development is more essential for the long-term success.

And as you may notice, Youdao Lingshi definitely is a strategic priority for our business. Although there are some short-term headwinds, we remain optimistic about the medium and long-term growth. We expect to sustain strong demand for the online learning services in the coming years. Ensuring the financial health of our business, we will facilitate the development of the learning service, particularly in Lingshi. We believe that is our long-term strategy.

We believe that increasing our market shares over the midterm to the long term will primarily come from providing the differentiated and high-quality products and services to the users and improving their learning outcomes. We think our flagship products offer a unique combination of AI tiered learning videos and comprehensive learning consulting services. Through the AI enhancements and ongoing product upgrade, we enabled the users to achieve personalized education, improve learning efficiency and outcome.

The comprehensive services, including the learning diagnostics, learning path planning, paired learning video, AI creates recommendations and AI collection and the categorization of the students' mistakes, learning consulting services, one class study experience and also the AI college admissions advisers. I think that's the kind of the full services generated and driven by our AI.

We will definitely continue to invest in our products and services, which have strengthened our users' loyalty, evidenced in the upgrade in retention rate for the first quarter. The current retention rate, we just give you a little bit color for the Lingshi, has already hit about 70% by now, although the retention period has not finished yet. It's almost over, up about over 5% compared with the same period of last year.

Looking ahead, I think I'm confident in Lingshi development for the next year. On one hand, we will continue to focus on our personalization, prerecorded video learning, leveraging our AI capabilities and upgrade and enhance our users' learning experience. On the other hand, we will explore more offline opportunities, offering offers and service to our customers. I think that's our priority. And in the long term, the last point, we expect we will increase the investments on the product upgrade and also the customer acquisition following the strategy of the total companies. Thank you.

Dr. Feng Zhou

This is Zhou Feng. Let me add one point. Yes, for Youdao Lingshi, so marketing and customer acquisition, particularly in the summer is very important for its growth and performance. So there were some challenges on this front this summer. So on the other hand, we always believe that customer satisfaction and retention are more important and more fundamental. So as long as our retention is leading, our satisfaction is leading, I believe we will always find ways to grow the business and grow the student base. If you look at the number that we just -- Su Peng just shared, so recent retention period, we've already reached 70% retention. That's very good and already competitive. So I think that is the key thing and we are building future growth on solid foundations. Thank you.

Operator

The next question we have comes from Brenda Zhao of CICC.

The next question we have comes from Thomas Chong of Jefferies.

Thomas Chong

We are pleased to see that the smart devices sector has resumed year-on-year growth in the third quarter. Can we expect this growth to be sustainable?

Dr. Feng Zhou

Yes. So net revenue from smart devices reached RMB315 million in the third quarter, up 25% year-over-year. I believe several factors contributed to the rebound of device revenue.

The first one is positive outcomes from our strategic focus and channel reorganization. So earlier this year, we had a review of our device business, and we decided that we need to focus the team's work. We want to do fewer things and do them really well. So since then, I think increased focus of our operations, in particular, more focus on the dictionary pen products really paid off well in Q3.

The new X7 and X7 Pro are one of our most successful launches ever. The high-end product X7 Pro equipped with the new AI camera and a suite of exciting AI features like Hi Echo, Mr. P AI tutor has received widespread acclaim from users. This positive reception in turn drove net revenues and gross margin and the gross margin of smart devices and revenue have reached the highest levels since 2023.

So during the recent Double 11, I also want to share Double 11 shopping festival, our dictionary pen has again secured the top spot in terms of sales volumes in its category on both Tmall and JD.com. That is for five consecutive years in a row. Furthermore, our newly launched dictionary pen X7 Pro achieved the highest single product sales in its category on both Tmall and JD.com. So these accomplishments, I think, reflect our continued dominance in the market with that outstanding performance. So revenues of smart devices, we expect them to continue to perform in the fourth quarter, continue to grow in the fourth quarter.

The second factor is kind of enhanced team capabilities. The team, I think it's much more important than the product or the strategy. So our device team has seen ups and downs. In particular, we faced much pressure since last year, leading to a lot of reflections, re-planning and changes in our execution. So I'm pleased to see that in such a challenging environment our team has shown remarkable resilience.

They asked the right tough questions and executed on the new focusing strategy. So I think the team executed really well across functions, including product design, R&D, supply chain, sales and marketing. So leading to a significant recovery of the business. I believe any team that was able to go through downturns and reemerge stronger is more likely to succeed in the future.

So looking ahead, from a product pipeline perspective, we expect to launch a new product in Q4 with more new products scheduled in Q1 as well. So in terms of product strategy for dictionary pens, we emphasize cost effectiveness for mid-range products, including our A and S series, high quality and differentiation for high-end products, that is the X-Series.

And the whole product line will employ more large language model features to greatly enhance user experiences. We are more convinced that LLM has a lot more to offer for education products for years to come. So the team will be busy integrating more of such features into the products in the coming quarters. So we are on the right track, I believe, to more leading products, better financial health and profitability for the device segment. Thank you.

Operator

The next question we have comes from Brenda Zhao of CICC.

Brenda Zhao

I noticed your online marketing service continued to see strong growth momentum. However, as the business had a high base in the fourth quarter of last year, where should we anticipate the future growth potential of this advertising business?

Lei Jin

This is Jin Lei. Net revenue from online marketing services has recorded rapid growth for eight quarters, primarily driven by advancement in AI, including ongoing algorithm optimization and enhanced data applications. Additionally, our team's execution is steadily improved. Looking ahead, I believe that there is a significant growth potential for both domestic and international advertising in the medium to long term. In the domestic market, we anticipate substantial opportunities in following sectors.

First, the online entertainment industry, such as gaming and social media. In this summer vacation, we drove the gaming AD revenues to a historical high in Q3. In addition, enhanced data analysis and optimized algorithm models have improved monetization rates by over 90%.

Second, AI tools. Since the rapid development of the domestic large language models in the later half of the last year, major tech companies had significantly increased marketing budget for their AI tools, a trend we captured on to drive rapid growth during the last several quarters. Future demand for AI tools advertising is excited to this future.

Third, the automotive industry. The consumption stimulating policies are anticipated to benefit the automotive and related services sectors, likely driving increase in advertising demand.

In the international market, we became a primary agent for TikTok in the first half of this year. Recently, we have established the initial intention for cooperation with several global tech gens with formal partnership is expected in the near future, being a solid foundation for our future global expansion.

In the meantime, growth in our advertising business also faced certain short-term challenges. For example, as you mentioned, AD revenue set a very high base in the fourth quarter of the last year, and e-commerce advertising has not been so robust during the recent Double 11 shopping festival. In addition, recent updates on our international macro factors have added uncertainty to overseas advertising. However, from a financial health perspective, the profitability of the AD advertising is expected to maintain a solid level in the fourth quarter. The focus aligns with our broader strategic objective for the year and remain a key metric under the current conditions. Thank you.

Operator

The last question we have comes from [Bo Zhang] of Huatai Securities.

Unidentified Analyst

This is [Jambua]. My question is about what is the management's outlook for the fourth quarter?

Wayne Li

Thank you, [Jambua]. This is Wayne. As we mentioned before, we have focused on the digital content services, online marketing services and AI-driven subscription services this year with a particular emphasis on advancing generative AI to achieve full year operating profitability in the near future.

For the past three quarters of this year, we have seen significant improvement from our financial side. Net revenue for the first three quarters of this year reached RMB4.3 billion, representing an increase of around 10% year-over-year. We achieved positive cumulative income from operations around RMB65 million compared with around RMB543 million loss from operations in the same period of last year, very significant improvement.

The strong financial performance fully demonstrates that our strategy around AI technology plus education is on the right path, and we are very confident that we will achieve the profitable objective of this year. Looking forward, we will continue to facilitate the integration of generative AI technology around our business to enhance competitiveness.

First, learning services. The robust demand for online learning services is expected to persist well into the coming years, and we are confident in the medium- to long-term growth potential of our learning services. Our success will hinge on our ability to deliver high-quality services and learning outcome at scale. As mentioned in previous questions, high school business remains our top priority. The demand for high school business is robust, which is likely to sustain in the coming years.

We've been building the best instructor team and incorporating AI function in our learning services for years. The strong AI technology advantages give us confidence in the strengthening competitive advantages in the high school business. In the chain of AI-driven subscription services, we are committed to advancing our current offering while exploring new avenues to enhance user experience in learning, work and daily life. For the fourth quarter, we still expect the total sales in AI-driven subscription services to maintain rapid year-over-year growth.

Second, online marketing services. We have witnessed rapid growth and continued improved profitability of online marketing services for eight consecutive quarters. In the near term, the advertising business serves as a cash cow and crucial profit center. Over the long term, we will continue to explore strategic growth area, both in the domestic and international market. As said, we will provide updates on significant developments as they arise.

Third, smart devices. We treat AI integrated smart devices as one of the most exciting opportunity of recent years. While smartphone and tablets continue to dominate many usage scenarios, the market for traditional smart devices is shrinking. However, the integration of AI into smart devices paves the way for innovation, including the creation of devices either smaller than smartphones or larger than tablets to meet user demand.

In addition, edge-based LM unlock new opportunity for smart devices. As discussed in today's prepared remarks, our Dictionary Pen X7 series have become the first learning device in the industry to support offline LLM translation with accuracy, surpassing online mutual machine translation as we are further tapping the potential integration of edge-based LLM into our smart devices to better serve users.

In the long run, our extensive experience in [edu-reasons], supply chain management and sales channels provide a strong foundation for sustainable growth in our smart devices segment. Additionally, our planning for next year is underway. We are looking forward to share more insights in the next earnings call. Thank you.

Dr. Feng Zhou

Let me add a little bit more information. This is Zhou Feng. If you look at our financial performance this year and last year, you can see that we improved the overall financials a lot this year. We are growing the business and operationally profitable two or three quarters this year so far and on the right track for Q4 and the full year. In addition to that, we have created new products and high-growth revenue streams like new online courses, RTA ads, international KOL ads, AI-driven subscription services, that's a highlight; and also high-end dictionary pens, the X7 series. These will drive our growth in the immediate future, and we will have more to discuss in future calls.

Putting this together, it means our focusing strategy this year and also our bet on large language model applications since last year, these two strategies have really been working. AI plus education is an exciting opportunity and is already having a great positive impact on our business. So Youdao is aiming to lead in AI plus education in China. Thank you.

Operator

That concludes our question-and-answer session. I would now like to turn the conference back to Jeffrey Wang for any additional or closing comments.

Jeffrey Wang

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

Operator

Thank you, sir. Ladies and gentlemen, that then concludes today's conference. Thank you for joining us. You may now disconnect your lines.