Youdao, Inc. (NYSE:DAO) Q1 2022 Earnings Conference Call May 24, 2022 7:00 AM ET

Company Participants

Jeffrey Wang - Investor Relations Director
Feng Zhou - Chief Executive Officer
Lei Jin - Vice President
Peng Su - Vice President of Strategies & Capital Markets
Yongwei Li - Vice President of Finance & Senior Financial Controller

Conference Call Participants

Elsie Sheng - Morgan Stanley
Hongyi Cao - CICC
Linda Huang - Macquarie
Thomas Chong - Jefferies
Candis Chan - Daiwa

Operator

Good day, and welcome to the Youdao 2022 First 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 for Youdao. Please go ahead.

Jeffrey Wang

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 the future performance and are subject to the 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 filings of the company with the Securities and Exchange Commission. The company does not undertake any obligation to update 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 definition of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2022 first quarter financial results news release issued earlier today.

As a remainder, 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's senior management is Dr. Feng Zhou, our Chief Executive Officer; Mr. Lei Jin, VP of Operations; 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

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 renminbi, unless otherwise specifically stated. We're pleased to report solid performance in the first quarter of 2022 following the cessation of our K-9 academic AST business, with record-high revenues and overall gross margin as well as a significant improvement in operating loss.

Q1 net revenue was RMB1.2 billion, up 26.6% year-over-year and 14.5% quarter-over-quarter, a new record high. We also achieved an overall gross margin of 53.5%, another record high. Given the disposal of K-9 academic AST business, Retrospective adjustments to the historical statements of operations have also been made for the previous periods, which provides a consistent basis of comparison for the financial results of the continuing operations. Furthermore, we narrowed the operating loss by 41.6% year-over-year to RMB125.1 million from a loss of RMB214.3 million in Q1 2021. These results amid a challenging macro environment clearly reflects our strengthening fundamentals as well as the effectiveness of our strategy.

Liquidity wise, we have adequate funding for long-term growth. First, as of March 31, 2022, Youdao's cash, cash equivalents, restricted cash, time deposits and short-term investments totaled RMB1.2 billion. Secondly, our controlling shareholder NetEase Group has been supporting our long-term growth. Until the date of this release, Youdao has received the various financial support from the NetEase school. Among others, including RMB878 million short-term loans and US$300 million revolving loan facility. In support of Youdao's future business, NetEase Group has agreed to provide financial support for our continuing operations.

Now, I'd like to share more details on our first quarter progress. First, let's look at smart learning devices. Our Q1 device revenue was RMB253.2 million, representing an increase of 25.4% year-over-year. This is remarkable growth given the COVID related supply chain and sales channel challenges. In total, we sold 430,000 devices in Q1. As we discussed in past quarters, devices are a key growth area for us. An important priority this year is to drive growth and synergy by scaling up R&D, updating existing product lines and shipping new products. We strictly followed our strategy in Q1. We added new dictionary databases to Youdao Dictionary Pen, while we already have the most comprehensive dictionary database.

We added 11 new series of English textbooks to Youdao listening part with the total reaching 19. In terms of new products, more recently, in early April, we launched the Youdao's Smart Light. A product in development for over a year. Yoda Smart Light is a smart desk lamp with integrated AI learning features, powered by our advanced AI algorithms. It automatically analyzes users' hand and body movements while sitting at the desk, allowing the user to seamlessly access a host of AI learning functionalities while they are reading, writing or doing homework. You can point to an English word to look up or tap a sentence to have it read to you or ask it to check your arithmetic worksheet for you. It even tracks the users sitting posture and will alert the user when detecting unhealthy postures. After we launched the Youdao's Smart Light, the initial feedback is very positive. We plan to grow its popularity over the coming months as we did with other products. We are also looking forward to introducing additional smart devices this year as planned.

Now let's talk about learning strategies. Our strategy here is to transition from an academic AST center business to STEAM and vocational courses center business at an accelerated pace. Since Q3 last year, Q1 is the third quarter in which our team scaled up our growth products like the Weiqi courses and graduate school entrance exam courses. While at the same time, closing down academic AST courses has been a challenging process, and we have continued to deliver steady progress in Q1.

Our new courses are growing quickly, which partially offset loss of revenue from academic AST courses. Net revenue from learning services reached RMB826 million in Q1 2022, up 36.1% year-over-year. If we were to compare with the learning services net revenue, including K-9 academic AST business in Q1 2021, it declined by 17.3% year-over-year. Note that we were positively impacted by seasonality because Q4 was a major renewal season and a large part of gross billings generated in Q4 were recognized as net revenue in Q1.

As for STEAM courses, Youdao Chess expanded particularly fast with its gross billings increasing 170% quarter-over-quarter. Besides, we established a strategic partnership with the Haidian Chess Association. In addition to courses, our Go and chess user community has been growing at a fast pace. Here, we have the Youdao Boardgame Academy app, where users can play against others or learn, Go or chess with the help of our proprietary AI technology. Every day about 200,000 go or chess games are played on the Youdao game economy app and our other assets. This approach of combining courses and the community and AI-based app experience, is a major competitive advantage for us. The courses and the app drive each other's growth. In addition, Youdao has become an official online testing and certification site for which economies in Beijing and Anhui province. Throughout -- through the test, users can receive certifications for their skill by the Chinese Weiqi Association or Beijing Weiqi Association.

Let's turn to vocational and adult education courses. In Q1, we upgraded our gradual school entrance exam courses hiring to offer a one-stop service for our customers. We also explored online-merge-offline courses to increase the learning efficiency and effectiveness. With ongoing upgrade, the gross billings from the gradual school entrance exam courses grew by over 160% quarter-over-quarter. We also saw growing demand for other vocational courses, such as constructor certification courses and accounting courses with gross billings increasing over 7x year-over-year in Q1.

Our other endeavors, including education digitization business, dictionary and translation apps and our charity initiatives are also progressing smoothly in Q1. Looking ahead, we continue to implement our strategy of 4 growth pillars, that is: smart devices; STEAM courses; vocational education; and education digitization. The first 2 devices and STEAM courses are at a larger scale and already a significant part of our business. The latter 2 are making good progress in product development and business model validation. We expect to see challenges, including this new wave of COVID in China. We intend to overcome them through our diversity of businesses, large user bases and deep technical routes for innovation.

With that, I will turn the call over to Su Peng to give you more details on our financial performance. Su Peng?

Peng Su

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights for the first quarter of 2022. We encourage you to read through our press release, issued earlier today, for further details. For the first quarter, total net revenue were RMB1.2 billion or US$189.4 million. This represents an increase of 26.6% from the first quarter of 2021.

Looking at this growth by segment. Net revenue from our learning services were RMB826 million or US$130.3 million increased by 36.1% from the same period in 2021. We attribute this growth to the increased revenue generated from our learning services which were further driven by the growth in active users compared with the same period of 2021. Net revenue from our smart devices were RMB253.2 million or US$39.9 million increased by 25.4% from the same period in 2021, driven by the increase in sales volume of Youdao Dictionary Pen in the first quarter of 2022. Net revenue from our online marketing services were RMB121.4 million or US$19.1 million, representing a 12.7% decrease from the same period in 2021.

For the fourth quarter, our total gross profit reached RMB641.8 million or US$101.2 million, increased by 29.3% compared with the first quarter of 2021. Gross margin for learning services was 63.9% for the first quarter of 2022 compared with 63.4% for the same period in 2021. Gross margin for smart devices was 33.7% for the first quarter of 2022 compared with 44.1% for the same period in 2021. Gross margin for online marketing services was 23.7% for the first quarter of 2022 compared with 16.4% for the same period in 2021. For the fourth quarter, total operating expense were RMB766.9 million or US$121 million compared with RMB710.8 million for the same period of last year.

With that, for the first quarter, our sales and marketing expense were RMB506.4 million compared with RMB548.7 million in the first quarter of 2021. Research and development expense were RMB203 million compared with RMB127.7 million in the first quarter of 2021. Our operating loss margin was 10.4% in the first quarter of 2022 compared with 22.6% for the same period of last year. For the first quarter of 2022, our net loss from our continuing operation attributable to ordinary shareholders was RMB95.4 million or US$15.1 million. compared with RMB219.3 million for the same period of last year. Non-GAAP net loss from continuing operations attributable to ordinary shareholders for the first quarter was RMB70.9 million or US$11.2 million compared with RMB204.8 million for the same period of last year.

Basic and diluted net loss per ADS from continuing operations attributable to ordinary shareholders for the first quarter of 2022 was RMB0.77 or US$0.12. Non-GAAP basic and diluted net loss from continuing operations per ADS for the first quarter was RMB0.57 or US$0.09. Our net cash used in continuing operation activity was RMB425.6 million or US$67.1 million for the first quarter.

Looking at our balance sheet. As of March 21, 2022, our contract liability, which mainly consists of the deferred revenue generated from our learning services were RMB729.5 million or US$115.1 million compared with RMB1.1 billion as of December 31, 2021. At the end of the period, our cash, cash equivalents, restricted cash, time deposits and short-term investments totaled RMB1.2 billion or US$183 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.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question will come from Elsie Sheng from Morgan Stanley.

Elsie Sheng

I'd like to ask about the non-identical or the STEAM courses business. Could you give us more color in terms of the progress of this business and also the competitive landscape in this business.

Feng Zhou

Yes, this is Zhou Feng. I'll take your question. As I discussed in our prepared remarks, we're making good progress here. Yes, STEAM courses achieved rapid growth again in Q1. And as you probably know, go and chess are a strong area for us. Yes, we've operated go and chess courses for -- added together for about 2 years now. So our teams are experienced, and we have a differentiated product strategy. So again, that is to combine excellent teaching staff with polished interactive cost materials and also with AI tutoring and online community. In terms of progress in Q1, we are already a market leader for and we keep any new customers every quarter. So chess was particularly a bright-spot for us for Q1. As I said, gross billings for chess in Q1 increased by over 170 quarter-over-quarter. So chess caters to a smaller, probably smaller than go, but more affluent population compared to go. So we believe both are good businesses for us, so we will focus on both these courses.

Again, our cost is very differentiated from our peers. So we provide an integrated experience to our users. So -- and we made particular progress with the AI and the online community this quarter. So we upgraded the app experience so that the AI is more helpful when the students actually go review their chess games and their Weiqi or go games. So this improves their learning. And we improved the matching between the players so that they have a better experience when they go to the app and they get to match with the player with similar skill levels. And this improves their learning and experience a lot. So as always, our approach is to really to pick good areas to work on and patiently produce the best product in that area. So we did that with our devices. We did that with the rate. And we are doing that with the chess. So we believe that is the recipe for success. We don't intend to work to have too many courses, so many products. We want to be focused.

Apart from go and chess, we actually plan to pick 1 or 2 other areas to also be our focus going forward in this nonacademic course area. So we will share more information with the new products when we have them. Thank you.

Operator

The next question comes from Hongyi Cao with CICC.

Hongyi Cao

Congratulation for the good performance. My question is, can you give us more color on the new product, Smart Light? And how is the sales performance? And what is the momentum for this new product compared to your Dictionary Pen.

Peng Su

Thank you. This is Su Peng. I will take these questions. The first is just trying to emphasize again about the numbers of the Q1 with the performance of our smart devices as we catch up favorable windows of the new school mass opening and generated revenue of RMB253.2 million, representing an increase over almost over 25% year-over-year from Smart Devices segment in the first quarter. And for the Youdao Smart Lights, we go back to your questions. We have -- it's kind of the AI desk lamps and has been welcomed by the customer first. And we think the first we can share the number -- share some -- share performance about the first batch of the Smart Light has been sold out within the first month. since its launched in early April, reflecting the great performance, reflecting about the demand from the market. And we think about the reason behind about why we see the very positive feedback from the market. It's about -- we think about is we are -- we did create a lot of some different other innovative experience with our products. For example, subretinal ratio of JD.com until now, Fingertip World Search and the Sentence Intensive Reading. And we think we are the top 2 functions that we are mentioned as well as price by our customers. We think about that's what we are. What we did is just we are always insist [ph], we always try to provide a high-quality product to the market to meet the demand from the customers.

And we think about we will keep moving on and try to upgrade more functions to our Smart Device. We think about it will be -- gets a very positive feedback from the market. Although right now, it's still in a very early stage, and we think we are still a long way to go. And -- but we are confident about the performance of these new products in the long run. We expect we can share more information on the numbers and data with you in the second quarter earnings. And we think about that we have enough time to -- analysis of all the feedback from our customers and we can provide more products to the market.

Operator

The next question comes from Brian Gong of Citi.

Unidentified Analyst

This is Katrina asking on behalf of Brian. So my question is how should we look at the margin trend for the second quarter of 2022 and the full year? Have we done any cost optimization measures? And how should we think about the cost control going forward?

Yongwei Li

Katrina, thank you for your question. This is Wayne. I will add some color for the margin for 2022. As you've seen in this quarter, we achieved a new high record in overall gross margin at 53%. Therefore, we are very confident about the improvement in our gross margin in the long run. For Learning Service settlement, which is the largest segment from a revenue perspective and we have always seeking to optimize the cost structure and to achieve economic scale to get a better gross margin. On a full year basis, we expect average gross margin of learning services for 2022 will keep stable when compared with last year. Meanwhile, we also noted that the seasonal fluctuation on a quarter-over-quarter basis in its gross margin is due to the seasonality of the recognized revenue. For the Smart Devices segment, which is another significant segment, where we continue to invest in R&D and other resources, and we expect to achieve some growth on a year-over-year basis. However, the lockdown policy caused by pandemic have been making a significant impact on the production and the delivery of our smart devices, which further results in more uncertainties on both sales and the change of gross margin for this segment.

We expect an improved gross margin of smart devices with realization of the greater economic sales. However, we need to keep a close eye on the uncertainty around the margin of smart devices. Considering the margin of smart devices is relatively lower than the learning services element at the current stage. If a higher revenue portion from smart devices is achieved, the overall gross margin level is expected to be lower. As for operating margin, on one hand, we put efforts on improving the efficiency of sales and marketing as well as staff costs. On the other hand, we continuously strengthen our technical and R&D investment to keep our technical advantages. As you see, improved operating margin was achieved in this quarter, and we have tried to seek a better performance in operating margin in the long run, wish it is helpful.

Operator

Next question comes from Linda Huang of Macquarie.

Linda Huang

My question is regarding for the recent pandemic. We all know that this COVID situation remains [indiscernible]. So how is the impact from the recent pandemic outbreak like the Shanghai and Beijing? And if the city lockdown or the social distance restriction remains, do we have any contingency plan to mitigate the impact. So it would be great if the management, you can elaborate on learning devices and the learning services business?

Peng Su

Linda, this is Su Peng. I will take these questions. And indeed, recently COVID issues in some cities in China actually have some impact on our business. Yes, we also come out with some contingency plan and try to mitigate about the impact. And we will divide it into that -- into 2 parts because with the different impact on this business. And as for the Learner Services segment, that's well our major revenue generated from. And I think our process of our services is primarily delivered via the Internet. So we don't need that really the physical contact with our customers. Most of our services have been offering over the online channels instead of the offline learning centers. So what we think about we have very limited -- a very, very limited impact on the online learning services business. And so that's the first part. And secondly, as for the -- they do have some impact on our Smart Devices segment. And it's because of the smart devices, whatever they purchase is online or they purchase on the retail store, we have to deliver our products to our customer, that will be related to the logistics transportation issues. So we think about right now, indeed, that part, we have some challenging things regarding logistics and transportation for our products to our customers.

But we think about all of that will be the short-term impact. In the long run, we don't think -- by now, we don't think about -- there's any impact on the demand from our customers regarding on the services provided by our smart devices from Youdao because we see a very strong momentum and the demand from customers in the last several quarters regarding new pen. You can see about the growth rate and the growth trend of our Smart Devices business in the last several quarters. So, we think about -- so I think in the long run, that will go back to the normal. And indeed, we do -- by now, we are -- definitely, we are doing something to mitigate about the impact short term. And for example, we are setting up the new warehouse in Tianjin, Chengdu, Wuhan and other area in Mainland, China and to delivering these smart devices directly to the region distributors.

So we think about that's what we did, and we hope we can just mitigate about the impact short term, and we expect we can see the -- we expect to see the business go back to normal right after the impact the COVID has been caused. I think that will -- we expect renewals in the middle of the Q2, and we expect to share more information after we finish out the Q2 season. Thank you.

Linda Huang

Just a very quick follow-up. Do you see this -- the logistics disruption are the situations getting better off? Or this remains similar in April and May?

Peng Su

Yes, we think about it, it's getting better and better with the times going and -- but that's still depend on regions. I think that's because in the different regions, they have different policy regarding on the COVID issue -- COVID impact issue. So -- but in general, we see it's getting better. And we expect that, that trend will keep moving on and we can just give more products to our customers.

Operator

The next question comes from Thomas Chong of Jefferies.

Thomas Chong

May I ask about the upgrade on education digitization strategies and the addressable market.

Lei Jin

This is Lel Jin. I would like to highlight the execution digitization allocated by national market policy in the year included in new infrastructure for education joint media [ph] 14 -- 5-year digital economy development plan unified and annual working plan of the Ministry of Education in Damucang Hutong. There in talking Investments in digitization is clear from the national level. The central government hope to improve the quality of its digitized approach, you would not use our own software, hardware, AI advantage and which teaching experience to help public and our customers to achieve it. The digitization business is to focus on localized services, but due to the impact of the eminent control the opportunity to contact school has been reviewed. There are some partial delays in the progress of solution implementation. I believe it is only a short-term impact we're still content in this business in longer run. And though this is still early stage, and there are some alternative impacts. We have received a lot of official recognition.

Firstly, project on smart education quality system and teaching plans was included in the first batch of 5G smart education Palo [ph] by the Ministry of Industry and Information Technology and the military of the education. Secondly, we were also honored to be included in the new base of education by the facing useful size and technology commission, administrative commission of [indiscernible]. Thirdly, our smart mean terminal was selected as the recommended product in 2021 by people for its innovation and the improvement of teaching [ph]. According to the statistics from mid of education, there were more than 500,000 [ph] of all live and [indiscernible] in 2021 with more than 290 million into students and $80 million full-time future. In terms of a potential market size of the execution digitization, it is expected to be over RMB650 million in 2023 according to the [indiscernible].

Operator

The next question comes from Candis Chan of Daiwa.

Candis Chan

Great. And I would like to ask about your adult education business. And how does the growth outlook look like in this year? And also, can you share a little bit more color on our device pipeline for this year?

Feng Zhou

Thank you, Candis. This is Zhou Feng. Yes, first, regarding the vocational and adult courses. So current objectives for the teams are to basically upgrade our courses and focus on the growth products. As you probably know from the past few quarters, so the other courses segment for us has seen some challenges for the past few quarters. So one of the key reason is that demand for English courses, which were a large part of the business was significantly impacted by COVID. So we are not out of the transitional period yet.

Yes. So with that said, we have actually several bright spots in Q1. So we saw good progress on graduate school and [indiscernible] exam courses. So the gross billings from the graduate school entrance exam courses grew by over 160% quarter-over-quarter. Another bright spot is constructor certification courses. So it is a vocational of course, to help prepare for the exam to acquire a professional constructor certificate. The gross billings of this course increased over -- actually over 10x year-over-year. in Q1, although from a low base. Given the current macro environment of -- the government actually very actively promoting vocational education and overall strong demand from the sector. So we think that the prospect is actually quite right. So we will be patient here and spend time growing new products, perfecting the courses. So we believe vocational and adult courses have a big future. So that's for application on adult courses.

And regarding pipeline for our devices, so we said we will have other new products this year. So we already had one out, so the Smart Light is in the early April. And we expect to launch another new category of smart device in the second half of this year. That's our current plan. So moreover, we will also continue to upgrade the smart devices portfolios in preparation for the sales season of the new school year that's in September. So our lineup is basically -- right now, it's like this. We have Dictionary Pen as our flagship product. Then we have the Smart Light and Listening Pod as new upcoming products. And these 2 products are becoming more and more popular. So if we compare this with last year, last year, we only have the dictionary pain. And we achieved good growth with 1 category of product. This year, we have a more comprehensive lineup. This allows for a larger addressable market and also internally, it allows more sharing of technology expertise and personnel among the product lines.

So we think this is a good strategy and a lineup for us. And the plan is to have another category of new product in the second half of the year. So yes, I hope that's helpful. Thank you.

Operator

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

Jeffrey Wang

Thank you once again for joining us today. If you have any further questions, please feel free to contact us as at Youdao directly or reach out to TPG Investor Relations in China or the U.S. Have a great day.

Operator

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