Youdao Inc (DAO) 2023 Q3 法說會逐字稿

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.

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 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 would affect Youdao's business and its 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 these 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'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.

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.

In Q3, we achieved record-high net revenues of RMB 1.5 billion, marking a year-over-year increase of 9.7%. Loss from operations narrowed by 73.7% year-over-year to RMB 57.7 million. Net cash used in continuing operating activities amounted to RMB 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 currently 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, especially 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 the domain. We are very excited about opportunities presented by large language models. I am delighted to share that Youdao is playing a leading role in the rapid advancement of LLMs and their application in education.

Recently, we achieved a notable milestone with the receipt of relevant filings for our proprietary LLM, Ziyue, this month. This underscores the acknowledgement 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 am happy to share that Hi Echo has already accumulated more than 100,000 registered users, a quick uptake. Additionally, we continued to enhance AIBox in Youdao Translation and introduced 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 RMB 950.8 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 digital content services exceeded RMB 400 million in Q3 with gross margin ratio exceeding 70% that hit the record high. During Q3, we released an AI quiz recommendations 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 2nd National Children's Weiqi Open Championship.

Turning to online marketing services, we continue to see strong growth momentum in Q3. Net revenue of online marketing services reached a historic high of RMB 336.1 million, marking a 113.5% year-over-year increase and 4 quarters of over 50% growth. We continue to deploy enhancements to both AI ad-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 segment, net revenues were RMB 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 of 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 continued short-term negative impact in this segment before the optimization is likely to conclude by the end of this 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 embraced 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 device Sell-Out 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 education 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 is Peng Su to give you an update on our financials.

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 revenues were RMB 1.5 billion, or USD 210.9 million, representing a 9.7% increase from the same period of 2022. Net revenues from our learning services were RMB 950.8 million, or USD 130.3 million, representing a 7.0% increase from the same period of 2022, primarily driven by the strong sales performance of digital content services compared with the same period of 2022.

Net revenues from our smart devices were RMB 251.9 million, or USD 34.5 million, down 29.3% from the same period of 2022, primarily due to our continuous efforts to streamline marketing channels with low return on investment for intelligent learning products in the third quarter of 2023.

Net revenues from our online marketing services were RMB 336.1 million, or USD 46.1 million, representing a 113.5% increase from the same period of 2022. The increase was mainly attributable to the increased revenue from performance based advertisements through third parties' internet properties. For the third quarter, our total gross profit was RMB 859.6 million, or USD 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 2022. 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 services 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 expenses were RMB 917.3 million, or USD 125.7 million, compared with RMB 979.2 million for the same period of last year.

With that, for the third quarter, our sales and marketing expenses were RMB 674.2 million, compared with RMB 709.8 million in the third quarter of 2022. Research and development expenses were RMB 187.3 million, compared with RMB 212.9 million in the third quarter of 2022. Our operating loss 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 operations attributable to ordinary shareholders was RMB 102.9 million, or USD 14.1 million, compared with RMB 183.9 million for the same period of last year.

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

Looking at our balance sheet, as of September 30, 2023, our contract liabilities, which mainly consist of deferred revenues generated from our learning services, were RMB 931.6 million, or USD 127.7 million, compared with RMB 1.1 billion as of December 31, 2022. At the end of the period, our cash, cash equivalents, restricted cash, time deposits, and short-term investments totaled RMB 360.1 million, or USD 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 Instructions) The first question comes from the line of Brian Gong with Citigroup.

I have a very good question on our AI product. We have launched our AI product Hi Echo for a while. So what's the user feedback you have received so far? And are there any plans for future updates?

So Hi Echo, the mobile app launched in October. And so far, we are very happy with this performance. User feedback has been very positive. As we discussed in the prepared remarks, the app already has over 100,000 registered users in a month, yes. 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 free phone conversation. So they told us through the feedback as well as they also like the 8 categories, 8 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. Yes. So basically, based on the feedback, we can see that the product, the idea behind the Hi Echo is a pretty sound one. The idea is that for a lot of users, the biggest, largest obstacle in learning the language is the lack of really high-quality language environment. So 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.

And another point is that now that we have received regulatory approval for and it's raised underlying language model behind Hi Echo. It's -- we will be able to increase distribution of the product and drive more user growth. So this is a great opportunity for Hi Echo, because users' interest 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.

And 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 the best. What I want to share is that it will 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 through needs, what they like, what they don't like, what makes them come back and what helps them learn, learn better and what leads them to pay. So we will update the product according to these understandings. And this 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.

The next question is from Caini Wang with CICC.

So my question is related to other language services. Would you mind provide some color on the overview of our learning services segment performance in the next quarter?

This is Su Peng. I will take the question first. And in this Q3, we believe it's a little bit different quarters compared with the last 3 years. And first of all, the students have a little bit different summer plans in this summer and like they do the traveling in the domestically and or the international trip in this summer. So I think in the same time, a lot of students has very less time or the less flexibilities to take courses at [Youdao]. So we think that's the first difference.

And secondly is about from our company just like doctor mentioned, we have been approved of large language models. We believe our product and content like Hi Echo is in the transition of the period from [the pure] we call it traditional courses format and to upgrade to the new format supported by the large language model. And we have already deployed the large language model skills to the -- to our teaching assistant system as well as the others so right now it's very limited scenario to deploy the technology, and we have seen a very great performance of the technology and also received a positive feedback from students. And we expect that can help us to increase -- decrease the cost in the long run and increased margin of our products and business.

And I think that's the -- and sometimes, we think because we are in that transition period we just limited about and take a little bit less investment in our traditional courses and content investment in the summer like customer -- as well as a customer acquisition cost. So we think that's -- 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 rates and courses. And that's because we think we can provide more interactive and content and more different formats of our services to the students in the next few quarters. That's my comments about the question.

And I think that my colleague will give you another comment for this question as well.

This is Lei Jin. I'd like to add to more points in financial aspects here. First one is we will continue to seek profitability and the positive cash flow from the learning services in the long run. And as implied before, we are more focused on the health of the business than the size. (inaudible) has reached a new high record of gross 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. Zhou and Su Peng.

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

The next question is from Thomas Chong with Jefferies.

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?

Thomas, this is Lei Jin. As for our online marketing services, the net revenue has grown over 50% year-over-year for the past 4 quarters in the Q4 last year. Moreover, the growth rate has jumped to around 100% for the last 2 quarters. The primary driver behind this growth is because of our AI technology. A key contributor in Q3 was the upgrade in our 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 improvement, it received a recognition from our clients and partners. The proportion of RTA application keeps increasing. And in Q3, the overall compensation rate of RTA improved by 3 or 4x.

The online entertainment and gaming industry also played an important role for our growth, with a huge increase in demand for advertisers industry. The RTA upgrade leads to over 100% year-over-year increase of net revenues from the entertainment industry in this Q3. And on top of that, the summer season was an important promotion period [with this client] further boosting our advertising performance. We have been trading on 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 Youdao's services to our client and achieve sustainable growth of our advertising business.

The next question is from Ya Jiang with Citic.

My question is about 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?

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 sell out RMB amount actually increased by over 10% year-over-year. So sell-out 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 mentioned this because we are adjusting -- currently experiencing a kind of adjusting period of our sales channels. And so the sellout amount and 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, we 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 the user feedback. So X6 Pro was hit among users. Owing to standout features like English grammar, instruction, digital human language coach and an impressive 100 days standby time. The first 2 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 engagements with X6 Pro. It actually acts a bit over 50% higher usage frequency than the other product, X6, 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 language model. And just to explain in the future 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 the positives between these different stages. Just as a teacher would explain the question in the classroom setting. So because of the much higher engagement level, we see that users really like these new features. So we -- so we think these are working great.

You also asked about the upcoming products. So regarding our upcoming smart devices released is we are focusing on harnessing capabilities of the language model to provide more high-value learning services, as you can imagine. And our goal here is to make the product experience as close as possible to what the students encounter when learning in person with the 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. Yes.

That concludes the question-and-answer session. I would like to turn the conference back over to management for any additional or closing comments.

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

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.