Youdao, Inc.

Good day and welcome to the UDAO 2022 Third Quarter Earnings Conference Call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, we will have a question and answer session. To ask a question, you may press star, then one on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Jeffrey Wong, investor relations, director of investor relations of Yodal. Please go ahead.

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 sleepover 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 UDOT's business and financial results is included in certain findings of the companies 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 Third Quarter Financial Review News release issued earlier today. As a reminder, the conference is being recorded. Besides, A webcast replay of this conference call will be available on UDOT's corporate website at ir.udot.com. Joining us today on the call from UDOT'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 Lee, 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 operating basis, and all numbers are based on M&B, unless otherwise specifically stated. We had a strong third quarter with solid financial and operating results. Our net revenue 1.4 billion, up 35% year over year. Total gross margin climbed to a record high of 54.2%, improving 1.6% year over year. These results were attributable to strong performance of our new services and smart devices. Sales of the JITO content services reached over RMB 400 million, with gross margin ratio exceeding 60%. For smart devices, the first 100,000 units of the newly launched UDAW Dictionary Pen X5 have been sold out, propelling net revenues from smart devices to RMB 356.5 million in Q3, a new record. In fact, net revenues from UDOT Externally PAN series in Q3 this year have grown tenfold compared with Q3 2019 after UDOT Externally PAN 2 was launched. The first 10,000 units of UDOT Smart Learning Path Y10 released in August have also been sold out, reflecting strong demand for this new category. In terms of our operating loss, it narrowed to RMB 219 million, with operating loss margin narrowing by 6.1% year-over-year to 15.6%. We have improved the margin structure of business lines while growing their top lines at the same time. For example, in Q3, for digital content services, U.D.A. dictionary pen and U.D.A. listening pod, their net revenues could cover their costs and operating expenses, respectively. Today we announce that the Board of Directors has authorized the company to adopt a share repurchase program in the near future in accordance with applicable laws and regulations for up to U.S. dollar 20 million of its Class A ordinary shares including in the form of ADS during a period of up to 36 months. We are bullish about the future growth of the business. With that overview, I would like to share more color on our business lines in Q3. Smart devices revenue reached RMB 356.5 million in Q3, a new record for the sector and up 40.1% year-over-year. Growth margin of smart devices reached 40.4%, up 6.7% year-over-year, mainly due to the launch of new products. The application of advanced AI technology and unique learning content make us confident that the gross margin of smart devices will be around 40% in the long run. Our new flagship dictionary pen, UDAL Dictionary Pen X5, is a great showcase of our strength in R&D and product innovation. In fact, in September, we cannot make enough X5s due to the strong demands. Not only did X5 feature even better translation precision, support for over 100 languages, and a whole new design, it also includes the world's first smart dictionary pen operating system. It allows users to download apps to customize the dictionary pen to their liking with endless possibilities. Many top content providers were already on board, including Shimalaya RFM, RAZ English, NetEase Cloud Music, and Kaishu Storytelling, Kaishu Jiang Hushu. They all created apps using our easy-to-use software development kit and offered them on UDAO Dictionary Pants, creating a unique ecosystem that will grow stronger when more consumers and developers join in. Recently, we launched UDAO Smart Learning Pad X10, our second learning pad product. with significantly improved AI precision learning, larger screen, more storage, and other improvements. In the long term, the learning path has significant market potential. According to Frust and Sullivan, expected volume of education tablets are likely to reach 7.26 million units in 2025, with total sales of RMB 25.2%. Our AI-adapted learning feature provides high-quality, personalized learning for students and has received very positive feedback from consumers. Over time, we expect the Udall Smart Learning Pad to become as popular as our Udall Dictionary Pad. Then let's turn to learning services. Net revenues from learning services reached a record high of RMB $888.5 million in Q3. up 37.2% year-over-year, with a relatively flat gross margin of 64.5%. Breaking this down a bit further, net revenues from STEAM courses increased by more than 200% year-over-year and accounted for over 25% of the net revenues of this segment. We continue to make progress on the UDAO GO course in collaboration with the Chinese Weiqi Association and the Jiangsu Chess Sports Association, we held the National Children's Weichi Open Championship in Q3, which was highly recognized by the General Administration of Sports of China. As for adult courses, we see a downward trend in gross margins year over year, mainly due to the macro environment. We are actively realigning our resources to focus on growth areas in this segment. Graduate school entrance exams and vocational courses are two bright spots. Their gross billings increased by over 150% and over 200% year-over-year, respectively. Looking forward, we are confident in our operations in Q4. The transition from regulatory changes last year is mostly finished. For the last four quarters, we have maintained our investment level for our business, kept innovating in challenging times. and this allowed us to gain share in the market. It was made possible by the long-term investment in AI technology and a diversified product portfolio, and also by firm support from our parent, Netease Group. Going forward, we believe we are in a good position today to achieve sustainable growth and drive towards profitability with a portfolio of strong products and businesses. Our team continues to capitalize on tailwinds, including the quick adoption of smart learning devices, digital content services, and Steam courses. We look forward to bringing our products and services to more and more consumers. With that, I will turn the call over to Supong to give you more details on our financial performance. Supong.

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights for the third quarter of 2022. We encourage you to read through our press release issued earlier today for further details. For the third quarter, total net revenue were RMB 1.4 billion, or U.S. dollar, 197.2 million. This represents an increase of 35% from the third quarter of 2021. Net revenue from our written services were RMB 888.5 million, or U.S. dollar, 124.9 million. representing a 37.2% 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 $356.5 million, OUS $50.1 million, up 40.1% from the same period in 2021, driven by the popularity of the newly launched products in 2022. Net revenue from our online marketing services were RMB 157.5 million, or U.S. dollar 22.5 million, representing a 14.9% increase from the same period in 2021. The increase was mainly attributable to the increase in performance-based advertisement through the third-party's internet properties. For the third quarter, our gross profits were RMB 760.2 million, or U.S. dollar 106.9 million, representing a 39% increase from the third quarter of 2021. Gross margin for learning services was 64.5% for the third quarter of 2022, compared with 65% for the same period in 2021. Gross margin for smart devices was 40.4% for the third quarter of 2022, compared with 33.7% for the same period in 2021. Gross margin for online marketing services was 27.1%, for the third quarter of 2022, compared with 29.2% for the same period in 2021. For the third quarter, total operating expense were RMB $979.2 million, or U.S. dollar $137.7 million, compared with RMB $772.6 million for the same period of last year. With that, for the third quarter, our sales and marketing expense were RMB $709.8 million, compared with RMB 553.4 million in the third quarter of 2021. Research and the development expense were RMB 212.9 million compared with RMB 163.6 million in the third quarter of 2021. Our operating loss margin was 15.6% in the third quarter of 2022 compared with 21.7% for the same period of last year. For the third quarter of 2022, our net loss from continuing operation attributable to ordinary shareholders was RMB 183.9 million, or U.S. dollar 25.9 million, compared with RMB 225.3 million for the same period of last year. Non-GAAP net loss from our continuing operation attributable to ordinary shareholders for the third quarter was RMB 164.4 million, or U.S. dollar 23.1 million, compared with RMB $200.2 million for the same period of last year. Basic and diluting landlords per ADS from continuing operations attributable to ordinary shareholders for the third quarter of 2022 was RMB 1.49, or US dollar 0.21. Non-cap basic and diluting landlords from continuing operations per ADS for the third quarter was RMB 1.33, or US dollar 0.19. Our net cash used in continuing operating activities was RMB 294.1 million, or US dollar 41.3 million for the third quarter. Looking at our balance sheet, as of September 30, 2022, our contract liabilities, which mainly consists of the deferred revenue generated from our loan services, were RMB 996.5 million, or US dollar 140.1 million. Compared with RMB 1.1 billion as of December 31, 2021, at the end of the period, our cash, cash equivalent, restricted cash, time deposit, and short-term investment totaled RMB 953.1 million, US dollar 134 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.

Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. Our first question comes from Brian Gong with Citigroup. Please go ahead.

Good evening, management. Thanks for taking my questions, and congratulations on the solid results. So I saw the revenue increased rapidly in the third quarter, and may I know what's the main contributors to our rapid transition, and how should we look at, you know, the growth in the future? Thank you.

Hello, Brian. So as for Q3 growth, so digital content services and smart devices are two main drivers for this quarter for our growth. And both are based on our strengths in technology R&D, as you know. So digital content servers are doing well. So compared with the online services that we offer before, The difference is they are mostly contains pre-recorded video content or interactive learning or STEAM content, STEAM courses. As with our courses before, they are live courses mainly. So the form is different. So it's a new product after last year. So in Q3, digital content services have maintained strong momentum. So sales reached over RMB 400 million compared with over RMB 200 million in Q2. So basically doubled quarter to quarter. So while gross margin also rose from over 50% in Q2 to over 60% in Q3. So moreover, their revenues from digital content services can cover their costs and operating expenses in Q3. So these supports are bottom line improvements in this quarter. So second, smart devices revenues are at, as you can see, a record high of RMB 356 million, up 40% year-over-year in Q3. Moreover, this course also comes with healthy operating metrics. Net revenue from UDOT Dictionary PAN and UDOT Listening Pod, for these two products, they can also cover their own costs and expenses in Q3. One product that's pretty important is Dictionary PAN X5, launched in August. This new generation of dictionary pen supports online translation of over 100 languages and is equipped with the world's first dictionary pen operating system, smart operating system. So after its release, it's already the top seller of dictionary pens or electronic dictionaries on both JD.com and Tmall, selling out the first batch of 100,000 units quickly. Another product is the launch of Udall Smart LearningPad Y10 and also more recently X10. These marked our entry into the learning tablet market and also the first batch of 10,000 Y10 units sold out in about two months. So that gives our teams more confidence in this category. So our plan is to have a steady flow of new learning smart devices products to drive sustainable growth in this category. So recently after Q3, we launched three more new products. That is UDOT dictionary, pen, P5 for more advanced learners and professionals and also Udall smart learning pad X10 I just mentioned so with a learning dashboard that further improves the AI precision learning experience and lastly an upgraded version of the Udall listening pod with new English and Chinese content in line with textbooks also with more advanced AI technology, helps users improve listening and speaking skills in both English and Chinese. So given the strong pipelines, we sold more than 100,000 units of UDAW dictionary pens in the Singles Day, November 11th shopping festival this year. So over 100,000 units of UDAW dictionary pens. Yeah. So that's an overview of drivers of growth for Q3. Thank you.

Thank you.

Our next question comes from Hongyi Cao with CICC. Please go ahead.

Okay, good evening, management. Thanks for taking my question, and congratulations on the good performance. We can see the strong growth of net revenue, but it does still face the operating loss. So my question is, what are our strategies for improving the loss-making sectors? Thank you.

Yeah, thank you, Bandar. Yeah, that's a very natural question. So first I want to say that drawing towards profitability is a priority for us. The operating loss in Q3 mainly came from our early stage products and businesses. These include STEAM courses, UDAO Smart Learning Path, the new device, and education digitization solutions. These are the three significant loss makers. We have plans for profitability for each product area here. So let me break that down a little bit. So our STEAM courses, they're growing fast and we believe they have a bright future. For this segment, what we are doing is to optimize our product offerings and marketing tactics And we're seeing continuous improvements in return of investments every month. The gold courses are more mature of all the STEAM courses. Our other STEAM courses, such as chess programming, science music, and Chinese painting, they are mostly still in their early days. So the investment we made in these areas, they are paying off. So Youdao Go and its companion app has accumulated over 1.6 million users and is already the leader in online Go learning in China. That's for the STEAM courses. For Smart Learning Pad, It is a strategic product for us, and it is in the early stages. The opportunity here is that the learning pad market is going through a generational transformation from a hardware and content-based business to a technology-centered, AI-adaptive learning-based business. We are taking advantage of this transformational opportunity, and it is a very good investment for us. And very importantly, the first two products, Y10 and X10, they are off to a good start, and we believe they have a bright future. As for the third category, the education digitization solutions. We recently reduced our resources here. There are progress in our products and services here. So our campus sports education digitization solution with vision and analytics was released and started to enter schools and schools like them. Due to macroeconomic challenges, the landscape has been different from our projections one or two years ago. Spending on digitalization solutions has been slower than we expected. Our goal here is to find better product positions in this challenging environment with less resources. achieve profitable growth. So all in all, if we add all our business that's operating profitably and also these three loss makers together, we've been able to narrow our net operating cash outflow to RMB 294 million in Q3. Operating loss also improved to RMB 219 million with operating loss margin improving 6.1% year-over-year. Going forward, the plan is to operate prudently, growing the business while at the same time drive towards profitability. I hope that answers the question. Thank you.

Thank you. Our next question comes from Thomas Chong with Jefferies. Please go ahead.

Hi, good evening. Thanks, management, for taking my questions. In Q2, I think we mentioned that we are confident in the prospect of second half this year. Would you please share your Q4 expectations? Thank you.

Thank you, Thomas. Yeah, I think... You have seen our Q3 numbers, and the solid Q3 financials and operating results, they give us confidence in Q4. Net revenue reached $1.4 billion in Q3, up 35% year-over-year. So one thing is, even if you compare the net revenue in Q3 to Q3 last year and Q3 2020, without giving effects to the recent disposal of our academic AST business, revenues still increased by 1.1% and 56.5% respectively. So in Q4, we look keep focusing on the healthiness of key financials and operating indicators, that's for sure. As for learning services, Q4 is the retention season for STEAM courses, which is expected to have a positive effect on the cash flow and other financial metrics. Besides, digital content services released in Q2 have performed well. in sales and gross margin over the past two quarters. In terms of smart devices, Q4 is typically a peak season with the November 11th and December 12th shopping festivals. Our smart devices sales performed well during the November 11th shopping festival. with aggregated sales over RMB $100 million in Tmall, JD.com, and Douyin, up over 80% year-over-year. So in terms of UDOT dictionary plan, it has retained the leading position in sales in its category for three consecutive years in both Tmall and JD.com. Your listening pod also ranks number one in sales in this category in JD.com. I think these all bodes well for Q4. Today we announced that the Board of Directors have authorized us to adopt a share repurchase program in the near future for up to $20 million. It basically reflects management's confidence in the business, both in the short term and in the long term. Yeah, I think that's all for me. Supong, you have anything to add?

Yeah, thank you so much for your questions. Just one more comment added after Dr. To and we think about all the for our expectation for the Q4, if the business will expect to maintain the momentum of the business growth and whatever in the digital kind of service, but also in the smart devices and the rest of the sector we are investing in. And we are feel confident about this growth, and we see we find the great potential of the market from the customer's demands. And that's why we think about the confidence. And also, we still have enough capability to invest with our new categories in the learning products, as well as our new initiatives, new services after the policy change. If you look at our balance sheet, we still have almost RMB $1 billion cash in our balance sheet, as well as we still have about $230 million US dollars revolving flow and from the net scoop that gave us the more capabilities we invest and waiting for and see the feedback from the market and that's what we feel about the promising about the market in the long run. I hope that answers your question. Thank you, Thomas.

Thank you.

Our next question comes from Linda Huang with Macquarie. Please go ahead.

Hi, management, and thank you for taking my question. My question is regarding for the learning devices because we launched a very successful learning tablet in the second quarter. So can you share with us how do you think about the future for this product? Especially management, you just mentioned about the very sizable, addressable market. So what kind of the market size we can capture in the long term? And we also hope that the management can share with us what is the product strategy. Maybe you can explain with us regarding for your product spec and your pricing strategy. Thank you very much.

Thank you, Linda. This is Supong. Thank you for your questions. And first of all, we are still confident about our products of the learning path. and we because we see about the great demandings from the market and we expect if you according to the Sullivan and the first Sullivan expect the volume of education tablets is likely to reach about seven million units in 2025 and with total sales above the 25 billion as we mentioned and as the last as we mentioned in last call we as you remember we said we feel confident about products and last time we just released in August we released about our new products of the UDAO AI smart learning pad and it's Y10. It's released in August and right now I think has been sold out for the first batch of the 10,000 units and that's I think reflecting the demand from this new category and more recently we just released about our next generation UDAO learning pad is called X10 And we think that we have to upgrade about the features and functions, and there will be more procession among the AI diagnostics. And we think that will be more suitable for the student learning role maps. And we think we try to build up kind of that role map for each individual student to provide a highly customized services for the different students based on the technology. So that's why we feel confident about our products. And even right now, we still see a lot of production, a lot of demand from the market. And right now, we're at a very early stage to see about finally how much market we will account for for this smart tablet market. But right now, we see the fast growth of our product sales weeks by week. So we think that shows our product success, part of our successful product strategy. And we will keep investing in this market and whatever, we will upgrade our products and upgrade the features and provide more diversified services to our customers. That's what I think about, that's our strategy and what we expectation for this market.

Yeah, so let me add a few points. So first, addressable market of learning tablets are larger than probably larger than dictionary pen. If you look at different numbers, it's either five times, six times, or maybe ten times larger. That's a very good market to be in if we can actually take shares from it. And the reason we think we are at a very good position to get our tablets into the hands of a lot of consumers is that, as I said, it's an AI-driven product. And from our experience for the last few years or so, whenever we can come up with really useful AI experiences, like for the dictionary pen, the very quick translation lookup of dictionary pen. And also, for example, for our recent dictionary pen P5, you can scan multiple lines with a single swipe of the pen. Whenever we can come up with experiences like this, we will be at a good position in the market. So the product will have good reputation and we will have lower marketing costs and everything. Things work in our favor. And we are going to just do that for the learning path. And our first two products have already bringing new experiences to our users. That's one. The other point I want to make is that we will be using a pretty quick product cadence, as you have seen. We have already released five different SKUs this year already, and that's faster than last year. That's because our teams have been gaining more and more experience. We have gained more know-how in the supply chain of learning hardware, and we're also getting more intellectual properties, more patents and everything. We have more of that technology. already in place so we can innovate faster. And we are also building an ecosystem of content providers as we have seen in the dictionary pen OS initiative. So that's also going well. So with that, I think we are at a good position with with a lot of effort from the team, of course, to be able to achieve a leading position in the learning tablet market.

Thank you. Just one more point to add here. If you go back to see our strategy, our dictionary pens, you can see that we spent almost two years we increased about 10 times in terms of the number of sales of units. So I think we also think for the AI tablets market, for us, it's a long-term strategy investment. We all be patient, and we expect to copy our successful strategy in our dictionary pen, in our smart tablets. So that's what we exactly expect for this special category. And so right now we are still in the investment stage, and it's at a various stage. It's just beginning, and we expect we can receive a lot of very strong demanding and I see it as a positive feedback from the market. That's our expectations from these new categories. Thank you.

Thank you. Thank you, management, for your detailed explanation. Thank you.

Thank you, Lian.

The next question comes from Lian Duan with Huadai Securities. Please go ahead.

Good evening, management, and thanks for taking my question. In recent quarters, we saw adult courses face some challenges. What is our strategy for improving the business? Thank you.

Thank you, Lian. This is Lian. Yeah, your question is, yes, the adult courses face the challenge. And given the macroeconomic factors and the pandemic, we adjust our strategy from the interest-related courses to the segment that gives students a better chance to get a job. There are graduate school entrance exam preparation and vocational education, such as digital skill improving. We have been seeing a booming demand from the graduate school entrance exam. There is a record high number of registrants of 4.5 million this year, and 21% growth year over year, and double the number from 2017. it is likely to grow further in the coming years because higher education means a higher probability for a better job. As our UDOT campus recruitment postgraduate resume, I have accounted for over 70% of the total candidates for the five years. Our graduate school entrance exam courses focused on personalized services. As we know, choosing a suitable college and subject is a key factor. So our AI assistant application consulting service offer a tailor-made advice to students based on their own academic performance and the big data of the graduate college recruitment. Well, OMO services, especially in the pandemic conditions, create a comprehensive experience in the online learning and offline summer camps. In terms of user acquisition, we have the most popular study APPs for college students in China, including Yu Dao Dictionary and China University MOOC. Inclusively, over 50% of the broad screening came from this organic traffic and increased over 150% year-over-year. Vocational education. especially digital skill improving is the other focus. It is consistent with the government's policy direction of boosting employment. Our digital skill courses mainly include data analysis and user-driven design, provide a virtual training system where learners could easily log in and practice with the web browser on any PC. With the virtual system, the training environment has already been set up, and all the operations by the learners can be recorded and replayed. Teachers could also have guidance and feedback in the online system conveniently. With the easy-to-use system, we can see approaching 100% year-over-year growth of the growth feeling from this process in Q3. Thank you.

Thank you for your detailed explanation. Thank you.

Our next question comes from Candice Chan with Daiwa. Please go ahead.

Great. Good evening, management. Congrats on the solid set of results. we actually see that for this quarter, the gross margin of learning services indeed has been very strong at close to about 65%. So I wonder whether this margin level will be sustainable in the following quarters, and any colors on the margin trend of learning services for the next year? That would be great. Thank you.

Thank you for your question, Candice. This is Wayne. You see in our gross margin, of course, Quota 3 arrived at around 55% up 13% quarter-over-quarter, which mainly contributed to the benefit from economic uphill from the higher revenue base and the approved margin for the digital content services. We are pleased to see the gross margin return to the similar level as last year after we experienced transitional period since the release of double reduction policy last year. In last quarter, we got a relatively low revenue base for our learning services due to the service transition, which directly resulted in decreased gross margin performance during the last quarter. With the launch of our new services, the digital content since Q2, and the relevant sales increased very quickly and reached over 400 million in this quarter, along with over 60% gross margin increase from 50% in Q2. With the further expansion of our new services, we expect to enjoy great benefits on the economic skills and the higher gross margin, whatever, for next year. Also, seasonal fluctuation will be studied. But in the long run, we are very confident in our revenue growth of learning services as well as its gross margin. That's for the learning services. growth margin. Actually, I'd like to add some other color to our smart devices growth margin performance as well. In this quarter, the growth margin of smart devices increased to around 40% from 34% for the same period of last year, which mainly contributed from the sales of X5, which carries a higher growth margin. Yodong has the advanced AI technology, has rich learning content, and good at technology innovation, which brings us the advantage in product and more premium price. Based on it, we also believe a higher growth margin will be achieved for our smart devices. So that's all. Thank you for your question.

That's very clear. Thank you.

This concludes our question and answer session. And we will turn the conference back over to the management for any closing comments.

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

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.