Youdao, Inc.

Good day and welcome to the YoDAO 2023 Third Quarter Earnings Conference Call. Today's conference has been recorded. At this time, I would like to turn the conference over to Mr. Jeffrey Wang, Investor Relations Director of YoDAO. Please go ahead.

Thank you, operator. Please note the discussion today will contain forward-looking plans related to future performance of the company, which are intended to qualify for the SIG PAPER from liability. as established by the U.S. Private Security Litigation Reform Act. Such statements announce guarantees of future performance and are subject to certain risks and uncertainties, assumptions, and other factors. Some of these risks are beyond companies' 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 UDAO's business and financial results. It's included in certain findings of the company with the U.S. Securities and Exchange Commission. The company does not undertake any obligation to update this forward-looking information except as required by law. During today's call, management will also discuss certain NANGAP financial measures for comparison purpose only. For the definitions of NANGAP financial measures, and reconciliations of gap to non-gap 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 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 Xu, 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 operations basis, and all numbers are based on MMB, unless otherwise specifically stated. In Q3, we achieved a record high net revenues of RMB $1.5 billion, marking a year-over-year increase of 9.7%. Lost firm 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're clearly making steady progress towards achieving profitability. In Q3, excluding the current 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, specifically 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're already witnessing accelerated changes in this domain. We're very excited about opportunities presented by large language models. I'm delighted to share that UDAH is playing a leading role in the rapid advancement of LLMs and their applications in education. Recently, we achieved a notable milestone with the receipt of relevant filings for our proprietary LLM, Ziyue, this month. This underscores the acknowledgment 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 Yuda Dictionary Pen X6 Pro in August and made its way to mobile app stores in October. I'm happy to share that High Echo has already accumulated more than 100,000 registered users. A quick update. Additionally, we continue to enhance AI Box in UDAO translation and introduce the 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 MLM products and features. Next, I will quickly outline key business developments in Q3. As for the learning services, 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 recommendation 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 billions 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 second National Children's Weiqi Open Championship. Turning to online marketing services, We continue to see strong growth momentum in Q3. Net revenues of online marketing services reached a historic high of RMB 336.1 million, marking a 113.5% year-over-year increase and four quarters of over 50% growth. We continue to deploy enhancements to both AI and 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 a continued short-term negative impact in this segment before the optimization is likely to conclude by the end of the 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 embrace our new products, including the UDAO Dictionary Pen X6 Pro and UDAO Listening Pod Pro, leading to a year-over-year increase of over 10% in smart devices' sellout R&B amount. U.Dictionary Pen X6 Pro, our flagship with LLM features, exhibited over 50% higher usage frequency than U.Dictionary Pen X6 in Q3, reflecting the popularity of its new features among customers. Our other efforts are also progressing well. For educational digitalization solutions, we successfully secured a project bid in Jiangsu and other regions in the third quarter. Education digitization 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 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 it's Pengsu to give you an update on our financials.

Thank you, Dr. Cho, 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 revenue, RMB 1.5 billion, or U.S. dollar, 210.9 million, representing a 9.7% increase from the same period of 2022. Net revenue from our lending services, or RMB 950.8 million, or U.S. dollar, 130.3 million. representing a 7% increase from the same period of 2022, primarily proven by the strong sales performance of the digital content services compared with the same period of the 2022. Net revenue from our smart devices were RMB 251.9 million, or US dollar, 34.5 million, down 29.3% from the same period of 2022, primarily due to our continuous efforts to streamline marketing channel with low return on investment for the intelligent learning products in the third quarter of 2003. Net revenue from our online marketing services were RMB $336.1 million, or US dollar $36.1 million, representing a 113.5% increase from the same period of 2022. The increase was mainly attributable to the increased revenue from the performance-based advertisements through the third party's internet properties. For the third quarter, our total gross profit was RMB $859.6 million, or $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 the last year. 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 service 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 expense were RMB $917.3 million, or US dollar $125.7 million, compared with RMB $979.2 million for the same period of last year. With that, For the first third quarter, our sales and marketing expense were RMB 674.2 million, compared with RMB 709.8 million in the third quarter of 2022. Research and development expense 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 the 2023, our net loss from continuing operations attributable to the ordinary shareholders was RMB 102.9 million, or US dollar 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 US dollar 9.2 million. compared with RMB 164.4 million for the same period of last year. Basic and diluted net loss from continuing operation per ADS attributable to the ordinary shareholder for the third quarter of 2023 was RMB 0.85 or US dollar 0.12. Non-GAAP basic and diluted net loss from continuing operation per ADS attributable to ordinary shareholder for the third quarter was RMB 0.55 or US dollar 0.08. Our cash provided by the continuing operating activities were RMB $294.7 million, OUS $40.4 million for the third quarter. Looking at our balance sheet as of September 30, 2023, our contract liabilities, which consists of the deferred revenue generated from our lending services, were RMB $931.6 million, OUS $127.7 million, compared with RMB $1.1 billion as of December 31, 2022. At the end of the period, cash, cash equivalents, the restricted cash, time deposit, and short-term investment totaled RMB 360.1 million or US dollar 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.

Ladies and gentlemen, we will now begin the question and answer session. If you wish to register for a question, you may press star 1 on your touch-tone telephone. If you want to withdraw from the queue, you can press star and two. The first question comes from the line of Brian Gong with Citigroup. Please go ahead.

Yeah, good evening. Thanks for taking my question. I have a very good question on our AI product. We have launched our AI product for a while. So what is the user feedback you have received so far, and are there any plans for future updates? Thank you.

Thank you, thank you. So HIACO, the mobile app, launched in October, and so far we are very happy with its performance. User feedback has been very positive. As we discussed in prepared remarks, the app already has over 100,000 registered users in a month. 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 liked the free-form conversation, so they told us through the feedback, as well as they also liked eight categories, eight 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 received 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. Basically, based on the feedback, we can see that the product, the idea behind Hayako is a pretty sound one. The idea is that for a lot of users, the biggest, largest obstacle in learning their language is the lack of really high-quality language environment. The idea of Hayako 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. So it is a breakthrough and very useful in language learning. And another point is that Now that we have received regulatory approval for Ziyue, and Ziyue is the underlying language model behind Hayako, we will be able to increase distribution of the product and drive more user growth. This is a great opportunity for Hayako because users' interests in language model-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 HIACO by the end of this year. We don't want to talk too much about it in advance. What I want to share is that it'll be a significant update. The benefits of actually being first to market, which is the case for iHireCo, is that you gain a deeper understanding of the user's true needs. What they like, what they don't like, what makes them come back, and what helps them learn better, and what leads them to pay. So we will update the product according to these understandings. And these will go into the major version I just mentioned. And we will also have some pleasant surprises for our users that the HiEcho 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. Thank you.

Yeah, that's very helpful. Thank you.

The next question is from Kelly Wang with CICC. Please go ahead.

Good evening, management. Thanks for taking my questions. So my question is related to our learning services. Would you like to provide some color on the overview of our learning services segment performance in the next quarter? Thank you.

Thank you, this is Supong. I will take the question first and in this Q3 we believe it's a little bit different quarters compared with the last three years and versus while the students have a little bit different summer plans in this summer and like they are traveling domestically and all the international trips in this summer. So I think at the same time a lot of students has very less time or the less flexibility to take process at zero. So we think that's the first difference. And secondly, it's about our companies. Just like Dr. mentioned, we have been approval by our large library models. We believe our product and content, like ECHO, is in the transition of the period from the pure, we call the traditional courses format, and to upgrade to the new format supported by the large library models. And we have already deployed the large-level remote skills to our teaching assistants as well as the others. Right now, it's a very limited scenario to deploy the technology, and we have seen a very great performance of the technology and also received a lot of feedback from students. And we expect they can help us to decrease the cost in the long run and increase the margin of our product and business. And I think that's the, and sometimes we think because we are in that transition period, we're just limited and take a little bit less investment in our traditional courses and content investment in the summer, as well as customer acquisition costs. So 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 service and the courses. And that's because we think we can provide more interactive content and more different formats of our services to students in the next few quarters. That's my comments about the questions. Thank you. And I think that my colleague will give another comment for this question as well.

I'd like to add two 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. As emphasized before, we are more focused on the health of the business than the size. We have reached a new high record on cross-margin of the 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. Tso and Sue Peng. Although we still have faced competition from peers and faced challenges from uncertainty operating environment, but we are playing a leading role in the development of large language models and the application in education, which give us great advantages. So we are very confident in our learning services on a going forward basis, which it is helpful. Thank you.

Thank you for the comments. That's very clear. Thank you.

The next question is from Thomas Chong with Jefferies. Please go ahead.

Hi, good evening. Thanks, management, for taking my questions. 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? Thank you.

Hi, Thomas. This is Lei Jin. Thank you for your question. As for our online marketing services, The net revenue has grown over 50% year-over-year for the past four quarters of Q4 last year. Moreover, the growth rate has jumped to around 100% for the last two quarters. The primary driver behind this growth is the use 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 recognition from our clients and partners. The proportion of RTA applications keeps increasing, and in Q3, the overall conversation rate of RTA improved by 3 or 4 times. The online entertainment and gaming industry also played an important role for our growth. with a huge increase in demand for advertisers in this field. The RCA 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 this time, further boosting our advertising performance. We have been trying 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 AD services to our clients and keep a sustainable growth of our advertising business. Thank you.

The next question is from Yukin Zhang with CITES. Please go ahead.

Hi, Benjamin. Thank you for taking my question. My question is about the learning devices. So what is the user feedback on the Dictionary 10X.0? Are there any plans to introduce new SKUs before the end of the year? Thank you.

Thank you for the question. So let me first talk a little bit about business operations and then user feedback. As I discussed in the prepared remarks, Q3 smart devices sell out RMB a month, 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 mention 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 done for this quarter. 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, again, we cut back on some sales channels that are providing 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 user feedback. So X6 Pro was a hit among users, owing to standout features like English grammar, instruction, digital human language codes, and an impressive 100-day standby time. The first two 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 engagement with X6 Pro. it actually exhibits over 50% higher usage frequency than the other product, S6, 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 the feature 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 pauses between these different stages, just as a teacher would explain the question in a classroom setting. Yeah, so because of the much higher engagement level, we see that users really like these new features. So we think these are working great. You also asked about upcoming products. So regarding our upcoming smart devices releases, we are focusing on harnessing capabilities of the language model to provide more high-value learning services as you can imagine. Our goal here is to make the product experience as close as possible to what the students encounter when learning in person with a teacher. This will make these devices 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. Thank you.

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 UDAO directly or reach out to Jason 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.