Q1 2023 Youdao Inc Earnings Call

Participants

Feng Zhou; CEO & Director; Youdao, Inc.

Jeffrey Wang; IR Director; Youdao, Inc.

Lei Jin; President; Youdao, Inc.

Peng Su; VP of Strategies & Capital Markets; Youdao, Inc.

Brian Gong; Assistant VP & Equity Research Analyst; Citigroup Inc., Research Division

Candis Chan; Research Analyst; Daiwa Securities Co. Ltd., Research Division

Unidentified Analyst

Presentation

Operator

Good day, and welcome to the Youdao 2023 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 of 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 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 risk factors that could affect Youdao's business and 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 definition of non-GAAP financial measures and reconciliations of GAAP to non-GAAP financial results, please see the 2023 first 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.

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.
Q1 net revenue was RMB 1.2 billion, a decrease of 3.1% year-over-year. Loss from operations was RMB 195.8 million, up 56.5% year-over-year. Net cash used in continuing operating activities was RMB 437 million, an increase of 2.7% year-over-year. During the first half of the quarter, our main learning services and Smart Devices businesses faced the significant challenges due to the pandemic. However, the challenges gradually eased in the second half and our business returned to growth. Despite the headwinds, our digital content services maintained a strong trajectory. In fact, its gross margin approached 70% and net revenues covered the cost and operating expenses for 3 consecutive quarters.
Furthermore, gross billings from learning services, excluding adult courses, increased over 40% year-over-year in Q1, rising by over 70% in February and March after falling by over 20% in January. In Q1, our advertisement business was a bright spot with net revenues of RMB 218.1 million, representing a 79% year-over-year growth. This was mainly attributed to the expansion of customers, led by the significant upgrade of advertising technology since Q4. We foresee continued positive momentum in the sector. In Q1, we also made notable progress with generative AI and large language model technologies that offer breakthroughs abilities in knowledge reasoning, language tutoring and other applications. This marks a significant inflection point in our 6-year journey of applying modern artificial intelligence to education, which began with the release of Youdao Neural machine translation technology in 2017.
As one of the first companies to release generative AI-powered education products, we recently launched Youdao AI Speaking, K-12 in Youdao Dictionary Pen, leveraging our proprietary generative model. We also unveiled AI box for Youdao desktop translation, which utilizes our generative AI technology. The AI box feature received an overwhelmingly positive response and contributed to a nearly 200% year-over-year increase in translation subscription fees. Looking ahead to the full year of 2023, I am confident in the growth and improved overall health of our business and also fruitful applications of generative AI in our products.
Regarding AI, we remain committed to abiding by related laws and regulations to ensure that our technology is developed and utilized in an ethical and responsible manner. Furthermore, our controlling shareholder, NetEase Group, will continue to support our long-term development. I would like to provide more details on our business segments in Q1. We generated RMB 732.4 million in net revenues from learning services, which represented an 11.3% year-over-year decrease, primarily due to the pandemic. Nonetheless, as we just mentioned, gross billings from learning services, excluding adult courses, increased over 40% year-over-year in Q1, indicating positive momentum.
Our STEAM courses continue to see notable achievements, contributing to the overall gross billings growth. In Q1, our flagship Youdao Literature, Youdao Go product gained even more popularity, while the Minecraft collaboration project, Youdao Literature Creative Writing, Youdao Go (inaudible) received positive feedback from more users. Additionally, the Champion Class of Youdao Go released in Q4 of last year had already coached an award-winning student who secured Top Spot in the youth group championship at The British Junior Go Championship. Our child-oriented digital online reading service, Youdao Fun Reading demonstrated promising growth in Q1 by utilizing AI algorithms to recommend books to readers of diverse ages and interests.
The gross billings of Youdao Fun Reading rose by almost 40% year-over-year. Furthermore, we were recently designated as a GESP certification service center of the China Computer Federation, signifying our recognition and leadership in competitive programming education. In terms of adult courses, our post-graduate entrance exam courses sustained a healthy momentum in Q1, posting mid-double-digit percentage growth in the gross billings of professional courses for post-graduates entrance year-over-year. Regarding Smart Devices, net revenue were RMB 212.7 million in Q1, representing a 16% year-over-year decline due to the pandemic. However, the sector saw a rebound of more than 20% year-over-year in the activation of dictionary pens in March.
The rapid recovery indicates that both the education needs of our customers and our distinct product design and features allows the device business to demonstrate resilience against the macro headwinds and the challenging consumer electronics market. We continue to improve dictionary pens experience with over-the-air updates to Dictionary Pen OS. In addition to the AI speaking feature we just mentioned earlier, users can now access other new applications such as Baidu Netdisk, Baidu Wangpan and Chinese Children's encyclopedia (foreign language).
Furthermore, Youdao Dictionary Pen X5 and P5 ranked the highest among a number of dictionary pens based on tests conducted by the China Academy of Information and Communications Technology, underscoring our product leadership. In addition, we recently upgraded our smart learning path by launching a comprehensive data-based learning dashboard and other significant updates. This dashboard enables parents to conveniently monitor their children study plans and daily learning programs.
Looking ahead to the remainder of 2023, assuming no unexpected macro events, we anticipate a continuation of the recovery in education, consumer demand and a robust market demand for digital learning products, including both our online learning services and smart learning devices. Moreover, generative AI technology will play a significant role in driving more consumer demand for digital learning products. We also expect continued growth from our long-standing advertising business, which will contribute to our overall expansion and profitability. At Youdao, we will continue to leverage our technological leadership and innovation capabilities to deliver industry-leading experiences that serve our users, consumers and stakeholders while driving sustainable growth. We will continue to provide high-quality education services and deliver pioneering solutions that have a positive impact on society.
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 from our first quarter of 2023. We encourage you to read through our press release issued earlier today for further details. For the first quarter, total net revenue were RMB 1.2 billion or USD169.4 million, remaining stable compared with RMB 1.2 billion for the same period of 2022. Net revenue from our learning services were RMB 732.4 million or USD106.6 million, representing an 11.3% decrease from the same period in 2022, primarily due to the decreased revenue derived from the adult and vocational courses and other courses compared to the same period of 2022.
Net revenue from our smart devices were RMB 212.7 million or USD31 million, down 16% from the same period in 2022, primarily due to the decreased demand for the learning products in the first quarter of 2023. Net revenue from our online marketing services were RMB 218.5 million or USD31.8 million, representing a 79.7% increase from the same period in 2022. The increase was mainly attributable to the increased demand for the performance-based advertisements through the third parties' Internet properties. For the first quarter, our total gross profit was RMB 601.9 million or USD87.6 million, representing a 6.2% decrease from the first quarter of 2022.
Gross margin for learning services was 62% for the first quarter of 2023 compared with 33.9% for the same period in 2022. Gross margin for smart devices was 39.6% for the first quarter of 2023 compared with 33.7% for the same period of in 2022. Gross margin for online marketing services was 29.1% for the first quarter of 2023 compared with 23.7% for the same period in 2022. For the first quarter, total operating expense were RMB 797.6 million or USD116.1 million compared with RMB 766.9 million for the same period of the last year. With that, for the first quarter, our sales and marketing expense were RMB 565.2 million compared with RMB 506.4 million in the first quarter of 2022.
Research and development expense were RMB 182.8 million compared with RMB 203 million in the first quarter of 2022. Our operating loss margin was 16.8% in the first quarter of 2023 compared with 10.4% for the same period of the last year. For the first quarter of 2023, our net loss from continuing operations attributable to ordinary shareholders was RMB 204.4 million or USD29.8 million compared with RMB 95.4 million for the same period of last year. Non-GAAP net loss from continuing operations attributable to ordinary shareholders for the first quarter was RMB 193.9 million or USD28.2 million compared with RMB 70.9 million for the same period of last year.
Basic and diluted net loss per ADS from continuing operation attributable to the ordinary shareholders for the first quarter of 2023 was RMB 1.67 or USD0.24. Non-GAAP basic and diluted net loss from continuing operation per ADS attributable to the ordinary shareholders for the first quarter was RMB 1.59 or USD0.23. Our net cash used in continuing operating activities was RMB 437 million or USD63.6 million for the first quarter. Looking at our balance sheet. As of March 31, 2023, our contract liabilities, which mainly consists of the deferred revenue generated from our learning services were RMB 832.2 million or USD121.2 million compared with RMB 1.1 billion as of December 31, 2022.
At the end of the period, our cash, cash equivalents, restricted cash, term deposit and short-term investment totaled RMB 601 million or USD87.5 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) And our first question today will come from Brian Gong of Citigroup.

Brian Gong

Just a very simple question. This year the macro is quite weak. So what are the reasons that management is quite confident in your development for this year? And what are the key drivers for the growth ahead.

Feng Zhou

In Q1, we faced a few short-term challenges due to the pandemic impact on our primary businesses that is learning services and devices. However, strong advertising results partially offset that decline. And both learning services and devices rapidly recovered in the second half of Q1. So we expected a negative impact of Q1 to be a onetime event. Our confidence for the full year 2023 comes from several reasons. First, for learning services, we actually see strong demand, and we have a strong and growing product lineup.
As we mentioned earlier, learning services and gross billings, excluding adult courses grew by over 40% in Q1. So that's actually quite strong growth. The growth is driven by both strong demand and the rollout of new and updated data content services. So including updates to Youdao literature, data content for high school and also Youdao Fun Reading as we mentioned. And we have more new learning services in the pipeline for later this year. So we are confident about learning services growth.
Secondly, for devices, we are also seeing good recovery, Dictionary Pen activations, that's for new devices in March were up 20% year-over-year. So we plan to release new devices in Q3. So we believe -- so updates to existing devices through software and also new devices this year will also drive growth given the high market share in Dictionary Pen market and also the other products that we have.
Thirdly, for ads, back in Q4, we reported accelerated growth from at 58%, almost 60% year-over-year. In Q1, that growth is even higher at 80%. So we believe we are in an advertisement growth cycle due to 2 factors. One is our significant algorithm updates to the platform in Q4 proves to be very effective, allowing us to attract more customers and more budget. Now also, in the current macro environment, businesses are actually leaning to performance ads, which is our main form of advertisement service that we rendered to our customers. Performance ads are what businesses are actually lying on to accelerate their recovery. So we expect the advisement growth cycle to continue.
So although we had kind of a hiccup in Q1, but as I just shown, we think the overall business is in a healthy state. We are executing towards our goals this year. And so we are quite confident about our development for the full year 2023. I hope that answers your question.

Peng Su

Brian, just only one more point added after Dr. Zhou's comments. And we just mentioned in the call and if you go back to see the difference -- performance in the different months in the first quarter. And the gross billings from -- I think that gross billings, number of gross billings kind of the indicator about the trend of our business. And in January, the gross billings from our learning services, excluding the adult courses, just down about over 20% in January. But right after that period in the February and March, the gross billing from the same sectors just rising by over 70%. So you can see the different performance, totally different performance. In January, we compare with February and March. So that's the reason why we expect just kind of impact -- this short-term impact, and we will be developing for this year.

Operator

Our next question today will come from [Kai Qian] of CICC.

Unidentified Analyst

(foreign language) So just a quick question regarding the AI. So would you please introduce our latest progress of artificial intelligence as it is the most promising and eye catching for the investors now.

Feng Zhou

Yes, yes. So there's a lot of attention on generative AI. And people say that the education is one of the first areas that it will have a big impact. And yes, we agree with that. So we think generative AI is (technical difficulty) of the technology that we see like every 10, 20 years or maybe more. And we plan to leverage generative AI as a competitive advantage. So the impact of generative AI on education and learning cannot be understated, and we are committed to driving innovation in this space. To this end, we announced the real educational large language model project.
The aim is to develop and apply large language model technology to enable personalized learning and tutoring. And tutor that has a deep understanding of the learning materials can quickly grasp the students' learning style and needs and provide effective teaching. This kind of a AI tutor, I would say it is the holy grail of education technology. Products that harness the power of this kind of generative AI will be in high demand in the market. And we are already making some rapid progress. We recognize that speed and fast generation are essentially in developing any kind of new groundbreaking technology. We have already released several generative AI-powered new products and features.
As we mentioned earlier, there is the AI box feature in Youdao desktop translation. Youdao AI Speaking in Youdao Dictionary Pen, and there is a generative AI-based Go game review and suggestions in our Go course. So we already have several of these products released. Since the launch of AI box less than a month ago, so it has been used by almost million times has been used almost million times. That is a promising early momentum. I also want to add that Youdao applying AI to education has already been a 6-year journey. We are good at it. And now the progress will be accelerated. So it began in 2017 with the release of Youdao Neural Machine Translation Technology. In 2018, we applied the transformers, the current most popular generative AI kind of underlying technology transformers to the translation engine in -- back in 2018.
In 2019, we embedded the transformers into the Dictionary Pen. In 2020, we developed a transformer-based high-quality voice recognition engine. And in 2022, we moved that voice translation -- voice recognition engine to the device side in Dictionary Pen P5. So we think we already have a head start in this area. And because of the fact that we already have a lot of investment into AI technology, in particular, transformer technology, we don't expect to need to increase overall R&D expenses to deploy generative AI. We will be leveraging our existing investments and redeploy and optimize our R&D resources in the process to do that.
Finally, I would like to reiterate that we remain committed to abiding by related law and regulations related to AI and ensure that our technology is developed and utilized in an ethical and responsible manner.

Operator

Our next question will come from [Howard Sun] of Macquarie.

Unidentified Analyst

Howard from Macquarie. I just wanted to know what is the main reason for the decline in revenue in smart devices in Q1. You have talked about it a bit. Could you elaborate a bit more?

Feng Zhou

This is Feng Zhou. As we mentioned earlier, smart devices revenue was down 16% in Q1, mostly due to the pandemic. In January and early February, consumer demand was very weak and many offline channels, many electronic stores were not open for business. However, demand quickly recovered and channel started operating normally close to the start of the spring school semester. Therefore, in March, business rebounded with over 20% year-over-year growth in new activations of dictionary pens. So that's how the quarter looks like if we look at it month by month. So it's already recovering.
So right now -- so we think consumer demand and channels are where we want them to be since March. Our teams are working hard to drive growth with product innovations. We received a very positive (technical difficulty) on the newly launched AI speaking and Baidu Netdisk features we added to the dictionary pen. Because of all the publicity about generative AI, users are really eager to try features like AI speaking. And Baidu Netdisk, had been the most asked for feature because a lot of users already use the Baidu Netdisk to store learning materials. The ecosystem is growing nicely.
If you look at the growth of the -- our dictionary pen user base, we have nearly 40% year-over-year growth of monthly active users of active dictionary pen users in Q1. This means more customers bought the device. And more importantly, they are actively enjoying the product, and they are satisfied with the experience. This is great, and this is what brings more business for us down the road. Compared with the other consumer electronics, smart educational devices demonstrate resilience under hard macroeconomic circumstances. Our new smart devices are expected to be released in Q3. So we look forward to new products bringing even more better -- even better experiences to our users.
In terms of sales channels, we have expanded our reach by utilizing more live streaming channels. Our partnership with Jiaqi, Austin Li, has led to nearly 20 live streaming sessions, featuring our dictionary pens. The collaboration has helped to boost our sales and strengthen our brand influence at the same time. So we will be doing more of that. So we expect the device revenue to gradually recover. We are confident in the long-term prospects of smart learning devices. I hope that answers your question.

Operator

Our next question today will come from Candis Chan of Daiwa.

Candis Chan

So congratulations on the very strong revenue growth of the online marketing services. Can management give us more granularity of the growth behind and for instance, maybe is it more driven by the macro recovery or the advertiser sentiment? Or is it something more related to the devices or app that we are seeing greater traffic?

Lei Jin

This is Lei Jin. As for advertising business, customer value is the first priority. We have been making -- make a big effort to create value for the customers. 8% year-over-year increase from the revenue side in Q1 shows we are on the right track. There are maybe 3 reasons for the growth. The first is macroeconomic recovery spur demand, especially for the fast moving consumer group. It's resulting in the revenue growth from the performance-based advertisement.
Secondly, performance-based advertisement was further improved in Q1. The system was upgraded in last Q4 last year. It has provided more timely and accurate contribution data from our customers. They give us the positive feedback on the greater position of the marketing capabilities by AI technology. Certainly, our AI evidence upgrades have increased our ability to better match advertisers with the users. Our audience is mainly made up of the college graduates, young professionals and young couples. This will help our team, our customers have recently been very successful marketing to their audience in sectors like fast-moving consumer goods, cosmetics and food.
By leveraging the power of AI, we can make more accurate predictions and recommendations, which turns to the better matching from our user and the customer. The positive momentum for this sector is targeted to continue in Q2.

Operator

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

Jeffrey Wang

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

Operator

The conference has now concluded. We thank you for attending today's presentation. You may now disconnect your lines.