Q1 2023 Zepp Health Corp Earnings Call

Participants

Leon Cheng Deng; CFO; Zepp Health Corporation

Wang Huang; Founder, Chairman & CEO; Zepp Health Corporation

Zhang Grace Yujia

Lisa Lee

Unidentified Analyst

Presentation

Operator

Hello, ladies and gentlemen. Thank you for standing by for Zepp Health Corporation's First Quarter 2023 Earnings Conference Call. (Operator Instructions) Today's conference call is being recorded. I will now turn the call over to your host, Ms. Grace Zhang, Director of Investor Relations for the company. Please go ahead, Grace.

Zhang Grace Yujia

Hello, everyone, and welcome to Zepp Health Corporation's First Quarter 2023 Earnings Conference Call. The company's financial and operating results were issued in our press release, the Newswire Services earlier today and are posted online. You can also view the earnings press release and slides referred to on this call by visiting the IR section of the company's website at ir.com.com -- ir.zepp.com.
Participating in today's call are Mr. Wang Huang, our Chairman of the Board of Directors and Chief Executive Officer; and Mr. Leon Cheng Deng, our CFO.
The company's management will begin with prepared remarks, and the call will conclude with a Q&A session. Mr. Mike Yeung, our Chief Operating Officer, will join us for the Q&A session.
Before we continue, please note that today's discussion will contain forward-looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the company's actual results may be materially different from the views expressed today. Further information regarding this and other risks and uncertainties are included in the company's annual report on Form 20-F for the fiscal year ended December 31, 2022, and other filings as filed with the U.S. Securities and Exchange Commission.
The company does not assume any obligation to update any forward-looking statements, except as required under applicable law. Please also note that Zepp's earnings press release and the conference call includes discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial information. That press release contains reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures.
I will now turn the call over to our CEO, Mr. Wang Huang. Please go ahead.

Wang Huang

Hello, everyone. Thank you for joining our call. In the first quarter, we recorded revenue of RMB 645.2 million with RMB 391 million from our sales branded products and RMB 254 million from the Xiaomi ODM business.
Our total revenue declined as cautious consumers limited discretionary spending due to volatile, to geopolitical and macroeconomic conditions in Europe and in the U.S. As we mentioned in the earlier quarters, we anticipate that the Xiaomi ODM business will diminish further that our self-branded product lines will become the main growth driver in the future.
In the quarter, we made progress globally by strengthening our go-to-market capabilities and increasing brand awareness. This along with the value of our product growth, higher shipments and market share gains with 20% increase in the Southeast Asia and East Asia region. Despite experiencing a decline in the consumer electronic device market during the first quarter of 2023, we maintain our optimism that macro headwinds will subside, and we expect to see a market recovery during the second half of the year. Furthermore, and now the cause for automation is that Canalys recently forecasted an increase in the smartwatch market in 2023. We strongly believe in Amazfit's long-term potential in the smartwatch market, presenting a significant opportunity to boost sales by enhancing our product competitiveness.
By leveraging our vertical integrated (inaudible) based chip and Zepp OS in all product lines, we can reduce product costs and improve product growth profit margins. Our high-end products offer similar performance to premium competitors, but at a fraction of the most of the cost and this longer battery life. This all helped us generate higher revenue and profit margins along with our integrated supply chain and efficient R&D. We will secure our position in the USD 100 to USD 200 market segment while expanding into premium segments and enhancing our sales channels and supply chain management for increased profitability.
With these enhancements now implemented, I am thrilled to share that our new products have achieved a remarkable 34.6% margin in the current quarter. We remain confident that the overall margin will improve in the future as we work towards achieving a more optimal inventory level. Moreover, the rapid implementation of OpenAI's LLM technology sets us apart from our competitors in the industry by utilizing sports watches powered by Generative AI. We will position ourselves as a trailblazer in the market, emphasizing our advanced great technology rather than traditional sports watches.
For example, as we mentioned last quarter, we have been the industry pioneer in integrating GPT technology into our products and services such as Zepp Coach and Zepp Aura. On March 29, we launched the beta version of an AI-powered Zepp Coach Chat function for Amazfit Falcon user, powered by this constantly learning and evolving AI chat capability, Zepp Coach Chat can provide users with abundant personalized and updated exercise recommendations.
In recent quarters, we have implemented refreshed marketing and product strategies that include creating communities for sports and out those insurances by leveraging Generative AI technology. We have not only supported the growth and development of athletes, both in (inaudible) and outdoor [initiative], but also build a thriving user community in the sports and outdoor sectors. This has resulted in the organic spread of positive word of mouth and distribution, which has further boosted our brand and reputation in the mid- to high-end market. As a result, we have also gained brand premium in the mid- to low-end market, driving higher profit margins in the future. Alongside our endeavors to equip our products with cutting-edge technologies, we have also been striving to expand our product portfolio, aiming to offer more diverse products to adjust different cohorts, [tennis], health and lifestyle needs.
In Q1, we launched the Amazfit T-Rex Ultra, our ultimate outdoor GPS smartwatch on March 20. It received positive feedback from outdoor sports enthusiasts for its rugged design, premium material and 160-plus sports modes. We have other exciting product plans for the year ahead aiming to bring [the one] features to more users. For example, on May 1, we released a significant firmware update for the Amazfit T-Rex 2 smartwatch. It includes heart rate recovery information, terrain metrics, altitude, water temperature, slope and automatic slope analysis. These enhancements improve the user experience, making our smartwatches reliable fitness companion for indoor and outdoor activities.
For the past few months, in 2023, we have seen some signs of economic recovery in certain markets. That said, the fragile economic environment in many other markets remains an uncertain factor, dampening consumer confidence and potentially our sales performance in the coming quarters. Nevertheless, we remain confident in our strategy described but -- and we believe this is the right path leading to the company's sustainable growth as we aspire to become a leading global healthcare solution provider, and it will enable us to deliver incremental value to our users and shareholders.
Thank you again for joining us today. I will now turn the call over to Leo to go over the highlights of our third quarter financial results.

Leon Cheng Deng

Thank you, Huang. Greetings, everyone. Let me walk you through some key metrics of our first quarter 2023 financial results.
In the first quarter, we recorded revenue of RMB 645.2 million within our guidance range and down 14.8% year-over-year. The decrease was mainly due to the global macroeconomic uncertainties that dampen discretionary consumption in the first quarter. According to Canalys, the value of the global wearable markets, including basic band, basic watch and smartwatch decreased by 8% in the first quarter. And more specifically, the basic band subcategory lost more than 30%.
Also, as I mentioned a few times before, Q1 is typically the lowest seasonal quarter of our financial year. Before diving into our financial performance, I would like to provide a brief overview of the macro environment. In the first quarter, we experienced a shift in China's COVID Zero policy, the reopening disrupted our new product launch schedule due to the factory closures. As a result, we had to postpone the release of some of our new product lines to subsequent quarters, which has a negative impact on our Q1 sales. At the same time, consumer spending was rather tepid, especially as the pendulum has swung away from goods and towards travel and services as the consumer enjoys some of the activities that they were deprived of during the pandemic.
The consumer electronics space, in particular, continues to experience softness to this matter, which together with the geopolitical risks in Europe, pressure on our top line in North America and Europe. Despite the challenging start of the consumer electronics market during the first quarter of 2023, we remain optimistic about the smart wearable market recovery in the second half of the year. Despite these headwinds mentioned above, as Huang just mentioned, in some of our global markets, our self-branded products achieved in current year-over-year sales growth during the quarter. Thanks to our enhanced brand value and product features, we remain confident in our ability to drive our self-branded products to grow further in the coming quarters.
Moving on to our gross margin, which can be influenced by various factors such as product mix, product launch timing and product life cycles, including model upgrades. As we took a ROI-oriented approach to optimizing our product and sales channel portfolio, the gross margin for our self-branded products remained relatively healthy. Meanwhile, gross margin for Xiaomi products declined significantly in the quarter as a result of its multiyear pricing strategy. Above factors combined drove our overall gross margin to 15.9% in the first quarter, down lowered by 4.2% year-over-year and 4.8% versus previous quarter. We believe with the launch of our new higher-margin products and continued pooling of our low-ROI products and channels, the gross margin of our self-branded products will expand further for the remainder of the year.
Now let's look at our costs, as we have always mentioned in our past earnings calls, costs remain a main forecast for the company, both in terms of their absolute amount and as a percentage of sales. Since Q3 2020, we have been pleased to see a trend toward a decrease in total operating expenses, while still making strategic investments in new products, technologies and footprint expansions to fuel our long-term growth. In Q1, we made good progress in cutting our expenses run rate further by successfully reducing our quarterly operating expenses to RMB 253.8 million, reflecting a year-over-year decrease of 17.5% and a quarter-over-quarter decrease of 13.3%.
Non-GAAP operating expenses decreased to RMB 229.8 million, which is the lowest level in the past 2 years. As a percentage of revenue, our first quarter adjusted operating expenses rate decreased by 3.3 percentage points year-over-year. Going forward, we'll continue to manage our expenses in a disciplined manner and enhance our operating efficiencies targeting to cut our expenses run rate to approximately non-GAAP RMB 200 million or lower in the coming quarters, which represents a significant decrease of around 33% of more than -- or more from the average of RMB 300 million per quarter in 2022 as we aim for our turnaround in profitability in the coming quarters.
Spending RMB in Q1 '23 was RMB 117.9 million, decreasing by 19.5% year-over-year. Benefiting from our enhanced R&D efficiency, it is also worth mentioning that R&D expenses now account for nearly half of our total operating expenses, as we remain committed to investing in our future by investing in new technologies to enhance offerings for our users.
Selling and marketing expenses were RMB 86 million declined by 16.6% year-over-year as we carefully review our sales channel strategy while still investing on opportunities with higher ROIs to fuel growth.
Q1 G&A expenses were RMB 49.9 million, lowered by 14.2% versus RMB 58.2 million in Q1 2022 and down by 6.5% compared with RMB 53.4 million in Q4 2022 due to organization delayering and strong cost control measures. We believe that our progress in cost optimization is a strong testament to our execution capability and will benefit our long-term growth. Thanks to decreased operating expenses, our adjusted operating loss narrowed by 10.9% year-over-year. However, our reduced cost did not fully offset the impact of a smaller revenue scale and lower gross margin for Xiaomi products during the quarter.
Our adjusted net loss in the first quarter was RMB 112.7 million versus a loss of RMB 75.7 million in the first quarter of 2022. While our Q1 2022 loss include RMB 66.3 million investment income generated by our [Sifi] investment, we will continue to enhance our cost culture policies by implementing more comprehensive measures, specifically targeting areas such as travel expenses, personnel-related costs and other expenditures incurred by the company. Simultaneously, we're dedicated to refining our product pricing strategy to optimize both our gross margin and sales revenue ultimately leading to an improvement in our bottom line performance. Despite the bottom line loss, our cash flow remains strong, thanks to our working capital management efficiency. We have sustained positive operating cash flow for 3 consecutive quarters since Q3 2022.
Now turning to the balance sheet. Cash and cash equivalent, restricted cash and the term deposits as of March 31, 2023, were RMB 1 billion, an improvement from RMB 973 million as of December 31, 2022. As we continue to execute our precise inventory management strategy, we further reduced our inventory balance to RMB 800 million by the end of the quarter from RMB 1 billion at the end of the year 2022. And it is the lowest level in the past 6 quarters. In November 2021, the Board approved the allocation of up to USD 20 million towards a share repurchase program. In Q1 2023, we continued our repurchase program as we remain confident in our business prospects in the longer term. We have bought back USD 11.1 million worth of shares by the end of March 31, 2023, and we intend to carry out with this buyback program.
Now let's discuss our outlook. In light of the ongoing geopolitical and macroeconomic challenges, our guidance for the second quarter of 2023 currently projects net revenue to be between RMB 650 million and RMB 850 million compared to RMB 1.1 billion for the second quarter of 2022. We expect roughly 65% to 75% of the revenue will be contributed by our self-branded products in the second quarter. Please note that this outlook reflects continued uncertainty around lower discretionary consumer spending, especially in our international markets and global macroeconomic weakness. That said, we have seen some positive signs and much of the year lies ahead of us. Furthermore, as we mentioned last quarter, the year may be somewhat back-end loaded as we gradually release our new products.
And with that, I would open it up for questions. Operator, please go ahead.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from [Nicola Jones] with [Brooks Investments].

Unidentified Analyst

So I have 3 questions. Firstly, can you please provide some color on the revenue trend of self-branded products in the second quarter and beyond? And then secondly, I'd like to ask if you can discuss factors that impacted your margins in the first quarter and margin outlook in the remainder of the year. And lastly, I'd like to understand a bit more about the revenue breakdown by region.

Leon Cheng Deng

Yes, it's a lot of questions. So let me start with the first question. I think it's on the self-branded product margin. Sorry, I think it's around self-branded product revenue outlook for Q2 and the quarters ahead of us, correct?

Unidentified Analyst

Yes.

Leon Cheng Deng

Okay. Now I think as we just guided, we were looking at roughly RMB 650 million and RMB 850 million for Q2 as our revenue range. And then we -- out of that number, there's going to be around 65% to 75% of the revenue, which is going to be contributed by our self-branded products. So if you take the mid number over there, in essence, we're looking at the second quarter revenue, which is going to be around, let's take a number of 7.5 -- sorry, RMB 750 million, and out of that, 70% would be our self-branded products. If that number is correct, I think that is actually going to be indicating that our self-branded products revenue is going to start to grow versus the same period of last year. And looking ahead, we have mentioned a few times that we're actually transforming more into self-branded driven revenue kind of company rather than in the past, majority of our revenue is actually consists of the ODM Xiaomi product. And you will see this trend starting to take a shape more in -- I think we have already started to -- you have already seen this trend. But I think after a few quarters, especially Q2, Q3, Q4 this year, you'll start to see a solid trend of majority of our sales revenue is going to be generated by self-branded products. Well, we still have a small portion of the Xiaomi and ODM products revenue and in return, that sales mix change is going to help us to deliver a higher gross margin. So I think that naturally goes into your second quarter, which is on the margin outlook. I think one of the things I would like to call out in the first quarter this year is that we have already seen -- I think we have already seen consecutively a few quarters in the past that our self-branded product gross margin is starting to recover, and we see this trend progressing into Q1 this year. And we have already mentioned in our prepared remarks, that in Q1, our new product sales gross margin is around 35%, which is a lot higher than what we have sold in the past. But our overall gross margin for the self-branded products in quarter 1 was still flat year-over-year, largely because we still have some of the old inventories from the previous generation products, which we carried over from previous years, which we try to sell off, right? And I think we're coming -- and that's why you also see our inventory balance decreased dramatically in the past 6 quarters, and we are now at RMB 800 million worth of inventory, which is if you put it into perspective, that's just equivalent to the sales outlook of a quarter out sales plus, right? And I think coupled with the clearance of the old inventory, which come more or less to an end right now, plus the newly launched product of self-branded products, which is going to take its shape in quarter 2 and ultimately into the high season of Q3 and Q4, we see the gross margin of our self-branded products as well as the overall gross margin is going to shoot up or continue to improve in Q2 and ultimately in Q3 and Q4. I think that should answer your second question.
And your third question, if I remember clearly, it's about the revenue breakdown by region. I think we have mentioned several times that our biggest sales region for our self-branded products is in Europe. And that actually stands for around 60% of the overall self-branded revenue for us. And in many of the big European countries, for example, Spain and Italy, we hold a very dominant market share position in those countries. So -- and we will continue to expand in Europe, especially in the east part of Europe as well as in the countries like traditionally a very strong brand awareness for our premium competitors, for example, Apple and the Samsung brand. You're more looking at countries like Germany and U.K., et cetera, et cetera, right? And apart from Europe, I think we also see United States as one of the countries and regions, which can give us quite a growth opportunity because we have been operating in U.S. -- in the North America market for roughly close to 2 years -- less than 2 years, and we have already developed our market share from 0 towards 11%. That's actually ranked ourselves among the top 5 players in the U.S. So I think U.S. will continue to push up after Europe. And the third biggest sales region for us is the Asian countries. You're looking at Japan, Korea and Malaysia, Singapore and India. These, we actually group them as one of the Asia Pacific countries. And then they also play as an important part of our self-branded revenue. And last but not the least, is China. And I think we also want to play smartly in China by selling selectively our premium products in China and try to look at the profitability rather than the scale because the competition in China is quite fierce, especially in the smartwatch domain. But I think in certain premium price segment, we have a unique position to compete over there. So that all together, hopefully, would give you a view on where we're going to push for this year's revenue for self-branded products.

Operator

(Operator Instructions) The next question comes from Lisa Lee with Alpha Research.

Lisa Lee

I have 2 questions. The first one is on the very strong margin that you just mentioned for your new products. You said it was around 35% in the first quarter. I'm just wondering what are the drivers behind this performance? And are there any further upsides to this number? And the second question is on the run rate of your operating expenses. You I think talked about a target of RMB 200 million on the adjusted basis in the coming quarters. But I noticed in the first quarter, your total operating expenses have reached around RMB 225 million, I think, on the adjusted basis. So are you being a little bit conservative on this target? And what is your run rate currently?

Leon Cheng Deng

Yes. So let me try to answer the easy ones. Let's start with the run rate of the expenses, then I'll get back to the margins because that's probably is going to be a little bit longer story here. Yes, you are right, Lisa. So if you look at our 2022 and 2021 quarterly expenses run rate were around RMB 300 million per quarter, so which is adding up the R&D, G&A plus the sales and marketing expenses altogether, right? So this is actually one of the key KPIs, the management plays a lot of focus into our day-to-day operation, okay? So we have done a few things. We actually look at our -- that's #1. It's definitely the personnel, right? So we look at our workforce, and we try to streamline our workforce and then we try to get it in line with our revenue scale. So that's definitely the one which we did in the past quarters. I think that's more or less coming to the end.
And the second one is what we did is to look at our expenses based on a so-called ROI return on investment approach. And we always look at the discretionary expenses in a way that whenever we could save, we ask people to be a little bit more cautious in, for example, traveling, for example, spending on our marketing campaign by looking twice or three times whether or not it makes sense and what's the return on that, right? And the last thing which we did is on R&D part. We are more applying a so-called platforming approach whereby we look at our vertically integrated chips, OS and everything together and try to lower the overall cost of delivery on our products, right? So that all translates into a lower R&D expenses and lower sales and marketing expenses and the lower G&A expenses, right?
And you are right, we have -- I think last quarter, we have guided that our target for this year probably is going to be achieving a run rate of RMB 250 million per quarter. And then we have already achieved that number. And we have overdelivered in assets this quarter around RMB 229 million for the quarter and where, as we mentioned in our prepared remarks, we're looking at operating expenses run rate of RMB 200 million for the year. And yes, I still think by applying a more target approach like what I just described, we still have room to push for a little bit lower than that number. But at this moment, we are more looking at a run rate of RMB 200 million per quarter for that, right?
And going back to your first question on the margin and then the margin development for our products for this year, I think there are a few drivers. Number 1 is that we are actually looking at -- as you know, we have 3 different product lines, which are targeting different type of consumers, right? Number 1 is our so called sports and outdoor range, which is supported by our watch like a T-Rex and Falcon series. These are the so-called the Apple Ultra and Garmin watch competitors, which we want to use these type of -- and we offer this watch at a relatively lower price with similar functionalities versus our competitors. And these watches actually have gained great tractions in the marketplace right now. And we want to actually deepen on building on those reputations, we generated through these watch and also the functionalities we have achieved out of this watch, and we want to actually use this type of reputation to sell our -- and increase our ASPs of our overall product portfolio at large, right?
And number 2 is actually what I mentioned just now on applying a vertical integrated supply chain as well as the chips, the OS and the R&D effort altogether, so called platform in approaching our R&D, right? In the past, if we have 10 platforms that in essence, you need to spend the money 10x. But if you can actually single everything into 1 platform, then you are going to reduce your cost dramatically and at the same time, deliver a user experience and functionalities much better than a scattered software and hardware landscape in the past. So I think with that second lever of vertically integration, we should be able to gain market share in those price segments between $100 and $200 range, which is also the part which our competitors like Huawei, like Xiaomi and other brands, there's a fierce competition over there, but I think through vertical integration and a pure player, we should have a better competitive edge over there. So number 1 is to increase the ASP on our premium watches. Number 2 is to use our vertical integrated system platforms and everything to increase our competitiveness on the lower-tier price points so that we can actually gain market share at the bottom from the Xiaomi, Huawei and Samsung guys and at the top from Apple and Garmin guys. Then altogether, that should be the path on how we're going to increase our gross margin for our products in the future. I hope that gives you a view.

Lisa Lee

Yes. It did.

Operator

As there are no further questions now, I'd like to turn the call back over to Grace Zhang for any closing remarks.

Zhang Grace Yujia

Thank you, once again, for joining us today. If you have further questions, please feel free to contact Zepp's Investor Relations department through the contact information provided on our website. This concludes this conference call. You may now disconnect your lines. Thank you.

Operator

Again, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.