Youdao, Inc.
Q3 2020 Earnings Call Transcript

Published: 19 Nov 2020

[Operator:]

Good day, and welcome to the Youdao 2020 Third Quarter Earnings Conference Call. Today's conference call is being recorded. At this time, I would like to turn the conference over to Regina. Regina, please go ahead.

[Regina 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 US 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 those 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 Youdao's business and financial results is included in certain filings of the company with the Securities and Exchange Commission, including our annual report filed on Form 20-F. The Company does not undertake any obligation to update this forward-looking information, except as required by law.

[Feng Zhou:]

Thank you, Regina, and thank you all for participating in today's call. Before we begin, I would like to remind everyone that all numbers are based on renminbi. Online education is more relevant today than ever before and it is profoundly transforming how people learn. We accelerated our rapid growth momentum in the third quarter and generated total revenue of RMB 896 million. Gross billings from online courses reached RMB 955 million, up 228% year-over-year and 76% quarter-over-quarter, supported by our large-scale marketing and branding campaign during the summer. Growth in our K-12 segment was particularly strong, reaching a record high. Gross billings from this group were RMB 676 million, up 369% and 120% year-over-year and quarter-over-quarter, respectively. K-12 paid enrollments reached 499,000, up 52% quarter-over-quarter. The K-12 gross billings proportion of Youdao Premium Courses increased to 77% from 67% in the same period last year. ASP for the K-12 segment was slightly down, primarily due to the increased proportion of primary school enrollments, which have relatively lower ASPs than our high and junior high school courses. Also, 22% of all newly enrolled students gross billings came from organic traffic from – for Q3, which grew 188% year-over-year. Gross margins also continued to improve with product improvements and larger scale. Overall gross margin was 45.9% and the gross margin for our learning services was 53.9%, up 220 basis points from Q2. We expect to maintain this growth momentum of our GP margin, mainly due to further improvement of economy of scale. We continue to strengthen our star instructor and teaching assistants’ teams. More than 70% of our current instructors come from Tsinghua University, Peking University, or a top 50 university in the world. This year, we hired only about 0.3% of all instructor candidates. We are committed to continue hiring elite instructors and to offer high-quality courses. Regarding TA teams, we continue to expand our capacity. Total TAs reached 3,368 at the end of Q3 at operation centers around the country.

[Peng Su:]

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights from our 2020 third quarter. We encourage you to read through our press release issued earlier today for the further details. We continued to scale our operations in the third quarter achieving considerable year-over-year growth. Our strong technology, curriculum and supporting intelligent devices and apps are well suited for exponential growth as we pursue additional marketing and branding activities to support our growth. For the third quarter, total net revenues were RMB 896 million or US$132.0 million. This represents an increase of 159% from the third quarter of 2019. Looking at this growth by segment, net revenues from our learning services and products grew 239.1% year-over-year to RMB 763.5 million or US$112.4 million. We attribute this growth to a sharp uptick in K-12 paid student enrollments and gross billing per paid student enrollment of Youdao Premium Courses on a year-over- year basis. Net revenue for online marketing services were RMB 132.6 million, or US$19.5 million, an increase of 9.8% compared with the same period of 2019.

[Operator:]

Thank you. We will now begin the question-and-answer session. . The first question today comes from Brian Gong with Citigroup. Please go ahead.

[Brian Gong:]

Thanks, management, for taking my questions. My first one is still about the competition. Can management give some updates on recent competitive landscape and the outlook and how does management see student acquisition cost trend to be for first quarter and for next year? And what would be our marketing budget for 4Q and next year? Thank you.

[Feng Zhou:]

Yes, this is Zhou Feng. So, first, a couple of points on the competitive landscape. So, I think what's obvious is the sector as a whole is growing quickly, yes, probably quicker than last year. And the sector is investing money, not earning money yet. So, I think players are willing to invest because two things. One is, parents are willing to pay for really high-quality education, and so profitability in the long run is very much there. And the second is total market size potential is huge. So, these two factors, they remain true. They're very much true in 2020, and that's why we invested in marketing in the summer and that's why I think what everyone is thinking about. So, we're bullish about the future, yes. So, that's one. And second is, I think, we see greater concentration in 2020 compared with last year. So in the sense that we only have five, six main players kind of doing K-12 large courses. So, with the investment we made in marketing in Q3, we significantly increased our customer base. So with the – I think with very competitive customer acquisition cost. So, this gives us better reach and more leverage. So, yes, I don't want to comment too much on our peers. So that's for us. Thirdly, I think in terms of – in the future, Q4 and how everyone competes and how fierce the competition is, I believe, it is important to appreciate the fact that we're still in the early days. So early in how we create content and present it. We're early in how we acquire customers. We're early in how we deliver and monetize the content.

[Peng Su:]

Thank you, Doctor, and Brian, for your questions. So first of all, the colors for the marketing expense for the upcoming quarters, I think, so first, we don't give any official guidance to the market, in line with school. That's the first. But yearly, we can share. For Q3, it will be our biggest investment season due to the summer campaign. So on a full-year basis, indeed, we significantly enhanced our marketing investment in the Q3 in this year, but we believe it is highly valuable for us to acquire the amount of new students with healthy unit economics. But because it is not one-time – for the K-12 business, it's not really the one-time track model for the K-12. Think of the lifetime value of the K-12 students, we expect those users to be able to stay with us for a long time. And we estimate to cover the – all the sales and marketing costs with one to two times for the repurchase for our K-12 users for our product. So, we achieved a great outcome through the summer marketing campaigns. And as Doctor mentioned, the payroll - paced enrollments increased over 400% in the – during the Q3. And if you discover the growth of subjects, our math product increased over 8 times year-over-year in terms of the paid enrollments. So we are dedicated on the continued – our fast healthy growth, we think. And we will not hesitate to keep investing in our top line expansion for those projects with healthy unit economics. And on the other hand, we believe because our pretty unique product mix, and we do not rely on the sales and marketing to expand our business. We can also rely on our apps. And like Dr. Zhou mentioned, for our intelligent devices, we shipped about over 250,000 units for our Dictionary Pen 2.0. In those users, over 70% of our Dictionary users were purchased by the or for our K-12 users. And I think that we can – in the future, we will deploy – discover more synergy between our intelligent devices and our online services. So I think for the last question about student acquisition costs, I think – I just mentioned about this as well. The summer campaign season really was the was this higher user acquisition costs due to the increasing customer demand and also – then the costs went down after summer season. But during the semesters, students and parents typically will wait until the winter season or the coastal winter season to choose after school children products. And we also, I think, actively trying to use the multi customer acquisition channels to attract users, like for our marketing, e-commerce platform and social network. I think the new paid enrollment marketing via the core marketing grow about several times compared with the same period of last year. So, we will keep close monitor about the customer acquisition cost to keep a healthy growth for our total business. So, I hope that answer your question. Thank you, Brian.

[Brian Gong:]

Yes, definitely. Thank you. Very helpful.

[Operator:]

Next question comes from Sheng Zhong with Morgan Stanley.

[Sheng Zhong:]

I have a couple of small questions. The first one is a follow-up about the internal MAU customer conversion. So, you have a quick MAU growth. And also, you have smart devices shipment to students. Can you share the number? How much percent of your enrollment is from your MA and your internal traffic? And do you have any expectation on this number going forward? And the second to me is you have a very strong gross margin improvement in past few quarters, especially the premium online courses. So, what's your view about the normalized gross profit margin for your online courses? The last one is a quick one. Maybe too early, but can you share some color on your retention rates on this fourth semester to winter courses? Thank you very much.

[Feng Zhou:]

Regarding converting MAUs from our organic traffic to paying users, I can give you one data point, is 22% of all our billings in Q3 come from internal traffic. That's 188% growth over same period last year. In terms of long term, you can do the math here. If you compute that number, the enrollment number as a percentage of MAU, which is over RMB 100 million. So, it's still very low. It's lower than 1%. There's still a lot of room for growth. The end stage – long-term potential, I think the short answer is, we believe a couple of percentage points is doable. To explain why, first, remember, we do have big price gaps. On one side is the free product, the dictionary. On the other side, it's a course of several thousand yen. So, it is non-trivial to do the conversion. On the other hand, we have become quite experienced at this. We do have the advantage that our dictionary users are quite loyal. They come back a lot. And we have many opportunities to touch them. We use ways like free trials, of course, and we did the introduction of customization features, letting users tell us who they are, things like that. And they have been quite useful in increasing the conversion. Our data we have, including the trajectory, shows that a couple of percentage points is credible in a few bps. We are always experimenting with ways to offer users more relevant courses and other services. So, it could be higher. And you also mentioned the learning devices. Yeah, we believe it's also a very good source of organic conversion. A lot of these devices are purchased by our K-12 students and there are over 250K of dictionary pens sold in Q3. So, it's already a sizable number. So, we will look at this probably in the future. And the second question regarding gross margin kind of in the long run. I think the short answer is, right now, we are at around 50%. We think 60%, 70% is completely doable. A lot of factors play into that. So, we will see. And last question is regarding retention. We're still early. But we did start signing up current students for winter and spring courses in late October. It is an ongoing process that extends into Q1 2021. But what I can share with you is, preliminary data shows that, in general, we've been able to significantly increase both the number of new students and improve the retention rate at the same time, over the same period last year. So, we feel good about the final results at the end of the retention period in January.

[Operator:]

The next question comes from Alex Xie with Credit Suisse.

[Alex Xie:]

Congratulations on the quarter. My question will be about competitive landscape. Several of the new players in this market made the comment that the top four players in K-12 Q3, they have advantages and, again, the non-top four will become bigger and bigger and we will also see several players raise the funding in September and then recently. So, what will be the positioning of Youdao in this market? And how do you think about competitive advantages in this kind of competitive environment? Thank you.

[Feng Zhou:]

About competitive landscape, what I'll say is, yes, in general, we are not operating around market share. We think our competitive strength is threefold. We focus on high quality content, product innovations and great technology. Three things, quality, innovation and technology. We don't intend to do all the courses and all the grades. Right now, if you look at our offerings, the focus is clearly – for K-12 is on junior high and high school, senior high school – junior and senior high school. If you look at our track record, the three things really, we think they really help us focus on quality, enabled us to deliver bestseller courses like Logic English and our junior high school Chinese course . Innovation led us to projects like the dictionary pen where we created entirely new product categories that people really loved and it's growing superfast. And technology innovation, like automatic essay grading, which we talked a little bit about in the past, and they're now being integrated into our services during the summer. We believe these three things are vital to our success. And that's the first point I want to make. Then, looking at operation side, in Q3, we added a lot of students. So, we did that because we think the products are ready. They offer a great value and retention potential for the users. So, that's why we did it during the summer. And for us, it obviously increased economy of scale and the impact of our products among the users. So, we are quickly expanding in our scale, which we expect to continue to do. And lastly, we are really happy about our product pipeline. That's pretty important. For K-12, for kind of preschool courses and also for adult courses, we have nice projects, really strong projects in R&D. When these products are ready, we will release and promote them. And I believe this is how we grow the business instead of just spending dollars on sales and marketing.

[Alex Xie:]

I have a follow-up on this question. So, since several new players are raise funding recently, what do you think will be the condition for Youdao to raise funding or what will be the conditions that you won't consider raise funding? Thank you.

[Feng Zhou:]

We're happy with our current cash position. One thing you want to look at is, if you look at our operating cash flow for the first three quarters, so it's actually a healthy process for us. That's one. And second is, obviously, we have ways to raise funding if we need. So, we will, of course, keep that in mind. And lastly, our controlling shareholder, NetEase, has always been very supportive of Youdao's business and they believe fully in the vision. So, they will always have our back.

[Operator:]

Next question comes from with CICC.

[Unidentified Participant:]

I have two questions here. First, we noticed strong growth of our learning devices. And why is that? And what will be Youdao's future strategy on that business? And what's the pen market and the overall market share we will have in a stable future? Second question is related to the GP margin. We noticed that we have a quite good improvement on the GP margin. Can management share for K-12 courses the average number of students per courses? And in addition, the average number of students served per teacher? Thank you.

[Peng Su:]

This is Su Peng. We think, for the intelligent devices, like Dr. Zhou mentioned, I think it's a sector developed by the Youdao team and you see the numbers of shipped for the dictionary pen in the Q3. I think it's grow very fast in the numbers. We are fully confident about the numbers growing in the next few quarters and we also we think – we are expecting to build up more hardware pipeline – intelligent pipelines in the future. We think that will combine with – will be part of the online education in the futures. And I think that combined with the – intelligent devices will combine with services. So, we think the market potential is tremendous, we believe, and we think we will spend more time and resources to develop more intelligent devices in the future.

[Feng Zhou:]

We'll have a new version on December 1. We really like the new version. We think there's a lot of innovation there. And I think the other thing about these devices is that it's not just a hardware device. It's actually device plus content. A lot of our thinking went into it by putting really unique content and technology in it. So, it has good margins and it's really sticky.

[Peng Su:]

I hope that answers the question about your intelligent devices. And second, for the marketing issues, as you mentioned, we have improved a lot of our GP margin in this quarter compared with the same period of last year. We think that's also leveraged from our economic scale as well as we restructuring our compensation structures of our business and faculties in this quarter. And for your questions about average classes, I think that's not really a – I think number of students who run classes, I think it's because we are offering most star teachers in this quarters as well. So, I think thinking about the average number, it has increased a little. But thinking about scales, . A lot of the new teacher and students had . And for the tutors – on the teaching assistant side, I think the average number is also around 200. But if you use the total enrollment divided by our total tutors, that will be different because we have to pre hire all the tutors before we offer the services to our students. So, that means some part of our tutors will be in training process in this quarter. So, from the operating efficiency for this quarter, we are improved a lot compare with the same period last year. So, we are fully confident about to increase our GP margin tremendously – gradually in the next few quarters.

[Operator:]

Next question comes from Binnie Wong with HSBC.

[Binnie Wong:]

I have already a question regarding on the competitive landscape. How do you see that get evolved into 2021, especially when like , a lot of these private players have been making a lot of capital and it seems that they're also spending a lot of – like, very low pricing, right, to just drive the user acquisition. I'm not sure, if into 2020, do you think we will also be stepping up in terms of the marketing expense to just drive a faster growth or maybe using any strategies that we can use more? And then, the second thing is a follow-up from the last question, is in terms of any, like, cross-selling ratio from the Youdao app, the dictionary app to cross-sell into the premium courses? And then, we saw the premium course growth actually accelerated to 300% Y-on-Y from a 200% growth last quarter. What are some of the key reasons that structurally we should be aware of and that can last into the next quarter now?

[Yongwei Li:]

This is Wayne. I'd like to take the last question. As just mentioned by Dr. Zhou, for the competition landscape, I think quickly. And with the combination of mentioned, we believe companies have more cash build definitely have the company in a better position when facing the competition. We are comfortable with our current cash level. We have some positive cash flow in the first two quarters and we have financial support from our parent company, NetEase, as just mentioned. And in the long run, we cannot expect huge cash position incurred for 2020 fiscal year. However, at the same time, you may notice our learning service and the products business very quickly, which improve our business . In terms of competition in user acquisition, I think market players seems to pick higher paying people at the current stage due to the good market window. And then, most companies are also are trying to get different user acquisition channels which will bring more cost benefit balance. The market size potential is very huge. And business is more concentrated, as just mentioned. So, if our unit economic is healthy, I think we will continue to take advantage of the to get opportunities to grow our business.

[Binnie Wong:]

[Yongwei Li:]

What's your follow-up question?

[Binnie Wong:]

[Feng Zhou:]

I think the Q3 is – so we kind of significantly raised our sales and marketing level. And as we talk about, we think Q3 is the largest of 2020. Obviously, for next year, the next year Q3, the summer, is also a good opportunity to acquire users. I think we're still early in total kind of scale. So, we are still small. We will basically – as Wayne talked about, unit economics is really key for our decision. I believe in Q1, Q2, we talked about – so we have we have prepared the money, we have prepared the budget, but we will really pull the trigger only when we see good UE for us. So, that reflects our ways of thinking. So, we're still small. Obviously, if UE is good, we will grow. And to kind of repeat, we talked about this many times. The way we look at UE is that the marketing spending is upfront. It's front-loaded. And then, we will basically look at the current quarter projected return from these investments next two, maybe three quarters, and then we will do a determination. Yeah, if we see good numbers and we see good opportunities to invest, then we will do it. So, that's the way we think about it. But the market is dynamic, of course, but we think probably next year, we'll also have good opportunities to invest in acquiring users. But we'll see.

[Yongwei Li:]

Indeed, as we believe, sales and marketing is one of the drivers for our business. But the second thing, in the fundamental, like Dr. Zhou mentioned, product quality and the differentiation of the product is also the fundamental issues to define about a structural total market. For example, if the student/parent approves your product, it's not because of sales and marketing, it's because how – what kind of the services you can provide to them and what kind of effect and the results or the consequence they can get from these courses. So, that's the key thing. That's the reason why we increased our number of star teachers as well as the number of teaching assistants. And simultaneously, with the increase of investment in the summer. So, we think – that's the product and content – the content and products will fundamentally change the structure of this competitive landscape, of all the other things. So, that's why we spend more time to develop more the different devices and services from Youdao.

[Operator:]

The next question comes from Thomas Chong with Jefferies.

[Thomas Chong:]

My question is about our advertising services. Given our large user scale, can you comment about how these business lines would trend in coming quarters? And separately. regarding our free cash flow, can you comment about – is there any timeline talking about breakeven or positive? Thank you.

[Lei Jin:]

For the advertisement, although there is very few – also have a very competitive landscape in the advertisement sectors. But very great opportunity, especially for the young generations. Although in terms of the revenue as well as the GP margin, we have improved a lot in this Q3 compared to the same period of last year. So, we think we are confident about the growth – about the healthy growth of our advertisement business in the future. But at the same time, if you see the growth rate of our different segments of our business, you will see the online courses grow much faster than advertisement. So, we believe the futures, we will – majority of the revenue is generated from our courses and education related business like intelligent devices. So, as a percentage, the advertisement will keep going down in the next few quarters. But we think that will be very healthy and a great business for us.

[Operator:]

This concludes our question-and-answer session. I would now like to turn the conference back over to Regina for any additional or closing comments.

[Regina Wang:]

If you have any further questions, please at Youdao directly or reach out to TPG investor relations in China or the US. Have a great day.

[Operator:]

This concludes our conference. You may now disconnect. Thank you for attending.