Youdao : Second Quarter 2020 Earnings Conference Call (Transcript)

YOUDAO 2Q 2020 CONFERENCE CALL SCRIPT

Speaker dial in numbers:

International: [phone]

Toll free (US): [phone]

Conference ID: 10146527

Operator introduction

Good day and welcome to the Youdao 2020 second quarter earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Pei Du, investor relations director of Youdao. Please go ahead.

Pei Du

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 these risks are beyond the Company's control, and could cause actual results to differ materially from those mentioned in today's press release and this discussion.

A general discussion of the risk factors that could affect 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.

During today's call, management will also discuss certain non-GAAP financial measures, for comparison purposes only. For the definitions of non-GAAP financial measures, and reconciliations of GAAP to non- GAAP financial results, please see the 2020 second 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, VP of Operations, 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, Du Pei. 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.

Our business continues to grow at a rapid and healthy pace. Our second quarter shows the strength of our online education courses and products. And despite the current uncertainty of the macro-environment, the online education industry's transformation is well underway. Youdao is well positioned to emerge as a leader among this change.

First, looking at online courses, our gross billings have more than tripled year-over-year, reaching RMB542 million in Q2. Gross billings from K-12 reached RMB307 million, up 229% year-over-year and up 60% quarter-over-quarter, driven by strong retention and larger-scale marketing. In addition to junior high school

math and physics that are strong, several other courses contributed significantly to our second quarter growth, primarily high school Chinese and primary school math. Our retention rate also improved by 1,000 basis points in the April to May retention season due to more and better courses, and more streamlined service. Summer enrollment for high school students, which used to start in Q2, were pushed back to Q3 due to Covid-19 as the semester ended later in most cities in China.

Gross billings from our adult segment also increased to RMB150 million, up 189% year-over-year based on the strong performance of our practical English courses. We released another new practical English course title in Q2, bringing the total to 5 courses, catering to different customer groups. Young white-collar workers are increasingly looking to learn English language and other skills online. We are working hard to capture this opportunity and drive growth by focusing on creating high quality content.

Building up our servicing capabilities is a current priority, as we work to significantly scale our business this year. In Q2, the total number of tutors increased to 2,699, in part to prepare for summer enrollments. This is also three-times the number of tutors we had in Q1. Our new tutors have been integrated smoothly, as we focused on leveraging hiring managers and assimilating our experienced tutors last year to prepare for a larger team this year. We also significantly increased our abilities to offer more personalized service in Q2, by offering stratified services to students within different grades.

For the second quarter, gross margins for learning services were flat with Q1 at 52%. While we continued to benefit from economies of scale, margins were partially offset by expenses from more servicing personnel. In the meantime, with improving unit economics, we maintained positive operating cash flow for the second quarter in a row, which came in at just under RMB93 million.

We continue to invest in product and technology innovation. We are in a year-long process of rolling out more Interactive Large-class features, to more subjects and more grades. In our high school Chinese courses,

we launched an "Intelligent Memorization Plan 智能背诵计划" feature using ASR technology. This is

highly integrated with course content and students can practice efficiently at their own pace. This contributed significantly to our double-digit increase in retention in high school Chinese. Similarly, our primary school math has highly tailored interactive exercises that can be generated real-time for different levels of students, all based on feedback data. For instance, in order to develop kids' number fluency, we

offer interactive exercises using a vertical strategy playbook(竖式计算), gamified roller pk games（滚筒

计算）, or our fill-in-the-blanks equation solver（数字填空）. After we made these upgrades, our

conversion rate in primary school math increased by 4%.

Turning to our intelligent learning devices, sales in this category also did well, reaching RMB86 million, up 2.5 times year-over-year. We released Dictionary Pen 2.0 Pro in June, with more premium content and Japanese and Korean language support, which were the No.1 requested features. Our Dictionary Pen 2 Pro also carries a higher price point than its earlier versions. During the online shopping festival on June 18, the Youdao Dictionary Pen 2 series was ranked the No.1 electronic dictionary in terms of sales, by both JD.com and T-mall.

As for our learning apps, in Q2 we grew our MAUs to 122 million, up 11% year-over-year. We continued to build our Youdao Dictionary App to incorporate more comprehensive offerings as we work to bring this popular tool into the realm of Super Apps in the learning category. Some of the new features include an English oral proficiency assessment feature, an English listening "mock test," and a postgraduate admission enquiry portal. In addition to launching a number of new features, we have strengthened the connection between Youdao Dictionary and our premium courses. In Q2, gross billings of new paid enrollments from internal traffic increased by 127% year-over-year.

Turning to our marketing, our advertising revenue reached RMB103 million, down 28% year-over-year, up 4% from 1Q. We expect to see continued volatility in this segment, with the ongoing impact of macro uncertainties.

Looking ahead, the summer enrollment season is already underway. Our experience shows that customers acquired in the summer are more willing to pay for more courses and renew in the future. And our data in the first half of this year shows that the positive trends in online learning is accelerating, regardless of the fluctuating impact of Covid-19. With this in mind, we are moving forward with the summer campaign we talked about in Q1. We plan to significantly increase our paying customer base this year and Q3 is an important quarter for achieving this goal. We are taking a three-fold approach to this campaign, first a brand-marketing campaign with TV ads, residential community ads, etc.; second, we're engaging in online multi-channelperformance-based customer acquisition activities; and, third, user conversion on our owned- and-operated assets. Our goal with our marketing activities in the second half of the year will be to acquire significantly more customers and increase our brand equity while maintaining a focus on healthy unit economics and ROI over the longer term. The investments we are making now, are designed to support our stable and sustainable future growth as we build our student community and brand reputation.

With that overview, I will now turn the call over to Su Peng to review our financial results. We will then open the call up for your questions. Su Peng?

Peng Su

Thank you, Dr. Zhou and hello everyone.

Today I will be presenting some financial highlights from our 2020 second quarter. We encourage you to read through our press release issued earlier today for further details.

We continued to scale our operations in the second quarter achieving considerable year-over-year growth across our business. We are well poised to continue our growth trajectory, supported by our strong technology and curriculum, and as we amplify our marketing efforts to further bolster our student base for the second half of the year.

For the second quarter total net revenues were RMB623.3 million, or US$88.2 million. This represents an increase of 93.1 % from the second quarter of 2019. Looking at this growth by segment:

• Net revenues from our learning services and products grew 190% year-over-year to RMB520.1 million, or US$73.6 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 revenues for online marketing services were RMB103.2 million, or US$14.6 million, a decrease of nearly 28.1% compared with the same period of 2019.

For the second quarter of 2020 our total gross profit greatly improved, reaching RMB281.5 million, or US$39.8 million, up 165.4% compared with the second quarter of 2019.

• Gross margin for learning services and products improved to 48.5% for the second quarter of 2020, up from 29.5% for the second quarter of 2019. The large margin growth was primarily attributable to improved online course margins, better economies of scale, and further optimization of our business and faculty compensation structure.
• Gross margin for online marketing services was 28.5% for the second quarter 2020, compared with 37.0% for the second quarter 2019. The decrease was mainly the result of lower gross margin revenue generated from the increased distribution of advertisements through third parties' internet properties.

For the second quarter, total operating expenses were RMB564.6million, or US$79.9 million, compared with RMB189.2 million for the same period last year.

We continue to invest in technology, student acquisition, and acquiring talented teachers to support our growing business over the long-term. In tandem with these investments, we are increasing our top line, structuring our model to become more efficient, and recognizing economies of scale. With that in mind:

• Sales and marketing expenses for the second quarter were RMB445.2 million, compared with RMB122.2 million in the second quarter of 2019.
• Research and development expenses for the second quarter were RMB91.4 million, compared with RMB56.3 million in the second quarter of 2019.

Our operating loss margin was 45.4% in the second quarter of 2020, compared with 25.7% for the same period of last year.

For the second quarter of 2020, our net loss attributable to ordinary shareholders was RMB257.8 million, or US$36.5 million, compared with a loss of RMB87.6 million for the same period last year. Non-GAAP net loss attributable to ordinary shareholders for the second quarter was RMB250.5 million, or US$35.5 million, compared with a loss of RMB86.2 million for the comparable period last year.

Basic and diluted net loss per ADS for the second quarter was RMB2.30, or US$0.33. Non-GAAP basic and diluted net loss per ADS for the second quarter was RMB2.23, or US$0.32.

Our net cash generated from operating activities for the second quarter was RMB93.0 million, or US$13.2 million.

Looking at our balance sheet, as of June 30, 2020, our contract liabilities, which mainly consist of deferred revenue for our online courses, were RMB711.5 million, or US$100.7 million, compared with RMB456.8 million as of December 31, 2019. At the end of the period, our cash, cash equivalents, time deposits and short-term investments totaled RMB1.8 billion, or US$253.4 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.

[Operator to prompt for questions]

After the Q&A …

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.

Pei Du

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 TPG Investor Relations in China or the US. Have a great day.