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..

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 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 from 20-F.

The company doesn't 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 purposes only.

For the definition of non-GAAP financial measures and the reconciliation 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 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. Wei 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..

First, a brand marketing campaign with TV ads, residential and community ads, et cetera. Second, we're engaging in online multichannel performance-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 return of investment over the longer term.

The investments we are making now are designed to support our stable and sustainable 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 questions.

Su Peng?.

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 continue to scale our operation in second quarter, achieving considerable year-over-year growth across our business.

We are well poised to continue to our growth trajectory supported by our strong technology and the curriculum and as we amplify our marketing effort to further bolster our student base for the second half of the year. For the second quarter, total net revenue were RMB 623.3 million or $88.2 million.

This represents an increase of 93.1% from the second quarter of 2019. Looking at this growth by segments. Net revenue from our learning services and products grew 190% year-over-year to RMB 520.1 million or $73.6 million.

We attribute this growth to a sharp uptick in K-12 paid student enrollments and the gross billing per paid student enrollments of youdao Premium Courses on a year-over-year basis. Net revenue for online marketing services were RMB 103.2 million or $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 RMB 281.5 million or $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 courses margin, better economics of scale and the further optimization of our business and the faculty compensation structure. Gross margin for online marketing services was 28.5% for the second quarter of 2020 compared with 37% for the second quarter of 2019.

The decrease was mainly the result of the lower gross margin revenue generated from the increased distribution of advertisements through the third parties' Internet properties. For the second quarter, total operating expense were RMB 564.6 million or $79.9 million compared with RMB 189.2 million for the same period of 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 this investment, we are increasing our top line, structuring our model to become more efficient and recognizing economics of scale.

With that in mind, sales and marketing expense for the second quarter were RMB 445.2 million compared with RMB 122.2 million in the second quarter of 2019. Research and development expense for the second quarter were RMB 91.4 million compared with RMB 56.3 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 shareholder was RMB 257.8 million or $36.5 million compared with a loss of RMB 87.6 million for the same period last year.

Non-GAAP net loss attributable to ordinary shareholders for second quarter was RMB 250.5 million or $35.5 million compared with a loss of RMB 86.2 million for the comparable period last year. Basic and diluted net loss per ADS for second quarter was RMB 2.3 or $0.33. Non-GAAP basic and diluted net loss per ADS for second quarter was RMB 2.23 or $0.32.

Our net cash generated from the operating activity for second quarter was RMB 93 million or $13.2 million. Looking at our balance sheet. As of June 30, 2020, our contract liability, which mainly consists of the deferred revenue for our online courses, were RMB 711.5 million or $100.7 million compared with RMB 456.8 million as of December 31, 2019.

At the end of the period, our cash, cash equivalents, time deposit and short-term investment totaled RMB 1.8 billion or $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 Instructions] The first question today comes from [Brian Wong] of Citigroup..

[Foreign Language] I will translate myself. Congratulations on the solid results. I have 2 questions.

First is regarding how is the new format of interactive beta classes progressing? And the second is regarding the summer promotion like the student enrollment and the student acquisition cost?.

[Foreign Language]Yes. So for the first question regarding interactive big class model features. So this is one of our most important projects on the product side this year. So we actually have a video presentation about this on our IR website. So I encourage you to go take a look.

So essentially, after 2 quarters of actually releasing features on this front, we are more than encouraged. We have routinely seen the percentages of students participating in these interactions and also participating in these classes increased by -- participation in these classes increased by 20%, 30%, yes.

So that's really good because more participation leads to more satisfied customers and leads to more -- better retention. So naturally, we've seen retention rate up significantly in some of these classes. So let me give you 2 examples.

One is in high school Chinese, we added -- I just talked about in the prepared remarks about a feature called Intelligence Memorization [Foreign Language]. So this is essentially to help students memorize a lot of the Chinese content they need for their exams. So we use ASR for that. And this is -- this really helps the student.

And overall, our high school Chinese retention rate has been increased by double digits. So that's one. Another example is for primary school math. So we added -- remember, in Q1, we already have interactions during live class for primary school math.

But in Q2, we added more types of questions, so right now to actually over 20 different types of questions. Because of this, the conversion rate of primary school math has increased by more than 4%. So if you have time, take a look at the video. Thank you. Yes. The second question, regarding the summer campaigns, yes.

So I can say a few words and maybe Su Peng can add to that. So basically, what we did in Q2 is that we talked about we allocated resources, allocated budgets for the summer campaign in Q1.

And what we did in Q2 is that we collected a lot of data, did some trials and then essentially decided that we would go ahead with the plan to use that budget because the data supports doing this. Really, it's a really good time to get students, acquire students for online courses.

And of course, we also see that some offline tutoring centers see actually students turning to online courses. So it's a really good opportunity. And for the summer, we are focusing mostly on junior high school courses in high school, yes. So we used to focus on these segments, and we are still focusing on these 2 segments for this summer.

We really like junior high school because it's a large segment for us and our teams are good at making high-quality courses here. And also, we can -- when students kind of retain, they become high school students, and this is really nice. And also, we have some primary school students acquired this summer.

So we have grade 6 and grade 5 math class that's really getting fantastic feedback. So that's a quick update. And yes, I don't know, Su Peng, if you have anything to add..

Thank you, Dr. Zhou. And Brian, this is Su Peng. We believe the summer enrollment business is already under way, I think, as Dr. Zhou mentioned in the early call. And we think -- we believe, as we mentioned, we expect to significantly increase our paying customer base in this year, especially in the K-12 segment.

So I think the summer is a key time -- is a key period for these goals. And we are -- in the Q1 and Q2, we are refining our models. And we just leveraged up our -- quality of our courses, and I think we'll be ready for that.

And by now, we think -- if you need some color, so we think right now it's so far so good and for all the summer marketing campaign. And I believe you have -- probably you have seen our advertisements with branding as well as the [Indiscernible] space advertisements through the different channels. We think we are on the way.

And right now, we see the positive feedback from the market. So we think because a very special year for this in 2020. The total industry changed a lot because of the COVID-19. So we expect that we are -- that we'll take these opportunities to grow our business..

The next question comes from Sheng Zhong of Morgan Stanley..

My first question is about the gross billing. Q2 still -- we still see a very strong gross billing growth while the momentum compared with last 2 quarters seem slightly slowed down. So wondering can you share more color about this growth? And what the outlook for the growth momentum in next 2 quarters this year? This is the first question.

And second question. Dr. Zhou mentioned that the K-12 retention rate improved by double digits. So wondering if can you share with us what the actual range now? And except for the technology improvement, I believe the teacher system should be a very important part of this.

So wondering if you can share something about your teacher assistance numbers now and what the further hiring plan?.

Yes. Thank you, Sheng Zhong. So regarding gross billing. So yes, so if you look at our K-12 gross billing, so it's RMB 307 million, up 229% year-over-year and up 60% Q-o-Q, yes. So yes, we think this is healthy for Q2. Seasonally, Q2 is a little bit weak, but we think this is good for Q2.

And yes, so for our adult segment, because in Q1 we had this very positive push from the -- from a lot of white-collar customers staying at home and some of them go look for opportunity to learn online. So we had a really strong adult -- second quarter for our adult courses in Q1. And in Q2, if you look at year-over-year, we are still quite strong.

It's RMB 150 million, up 189% year-over-year. So we still really like the segment. And we think in -- we added a new course, so up to 5 quarters now. So we expect our adult segment to continue to have healthy year-over-year growth in the coming quarters. So a couple of more points for K-12.

So one of the key focus for us is that we look at our subjects or courses and decide on their competitiveness. So we have this so-called Class A subjects internally, which means really competitive and unit economic-wise really working well, these courses. So we have added new Class A subjects in Q2.

So we have a couple of more courses that achieve the Class A status, and we think this will really help with our growth in the coming quarters. So for Q3, we are quite bullish. We think -- what we see is that demand in the summer is really strong. So kind of in Q1, we look at -- we can look at it both ways. So maybe it will be strong or maybe not.

But now we know that the demand is really strong. And so -- and overall, we think the summer campaign is going on really well. So we are really seeing parents actually move to online courses, a lot of them at quite a large scale. So we are trying to capture this opportunity. So we'll basically double down on the summer.

I'll talk about the tutors first, and we can talk about retention. So the number of tutors has grown substantially, if you look at it, from 800 to over 2,500. So it's about 200% growth. So we've actually added new operating centers in Hangzhou and in [Jinan], in addition to the existing 4 of them.

So we already -- we used to have [Jian], Nanjing, [Xinxiang] and [Indiscernible]. Yes, now we have 2 more, Hangzhou and Jinan. So we think things are going smoothly. So we expect to continue to grow that tutor team and to train more personnel and to pay them well and meet the increasing demand of servicing and the conversion.

So in Q2, so there were some projects actually getting positive results, like we improved the collaboration between these tutors and the instructors. We designed new mechanisms for them to work better. Kind of the first time a new course is released, the tutors will already be very ready to service the students.

And we also talked about -- we have improved our stratified or tiered servicing strategy so that for different students with different levels of learning, we get -- they get tailor-made service based on their learning level, yes. So that's for the tutors, yes.

Su Peng, if you can talk about the retention?.

Yes. For the -- thank you, Dr. Zhou. And as Dr. Zhou mentioned, we increased substantially our tutors from the 865 to the -- over 2,000. And I think in this year, so we expect to provide more services to our clients to enhance our retention rates. And especially, in this year, we are dedicated on what we call the grade level class.

That means the grade 6, grade 9 and grade 12. So I can -- I think we are improved a lot grade class retention rates in our business. And for example, our grade 6 to grade 7 retention is around 60% during this retention period. We expect to improve more in the next retention season. I hope that answered your question..

Yes, grade 6 and Grade 7. So this is basically going from primary school to junior high school. Yes. So this is kind of a more challenging grade to have retention on. So we think our number there is really competitive. And yes, maybe I can give another data point is that, yes, so we really like our -- so this is not a curriculum course.

We really like our kids programming course. So in -- with adding more interaction and more features, we've been able to achieve actually over 85% of retention for these courses because of our collaboration between the instructor and the tutors and also with the interactive large class model. Yes, so that's one of the points we can share..

The next question comes from Alex Xie of Crédit Suisse..

Congratulations on a very strong growth momentum. I have 2 questions. So my first question is about the enrollment and ASP. It seems to me that ASP in terms of gross billings divided by student enrollments decreased.

And would you please share if there's any special reason for that? Did you change the -- say, the definition for enrollments? And what's your actual ASP after adjusting such changes? Secondly, I would like to know more about your plan to further improve or keep your margins of your online courses business.

Do you have a target, say, in the future or in the long term? What kind of GP margin can you achieve? So maybe I'll just ask the first question in Chinese again. [Foreign Language].

The pick-up in enrollment growth is very fast. It was over 300% growth in Q2. And this is mostly driven by the number of students, especially in our junior high school segment. There are also some impacts from maybe 2 other reasons, right, the enrollment split. Last year, the regulator issued a requirement on the cost duration.

So this is the summer and 4 courses into more enrollment to be in compliance. Also, we add some -- as Dr. Zhou mentioned, a Class A subject. It makes more cross-sell per student as well. And ASP, maybe....

Right. Yes. And also one additional comment for ASP. So for this year -- for the first half of this year, our kind of price increase, if you look at for our precision price. So our price increase is really modest. So we didn't increase our price for our courses a lot.

So -- and if you look at the splitting effects due to compliance -- and yes, so that's why you see ASP lower a little bit, yes..

Yes. And also, we think -- and also there's in the spring matters, we also offer a different type of the products to our student. We launch of some, we call them short-term course. And we have short-term concentrated class, and they will be less than -- shorter than our regulars, we call them semesters.

So that's the total package will be cheaper than the regular price. So I think that's the combined reason why you see the average ASP going a little bit down compared with last year..

First, further access from economics of scale were expected. We believe our large class teacher model will continue to gain more benefit as we achieve even more economic of scale. For example, we expect to have bigger class size due to our increased paid student enrollment from our summer campaign. Secondly, more room to achieve the higher ASP.

Just mentioned by Dr. Zhou, our ASP is modest. And the average selling price or ASP for our premium courses was around RMB 1,140 in second quarter, up 30% year-over-year. However, ASP was relatively cheaper when compared with some of our online and off-line peers.

This summer, we understand that our peers such as [The NT Group] and [Indiscernible] charge 10% to 80% premium price compared with last year's ASP. So we still have a lot of room to charge higher price for our courses as well. In addition, even for some of our courses with higher ASP, we're receiving excellent feedback from our users.

For example, kid program courses, we have a relevant retention rate of over 80%. Finally, better compensation structure. The better compensation structure, we've aligned -- our sales will help us to get better GP margin as well.

Although the GP margin may be negatively affected by modular courses in the short term, we believe our GP margin will rise to industry average level in the longer term, which this is helpful..

The next question comes from Thomas Chong of Jefferies..

[Foreign Language]I have 2 questions. The first one is about our operating cash flow. Can management comment about the direction that we should think about in terms of the cash flow as well as the timing to profitability? And my second question is about our synergies with our existing product offerings.

Given the fact that Youdao Dictionary also demonstrate very good results, how should we think about our strategies in generating synergies with our K-12 going forward?.

I will take your first question. This is Wei. In terms of the operating cash flow, we have positive operating cash flow in first quarter and this quarter, totaling over RMB 140 million in the first half year, which can be attributed to our overall improvements to our business fundamentals.

For example, the higher GMV level achieved, the better GP margin and more healthy unit economic effects are realized.

While we don't provide any quantitative guidance on our operating cash flow, it is safe to say that our increased marketing and promotion expenditures to acquire more users during the summer promotion season will place pressure on our operating cash flow for the next 1 or 2 quarters.

We think this seasonal fluctuation is acceptable for the online learning market. We are keen to take advantage of the growth opportunity in the online learning industry. And we expect a healthier longer-term operating cash flow in the near future.

For the profitability, I'd like to give you some color without giving any positive guidance, which we don't provide. You can see our business fundamentals have improved across the board as mentioned. We increased our GMV as well as our operating cash flow. We are also realizing the increased benefit from economic of scale quarter-over-quarter.

And our current growth stage profitability is not our first priority. We believe now is the time to continue to invest more in our technology and marketing activity and continue to improve our servicing capability to enhance our user learning experience. Thank you..

Thomas, for your second question about the synergy between our apps as well as hardware with our courses. So I think if you recently open our -- for example, if you recently open our Dictionary app, you will see that it's not only everything we've just tried to just upload a new page for our Dictionary thing. We'll just add more functions on that.

It's not only for the translation in the future, we believe. It will be more useful for the student to looking for learning information and material to help them to find more information. So we think we will hold more seminar things online and it will help them to know more about the learning as well as the test information.

That will also help us to know the profile of students. And it will be more easier for us to convert them from our learning apps to our online courses products. On the other hand, for our hardware aspect, for example, for our Dictionary Pen, most of our customer is a student from the primary school to high school.

So I think that's the -- will be the same users pool with our online courses. We are on the way to develop more functions on our hardware to try to lead them to convert them from our hardware to our online process products. And I think that will be the next step in this year. We will show you more data in the second half of this year..

The next question comes from Binnie Wong of HSBC..

Just a question for Dr. Zhou. Is there like -- remember, I guess last quarter, also since IPO, we talked about like more in terms of Youdao is really differentiated with this technology using the AI-driven interactions and also provide more personalized exercise.

Is that one of the reasons that we have seen an improvement in the conversion rate because we see an uplift in the conversion rate this quarter? And then how do you see where we can use technology even more to drive to meet up the conversion rate because our conversion rate is still lower? And then we can -- if there's a lot of more room we can deepening the conversion here? So that is my first question.

And the second question is on the sales and marketing. It seems that the sales and marketing dollar per student, if I just look at the sales and marketing efficiency, it seems that it's getting higher and higher.

Is that just because of a user base? Because our user base is getting bigger, so that's why the incremental marketing dollar spend will be higher? Or is that because competition for users has been intensifying again, again, again? Because we have been seeing like the industry or everyone is stepping up in sales and marketing in online education.

So how do you see the rest of the year and how that will position you differently?.

Thank you, Binnie. Yes, you're absolutely right that -- so we view technology as one of our key differentiation factors to compete in this industry. And we truly believe that -- so the long-term competitiveness of any online education company is -- so technology is a key factor there.

So we are called a tech industry for that reason, right? So it's the key thing. So -- and if you look at our projects that we talked about, so last year, we actually talked a lot about the smart pen that we use. And we've shipped more and more smart pens to our students last year and more this year.

And this year, the interactive large class model is actually sort of an upgraded version of the smart pen project last year. So it contains more ways to improve the students and parents experience. So we talked about improved retention, improved conversion. And I can give you -- one more example is in the programming course I talked about.

So we've actually successfully deployed some of the special made hardware for students to program on. And that's what helped us achieve the over 85% retention rate for that particular course.

So you can imagine that the dynamics within the teams, when they look at these numbers and when they do these projects and improve the retention, improve the conversion and the parents are generally thanking our instructors for providing them with this experience. So we think this is a really good direction.

And it will take quarters and years, but we think this is what kind of gets up -- what every one of us gets up to work thinking about every day. So we think this is a really good point. Yes. So about sales and marketing, yes, so maybe Su Peng can talk a little bit, and I can add..

Yes. And Binnie, for the sales marketing efficiency, as you mentioned, if you see the numbers, for real, it looks like efficiency going down compared with the first quarter. But there are 2 things impact for this one. First is about just like you see, the number of tutors increased a lot.

And in the Q2 compared with Q1, we also -- to prepare for the summer campaign, we also have to, in advance, hire more sales in our team to prepare for the summer's promotions because we expect there will be more students coming out from -- in the summertime.

On the other hand, and also for the marketing side because for the K-12, June, this will be the season to spending the money for the marketing to acquire the new users. So we have -- for the marketing, we have to make the -- spend marketing dollars at once and to convert them in the next few weeks after we spend marketing dollars.

So that we'll show in the June. We're spending the money, and they will show the results in July. And I think that's also impacted our quarterly numbers of other sales and marketing. So I think that's the 2 factors we believe impacted efficiency..

Yes. What I would add is that for sales and marketing, we take a really disciplined and data-driven approach to this. So because we have more and more data, so we now kind of have data for every team. For every team, we will look at how long the investment will be made back, what time of profitability horizon we are looking at for each team.

So we think this year, it's a good opportunity to acquire more users. So that's why we ramp up the spending on sales and marketing..

Yes. Yes, I think so. For my team, that will be dedicated on we call the healthy unit economics. So I believe that will be the fundamentals for the whole business..

Okay. May I just have a very quick follow-up here It's that if -- do you see this year, just on the industry wide, is it getting more aggressive than last year in terms of spending? Or is it rationalizing? Because as -- of all these like online players, they probably have been navigating ready find an optimal way for them to acquire users.

So do you think it's relatively speaking, just compared to last year, is it rationalizing all more aggressive? And then I guess with that, Youdao here is that what is kind of like an ROI level that we are seeing versus the industry?.

Yes. I think every company needs to decide for herself, yes. So what strategy, what kind of customer acquisition cost they are willing to take, right? So for us, we are essentially looking at the numbers and looking at kind of -- if we get more users, what value we can provide them, how confident are we can retain them.

And also with better scale, how much cost reduction can we get and what more data we can get to improve their experience. So it's a holistic thing to look at. So every company, I think, have their own thinking. And the thing I would point out is that we are still kind of at the really early stage.

So there are like over 90% of students in China that are not taking online courses. Yes. So the ceiling is really high. So we think given the current market dynamics, yes, our decision is we should take the initiative to acquire more customers..

The next question comes from Jessie Xu of Nomura..

I understand that we rolled out more stronger subjects this year. I suppose we can do more combo sales or cross-selling now.

So may I ask what is the average number of enrollment per student? Could you share your cross-selling strategy or some of your thoughts here?.

Thank you, Jessie. And our cost retention, cross-selling and so rates for 2 semesters commonly are all in the improving trends. For instance, the number of subjects signed up by the enrollment students in high school increased by over 20% quarter-over-quarter and 6% year-over-year.

We expect the number of subjects signed up by the enrolled students for our middle school segments to continue to increase with more Class A, we call Class A subject coming out by using a bundle of the marketing strategy. I hope that answers your question..

I have a second question. We noticed that the revenue growth of smart devices was pretty strong in 2Q.

Could you share with us some updates or more details?.

Sure. Yes. Smart hardware sales were RMB 86 million in Q2, up to 50% year-over-year and 63% quarter-over-quarter. So our supply chain and also sales channels were affected by COVID-19 during January and February in Q1 but was back to normal since March. Yes. So mostly back to normal. So in Q2, we also released a new product, Dictionary Pen 2 Pro version.

So this is -- yes, so this is well received because a lot of our customers actually wanted to learn Japanese and sometimes use and learn Korean language. So these features are really well received. And therefore, we are able to charge a higher unit price, actually, about RMB 1,200 compared to RMB 800 with the original non-pro version.

So this is really helpful, so to contribute actually higher gross margin for the hardware segment in Q2. And well, I can say, we're not done yet for this year. So we have more new products coming in second half of this year, and we think kind of education-oriented and especially AI-enabled. Our Dictionary Pen is actually AI-enabled smart device.

So they present a large opportunity for us because these students, young folks, they're really kind of digital natives, working with smartphones and everything. And when they are learning, they -- sometimes they cannot use their cell phones. The student -- the school doesn't allow them to use smartphones.

And they need these special devices for them to do that. And the parents are really willing to pay for these devices, just like parents are willing to pay for courses. Yes. So they're not price-sensitive on that front. So we think we really like our product pipeline. So in the second half of this year, we'll have new products.

And yes, we will continue to innovate, which we are -- we think we are kind of quite ahead in this area. So we'll continue to innovate. And yes, so we were bullish on this..

In the interest of time, this does conclude our question-and-answer session. I would like to turn the conference back over to management for any closing remarks..

Thank you once again for joining us today. If you have any further questions, please feel free to contact at Youdao directly or reach out to TPG. Good night..

Thank you..

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