Good day, and welcome to the Youdao 2021 Third Quarter Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Jeffrey Wang, Investor Relations Director of Youdao. Please go ahead, sir..

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 the certain filings of the company with the Securities and Exchange Commission. The company does not undertake any obligation to update these forward-looking information, except as required by law.

During today's call, management will also discuss certain non-GAAP financial measures for comparison purpose only. For the definitions of non-GAAP financial measures and reconciliations of the non-GAAP -- of GAAP to non-GAAP financial results please see the 2021 third quarter financial results news release issued earlier today.

As a reminder, please -- that the 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..

Thank you, Jeffrey, 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. The third quarter was a good quarter for us with some development of our non-tutoring business.

With the announcements of sweeping industry changes in late July, we quickly evaluated our business and set out steps to better align with the PRC's latest regulations.

On September 30, we anticipated to terminate and announced the plan to dispose of the after-school tutoring services for academic subjects included in China's compulsory education system and applied to the competent local governments to approve the proposed disposal.

We expect the disposal to be completed by the end of 2021, subject to regulatory approval. There can be no assurance regarding the ultimate timing or that the transaction will be complete.

Due to the execution of the double reduction policy, gross billings from academic subjects included in China's compulsories educating system decreased by approximately 70% year-over-year in the third quarter. Gross billings, including adult courses decreased by 33.9% year-over-year to RMB631 million in the third quarter.

Total net revenues for the third quarter were RMB1.4 billion, representing a 54% increase year-over-year, with approximately 25% of our total revenue derived from academic tutoring for compulsory education.

Operating loss decreased significantly to RMB129 million, and the operating loss margin was 9.3%, a sharp narrowing compared with 99% for the same period of last year. As we mentioned in the last call, learning products, adult in vocational courses, STEAM courses and education digitization solutions are the 4 core pillars for our future growth.

Now let me walk you through the progress of each segment. First, our learning products segment maintained strong growth momentum. Q3 learning product revenue reached a record RMB254 million, a 56% increase year-over-year and 23% increase quarter-over-quarter, led by our industry-leading Dictionary Pen.

We continue to upgrade the Dictionary Pen and launch the people's education version in collaboration with people's education electronic and [indiscernible] press in September. The product marks our first significant partnership with PE EAP, whose parent company publishes basic education textbooks directly under Chinese Ministry of Education.

Through the upgraded Dictionary Pen, we provide over 4,000 recordings of listening and speaking training textbook content. In Q3, we shipped approximately 400,000 Dictionary Pens.

We also launched Youdao Dictionary part, Youdao [indiscernible] powered by our new generation adapted AI learning technology, features like AI subtitles, real-time speech scoring and pronunciation correction facilitate students more effective in gross learning.

The first batch of Youdao listening part were sold out within 1 week, reflecting strong demand. We encourage you to view a related video on our IR website to get a more complete picture of Youdao listening part. Now let's look at a STEAM courses. Youdao Weiqi or Youdao is becoming more and more popular each quarter.

In Q3, revenue from Youdao Weiqi again increased by more than 30% quarter-over-quarter. We upgraded our Weiqi AI system and launched a mini program, which supports assessments and interactive features so that students can check their learning progress at any time.

As for our used programming product, ICOS, we launched a new pipeline course, which our users have asked for a lot. Also, a lot of middle school and high school students are learning coding to participate in programming content like the CSP or NOIP, the most popular use programming contacts in China.

Youdao provides a CSP assessment to allowing students to better understand how well they are doing. It has become quite popular and is now used by more than 1/3 of all CSP contestants.

Finally, China computer federation, the organizing body of CSP NOIP context officially announced that Youdaa has become a programming trainer accreditation PTA member in the third quarter, combining efforts in promoting programming teacher training. Overall, team is already a very active area for us, and we are seeing good results.

Moving on to adult and vocational courses. Gross billings were RMB182 million, with a slight decline of 9% year-over-year. The decrease is mainly due to relative weakness in English learning courses for reasons including COVID. The memory training cost, Extraordinary Memory Feifán de jìyì is doing very well.

It retains the leading position in the segment with gross billings approaching RMB100 million in Q3. Recently, NetEase Cloud Classroom officially launched about 100 digital training courses of Amazon web services in Chinese.

It is created by Amazon web services experts, and we promised to provide these courses complementary to the whole society to help learners improve their cloud-related [indiscernible]. On a more general level, there are increasing consumer needs for adult learning and vocational training courses.

It is also an area supported by government policies going forward. Our teams have a lot of experience in creating popular learning content like the Extraordinary Memory courses. We will release more self-developed courses in the coming quarters and drive growth in this area.

As for education digitization solutions, the Ministry of Education and other departments jointly issued guidelines on this initiative called new infrastructure for education in Q3. The guidelines proposed, constructing an intensive, efficient, safe and reliable national new education infrastructure by 2025.

The initiative requires the comprehensive application of new technologies, such as 5G, artificial intelligence, big data, cloud computing and blockchain. We believe our products and expertise, fitness and other recent policies very well.

In Q3, we launched Youdaa's smart learning Terminal-II, and AI-driven appliance that helps classrooms process homework and learning materials digitally. It supports high-speed scanning of paper-based homework and test, automatic grading of the student work and generation of in-depth analytics for students, teachers, schools and school districts.

It is the first of this kind product that seamlessly bridges paper-based learning and digital intelligence, which we believe is both easy to deploy and truly helps teaching a lot. Since last year, the first generation of Youdao's smart learning terminal has been deployed in many schools.

We look forward to working with more schools and educators on the adoption of the second generation. Looking at other parts of our business. In Q3, Youdao Dictionary launched an academic search function in its mobile app, supporting searching for economic papers and one click translation.

We also extended its search functionality to content like learning videos. Youdao Dictionary reached a milestone of 900 million cumulative users in Q3. Moreover, as an intelligent learning company with a mission to help all learnings achieved more efficient learning.

Youdao Dictionary started to provide accessible services for digitally challenged users. This feature aims to support users with disabilities to enjoy the benefits of technological advancements and expand their learning equitably. We also help those in need when we can.

In Q3, we help the customers of some tutoring companies going out of business by exchanging course hours on these companies for Youdao's. Youdao was commented by the China association for nongovernment education for these industry mutual assistance efforts. So far, we have helped customers from over a dozen AST institutions.

The last few months have been a period of introspection planning and implementation for us. In July, we started on a journey in transforming our company to a new growth trajectory. As we finish Q3, we have made good progress.

As always, we are committed to running the business within the scope of laws and regulations and taking on corporate responsibilities for our community and the society are large. We believe we have a solid growth plan and the right teams to execute it. We look forward to helping a lot more users learn better through all of our efforts and products.

And with that, I will hand over to Su Peng to give you more updates on our financials. Thank you..

Thank you, Dr. Zhou and hello, everyone. Today, I will be presenting some financial highlights from our 2021 third quarter. We encourage you to read through our press release issued earlier today for further details. As for tutoring service, gross billing and paid student enrollments decreased due to the execution of the double reduction policy.

Gross billing from academic subjects included in China compulsory education system decreased by approximately 70% year-over-year in the third quarter. Total gross billing, including adult courses decreased by 33.9% year-over-year to RMB631.6 million in the third quarter.

Paid student enrollments included in China's compulsory education system decreased by approximately 70% year-over-year in the third quarter as well. Total paid enrollment, including adult courses for premium courses decreased by 40.9% year-over-year.

Paid student enrollment from our K-12 and adult segments account for 64% and 36% of the paid student enrollments for premium courses, respectively. For the third quarter, total net revenue reached a record RMB1.4 billion or USD 215.3 million. This represents an increase of 54.8% from the third quarter of 2020. Looking at this growth by segment.

Net revenue from our learning services were RMB995.7 million or USD 154.5 million, up 65.9% from the same period in 2020. We attribute this growth to the increased revenue generated from our tutoring services, which were further driven by the growth in paid student enrollments during the period in the second quarter of 2021.

Net revenue from our learning products were RMB254.5 million or USD 39.5 million, up 56% from the same period in 2020, driven by the substantial increase in sales volume of Youdao Dictionary Pen. Net revenue from our online marketing services were RMB137 million, or USD 25.3 million, representing a 3.4% increase from the same period in 2020.

For the third quarter, our total gross profit reached RMB785.6 million or USD 121.9 million, up 90.9% compared with the third quarter of 2020. Gross margin for learning services increased to 66.2% for the third quarter of 2021, up from the 53.9% for the third quarter of 2020.

The increase was driven by the improved economy of scale and ongoing optimization of Youdao's faculty compensation structure. Gross margin for learning products increased to 33.7% for the third quarter of 2021 from 29.8% for the same period in 2020.

The improvement was mainly attributable to substantial rise in the sales volume of Youdao Dictionary Pen version 3, which carry a higher gross margin than other learning products. Gross margin for online marketing services was 29.2% for the third quarter of 2021 compared with 29.5% for the same period in 2020.

For the third quarter, total operating expense was RMB914.9 million or USD 142 million, down 29.9% from RMB1.3 billion for the same period last year. With that, for the third quarter, our sales and marketing expense were RMB650.2 million, significantly decreased from RMB1.1 billion in the third quarter of 2020.

Research and development expense were RMB193.3 million compared with RMB121 million in the third quarter of 2020. Our operating gross margin was 9.3% in the third quarter of 2021 compared with 99.8% for the same period of last year.

For the third quarter of 2021, our net loss attributable to ordinary shareholders was RMB128.9 million or USD 20 million, compared with RMB877.8 million for the same period last year.

Non-GAAP net loss attributable to ordinary shareholders for the third quarter was RMB101 million or USD 15.7 million compared with RMB865.7 million for the same period last year. Basic and diluted net loss per ADS for the third quarter was RMB1.05 or USD 0.06. Non-GAAP basic and diluted net loss per ADS for the third quarter was RMB0.82 or USD 0.13.

Our net cash used in operating activity for the third quarter was RMB628.7 million or USD 97.6 million. Looking at our balance sheet as of September 30, 2021, our contract liability, which mainly consists of deferred revenue for our choosing services were RMB1.1 billion or USD 175.8 million compared with RMB1.4 billion as of December 31, 2020.

At the end of the period, our cash, cash equivalents, restricted share, cash, term deposits and short-term investments, total RMB1.3 billion or USD 201.7 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 comes from the line of Zhong Sheng of Morgan Stanley..

And congratulations for the good result. So like I said, after the double reduction, I think all the eyes are on the potential of the non K-12 business. And I would like to start my question from the learning devices.

Can you please give more color on the learning devices sales momentum? And what's the product pipeline and any management target for the learning devices next year? And also, Q3 we see the gross margin of learning devices is a bit lower than last quarter.

Any particular reason for this? And what is the normalized margin should be for the learning devices?.

Thank you, Sheng, for the question. Yes, this is Feng Zhou. Yes, learning products revenue comes in at RMB255 million. Yes, so it's 56% year-over-year growth. So we're happy with it. Yes, so it is positively impacted by new product launches like the people's education, Dictionary Pen, in collaboration with people's education.

It is negatively impacted by COVID episodes in August and September. Yes, so within the quarter, September sales were the strongest in Q3. So this is the start of the new school year and September, started this new school year. And parents and students, they shop for new learning gears.

So our lineup of products this year turned out to be performing very well despite more competition. Last year, we didn't have any competition. This year, we have more competition. And despite the COVID episodes. So more recently, last Thursday was the conclusion of [indiscernible] shopping festival.

Yes, so our learning devices sales were up 57% compared to 2020 is [indiscernible]. Yes, so we have been the leading electronic dictionary seller for 3 consecutive years on the JD platform. The -- talking about new products. So the People's Education Dictionary Pen was released on September 1.

And it includes the full text and the audio materials on all the official elementary school English textbooks. So this is -- as we said, this is the number 1 feature for the Dictionary Pen since the Dictionary Pens release. So now finally, the students can enjoy a more convenient and economical textbook experience.

And we also have another new product, the Youdao listening part, it is also released in Q3. Let me talk a little bit about its performance. So it is our first new product, new category product since 2020. It focuses on enhancing students, English listening and also speaking capabilities.

So it provides over 4,000 of listening, material employees in adaptive driven learning technology and solves key challenges students face in standardized English test. So it really solves students keep on. And perhaps more importantly, it provides all these features without using the cell phone.

So the students enjoy a learning experience without the distraction from cell phones. Yes, so once it's released, it actually turns out to be quite popular. As we said, the first batch of several thousands of the listening pods was sold out in a week. So it was off to a great start. Yes. So let me quickly comment on the competitive landscape here.

The key thing is that for every learning product, we always leverage our proprietary AI technology and our deep understanding of students' learning patterns. So these comes from many years of R&D and working on these education products.

So we believe these are our advantages against other hardware companies and also Internet companies entering this space. Also, as we talked about in Q2, we are doubling down on learning products R&D. So we believe now we have the strongest ever product pipeline in the next few quarters. Yes. So new products will come out in the next few quarters.

And we'll share more information about them as we get close. So our teams are very confident about these future products. So we can await. And talking about the margins. So gross margins for learning products, it's actually increased compared to the same period last year from 29% to 33%. Yes. So compared to Q2, it's a little bit -- it's down from 43%. Yes.

So it is mainly due to the timing because we are now at the end of the lifecycle of the second-generation Dictionary Pen. So we are selling more third-generation Dictionary Pens than the second generation. But as we get close to the end-of-life for second generation. So naturally, we lowered the price to clean the inventory. Yes.

So we expect this to be a temporary situation. After cleaning up the Dictionary Pen 2 inventory, the gross margin, we expect to start to increase. Yes. I hope that answers your question..

The next question is from Brian Gong of Citibank. The next question is from Yuzhong Gao of CICC..

Following the government's opinion, many other leading AST companies also plan to transform their business to STEM courses such as coding or [indiscernible], et cetera, in the future.

So what do you think about the competition in this sector? And what is our competitive advantage?.

Yes, this is Zhou Feng. Yes. So STEM courses or STEAM courses, yes. So it's -- a lot of companies are focusing on this segment now. Yes. So I can share with you several thinking's we have right now in terms of competition. Yes. So first is, we always try to focus on large verticals that we really think we have a competitive advantage.

So STEM and STEAM, they -- they are actually quite large areas, segments. Yes. So when we talk about STEM or STEAM courses, we're actually talking about a specific vertical. So for example, so a lot of people ask us, why do we focus on Weiqi? Yes. So when we start doing in -- starting -- doing the Weiqi cause, it's a very small area.

So not a lot of people pay attention to it. But if you look at how many people are actually interested in learning Weiqi and why they actually have a hard time learning it themselves, then you can understand that it is a good choice for online courses.

So for example, according to the President of the Chinese Weiqi Association, there are over 60 million Weiqi players in China. And every year, 3 million new learners actually go about learning Weiqi. So we think it's -- it potentially has a lot of users, and it is hard actually for people to learn Weiqi by themselves because it's a hard game.

So in Q3, so Weiqi revenue grew 30% sequentially. So we so we think we chose the right product. So we expect it to continue to grow quickly. Yes. So first, we focus on large verticals, potentially large verticals. Yes.

So the second one, principle we have is that we think quality and depth are key for kind of long-lasting and highly satisfied courses or products quality and depth. So both Weiqi and coding are top products right now have been in development for more than 2 years.

So we involve our self-developed AI systems, interactive learning techniques or even hardware products. So we have a hardware product for our coding costs. It's got good feedback. So overall, we think so product excellence is more important than the marketing as always. So especially so given that double reduction limits marketing.

And we think our teams are very good at building excellent products and also grow the product with [indiscernible]. So we think we have a very good shot at STEM courses because we focus on quality and depth. And lastly, I think the students' needs are increasing. So for example, because a lot of students, young students have more time.

So students use used to -- they now have more time to pursue their STEAM interest after double reduction. And we will also work with schools and other institutions on this courses. So again, we expect the market to be more organic and rational after double reduction. And so no money burning promotion was.

So we think the high-quality and are really, really good products. They will win in the end..

The next question is from Thomas Chong of Jefferies..

And first question regarding our adult education, can management comments about our strategies in the competition as well as our competitive edge in this segment?.

And I will handle your questions and the first I will probably ask your second question first. And I think it's about the intensive competitive landscape. And yes, indeed, because of the regulation change, more and more players enter into the adult education business, enter into the education business.

But we just have -- we just want to highlight for these [indiscernible] because we are not start our business just now. And we have already set our business back to the 2016 when we start our education business. We restart our business from our that's China English test Level 4 and Level 6 test for the education business started in [indiscernible].

So we think about we have already collected a lot of the cumulative experience about how to operate our business and how to build up the high-quality online process content for that for the adult education for different SKU.

Especially, we very successfully built up the SKU for the English education as well as for the Extraordinary Memory courses for the adults.

So we think in the long run, we will -- definitely, we will be followed with our experience to how we build up the content and how we operate about those success for courses for the adults and to offer more content and services to the adult -- for their upcoming needs in the long run.

And also, in addition, we think we strengthen our planning to investment in the [indiscernible] training as well and especially in the third quarter -- after quarters and before there's a lot of support from the different level of government to encourage all the investments as well as more resources into the this sector helps us to promote about that vocational education in China.

So we think about there's some great potential for this area. So we think about that very bright futures for this business. And so go back to your first question about the progress on our courses.

Yes, we are, right now, we are in good of our SKU pipeline, and we expect the size of our English courses and also our extraordinary courses, we expect to offer more vocational training, especially for the IT training and also the other cases in the next few quarters. We expect to share more information with you. And when I get closed.

I hope that will answer your question..

The next question is from Candis Chan of Daiwa..

And my question is about the education, digitalization.

Can you share the progress in this business? And also, will you further increase the investments in this segment? And finally, may I ask one more question is about who are the key competitors in this area?.

We believe that it's a huge potential for digitization solutions. Talking to the [indiscernible] market size is over RMB650 billion in 2023. And we build the new team intelligence education department in our company, which should be targeted to fee development of patient digitalization solutions.

The policy in companies with advantaged technology to help [indiscernible] and the public schools to establish the education. Youdao have AI and related technology, hardware design and integration experience and digital content accretion ability. And we have a deep understanding of education.

Therefore, we believe we have advantage to meet the demand of education transfer building. In this quarter, we launched the Youdao smart learning device learning terminal 2. This is first to create a high-speed scanning and high-speed printing 2-in-1 functions.

With Big data, AI and other technologies, effectively create teaching Lu that spans before after class to comprehensively contact the data in daily teaching percent through the hardware, software and content opportunity of within data collection analysis, we achieved a targeted teaching and [indiscernible] with data intelligence and help indicators and don't learn more effectively and efficiency using our technology..

Yes. Let me add a few words on the position. So education digitalization solutions. So this is a quite large area. So $400 billion to $500 billion kind of total market as there are not actually companies doing this. So more traditional companies doing this for a longer time, not necessarily traditional. Companies doing this for a longer time.

These include [indiscernible] And there are also new companies entering the space, including more familiar names like by dense and Tencent. Yes.

So a lot of companies are interested in doing this, but we think we have been doing education products for a long time, and we can combine -- as our product has shown, we combine hardware, artificial intelligence and education content. So we think we can have a different way of doing these products in a better way..

[Operator Instructions]. The next question is from [indiscernible] of Macquarie..

My question is about the spinning off of the [indiscernible] business.

What is the progress of it? And how -- what do you project it's all finished in more specific time? And my second question is how about the business license application, what is progress of that?.

This is Wang. I will take your question. We are still in the process of disposing our academic SD business or business for commentary education. As mentioned in our revenues from our [indiscernible] business accounted for approximately 25% of our total revenues in the third quarter.

Up to now, the government authority is actively accessing on the material-related to the business license application for the nonprofit organization. But there's still no clear timetable on this.

We will continue to work constructively with the government authority in connection with the proposed deal and still expect business to be disposed of the terminated by the end of this year. As disclosed in our official announcement on September 30 for the earnings base this time.

We reminded all of you again that there is no any assurance regarding the ultimate timing of the proposed deal or that the transaction will be completed. We will update the status of the deal or the data of business license application to the market, if any material process was made..

The next question is from Brian Gong of Citibank..

I'm very sorry about the technical area just happened earlier. And my question is that it has been a few months since we proposed on some new directions on the business, which includes other education, STE, AM courses and also smart devices.

So can management give us some update on the latest progress and whether there are any modifications to our new strategies?.

Yes.

So you're asking about the -- whether there's any change to the new strategy after double reduction?.

Yes..

Yes. So -- let me talk about a few key things. Yes. So yes. The short answer is that we think we have the right strategy, and we are executing it, and we are making good progress. And yes, let me talk about a few things about actually more thinking about the 4 pillar, what we call the 4-pillar strategy.

So the first point I want to make is that our business always will have a strong core. That is the AI and learning content creation. Yes. So we talk about the 4 directions for businesses. But it's actually centered around a single core. The core is artificial intelligence and learning content.

So around this call, we have built these 4 different products or services. And right now, we think about whether we want to -- we thought about whether we want to focus on one of them or 2 of them. But we do think that all of them represent good growth opportunities. And we will put efforts into each of them right now.

And down the road, we may find that one of them is more -- is so compelling that we will just focus on that. That could be the case. But now we think this is a good setup for us. So the second point I want to make is that the importance of good products.

So I've always had the view that if you can build one differentiated focused product that solves a lot of people's, then you can already build a very strong business around the product. So product progress is key for future growth of our business. Yes. So at this particular time, when some of these 2 4 businesses are relatively small in scale.

So it is more important to actually look at product programs. That's why we spent more time talking about products during the last 2 quarters. Yes. So we will watch for a sign of success from these products. So for example, I talked about Youdao listening pod, Youdao selling out the first batch in a week.

It's an early sign that shows that we've actually likely achieved product market fit for this product after many months of R&D. Yes. So we think this is just the key. Yes. So as long as we have product market fit for products, then we can relentlessly iterate and improve and spend more energy on marketing and sales. And then we can scale the business.

Yes. But before all that, achieving product market fit is key. So we will pay more attention and talk to you more about product progress. And let me also share with you that another example is that we launched a cost Odisha course in September.

So I think it's a pretty special course because it uses innovative teacher methods, combining Chinese and English and also it's bilingual and also interactive AI-based teaching. Yes. So the first month, we watch for its trajectory.

And we found that the chess cost was actually multiple times better compared with Youdao Weiqi for the first -- for Weiqi's first month. So we think that's another way -- another sign that we are doing something right. Yes. The third and last point I want to make is, what about the financial ramifications of this new strategy for going forward.

So as the academic tutoring side of our business quickly goes down, that's to be expected. And non-tutoring business, they actually keep growing. They have been growing for some time for many quarters now, but they keep growing. And overall, we expect our top line growth to see a deceleration in the short term.

And after that, accelerated growth again because the non-tutoring business will take more part be a larger part at that time. So in terms of bottom line, we expect to see relatively stable or slightly improving bottom line as sales and marketing, S&M cost expense quickly go down in the short term.

I would like to highlight that in Q3, operating loss has substantially shrunk. Yes. So it's 130 million versus 90 million year-over-year or compared with 540 million last quarter. So I think we're making good progress. Yes. So that's the 3 points. Yes. So I hope that answers your question..

And that concludes the Question-and-Answer Session. I would like to turn the conference back over to the management for any additional or closing comments..

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 U.S., have a great day..

Ladies and gentlemen, thank you for joining. The conference is now over. You may disconnect your telephones. Thank you..