Youdao Gets Boosts From AI, Patient Parent

Key Takeaways:

• Youdao’s revenue grew 26.2% in the second quarter, bouncing back from a decline in the previous quarter, on strong performance for its marketing services
• The provider of education products and services said its parent agreed to a three-year extension for $200 million in loans coming due next March

By Doug Young

There are a few lessons in the latest financial report from Youdao Inc. DAO, a company trying to find its way in China’s rapidly changing landscape for providers of education products and services.

Perhaps most interesting, Youdao’s results offer a convincing case for the power of artificial intelligence (AI) to really breathe new life into a relatively mature business, in this case the company’s marketing services. The company also appears to be leveraging AI in its core education services, making use of generative AI technology to improve its online learning courses.

Separately, Youdao is also showing the importance of having a strong, supportive parent in China’s brave new world of providing education services. The company was rapidly burning through its cash and had some major debt coming due next year to its parent, gaming giant NetEase NTES. But like any good parent would do, NetEase has graciously extended the due date for that debt by a generous three years to give its offspring more time to stand on its own.

Despite everything the company has going for it, including a history of strong double-digit revenue growth, Youdao is quite the investor laggard among its peers. Its stock currently trades at a price-to-sales (P/S) ratio of just 0.63, compared with around 1 for QuantaSing QSG, which focuses on adult education; 1.03 for Zhihu ZH, an online Q&A site with a strong education component; and 1.15 for iHuman IH, which focuses on children’s learning devices.

Investors continued with their tepid view on Youdao after publication of its latest results, bidding down the shares by 2.4% last Thursday after the report came out. The stock is down 36% year-to-date.

Truth be told, we’re not completely sure why the company trades at such a discount, since Youdao is a fairly well-respected brand in China and consistently posts double-digit revenue growth and narrowing losses. That said, a loss is still a loss, and the analyst community doesn’t expect Youdao to become profitable this year or next.

We’ll start off with the big top-line number that showed Youdao brought in 1.2 billion yuan ($166 million) in revenue in the second quarter, up 26.2% year-on-year. The growth rate marked a big improvement from the first quarter, when the company also reported 1.2 billion yuan in revenue, which was down 3.1% year-on-year as demand for its core learning services declined.

The company didn’t give any clear reason for the unusual first-quarter drop in its learning services. But that category, its largest, accounting for about 60% of revenue, returned to strong growth in the second quarter, rising 20.8% to 681 million yuan. It didn’t comment very precisely on the return to growth for the category in the second quarter either. But it’s possible that last year’s base was low due to low demand during China’s widespread lockdowns to control the Covid Omicron variant, including a complete lockdown of the entire city of Shanghai in April and May last year.

Marketing Services Shine

While education services performed well, the real star of Youdao’s latest quarterly report was its marketing services, a relatively mature segment that hasn’t done well in China lately as companies rein in their marketing budgets. Revenue from Youdao’s online marketing services defied broader market trends, nearly doubling during the quarter to 304 million yuan, accelerating from a similarly strong 80% growth rate in the first quarter. Marketing services now account for about a quarter of the company’s revenue, roughly double their contribution for all 2022.

By comparison, internet search leader Baidu BIDU, considered a benchmark for China’s advertising market, recorded much slower 15% growth for its core marketing services in the second quarter.

CEO Zhou Feng attributed the strong gains to Youdao’s use of AI-generated content, or AIGC. “By empowering our advertising business with AIGC, we ensured more precise targeting, which helped our customers reach their desired audience faster and more accurately, resulting in historic high net revenues of 303.6 million yuan from online marketing services,” he said.

The company’s smart devices, its third major revenue source, continued to be a laggard in the latest quarter. That segment’s revenue fell 7.4% for the period to 222 million yuan, representing a slight improvement from a 16% decline in the first quarter. The declines could represent a recent trend by Chinese consumers to cut back spending on more expensive items like cars, smartphones and other computing devices in the face of uncertainties now facing China’s economy.

Such caution could become a bigger factor for all of Youdao’s businesses in the future, though the company doesn’t typically give guidance for upcoming quarters.

Youdao managed to keep its operating expenses roughly flat year-on-year, with the result that its gross margin improved to 47% from 42.8% a year earlier. As a result, its net loss from continuing operations improved to 299 million yuan from a 454 million yuan loss a year earlier.

We’ll close with a brief discussion of the company’s cash, which we raised earlier, and is always problematic for this kind of company with a long history of losing money. Youdao pointed out that it continues to rapidly burn through money, noting the value of its cash and short-term investments fell to a relatively low 680 million yuan by the end of June from 1 billion yuan at the end of last year. It also noted that it has 878 million yuan in short-term loans and $80 million in long-term loans from NetEase that will come due next March 31.

Such obligations to anyone else would normally put any company in financial difficulties. But NetEase is quite profitable and doesn’t seem in any hurry to collect the debt, and instead agreed to extend the repayment deadline by three years to March 2027. So Youdao can continue trying to improve its business without worry of a cash crunch.

“We are on a clear path to achieving profitability,” Zhou said on the company’s earnings call, as if to address that concern, though he declined to give any timeline.