Youdao, Inc. (NYSE:DAO) Q3 2024 Earnings Call Transcript

Youdao, Inc. (NYSE:DAO) Q3 2024 Earnings Call Transcript August 22, 2024

Operator: Good day and welcome to the Youdao 2024 Second 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.

Jeffrey Wang: Thank you, operator. Please note the discussion today will contain forward-looking statements, related to the 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 company filings with the U.S. Securities and Exchange Commission.

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 2024 second quarter financial results news release issued earlier today. As a reminder, this conference is being recorded. A webcast replay of this conference call will be also available on Youdao’s corporate website at ir.youdao.com. Joining us today on the call from Youdao’s Senior Management are Dr. Feng Zhou, our Chief Executive Officer; Mr. Lei Jin, our President; 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, 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, unless otherwise specifically stated. In the second quarter of 2024, net revenues reached RMB1.3 billion, growing 9.5% year-over-year. Operating cash inflow reached record level of RMB250.2 million, an increase of 88.2% year-over-year. Loss from operations was RMB72.6 million as Q2 is typically seasonally weak in the bottom line, and it narrowed by 74.9% year-over-year. In the first-half of 2024, net revenues reached RMB2.7 billion, marking an increase of 14.5% year-over-year. Loss from operations was RMB42.6 million, narrowing 91.2% year-over-year. Operating cash outflow was reduced to RMB140.8 million, reflecting an improvement of 53.7% year-over-year.

The financial performance was in line with our plan. Now, let’s review the major developments across our business lines in the second quarter. Net revenues from learning services were RMB643.8 million, slightly down by 5.5%, compared with the same period of last year. Digital content services maintained a healthy growth trajectory, achieving net revenues of RMB403.3 million, up 6.8% year-over-year. Operating cash inflows generated by digital content services exceeded RMB200 million. Youdao Lingshi continued to drive product upgrades and customer satisfaction. Firstly, in Q2 we released over 400 new carefully-calibrated tiered-learning videos for students of different levels. We also significantly upgraded the class-based study experience for better motivation and context.

As we discussed before, Lingshi pioneered the approach of personalized pre-recorded video learning. Building upon this vast library of thousands of high-quality videos, we offer a set of important services, including automatic diagnosis of students’ current learning levels, class-based digital learning, personalized quiz generation, and week-end live consultation with our experienced staff members. These are all key to the high effectiveness of our products and we keep improving them every year. Second, in terms of application of AI and growth initiatives, we upgrade our college admission consultation services to the all-new AI College Admission Advisers AI [Foreign Language] in Q2. Using Large Language Models, the AI Advisor effectively discusses and guides students in their college application process, helping them in choosing universities and majors.

Since the new release, the service saw nearly 3 million page views, rising by 30% year-over-year, making it a key asset in attracting new students and parents. Continuous product and service upgrades significantly boosted the retention rate of Youdao Lingshi, reaching over 70% in the second quarter, a record high and an increase of more than 10 percentage points year-over-year. In addition, as for Youdao Literature, we offered nearly 40,000 high-quality AI writing refinements in the second quarter, improving our retention rate by approximately 10 percentage points on a year-over-year basis. Next in learning services segment is our AI-driven subscription services. In the second quarter, our AI-driven subscription services maintained rapid growth, with total sales surpassing RMB60 million, marking a nearly 200% year-over-year increase and over 30% quarter-over-quarter growth.

Moreover, this represents the sixth consecutive quarter of over 50% year-over-year growth. Product wise, in June, we launched a major new mobile app, Mr. P AI Tutor, the first all-subject AI tutor in China and it received positive feedback from users after its initial integration into Youdao Dictionary Pen earlier this year. Second, AI translation in Youdao Desktop Translation now supports languages other than English and Chinese. There is also new support for term databases and multi-modal document input. These upgrades pushed AI translation usage to exceed 30 million times in Q2. Third, in collaboration with NetEase Cloud Music, Youdao Dictionary introduced a music sentence feature in the second quarter, helping users learn vocabulary while listening to music.

Last but not least, Hi Echo introduced Children Mode, offering tailored topics for children, child-friendly digital avatars, and generating exclusive post-conversation reports to aid children in improving their English speaking skills. We are also delighted to observe that the average usage time of Children Mode is nearly twice that of other modes, highlighting its effectiveness in engaging and retaining users, as well as enhancing their English proficiency. Our online marketing services segment maintained a strong growth trajectory in Q2, with net revenues reaching RMB511.2 million, hitting a record high and representing an increase of 68.4% year-over-year. This marks the seventh consecutive quarter of over 50% year-over-year growth, driven mainly by RTA, Real-Time API, and domestic KOLs’ ongoing robust performances, with RTA revenues more than doubling year-over-year in Q2.

Furthermore, as large language models rapidly advance in the market, the demand for promoting these models and their applications among tech companies has surged. Our team seized this opportunity and is helping leading players like ByteDance, Doubao, Zhipu and Baidu ERNIE in this area to grow their products. In Q2, net revenues from AI tools advertisement grew by more than 100% quarter-over-quarter. Additionally, our advertising collaboration with NetEase Group has been advancing smoothly and demonstrating synergy. On one hand, Youdao’s data application significantly enhanced the traffic monetization rate on a number of NetEase assets by over 100% in Q2. On the other hand, our improved advertising performance has attracted more NetEase product teams to use our service.

In the second quarter, the percentage of our total advertising revenue from NetEase as our client increased around 3 percentage points quarter-to-quarter, it is still less than 10% of our total ad revenue, indicating significant future growth potential. Regarding the smart devices segment, the net revenues were RMB166.7 million in Q2, down 25% year-over-year. The decline was in large part due to unfavorable product mix. In Q1, we updated our entry-level dictionary pens, so these reached record unit sales in Q2. In the meantime, our high-end products were from last year and reached the later part of their life cycle in Q2. So high-end products had relatively lower sales. These factors negatively impacted total devices revenues and also average unit price for Q2.

We expect Q2 to be the low point operationally for the device business this year as we are currently ramping up high-end products for the new school year. In fact, Youdao Dictionary Pen was again the category top seller on JD.com during the June 18th Shopping Festival for the fifth consecutive year. And Q2 unit sales showed a year-over-year increase of over 50%, broadening our brand’s reach. More recently, we launched the new high-end Youdao Dictionary Pen X7. Large Language Model functions like AI translation and Mr. P AI Tutor have already been widely welcomed by users. First-month sales units doubled those of the X6 Pro, the high-end product released last summer. This week we just released our top-of-the-line X7 Pro, with a premium screen and more advanced AI features, it is gaining a lot of interest.

Looking at our business as a whole, in the first-half of this year, we executed on our overall strategy of AI plus education and made significant progress in our journey. We focused our resources on three core businesses: digital content services, especially Youdao Lingshi, online marketing services and AI-driven subscription services. All three areas show good growth, healthy economics, our unique competitiveness and long future runways. And more importantly, they are key assets in our mission of helping every person learn more efficiently. In the meantime, financially we worked hard to drive towards sustainable profitability, which we believe is the foundation for our next phase of growth. I am pleased with the team’s progress and solid execution.

Our operational and financial metrics show increased competitiveness of our business. For example, in addition to the numbers I shared at the beginning, the ratio of sales and marketing expenses to net revenues was 35.8% in the first-half of this year, down by approximately 13 percentage points year-over-year, a very good improvement. Looking ahead, barring unexpected market changes, we expect the business to achieve full-year positive operating income in the near future. Youdao’s strength lies in our unique ability to advance AI empowerment across business lines, combining technical strength with operational excellence. The rapid development of our online marketing and AI subscription services proves this and will continue to drive our growth.

Our online courses, underpinned by high-quality content, differentiated services and unique ways of leveraging AI, are another pillar of our future growth. In the long-term, the future of AI plus education looks incredibly bright and we will strive to lead the charge. With that, I will turn the call over to Su Peng to provide you with more detailed insights into our financial performance. Thank you.

Peng Su: Thank you, Dr. Zhou, and hello everyone. Today I will be presenting some financial highlights from the second quarter of 2024. We encourage you to read through our press release issued earlier today for further details. For the second quarter, total net revenues were RMB1.3 billion or US$181.9 million, representing a 9.5% increase from the same period of 2023. Net revenues from our learning services were RMB643.8 million, or US$88.6 million, representing a 5.5% decrease from the same period of 2023. Net revenues from our smart devices were RMB166.7 million, or US$22.9 million, down 25% from the same period of 2023, which was mainly attributable to the decreased unit price due to the change of product mix. Net revenues from our online marketing services were RMB511.2 million, or US$70.3 million, representing a 68.4% increase from the same period of 2023.

The increase was primarily due to increased sales of the performance-based advertisements through third parties’ internet properties, which was driven by our continued investments in cutting-edge AI technology. For the second quarter, our total gross profit was RMB636.8 million, or US$87.6 million, representing a 12.3% increase from the second quarter of 2023. Gross margin for learning services was 60% for the second quarter of 2024, compared with 57.4% for the same period of 2023. Gross margin for smart devices was 30.3% for the second quarter of 2024, compared with 35.8% for the same period of 2023. Gross margin for online marketing services was 39.1% for the second quarter of 2024, compared with 31.9% for the same period of 2023. For the second quarter, we reduced our total operating expenses to RMB709.3 million, or US$97.6 million, compared with RMB856.3 million for the same period of last year.

Looking at our expenses in more detail: Sales and marketing expenses declined to RMB515.7 million, compared with RMB587.7 million in the second quarter of 2023. Research and development expenses were decreased to RMB153 million, compared with RMB205.1 million in the second quarter of 2023. Our operating loss margin also significantly narrowed to 5.5% in the second quarter of 2024, compared with 24% for the same period of last year. For the second quarter of 2024, we narrowed our net loss attributable to ordinary shareholders to RMB99.5 million, or US$13.7 million, compared with RMB299.2 million for the same period of last year. Non-GAAP net loss attributable to ordinary shareholders for the second quarter was RMB96 million, or US$13.2 million, compared with RMB283.6 million for the same period of last year.

Basic and diluted net loss per ADS attributable to ordinary shareholders for the second quarter of 2024 was RMB0.85, or US$0.12. Non-GAAP basic and diluted net loss per ADS attributable to ordinary shareholders for the second quarter was RMB0.82, or US$0.11. Our net cash provided by operating activities was RMB250.2 million, or US$34.4 million, for the second quarter. Looking at our balance sheet, as of June 30, 2024, our contract liabilities, which mainly consist of deferred revenue generated from our learning services, were RMB1 billion, or US$142.9 million, compared with RMB1.1 billion as of December 31, 2023. At the end of the period, our cash, cash equivalents, current and non-current restricted cash, time deposits, and short-term investments totaled RMB568.5 million, or US$78.2 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.

Q&A Session

Operator: Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question today will come from Brian Gong of Citi. Please go ahead.

Brian Gong: Thanks, management, for picking that question. I have a question regarding our strategy on education sector. So as we observed, competitors are wrapping up their investment in the whole sector, right, education sector. Given the intensified competition, what is our strategy? Thank you.

Peng Su: Thank you, Brian. This is Peng. I will handle the question first. And before answering the question, I will give a very quick background regarding the education scenario in China. And if you see the numbers of the candidates registered for the college entrance exam has been increased from roughly 10 million in 2019 to over 30 million in this year. It’s likely to keep increasing in the next decades as well. Also the exam is getting more comparative. The overall college entrance exam scoreline has been shown as the upward trend. Taking the example as the — in Tianjin, it has been increased by more than 70 points, compared to the 2019. So we think about the demand for the college entrance exam preparations will continue to rise.

If you go back to questions, we do see the competition intensify moderately for the pre-college learning services in this year. That’s understandable given the current market conditions. I believe we have the necessary means to continue to invest to be — still be the — keeping to the leading player here and benefit from the more dynamic markets. The first thing we do is we will still continue to drive the customer satisfaction and the retentions. We have already passed industry-leading satisfaction and retention rates. During the first-half of this year, our retention rates reached a historical high in Q2 exceeding about 70% and representing a year-over-year increase of over 10%. I think that metric is a testament to the user’s recognitions of our products and services.

Secondly, we think we will continue to produce outstanding learning results. As long as we had already helped the students get the good results and get into their dreaming university and school, most students will come to us and if you look at our results from the last year and this year, we almost more than doubled the number of the students getting to the top school and universities in this year. I think that is important thing that can help us to build up our reputations in the market. I think that this is possible, because I think you don’t ensure 10-years format of our classes, the AI plus content and the comprehensive service models. I think that’s pretty innovative and creative and the proven learning methodologies for the college entrance exam preparation and the others.

Third, we think we are applying more AI technology in our business, such as the segment we have been mentioning previously, like the AI Quiz recommendation and the AI-based college admissions advice services. In Q2, our AI College application advisors generate nearly 60,000 application form, roughly 30% increase year-over-year. Positioning, I think we believe that is — will be the leading one in the market in this year. I think the AI — kind of what AI can bring us the privilege over the market. The fourth one we think we will keep innovating and investing in the market as well. We will continue to strengthen our market channels and the branding development, providing a better integrated experience for the users through online and offline coordination.

This year, through the month of — such as the WeChat video accounts, [Foreign Language], we have enhanced the localized live broadcast and operate to provide the users with a range of localization services and highly customer services in the different cities. We will fully leverage our teaching strengths and IT operational experience to enhance our online customer acquisitions, competitive and reduce customer acquisition cost. I think as we will persist in exploring offline services and opportunities and looking for the better chance to invest into that market. I think above all, we think that’s what we are confident about future development of the Youdao interest business and service. We think in the long run, definitely the high quality products always will be the answer for the competitive market.

[Indiscernible]

Brian Gong: Yes, thank you.

Unidentified Company Representative: Yes. Let me add a point. So I think what’s the most important thing is the product. In the end, it’s about how well you understand the customers and how to best satisfy the customer’s needs. So we think our teams are very good at this, because Feng Zhou and its predecessor have been a long running business at Youdao. We’ve been doing it for 80-years already, yes. So and within the process we actually innovated several times. So the current AI plus pre-recorded video plus comprehensive service model, it was introduced in 2021. So it was a big change. But if you think about it, it really makes a lot of sense. Because for students preparing for college entrance exam, what they really lack is they lack a lot of free time.

So the traditional life course format is not such a good fit. So that the team had actually been preparing for the change for a year at that time. And the market condition in 2021 pushed the team to make the leap. And that’s why we’ve been able to grow the business several times since then. So I think that proves the innovation capability of our teams and I expect the Lingshi team to keep innovating and keep loving what they do. That is what the NetEase and Youdao culture is and what makes us good at making high quality content. Yes, so I think that’s the most important thing. We’ll keep improving the product and serve the customer better.

Brian Gong: Thank you.

Unidentified Company Representative: Thank you, [Indiscernible].

Operator: The next question will come from [Peng Zhao] (ph) of CICC. Please go ahead.

Unidentified Analyst: Good evening, Dr. Zhou, Feng Zhou. Thanks for taking my questions. Your online marketing business saw very strong revenue growth in the first-half of the year. Could you please tell what’s the outlook of this business in second-half of the year? Thank you.

Lei Jin: Hi, this is Lei Jin. For the second-half of the year, our outlook for online marketing services remains positive. We have seen net revenue growth significantly from around RMB200 million per quarter to over RMB500 million in Q2 of this year. This marks seventh consecutive quarters of year-over-year net revenue growth, exceeding 50%, alongside continuous improvement in profitability. We excited year-over-year revenue growth to continue through the second-half of this year. Several key factors are driving this sustainable growth. First, our robust data accumulation, advanced AI algorithms, and a deep understanding of customer demand, form the cornerstones of our long-term competitiveness. As we continuously collect and feed data into our data management platform, DMP, we achieved more accurate prediction, better decision-making, and more refined online marketing services tailored to user needs.

Second, our expansion to overseas advertising has been a significant growth driver. We offer the client comprehensive and personalized international advertising services, including brand communication, global KOL marketing, overseas AD placement, and live streaming commerce. Leveraging our deep understanding of client needs, we have accelerated the development of international advertising infrastructure. By the end of Q2, our international carrier database has exceeded 7 million, a year-over-year increase of over 200%. This drops Q2 net revenue from international performance based advertising to nearly RMB100 million, a growth rate of about 30 percentage points higher than in Q1. In this second-half, we will continue to capitalize on the growing demand from Chinese companies looking to expand internationally.

First thing, the sustainable development of international advertising efforts. Third, our collaboration with NetEase Group has been mutually beneficial. In Q2, Youdao data adaptation significantly improved monetization rate by over 100% of NetEase Group’s traffic. In return, NetEase Group provides us with more controllable and predictable traffic resources. Moving forward, we will keep upgrading our algorithm and the [BMP] (ph) platform to enhance our AI-driven data capabilities, improve advertising efficiency, and boost revenue. Well, we are mindful of the increasing risk of traffic computation. We are committed to receiving opportunities to assist Chinese companies in their global expansion. At the same time, leveraging our strength in customer relations, AI and the data.

We are gradually establishing our own exclusive AD network. This will help for the sustainable and help development of our AD business. Thank you.

Operator: Our next question today will come from Thomas Chong of Jefferies. Please go ahead.

Thomas Chong: Hi, good evening. Thanks management for taking my question. May I ask about AI-driven subscription services? We’re actually seeing the subscription services continue to expand. What is the commercialization part for Mr. P AI Tutor? Thank you.

Feng Zhou: Hi Thomas. Yes, this is Feng. The key thing here is the user scenario. In Youdao we focused a lot on user scenarios. And Mr. P serves the home learning scenario, which we believe is the number one or number two of all consumer learning scenarios for students. So it is very important and not served well by current products. So we think Mr. P fits this scenario very well. In terms of the product and our learnings and also the commercialization path, as you asked, I have several points to share. The first one is that the initial feedback for the app is very positive. The recent release of Mr. P is our — what we call broad release for us. So in the app form factor and in the X7 and X7 Pro dictionary pens. In its first month on the market, users engaged with Mr. P AI Tutor for nearly 2 million times, ranking it actually as the second most used feature of the X7 dictionary pen only after word lookup and translation, which is kind of the basic function of the device.

So it is already number two. So it surpassed the previous favorite features like Wayne and Xinjiang, so I think that proves its popularity. The second point I want to share is Mr. P is quite unique and leading product in the market in terms of functionality. It is the first all subject, that’s nine in total, K-12 AI learning companion app with high-quality results. Some of our peer companies focused on one or two subjects. Others, their product doesn’t yet deliver high-quality results. So, our engineering and research team has developed a key set of technologies that make Mr. P possible and are now working hard to keep improving it. Obviously, we’re still in the early days. So, we expect the experience to become much better over time. And we believe this technology holds a lot of promise.

So, I would think every family in China with students need this AI companion. So, yes, think about it. So, either in apps form or in highway devices or other phones, actually, not only in China but in other countries as well. So, that’s how we look at it. Third point is that regarding monetization and commercialization, we think subscription fees are a very scalable way of monetizing generative AI technology. And obviously, we also look at other ways like Smart Devices, B2B licensing, and also international markets. So, I do not want to talk too much about our concrete plans, but you can look at our existing products to get some ideas. For example, Hi Echo is already a significant contributor to our overall AI subscription sales, which in total, we just shared, reached over RMB60 million in Q2 and grew nearly 200% year-over-year.

And the growth for Hi Echo comes from several things, continuous product improvements positive word of mouth, and a lot of the users to use the referrals. So, we expect Mr. P to follow a similar path. So, we also did some projects for Hi Echo on the B2B front. Hi Echo has entered over 100 schools nationwide. We also focused on partnerships. Hi Echo became an official partner of the British consoles IELTS test. So, I believe this is also our strength. It has a long history of working effectively with international companies and institutions. Hi Echo was also recently featured on the App Store, Apple App Store homepage, which is a testimony of its quality and popularity. So, overall, we find that AI apps are popular online users, and we have a lot of ideas.

Our team has a lot of ideas how to commercialize them. And we expect this year and next year to be a very good time period, time window to grow and monetize these AI apps. Yes. So. we will focus on them. Yes, thank you.

Thomas Chong: Thank you.

Operator: Our next question today will come from Howard Ton of Macquarie. Please go ahead.

Howard Ton: Hi, good evening and thank you for taking my question. My question is about the non-academic tutoring market. So, I’d like to know more about your company’s progress in STEAM courses and whether you will accelerate investments in the future?

Peng Su: Thank you. This is Peng. I will handle the questions. And in the second quarter, we made some progress in our nonacademic process. Although our language screening and logic thinking courses are in their early stage. But in terms of the gross billings, both have experienced year-over-year growth over 100%. As in English, our communication and the other skills-based training has always been the strength of as you know, and empowered by the AI, we can now provide the users with very comprehensive services and highly customer services during, before, and after classes. On the other hand, we have already had very strong faculties and high-quality content to provide excellent in-class services to the users. With the rapid development of our AI-driven subscription services, and we can also exist in the users in personalization and post-class scenario to their listening and speaking capabilities.

For example, as we mentioned in the last several quarters, the higher cost allow users to engage in oral communication anytime and anywhere and generate personalized analysis report to correct the issues related to speech and grammar during the [indiscernible]. For logic thinking courses, it is highly demanded by the users. Clients always hope to that kind of through the course, I think they are children thinking abilities will continuously improved. Our products meets the needs of the parents. And additionally, when the students encounter problem after classes, as Dr. Zhou mentioned, Mr. P AI Tutors can help them to answer the questions and I think it’s a different way. And we didn’t just like a mentioned, semester is not directly give them the answers, but just to try to lead them to think about all the path.

We think that will be the kind of innovation, and that will be really need from the family education scenario. Looking ahead, we will continue to emphasize the high-quality development of the nonacademic process. If we identify the clear opportunities, we are encoding the health and of our business. We will consider increasing the investments in the non-academic courses. Thank you.

Feng Zhou: I think you need to choose which causes to provide very carefully to be successful. So, it is particularly important for nonacademic learning because they can be very wide in terms of topic. So, you can choose from a very wide set of topics. But you have to choose very, very carefully because parents, they may initially be interested in different topics. They may want to try it. But in the end, they choose the courses that’s really helpful for their kids in the long term. Only those courses will become popular for the long-term. So, you need to choose comfortably. So, that’s what we focus on for non-academic courses. Yes, for example, we believe Chinese literature abilities are very, very important for kids. Being able to grasp the power of language is one of the key abilities that benefits our persons of life.

So, that cost has proven successful with your double in the last several years. So, we will keep improving. And also, one other thing we think that’s really important is computing skills. Everyone knows that it’s key for future careers. So, our competitive program, of course, Youdao Little Tooling has been running for six years. We had our first national NOI gold medalist for this year. Yes, so the key thing is that if we start some course, some non-academic course, we will make sure that we choose carefully and we want it to be successful for many years to come. Yes, so I think that’s important.

Operator: Our next question today will come from Bo Zhang of Huatai Securities. Please go ahead. Hello, Zhang — Bo Zhang, your line is open.

Bo Zhang: Hello. Can you hear me?

Operator: Your line is live. Yes, thank you.

Bo Zhang: Thank you, manager, for taking my question. And congratulations on the strong performance this quarter. I have a question regarding Smart Life. We saw the revenue from the smart device is still decreasing. Could you share some color on strategy for your entire document plan for the second half of the year and average offers? Thank you.

Feng Zhou: For the last few quarters, we’ve reorganized our sales channels as we communicated in the last several quarters. We also focused our products to be, again, around our core fixed are paying category. This year, we’ve released four Dictionary Pens from the mid-tier X6 Pro, to flagships, X7 and X7 Pro. So, the good thing is, users have told us that they really like these new products. So, the Youdao Dictionary Pens is ranked the number one seller in the category during the June 18th Shopping Festival on JD.com for five years consecutively, reflecting their users’ preference for our brand. X7 in its first month on the market, generated twice the revenue of last year’s flagship X6 Pro as I just talked about during the prepared remarks.

So, this good news tell us that our overall strategy of focusing on core products and channel efficiency are correct. What we need to do now is we need to continue to focus on our key products, mainly Dictionary Pens and strong sales capability and efficient channels at the same time. Another good thing is that the device business and the financial performance has improved after the refocusing. So, that set up a good foundation for the business to build on. So, here are a few more kind of points about the Dictionary Pen. The first one is about high-end products. These are our strengths. And our first large language model applications were on our high-end products. So, in July, we launched the Dictionary Pen X7 and last week, X7 Pro, both of them carry life language model features, including Mr. P and the AI translation.

So, as we just shared, Mr. P is the number two most popular function. And the AI translation is also very popular. So, that’s really encouraging for us because only our products have these features right now. Second point I want to share is regarding price point. Last year, we expanded into the midrange market with the launch of the SNA series, aiming to serve a broader audience and meet diverse user needs. In Q2, one of the results is Dictionary Pen unit sales grew by over 50% year-over-year. And in addition, net revenue from Dictionary Pens increased nearly 10% year-over-year. So, unit growth, 50%, revenue growth, 10%. So that means the strategy of not going for a very low price is correct. We didn’t go for a price war. So, our cheapest product, X6 Pro still RMB50 or RMB100 higher, more expensive than our peers.

So, we believe that’s a good balance to strike. So, it allowed us to achieve both unit growth and revenue growth. I think that’s a good trend. Yes. The third point is regarding gross margin ratio because this is something that people look at carefully. So, in Q2, our gross margin ratio for Smart Devices was a bit low at 30%. Again, that was mostly due to the product mix as we just discussed. So, more mid-tier product, fewer high-end products. However, as we ramp up on higher-end product in Q3 and Q4, we are still targeting 40% gross margin ratio as before. So, we have a good feature differentiation, a lot of AI features. And the hardware is much stronger with AI cameras the first time this year and with much better screens that users really like.

And we also improved our supply chain a lot over the last year. So, that lowered our supply cost. Yes, so we think 40% gross margin ratio is a reasonable and feasible growth target to shoot for. So I think, all in all, as we said, we expect Q2 to be the low point operationally for the hardware business. So, we’re looking forward to its future performance, yes.

Bo Zhang: Thank you.

Operator: Our next question today will come from [Indiscernible] of CITIC. Please go ahead with your question.

Unidentified Analyst: Good evening, management. Thank you for taking my question. My question is about the profit. Will we achieve profitability this year? And if so, will we be able to sustain profitability in the future? Thank you.

Wayne Li: Thank you for your question. This is Wayne. I will take your question. We have fully committed to improving the overall health and achieving full-year positive operating income in the near future. Over the past year, we have successfully reduced operating loss on a year-over-year basis, especially in the first half of this year, where operating loss were reduced by over 90% year-over-year to approximately RMB40 million. Historical data indicates that due to seasonal factors typically higher operating income in the second half year compared to the first-half year, giving us confidence in achieving positive operating income for the full-year of 2024 despite intense competition and various uncertainties. We believe that this profitability is expected to be sustainable on a full-year basis in the future due to the following reasons.

First, strong profitability in three core areas. Digital content services, online marketing services, and AI-driven region services have been identified as our key strategic focus areas. We allocate more resources to these areas, which has resulted in profitability, and we will continue to do so. Our online marketing services fueled by our RTA technology, data capability, and precise understanding of user needs have achieved over 50% year-over-year net revenue growth for seven consecutive quarters driving profitability. Through leveraging AI technology and high-quality content, our digital content services actually have improved learning efficiency and effectiveness for our users. Lingshi is a leading products and services have been pivotal in driving revenue and profit growth.

AI-driven subscription services, a key aspect of our AI commercialization efforts have experienced the strong sales growth, and we have confidence in the future profitability. Second, enhanced financial performance in non-core business. For non-core business, such as smart devices and nondigital content services, we have implemented stricter health requirements, focusing on higher ROI metrics and the labor efficiency. This has resulted in a temporary decline in overall business scale but has significantly improved the health of this business and reduce the losses. Third, operational efficiency improvement through AI technology and content innovation. To achieve profitability, we are continuously striving to improve marketing efficiency through innovation and enhanced user experience through the creation of our premium learning content.

We explore various innovations, such as diversified marketing channels and deleveraging advanced AI technology to optimize marketing efficiency and mitigate challenges like rising acquisition costs due to intense computation. By innovating premium content, such as our transition from traditional living stream online classes to provide content embedded with AI technology, like adaptive Question Bank, we address user concerns such as influx schedules and provide personal life learning experience. This premium content has exited strong user engagement with over 70% retention rate in Q2. In summary, our strategic focus and the innovative approaches have resulted in continued improvement in our operating margins, giving us confidence in sustained profitability of our business in the future.

Thank you.

Operator: Our next question today will come from Crystal Li of China Merchant Securities. Please go ahead.

Crystal Li: Hi, thanks management for taking my question. Congratulations on the strong results. I just want to know how should we interpret the recent opinions on promoting the high-quality development of service consumption, and particularly regarding the education and training consumption?

Peng Su: Thank you .Yes, we have noted that earlier this month, the state counselors issue opinions and promoting the high-quality development of services consumptions, which emphasize the meetings of diverse and personalized learning needs of the general public and the promoting the social training institutions to enhance service quality in response to the public demands. First I think I will just to make it clear, Youdao has always consistently to embrace the policy and adhere to operating within the scope of the permitted by policies. And by now, it’s still in the very early stage, and we don’t know any further on the detailed information like scope and the category of the policy. First, definitely we will wait the following information related with the public regarding the detailed information.

And what we can say now is about the strategy of Youdao is to consist to invest into the education sector within the AI features. And if you see the dynamic of our products, we always be innovative and have creative to create a new format of our products following the policies. We think we will keep the update on the existing product and provide new services following the instruction of the existing policy and upcoming ones. Everything that will be the consistent thing so we deliver to deliver the message regarding the policies. And we can discuss more in detail so that after we receive more information from regarding on the special policies. Thank you.

Crystal Li: Thank you.

Operator: At this time, we will conclude the question-and-answer session. I’d like to turn the conference back over to management for any closing remarks.

Jeffrey Wang: Thank you again for joining us today. If you have any further questions, please feel free to contact us at Youdao directly or reach out to Piacente Financial Communications in China or the U.S. Have a great day.

Operator: The conference has now concluded. Thank you for attending today’s presentation, and you may now disconnect.