Good day, and welcome to the Youdao 2022 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.

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. Securities Litigation Reform Act. Such statements, are not guarantees of 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. 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 GAAP to non-GAAP financial results, please see the 2022 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 the Youdao senior management is Dr. Feng Zhou, our Chief Executive Officer; Mr. Lei Jin, our President; Mr. Peng Su, our VP of Strategy and Capital Markets; and Mr. Wei Lee, 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 the financial information and non-GAAP financial information mentioned in this release is presented on a continuing operations basis, and all numbers are based on renminbi unless otherwise specifically stated. As you may have noticed, in Q2, regional COVID-19 resurgence significantly disturbed the macro economy, especially in April and May. By June, the economy began to recover, and our business followed suit. Despite the challenges, Q2 net revenue was largely stable year-over-year, at RMB 956 million. We narrowed our net loss to RMB 461 million in Q2, a 12.3% improvement year-over-year. Besides, operating cash flow reached positive RMB 104 million in Q2, the highest we have achieved in any second quarter period since our IPO. Mainly due to the strong sales performance of our new services and smart devices. One metric we track is digital content services, defined as sales of new digital non-hardware services released after the double reduction policy. Sales of digital content services reached over RMB 200 million in Q2, with gross margins exceeding 50%. With persistent demand, we expect digital content services to keep growing for the next few quarters. Because of the quick ramp-up of our new products and services in the first half of the year and relatively strong demand from consumers across our business lines, we believe our prospects for the second half of the year are strong. With that overview, I would now like to share more color on our strategy and progress in the second quarter. Technology and innovation are the cornerstones of our business and directly deployed to our smart devices. Net revenues from smart devices reached RMB 239.9 million for the second quarter, up 16.3% year-over-year. Despite the…

Thank you, Dr. Zhou, and hello, everyone. Today, I will be presenting some financial highlights for the second quarter of 2022. We encourage you to read through our press release issued earlier today for further details. For the second quarter, total net revenue were RMB 956.2 million or USD 142.8 million. This represents a decrease of 2.4% from the second quarter of 2021. Net revenue from our learning services were RMB 563.6 million or USD 84.1 million representing a 7.3% decrease from the same period in 2021. I will attribute this decrease to the decline in revenue from the adult courses resulting from the decrease in demand due to the resurgence of COVID-19. Net revenue from our smart devices were RMB 239.9 million or USD 35.8 million, up 16.3% from the same period in 2021, driven by the popularity of the newly launched products since last year. Net revenue from our online marketing services were RMB 152.8 million or USD 22.8 million, representing an 8% decrease from the same period in 2021. The decrease was mainly attributable to the curtailed advertising budget of partially advertising customers. For the second quarter, our total gross profit was RMB 409.7 million or USD 61.2 million, representing an 18.1% decrease from the second quarter of 2021. Gross margin for learning services was 52.2% for the second quarter of 2022 compared with 58.8% for the same period in 2021. Gross margin for smart devices was 30.6% for the second quarter of 2022 compared with 43% for the same period in 2021. Gross margin for online marketing services was 27.7% for the same quarter of 2022 compared with 32.7% for the same period in 2021. For the same quarter, total operating expense were RMB 864.9 million or USD 129.1 million compared with RMB 755.1 million for…

[Operator Instructions] Our first question today will come from Elsie Sheng of Morgan Stanley.

Congratulations on the 2Q results. I have a question on review of the second half -- you mentioned that you have a strong view on the second half. Could you elaborate more on why we are confident on the outlook? And what area do we expect you to really see the potential?

Thank you, Elsie. This is Zhou Feng. There are a number of factors that give us confidence in the second half. Firstly, we have mostly completed our products and offering transitions after the double reduction last year. So our revenue structure, you see have changed very dramatically. So net revenue from new services and devices, as I just talked about, launched after double reduction already accounted for over 40% of our total net revenue in Q2. So we basically went from 0% to 40-plus percent in less than a year. And the rest, 60% are pretty stable businesses, including some devices that we launched before double reduction. And also our online marketing business and everything else. So this quick ramp-up of new business gave us confidence that we can actually continue to grow new revenue going forward. So we see this trend extend to second half of the year. So that's one. So secondly, sales of our smart devices continue to grow. So Q2 was actually a very challenging quarter for our device team because of COVID, because of the logistics difficulties and the surprising factor of the pandemic situation in April and -- especially in April and May. So despite that, revenue for our smart devices were up 16% in the quarter to RMB 239 million. So if you look at per months trend, April and May sales of devices were actually down multiple double-digit percentage. So a lot of challenge. And however, June sales rebounded very quickly to achieve for the overall -- for the whole quarter year-over-year growth. So we may -- I think we may still see challenges from COVID down the road. But as I think the government gets better at -- local governments gets better at handling these situations, and also the growing demand for our devices and our new device that we launched after Q2 and Q3. So we think we have already shown that, the demand for our learning devices is strong. And if you look at the whole learning device market, Frost & Sullivan they estimate that the smart learning devices market to be RMB 66 billion in last year, 2021 and expect it to grow to RMB 145 billion in 2026. So we think we have a pretty long run rate to grow here. And finally, our new digital content services are growing rapidly, and we expect to see continued fast growth in the second half of this year. As I said, the gross billings for digital content services reached over RMB 200 million in Q2, and gross margin was over 50%. So we expect this sector, digital content service. That's basically new services and products, not including the hardware to keep the momentum in the second half of this year. I hope that helps.

Our next question today will come from Brian Gong of Citigroup.

I notice we just mentioned that we plan to introduce smart learning pads. Can management give some more elaboration on this product, like what's the reason we launched this product. And what's our expectation for this product over the long run.

Yes, Brian. So the Youdao Smart Learning Pad was launched a couple of weeks ago. So it's already launched. So I think what's interesting here is that there's a clear generational transformation that is taking place in the learning tablet or education tablet market. So that's going from kind of content based or recorded video-based learning experience to a AI adaptive learning technology center experience. So of course, we all know that whenever there's this kind of a generational change either in technology or in a business model, yes, there's an opportunity for new players for newcomers. So that's basically what we are trying to leverage here. And we have -- and the whole learning tablet segment is pretty popular product segment. So overall, we think it's a good opportunity for us. So talking about the product form factor a little bit. So the AI adaptive learning technology is -- can be very effective if it is done right. So in the U.S. market, a lot of companies are offering adaptive learning products for school learning, and including, I think, Google, Talent Academy and PSC and other companies. So in China, our view is that home learning is actually the most promising market the adaptive learning technology to have a great impact because the sort of the tradition of actually apparent buying home learning devices. So with the Youdao learning pad, the AI can diagnose a learner's weak points either within 6 minutes of quick quizes or by actually mapping a picture of the learners school test kits. So then -- so it is very convenient. Then the learners learning efficiency can be increased by learning in a more personalized way with videos and exercises. So this is a very attractive value proposition for learners and that's the key benefit…

The next question will come from Liping Zhao of CICC.

I noticed the STEAM courses gross billing achieved 7% compound quarterly growth rate post double reduction policy. Could you please share the growth strategy for your STEAM cost sector? And what's Youdao’s competitive advantage in this business segment?

This is Su Peng. I will take the questions. And the first thing that we think we achieved faster and sustainable growth of the STEAM process, and gross billings increased over 900% year-over-year in Q2. We think that's basically from the numbers you can see that we just built up a very strong momentum for our -- for the business growth. And I think as Dr. Zhou discussed in his prepared remarks, we think we always try to build up the high-quality content and provide that kind of unique also different experience to our customers always. And if you see the -- for example, if you see about our Chinese core program, and there's almost -- right now its one of the biggest of our program, we are -- operating by us in the STEAM courses. And it's almost 2 years ago, we just released our products to the market. And we are not the only 1 at that time, solving that product, and we are not even the first one to our offering that services to the customers. But if you go back to see the performance of this product right now, you can see we have become at least 1 of the leading companies in these areas, and maybe the biggest 1 in this sector. And so we think what have achieved in this sector is simply put, we are not following the routine way to build up that program and to -- and create that service. And we leverage our technology edge into the products. It's kind of the gaming part. And we think we have experienced and learned a lot from the group, and how can we help them to build our brand and interesting and attractive programs for the kids. And we think we can…

Our next question today will come from Thomas Chong of Jefferies.

Can you share about the progress for our education digitization solutions?

Thank you, Thomas, this is Lei. For the education digitization solutions, the main product is Youdao Smart Linear Terminal. It targets a homework scenario with AI function. In the semester, over 30,000 students used it in the school and they collected more than 2 million pages of homework with the report from the homemade teacher would plan their targeted license more efficiently, with our personalized practice student would also enhance learning efficiency. Our homework digitalization solutions have been awarded by the typical cases of using information technology of homework management, new cities with an [indiscernible] by the government in the following 4 areas: Haidian in Beijing, [Zhejiang] in Hangzhou and [Sudo] and [Haitang] in Shanghai. In addition, Youdao art education was selected as one of the digital trade innovation and excellent application cases of Guangdong Province in 2022 and was the only 1 outstanding case of the Smart Education segment. In Q2, we also introduced a new compact [sport] education digitization products with our cutting-edge video analytics technology. It automatically recorded measures and analyse the performance of the students in the playground without any wearable device. As we know, the [sport] is advocated by the policy, and it has less English to become the third largest -- during the comparably educated stage. So the demand for the [sports] teachers has increased. And traditionally, the [sports] teacher have to cover dozens of students and manually cover their performance when they learn. And it also takes a lot of time to prepare the [sport] improvement. With our products, a lot of teachers no longer need to record a measure repeatedly, that have more time to give students more strategic advice with digital data and digest report derived from the students exercise. As for students, they have more chance to access at freely by themselves with probably any device. In addition, their parents can better understand their children physical condition and growing progress. On the whole, despite budget control from the government due to the COVID-19, we are optimistic to achieve better financial performance for education digitization solutions in the second half of the year.

And our next question today will come from Candis Chan of Daiwa.

I want to follow up on your earlier comments for the second half outlook, specifically for the vocational and adult courses given the current macro and also the COVID situation. How the demand recovery and also the growth outlook for the second half?

Su Peng here. I think because, first of all, there's another diversity in that sector, although they only – they’re all called vocational and adult courses. But in these sectors, there are diversified products and services in this area. So we are -- right now, we are focusing several different vertical sectors. And first of all, I think the graduate school entrance exam courses are likely to keep the momentum in the second half as well. And we think that courses is our top priority and adult courses in this year. I think if you see the numbers of the students who registered for the graduate school entrance exam, in 2022, it's reaching about over 4.5 million. So increase about almost 800,000 people compared with the same period of last year. So we think about there's a lot of -- the growing demand from the market. We think that's the reason why we are focused on these carriers. And the other thing that's also can leverage some of our advantage in these sectors. The first of all, that thing will be the users, and we are operating the largest dictionary apps in the China and most of the -- at least we think about roughly about half of the registers is above the 18 age, that means potential college students, and we think we can -- that's the first part. And then on the other hand, we're also operating the largest Chinese university MOOCs products. And in terms of the number of the registered college students, almost over 40% of university -- students in the university registered for our products. So we think about we have a great potential users too in our products. So we think we can easily leverage about our advantage to convert them to our product…

Our next question will come from Linda Huang of Macquarie.

I have 1 question regarding for the margin because we saw that a certain headwind for the second quarter. But looking into the longer term, how should we think about the normalized gross margin for the different business division? And in terms of the operating profit margin, can you also give us an outlook on what is the normalized level for the longer term?

Thank you, Linda. This is Wei. I will take your question. In respect to our gross margin, we saw decline from 51% in last quarter to 43% in this quarter. This change was mainly from the seasonality fluctuation due to the seasonality of the recognized revenue of our learning services. On revenue side [Technical Difficulty] new generation of Dictionary Pen X5, both of which potentially improve our gross margin. On cost side, we will continue to explore different ways to optimize our cost structure to improve our margin. Considering the factors mentioned above, we are very confident in our ability to improve our gross margin over the long term. Let's look at some details on the margin of our learning services and smart devices sector. For learning services, we expect a much higher revenue base in the second half year with the completion of our learning services transition, the economics will be expected to be back to normal level, and we expect the annual gross margin for our learning services were expected to be stable, even better than last year. As for smart devices, the lockdown policy caused significant uncertainty on the production and the delivery of our smart devices. Following a relatively slow in April and May, we saw signs of recovery across this business in June. And finally, we achieved a 15% annual increase on a year-over-year basis despite the challenge we faced during the COVID resurgence and adverse macro environment, we actively adapt and remain focused on our long-term strategy by continuing to strengthen our capabilities in creating value for our customers. The release of our new product series, such as X5 and Learning Pad, make it possible to achieve higher skills and better profitability in our smart devices category. As for our operating margin, while we dedicated resources to improving sales and marketing efficiency, as well as our staff costs, we are continuously strengthening our technical and R&D investment to maintain our advantages in technology. As you can see, in this quarter, our net loss narrowed by 12% to RMB 450 million. We have been working on the long-term solution to improve our operating margin.

Our next question today will come from [Leon Van of Haiti Securities].

My question is about could you please update the proportion of sales channel for online and offline for smart devices? And we understand that there could be some impact on Q2 and how do you see the momentum of sales of new service and new products in second half year?

Sure, so regarding the different sales channels, yes, so right now, over 50% of our devices sales are through online channels, yes. So the -- of course, the major e-commerce services are the key online channels. And also we have the live channels, the live video channels for sales of these devices also online. And the offline channels are also very important to us because we have been working with these partners for a long time. And through the several thousand, we have several thousand sales endpoints across the country, these are actually very important for kind of mid-income areas, not the Tier 1 cities, but the mid-income areas, mid-income cities. A lot of customers there, they like to buy pirated devices from the offline shops. And the Q2, the impact from COVID, it's actually several factors. Yes, let me explain that a little bit. So one is actually the delivery process. And the impact kind of is -- the key reason is that when people go online, they want to order a device. When they see that the device kind of takes several weeks or even sometimes even longer to arrive, it impacts their willingness to place the order. So that impacts our overall sales process and efficiency. So that's 1 of the key reasons. Of course, in kind of -- in Shanghai where people, they don't have -- the delivery cannot happen at all. Of course, there's basically no sales. But for other areas, there's still impact because of the logistic kind of difficulties. And the other impact is for storage and -- for the storage of the devices that we have some warehouses that's within the impacted area. So that's also another factor. And looking ahead, as I said, I think the local governments are getting increasingly better at handling the COVID events without actually incurring a lot of logistics troubles. So we see that as a fact that will help down the line. And also, we have also -- we have also kind of rearranged our warehouses so that it's more diversified in terms of locations. So we think that should help too. So overall, we are pretty -- we see promising trends for the device sales in the coming quarters. And the new Dictionary Pen X5 is -- we think it's a great product. So yes, check out the video on our IR website, and I think you will like it. And of course, we are looking at from -- to look at this from a very long perspective. So we think our teams have a lot of experience in designing good devices. So the learning tablets, learning pads are a very important category for us. So we will look at this category very carefully, and we will have new devices down the line. So yes, we will keep you posted.

Yes, and just 1 more point we think added here is just for the online offline channels, questions. If we think about this, if you go to the different tier of cities, that will be a little bit different following those comments. And you will see in the Tier 1, Tier 2 cities that they sell more devices through the online channel and e-commerce platforms in that area. But in the 3 tiers -- before we used to sell more through the offline channel in the Tier 3 and below cities. And right now, because of the penetration of the short video platform like Douyin, like the other platforms, and as Doctor mentioned, we host kind of the label channels in that platform. And we expect in the long run, that will be a change -- probably they'll be changed in other percentage of online and offline channels in the Tier 3 and below cities. That's what we think about that, that probably will be the trend in the long run. So I think that's my adding comments.

And that concludes the question-and-answer session. I would like to turn the conference back over to management for any additional or closing comments.

Thank you once again for joining us today. If you have any further questions, please feel free to talk to us at Youdao directly or reach out to TPG Investor Relations in China or the U.S. Have a great day.

The conference has now concluded. We do thank you for attending today's presentation. You may now disconnect your lines.