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Elevator pitch
Youdao, Inc (New York Stock Exchange: Dow) The stock is still rated a Buy.
Earlier, I outlined my predictions regarding Youdao’s financial outlook for the entire fiscal year 2024 in my article dated March 12, 2024. In the current article, I highlight how the above DAO forecast The results of the first quarter of 2024 have validated my positive opinion of the company’s financial outlook.
I remain bullish on DAO in light of the company’s recent quarterly disclosures. Youdao’s results for the first quarter of 2024 feature positive readings of the company’s performance over the entire year. Furthermore, Youdao’s AI-related subscription offerings have good growth potential as evidenced by strong revenue growth during the latest quarter.
First quarter results exceeded expectations
The DAO released the company’s first quarter 2024 results announcement on May 23 before trading hours. Youdao’s latest quarterly financial performance was a positive surprise.
Youdao’s revenue increased +20% year-on-year to CNY 1,392 million in the first period quarter of this year. This means that DAO’s top line expansion has accelerated significantly over the last quarter. For reference, the company achieved more modest year-over-year revenue growth rates of +10% and +2% for Q3 2023 and Q4 2023, respectively. To make matters even better, Youdao’s actual top line in the first quarter exceeded the consensus estimate of CNY 1,324 million (Source: Standard & Poor’s Capital IQ) by +5%.
In my previous March 2024 update, I shared my view that the “rapid rate of revenue expansion for our online marketing services business” and “the transformation in our smart devices business” will likely be the key drivers of DAO revenue growth this year. My view has been supported by Youdao’s latest quarterly performance.
Revenue for its online marketing services business grew +126% year-on-year to RMB493 million in Q1 2024. In its first-quarter earnings call, Youdao explained that its online marketing services business benefited from rising “advertising sales performance-based” thanks to its “continued investments in cutting-edge AI technology.”
On the other hand, the sales contraction of DAO’s smart devices business narrowed significantly from -28% y/y for the fourth quarter of 2023 to -15% y/y in the last quarter. There are good reasons to believe that the top performance of the smart device business will continue to improve in the coming quarters. Youdao confirmed in the company’s analyst call for the first quarter of 2024 that it is “in the process of driving the recovery of the (smart devices) business” as “we are building new sales channels and releasing new products” in the current year.
Separately, the company went from a net normalized loss attributable to shareholders of -CNY194 million for the first quarter of 2023 to report a positive normalized net loss of +CNY20 million in the first quarter of 2024. In comparison, the analyst consensus is on the sell side Q1 2024 bottoms out – DAO’s linear forecast was a non-GAAP adjusted net loss of -CNY151 million according to Standard & Poor’s Capital IQ Data.
The turnaround in Youdao’s profitability last quarter can be attributed to the company’s efforts to optimize marketing expenses and improve the gross profit margin of its larger business segment.
The company’s sales and marketing costs fell by -19% year-on-year to CNY455 million in the first quarter of this year. This also indicates that DAO’s sales and marketing costs to revenue ratio decreased from 49% in Q1 2023 to 33% in Q1 2024.
DAO’s Learning Services business is the company’s largest segment, contributing 52% of Q1 2024 revenue. Gross margin for the Learning Services business expanded +160 basis points year over year from 62.0% in Q1 2023 to 63.6 % in the last quarter.
I previously stated in my March 12, 2024 article that “increased use of artificial intelligence or AI for DAO’s learning services will likely translate into higher gross margins” by “making its teachers more productive with the help of AI.” As such, it is reasonable to assume that AI would have played a role in improving the profitability of Youdao’s learning services segment for the first quarter of 2024.
To sum things up, Youdao’s better-than-expected Q1 results give me confidence that the DAO’s full-year 2024 performance will be superior to last year’s performance.
Valuations could be boosted by fast-growing, recurring AI-related revenues
DAO is currently trading at a very accommodating level of 0.77 times consensus enterprise value to sales for the next 12 months according to Standard & Poor’s Capital IQ Data.
One of the driving factors for Youdao’s revaluation may be the improvement in its financial performance. The market expects DAO’s revenue growth in RMB terms to accelerate from +7.5% last year to +10.0% this year, while the company’s normalized net loss is expected to shrink from -CNY475 million to -CNY95 million in the same time frame. These consensus forecasts are taken from Standard & Poor’s Capital IQ.
Another driver for DAO revaluation may be the rapid expansion of recurring revenue related to AI.
Youdao highlighted in its Q1 2024 results announcement that sales derived from “AI-driven subscription services” jumped +140% year-on-year in Q4. In its Q1 analyst briefing, DAO shared that its AI subscription offerings include “translation apps” like Youdao Desktop Translation and a “digital human language coach” that helps prepare for the IELTS (International English Language Testing System) exam known as Hi Echo . .
The company’s revenue generated from “AI-driven subscription services” represented only a low-single-digit percentage in the first quarter of 2024, so there is huge growth potential in this space. Moreover, gradually increasing the top-line contribution from recurring subscriptions (versus transaction revenue) will help improve Youdao’s overall revenue quality.
It would be realistic to believe that Youdao can trade at higher valuation multiples in the future, when both its sales contribution from AI-related offerings and proportion of recurring revenues grow over time.
Variable width
The main risks facing the DAO relate to the transformation of the smart device business and the growth of artificial intelligence services.
One risk factor worth noting is that Youdao’s smart device business has failed to return to positive sales growth this year. DAO has already taken the right steps to introduce new offerings and improve sales channels, but failure to execute well on these initiatives could result in sales below expectations.
Another risk factor worth monitoring is the revenue growth momentum of DAO’s “AI-driven subscription services.” The market could be disappointed if Youdao’s actual AI-related revenue and recurring revenue contribution for the future turns out to be lower than expected.
Concluding thoughts
My Buy rating for DAO remains unchanged. I’m impressed by Youdao’s above-expected financial performance in Q1 2024 and the strong growth of its AI offerings. Therefore, I view DAO shares as undervalued, considering that the stock trades at an attractive enterprise value to revenue multiple of less than one.
