Is Youdao finally learning how to earn profits?

The education spinoff of gaming giant NetEase reported narrowing losses in the second quarter and said it expects to be profitable on an operating basis this year

Key Takeaways:

• Youdao reported its revenue grew 14.5% revenue in the first half of 2024, while its operating loss narrowed by more than 90%
• The education company’s revenue from online marketing services doubled in the first half, while its learning services and smart devices revenue fell by 4% and 20%, respectively

By Edith Terry

The last few years have been a learning period for Youdao Inc. (DAO.US), as the separately listed education arm of gaming giant NetEase (NTES.US) was hit by a wave of regulatory tightening against big tech in China. The company’s K-12 online education business was obliterated during a crackdown on after-school tutoring companies, leading Youdao to sell that business in 2021.

Since then, investors have shown little love for the company. Its shares are down 17% so far this year and have lost about three-quarters of their value since their New York listing in 2019. That downward trajectory continued after it released its second-quarter results last week, even as its latest report showed sharply narrowing losses and the potential for profits in the not-too-distant future for a company that has nearly always lost money.

Despite that relatively upbeat outlook, investors bid down the shares by 11% in the days after the latest report’s release.

Youdao thinks investors should give it a new look. Vice President of Finance Wayne Li told analysts on the company’s earnings call last week that a 92% drop in its operating losses in the first half, to 43 million yuan ($6 million) gives “us confidence in achieving positive operating income for the full year of 2024 despite intense competition and various uncertainties.”

Youdao reported its revenue rose by 14.5% to 2.7 billion yuan in the first half of the year, while its net loss narrowed by 83% to 85.9 million yuan. Its operating loss for the six-month period shrank 92% to 42.6 million yuan from 484.9 million yuan a year earlier.

Youdao actually turned a small profit in this year’s first quarter before going back into the red in the second as it sharply boosted its operating expenses. The latest results noted that NetEase, which is highly profitable, continues to offer financial support for Youdao through 878 million yuan in short-term loans and $126.5 million in long-term loans drawn from a $300 million revolving loan facility. 

Youdao seems to be inching ever closer to profitability, even though that road has been far from smooth. That uneven progress was reflected in the mixed results for the company’s three core business segments in the second quarter.

Its online market services were the star performer for the three-month period, with revenue up 68.4% to 511.2 million yuan. But revenue from smart devices fell by 25% to 166.7 million yuan, and learning services revenue also dropped by 5.5% to 643.8 million yuan. Its net loss for the quarter narrowed by about two-thirds year-on-year to 99.5 million yuan from 299.2 million yuan.

Pivot to advertising

A closer look at the results may lead some to conclude the company is inching away from its roots in edtech to becoming a platform offering marketing services for tech companies looking to promote their artificial intelligence (AI) tools. Those marketing services, which also use AI tools, accounted for about 40% of Youdao’s revenue in this year’s second quarter, compared with just about 15% two years earlier.

Customers for those services include big names like ByteDance and Baidu’s Ernie, as well as NetEase. In the second quarter, net revenue from ads by customers promoting their AI tools grew by more than 100% quarter-over-quarter, CEO Zhou Feng said on the earnings call. The strong growth in marketing services helped Youdao improve its gross margin to 48.2% in the second quarter from 47.0% a year earlier.

One of the main drivers in the marketing services surge was overseas advertising by Chinese companies. “Leveraging our deep understanding of client needs, we have accelerated the development of international advertising infrastructure,” said Youdao President Jin Lei. “By the end of the second quarter, our international carrier database has exceeded 7 million, a year-over-year increase of over 200%.”

The numbers suggest that Youdao is taking cues from Facebook owner Meta, which made nearly all of its revenue from advertising last year, much of it driven by personalized algorithms that identify and deliver ads to consumers who are most likely to respond to them. In Youdao’s case, its ads attach to digital content such as its dictionaries and its large language model called Ziyue, or “Ask Confucius.”

Youdao’s learning services for children and adults are subscriber or fee-driven, and that part of its business is shrinking fast, falling from 64% of total revenue in the first half of 2022 to about half in the first six months of this year. The company’s other main revenue source, smart devices is on a similar trajectory, falling from 23% of revenue to 12.8% over the same period.

So, what does all this mean? For one thing, edtech in China seems to be finding new outlets after being banned from targeting after-school tutoring for K-12 students. Recent government calls promoting “high-quality” consumption should also work in Youdao’s favor, since it increasingly brands itself as an AI company in addition to its core business providing learning services.

In its struggling smart device segment, Youdao has started moving down its price points to a more mass-market level, though it still charges 50 yuan to 100 yuan more for its styluses than its peers by promoting their AI features. Sales of its entry-level dictionary pens grew by 50% year-over-year in the second quarter in unit terms, and net revenue was up by 10%.

In its learning services, Youdao now focuses entirely on non-academic courses on Chinese literature and computing, which are still allowed after the earlier crackdown. “Everyone knows that it’s key for future careers,” CEO Zhou said of Youdao’s computing courses.

Despite continuing to lose money, the analyst community remains relatively upbeat on Youdao as its business model shifts. Of the 10 who follow the company polled by Yahoo Finance, nine rate it as a “strong buy” or “buy.”

Youdao’s price to sales (P/S) ratio of 0.48 makes it look undervalued compared to Gaotu Techedu (GOTU.US), which trades at 2.48. After losing two-thirds of its business in the education crackdown, Gaotu has reinvented itself as an adult education company. Recently listed corporate education services provider YXT.com (YXT.US) has an even higher P/S ratio of 8.33, suggesting that investors may want to take a closer look at Youdao.

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