maybefalse
My Buy investment rating for Youdao, Inc.’s (NYSE:DAO) shares stays unchanged. DAO’s Q2 2024 bottom line beat and results briefing commentary indicate that the company is coming closer to reaching an operating profitability inflection point.
DAO’s first quarter results and its AI-related revenues were the focus of the prior May 27, 2024 update. I review Youdao’s latest second quarter bottom line performance with this latest write-up.
Narrower Than Expected Losses Were The Key Highlight Of DAO’s Q2 Results
Youdao’s bottom line performance for the second quarter of 2024 was much better than what the market had anticipated.
The company’s Q2 2024 top line was largely in line with expectations.
As disclosed in its results release, DAO’s revenue expanded by +9.5% YoY to RMB 1,322 million for the recent quarter. A +68.4% YoY growth in sales generated by the online marketing services business more than offset the -25.0% YoY revenue drop and -5.5% top-line contraction for the learning services and smart devices businesses, respectively in Q2 2024. The company’s actual Q2 revenue was marginally or -0.4% below the consensus top-line projection of RMB 1,327 million as per S&P Capital IQ data
The significant improvement in DAO’s losses on a YoY basis was the major positive takeaway from the company’s latest quarterly performance.
DAO’s operating loss narrowed from -RMB 289 million in the second quarter of last year to -RMB 73 million for the second quarter of the current year. The company’s non-GAAP net loss attributable to shareholders improved from -RMB 284 million in Q2 2023 to -RMB 96 million in Q2 2024. Youdao’s most recent quarterly normalized net loss attributable to shareholders was much better than the consensus bottom-line estimate of -RMB 129 million, according to data sourced from S&P Capital IQ.
Youdao has done a great job managing the company’s costs, and this has paid off in the form of a bottom-line beat for Q2 2024.
The aggregate operating costs for DAO decreased by -17.2% YoY to RMB 709 million. The company’s largest expense line item is S&M (Sales & Marketing) costs, which accounted for 72.7% of its total operating costs in the latest quarter. Youdao’s S&M costs as a proportion of total revenue declined from 48.7% in Q2 2023 to 39.0% for Q2 2024.
Youdao Is Expected To Deliver Positive Operating Profit In Fiscal 2024
The operating profitability inflection point for DAO is in sight this year.
At the company’s Q2 2024 analyst call, Youdao indicated its “confidence in achieving positive operating income for the full-year of 2024.” This is consistent with the sell-side analysts’ consensus FY 2024 operating profit forecast of +RMB 54.0 million.
DAO’s operating loss narrowed substantially from -RMB 485 million in the first half of last year to -RMB 43 million for the first half of this year. There are good reasons to believe that Youdao can register positive operating profit in 2H 2024 and full-year FY 2024.
One factor is that Youdao’s financial performance has historically been better in the latter half of the year, which points to seasonality effects. As an example, DAO’s 2H 2023 top line was +27.4% higher than its revenue for 1H 2023. Also, the company recorded a positive operating income of +RMB 19 million for 2H 2023 vs. an operating loss of -RMB 485 million in 1H 2023. In its FY 2023 20-F filing, Youdao noted that its second half results are usually superior to that for the first half due to “the commencement of school term in September and various e-commerce promotions in November and December.”
Another factor is that DAO has shown a willingness to trade off slower top-line expansion for an improvement in profitability. The company shared at its second quarter analyst briefing that it has placed a greater emphasis on “higher ROI (Return On Investment) metrics” and “labor efficiency” for certain “non-core businesses.” This implies that Youdao is keen on expanding the profit margins of specific businesses at the expense of lower revenue contribution.
Also, I mentioned in the preceding section that Youdao has found success in lowering the company’s S&M expenses in a meaningful way for the recent quarter. DAO touched on the utilization of “AI technology to optimize marketing efficiency” at its Q2 results briefing, so there is room for the company’s S&M costs-to-revenue ratio to decline further in the quarters ahead.
Key Risks
The two most significant risk factors relate to Youdao’s operating profitability outlook.
A failure to control costs well will make it tough for DAO to meet its positive operating profit goal in the current fiscal year.
Youdao’s second half performance might not be significantly better than its first half results, if e-commerce sales and school enrollments (the typical key drivers of a seasonal improvement in 2H as per 20-F filing) are below expectations.
Closing Thoughts
The market is now valuing Youdao at a consensus next twelve months’ Price-to-Sales or P/S ratio of 0.45 times. This is way below its three-year historical P/S multiple mean of 1.1 times according to S&P Capital IQ data. It is reasonable to expect DAO’s P/S metric to re-rate in a positive manner, when the company is able to generate positive operating profit. This explains why I have chosen to retain a Buy rating for Youdao.
