Results Beat Validates My Positive View Of Youdao (NYSE:DAO)

Elevator Pitch

Youdao, Inc. (NYSE:DAO) stock is still rated as a Buy.

Earlier, I outlined my expectations regarding Youdao’s financial outlook for full-year FY 2024 in my March 12, 2024 write-up. With the current article, I highlight how DAO’s above-expected Q1 2024 results have validated my favorable opinion of the company’s financial prospects.

I remain bullish on DAO in view of the company’s recent quarterly disclosures. Youdao’s Q1 2024 results beat has positive read-throughs for the company’s full-year performance. Furthermore, Youdao’s AI-related subscription offerings have good growth potential as evidenced by the robust growth in revenue for the latest quarter.

First Quarter Results Exceeded Expectations

DAO released the company’s Q1 2024 results announcement on May 23 before trading hours. Youdao’s latest quarterly financial performance was a positive surprise.

Revenue for Youdao rose by +20% YoY to RMB1,392 million in the first quarter of this year. This implies that DAO’s top-line expansion had accelerated significantly for the recent quarter. As a reference, the company achieved relatively more modest YoY revenue growth rates of +10% and +2% for Q3 2023 and Q4 2023, respectively. To make things even better, Youdao’s actual Q1 top line surpassed the consensus estimate of RMB1,324 million (source: S&P Capital IQ) by +5%.

In my previous March 2024 update, I shared my opinion that “a rapid rate of revenue expansion for its online marketing services business” and “the smart devices business’ turnaround” will most likely be the key revenue growth drivers for DAO this year. My view has been supported by Youdao’s latest quarterly top-line performance.

The online marketing services business’ revenue grew by +126% YoY to RMB493 million in Q1 2024. In its first-quarter earnings announcement, Youdao explained that its online marketing services business had benefited from higher “sales of performance-based advertisements” thanks to its “continued investments in cutting-edge AI technology.”

On the other hand, the sales contraction for DAO’s smart devices business narrowed significantly from -28% YoY for Q4 2023 to -15% YoY in the most recent quarter. There are good reasons to believe that the smart devices business’ top-line performance will continue to improve in the coming quarters. Youdao emphasized at the company’s Q1 2024 analyst call that it is “in the process of driving the recovery of the (smart devices) business” as “we build new sales channels and release new products” in the current year.

Separately, the company turned around from a normalized net loss attributable to shareholders of -RMB194 million for Q1 2023 to report a positive normalized net profit of +RMB20 million in Q1 2024. In comparison, the sell-side analysts’ consensus Q1 2024 bottom-line projection for DAO was a non-GAAP adjusted net loss of -RMB151 million as per S&P Capital IQ data.

The profitability turnaround for Youdao in the recent quarter can be attributed to the company’s efforts to optimize marketing expenses and the gross margin improvement for its largest business segment.

The company’s sales and marketing costs declined by -19% YoY to RMB455 million in the first quarter of this year. This also suggests that DAO’s sales and marketing costs-to-revenue ratio decreased from 49% in Q1 2023 to 33% for Q1 2024.

DAO’s learning services business is the company’s biggest segment, having contributed 52% of its Q1 2024 revenue. The gross profit margin for the learning services business expanded by +160 basis points YoY from 62.0% in Q1 2023 to 63.6% in the recent quarter.

I had mentioned earlier in my March 12, 2024 article that “the increased utilization of AI or Artificial Intelligence for DAO’s learning services is likely to 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 Q1 2024.

To sum things up, Youdao’s better-than-expected Q1 results have given me confidence that DAO’s full-year 2024 performance will be superior to that of last year.

Valuations Could Be Boosted By Fast-Growing And Recurring AI-Related Revenues

DAO is currently trading at a pretty undemanding 0.77 times consensus next twelve months’ Enterprise Value-to-Sales as per S&P Capital IQ data.

One valuation re-rating driver for Youdao could be the improvement in its financial performance. The market is anticipating that DAO’s revenue growth in RMB terms will accelerate from +7.5% last year to +10.0% this year, while the company’s normalized net loss is expected to narrow from -RMB475 million to -RMB95 million in the same time frame. These consensus forecasts are taken from S&P Capital IQ.

Another valuation re-rating driver for DAO might be the rapid expansion in recurring revenue relating to AI.

Youdao highlighted in its Q1 2024 results announcement that sales derived from “AI-driven subscription services” jumped by +140% YoY in the most recent quarter. At its first quarter analyst briefing, DAO shared that its AI subscription offerings include “translation apps” like Youdao Desktop Translation and a “digital human language coach” that helps in “IELTS (International English Language Testing System) exam” preparation known as Hi Echo.

The company’s revenue generated by “AI-driven subscription services” only accounted for a low-single-digit percentage of its top line in Q1 2024, so there is tremendous growth potential in this area. Furthermore, a gradual increase in top-line contribution from recurring subscriptions (as opposed to transactional revenue) will help to improve Youdao’s overall revenue quality.

It will be realistic to think that Youdao can trade at a higher valuation multiple in the future, when both its sales contribution from AI-related offerings and the proportion of recurring revenue grow over time.

Variant View

The major risks for DAO relate to the turnaround of the smart devices business and the growth of AI services.

A risk factor worthy of attention is that Youdao’s smart devices business fails to return to positive sales growth this year. DAO has already made the right moves to introduce new offerings and optimize sales channels, but a failure to execute well on these initiatives could lead to below-expectations sales.

Another risk factor that deserves to be watched is the revenue growth momentum for 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 turn out to be lower than expected.

Concluding Thoughts

My Buy rating for DAO stays unchanged. I am impressed with Youdao’s above-expected Q1 2024 financial performance and the strong growth of its AI offerings. Therefore, I view DAO’s shares as undervalued, considering that the stock trades at an appealing Enterprise Value-to-Revenue multiple of under 1 times.