DAO - Youdao: A Bright Future Lies Ahead

2023-05-11 11:40:38 ET

Summary

• Youdao, Inc.'s financial outlook for 2023 is favorable, as I expect Youdao to report solid top line growth and a narrower net loss in the current year.
• In the medium to long term, Youdao, Inc. can take advantage of the growing interest in Artificial Intelligence or AI to create new revenue streams from related products.
• I stick to a Buy rating for Youdao in consideration of the company's short-term prospects and growth runway for the long run.

Elevator Pitch

I continue to have a Buy rating assigned to Youdao, Inc. ( DAO ) stock.

In my prior article for Youdao written on February 6, 2023, my focus was on previewing the company's Q4 2022 financial performance. I had previously predicted that DAO won't disappoint the market with its fourth quarter results, and I was proven right as both its top line and bottom line exceeded expectations .

I touch on Youdao's full-year fiscal 2023 outlook and the company's efforts to capitalize on the rise of Artificial Intelligence, or AI, in the current update. As per my analysis, I conclude that DAO has a bright future ahead and it should trade at a higher valuation multiple in consideration of its growth prospects. As such, I make no changes to my existing Buy rating for DAO.

Strong Top Line Growth And Narrower Net Loss Are Expected In 2023

I am of the opinion that Youdao is well-positioned to achieve meaningful revenue expansion and narrower losses this year. Specifically, I expect DAO's top line in local currency terms to grow at least +20% to over RMB6 billion for FY 2023. I see Youdao's normalized net loss per share halving from RMB5.18 last year to RMB2.59 for the current year, with the company delivering its first-ever quarter of positive earnings by Q3 2023.

I have identified three growth drivers for DAO.

Youdao's first growth driver is smart devices. I mentioned in my early February write-up for DAO that the "educational smart hardware" market in China is projected to grow by +100% between 2021 and 2024 while the company's market share is a mere 2% even though it is a leading company in this space. Separately, Frost & Sullivan's research suggests that Youdao is operating in a fast-growing segment of the educational smart devices market, "translation pens, which market is still emerging," as per the IPO prospectus of DAO's peer, Hong Kong-listed educational device company, Readboy Education [2385:HK]. The combination of share gains and a larger educational smart devices market in the future will naturally translate into robust sales growth for Youdao.

The second growth driver for the company is an increase in demand for DAO's learning services offerings in the area of computer programming and STEAM (Science, Technology, Engineering, Arts and Mathematics) subjects. The "ban on for-profit school tutoring" as highlighted in an earlier July 25, 2021 Seeking Alpha News article has prompted Chinese parents to invest in other non-academic areas to support their children's education and development. As a result, Youdao's STEAM- and computer-related education services are expected to continue enjoying strong demand in the foreseeable future.

DAO's third growth driver relates to exploring new channels of selling the company's learning services. Besides organizing in-person classes, Youdao has also rolled out digital courses relating to creative writing (Youdao Literature) and board games (Youdao Go) that offer interactive content. At the company's FY 2022 earnings briefing , DAO revealed that "these services (digital learning courses providing interactive content) have consistently expanded for us in 2022." It is reasonable to be hopeful that the positive growth momentum relating to Youdao's digital courses in the prior year can be sustained in 2023, as DAO comes up with similar offerings in different categories (e.g., introducing digital courses for other types of board games).

As Youdao continues to deliver reasonably strong top line expansion, the company's bottom line should also benefit from positive operating leverage translating into narrower losses (and eventually profitability).

Capitalizing On Long Term Growth Opportunities In Artificial Intelligence

According to Chinese financial portal SINA's May 6, 2023 news report translated using Google Translate, Youdao had "become one of the first few companies in China to implement AIGC (AI-generated Content) technology in the Chinese education industry" with the introduction of an "English conversation practice AI application" in early-May

Previously, DAO had emphasized at its 2022 earnings call that "AIGC and large language models are going to have a significant impact on education technology." Youdao also guided for "new products" in 2023, and "a lot of new ideas" for 2024 and beyond.

Youdao's other AI-related products have also done pretty well. At its most recent results briefing, DAO highlighted that the sales volume its new "Youdao Smart Learning Pad X10" with an "AI-supported learning dashboard for better personalized learning experiences" introduced in Q4 2022 was almost 100% better than its earlier Y10 model.

AI is a long-term growth theme, and Youdao has the ability to roll out new product and service offerings to meet demand in this area as evidenced by its recent new product launches mentioned above.

Youdao Valuations

DAO is currently valued by the market at a substantial discount to the company's peers based on the Enterprise Value-to-Revenue valuation metric.

Peer Valuation Comparison For Youdao

Source: S&P Capital IQ.

Youdao's expected top line expansion is on par with Readboy Education and slower than iFlytek as per the peer comparison table presented above. It won't be unreasonable for DAO to command a much higher Enterprise Value-to-Revenue multiple in the 1.5-2.0 times range to be on par with its peer Readboy Education in my opinion.

Closing Thoughts

I have a favorable view of Youdao, Inc.'s growth outlook for both the short term and long run, but DAO trades at a substantial valuation discount to peers, which I think is warranted. In that respect, a Buy rating for Youdao is justified.

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