DAO - Youdao: Don't Ignore Smart Devices Business' Growth Potential

Summary

• There shouldn't be negative surprises when Youdao reports its Q4 2022 results in late-February.
• I think that DAO's smart devices business has a long growth runway, and I view the stock's current price-to-sales valuation as undemanding.
• I rate Youdao's shares as a Buy now, after previewing DAO's fourth quarter results and assessing the growth potential of its smart devices business.

Elevator Pitch

My rating for Youdao, Inc.'s ( DAO ) shares is a Buy.

I reviewed Youdao's financial results for the second quarter of the previous year with my earlier write-up for DAO published on August 23, 2022.

In this latest update, I raise my investment rating for DAO from a Hold previously to a Buy now. Youdao's current valuations have yet to factor in positives such as the long term growth outlook for its smart devices business and the low likelihood of below-expectations Q4 2022 results.

Q4 2022 Earnings Preview

DAO will disclose the company's Q4 2022 financial performance on February 23 , before the open. The market expects Youdao to deliver a good set of results for the fourth quarter, and I am of the view that DAO will live up to the analysts' expectations.

Youdao's top line growth is projected to accelerate from +1.1% YoY in the third quarter of last year to +36.4% YoY for the final quarter of 2022 in local currency or RMB terms as per consensus financial data obtained from S&P Capital IQ . The sell-side sees DAO's EBIT losses narrowing from -RMB203.0 million in Q3 2022 and -RMB169.3 million in Q4 2021 to -RMB78.7 million for Q4 2022.

According to news reports by local Chinese media, Youdao's product sales during the Double 11 Shopping Festival in November last year jumped by +88% YoY to around RMB120 million, and its brand of dictionary pens generated the highest sales among competitors on JD.com ( JD ) and Alibaba's ( BABA ) Tmall platforms for Double 11. This means that there is a high probability of DAO's actual revenue for Q4 2022 coming in inline with what the market expects at the very least.

Separately, DAO has been optimizing the company's revenue mix to drive an improvement in profitability. Specifically, Youdao is working very hard to grow the company's revenue contribution from learning services and smart devices at a faster pace.

The gross profit margins of DAO's learning services and smart devices businesses are at the 60% and 40% levels, respectively; while Youdao's online marketing services business generates relatively lower gross margin in the 20%-30% range. By introducing new smart devices and learning services, DAO is able to gradually shift its revenue mix in favor of higher margin businesses such as learning services and smart devices over time. As such, it is reasonable to assume an increase in gross margin and a narrowing of operating losses for Youdao in the fourth quarter of 2022 and beyond.

In conclusion, the risk of a substantial share price correction for Youdao post-Q4 2022 earnings announcement is low, as I expect DAO to report in-line financial results in a few weeks' time.

Smart Devices Business' Growth Potential

I have an optimistic view of the growth prospects for Youdao's smart devices business.

Chinese private equity firm, DuoJing Capital , published a research report titled "China Educational Smart Hardware Industry Report" in 2022. According to DuoJing Capital's research, the number of online education participants grew from 140 million in 2016 to 320 million by 2021. During this time frame, the penetration rate of "educational smart hardware" among Chinese online education participants increased from 19% to 32%.

With expectations that smart devices relating to education should become even more popular in the future, DuoJing Capital has forecasted that the size of the "educational smart hardware" could potentially double from RMB65.4 billion for 2021 to RMB131.8 billion in 2024.

Sales of DAO's smart devices expanded by a strong +40% YoY to RMB357 million in the third quarter of 2022. Although Youdao is the market leader in specific smart device product categories in China such as dictionary pens, its annualized revenue contribution from the smart devices business is only approximately RMB1.4 billion. This implies that DAO only has a low single-digit share of China's education-related smart device market (RMB65.4 billion market size estimate for 2021). In other words, Youdao is well-positioned to grab a larger share of the growing smart device market in China by leveraging on its current market leadership to launch more new products.

Notably, Youdao also indicated at its Q3 2022 earnings briefing that the smart devices business has the potential to achieve higher profit margins in the future as a result of "the application of advanced AI technology and unique learning content."

Share Buybacks And Valuations

In November 2022, DAO revealed that it has initiated a new $20 million share buyback program which expires at the end of three years.

This share repurchase plan isn't very significant in quantitative terms. Assuming that Youdao spends the full $20 million on share buybacks in three years, this works out to be an annualized share buyback yield of 0.7%.

Nevertheless, the new share repurchase program still send positive signals about the stock's undervaluation. As per S&P Capital IQ's valuation data, Youdao is currently valued by the market at a consensus forward price-to-sales ratio of 1.03 times. In comparison, the three-year mean price-to-sales valuation multiple for DAO is 3.13 times, and Youdao has traded as high as 10.6 times forward price-to-sales in the past three years.

Concluding Thoughts

I am of the opinion that there is a mismatch between Youdao's current undemanding valuations and its reasonably good business outlook. DAO's current price-to-sales multiple is appealing on an absolute and a relative basis (compared to history). I expect Youdao's upcoming Q4 2022 results to meet analysts' expectations, while I think that DAO's smart devices business has significant growth potential.

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