DAO - Youdao: Q3 2023 Results Beat Validates My Bullish View

2023-11-17 09:00:09 ET

Summary

• Youdao's Q3 2023 top line, gross margin, and bottom line turned out to be better than what the sell-side analysts had projected.
• DAO's current $40 million share buyback program expires in November 2025, but it has already completed close to half of its share buyback plan, or $18.3 million to be exact.
• I still remain bullish on DAO, taking into account its third quarter results beat and its faster-than-expected pace of share repurchases.

Elevator Pitch

I rate Youdao, Inc. ( DAO ) stock as a Buy.

In my prior update published on July 25, 2023, I wrote about Youdao's growth potential associated with Artificial Intelligence or AI, and I analyzed the stock's key valuation metrics.

I review Youdao's recent quarterly results and assess the progress of its share buyback plan in the current article. DAO's Q3 2023 financial performance beat the market's expectations, and the company also executed on a greater quantum of share repurchases than what I had anticipated. Considering these positive factors, I continue to award a Buy rating to Youdao.

DAO's Q3 2023 Performance Was Above Expectations

Youdao issued a press release disclosing the company's results for the third quarter of 2023 on Thursday November 16 after the market closed. The company's headline numbers and key metrics came in better than what the sell-side analysts had previously estimated.

DAO's top line rose by +9.7% YoY from RMB1,402.4 million in the third quarter of the prior year to RMB1,538.8 million in the most recent quarter. Before the company reported its actual third quarter results, the analysts had projected that Youdao's revenue would increase by +5.2% YoY to RMB1,474.7 million for Q3 2023 as per S&P Capital IQ consensus data. This means that Youdao had achieved a decent +4.3% revenue beat in the latest quarter.

The company's gross profit margin expanded by +170 basis points YoY and +890 basis points QoQ to 55.9% in Q3 2023. Youdao's actual Q3 2023 gross margin turned out to be +3.4 percentage points above the market's consensus projection of 52.5% (source: S&P Capital IQ ).

The actual Q3 2023 normalized net loss of -RMB67.3 million for Youdao was significantly narrower than the sell side's consensus estimate of -RMB110.0 million based on S&P Capital IQ data. As a comparison, DAO's non-GAAP adjusted net losses were wider at -RMB164.4 million and -RMB283.6 million for the third quarter of 2022 and the second quarter of 2023, respectively.

The above-expectations Q3 2023 revenue for Youdao was largely attributable to the strong performance of the company's online marketing services business. Sales generated from DAO's online marketing services segment jumped by +113.5% YoY from RMB157.5 million for Q3 2022 to RMB336.1 million in Q3 2023. In its recent third quarter results release, Youdao explained that it "provided users with more personalized solutions" by "leveraging AI technology" for its online marketing services business in the latest quarter and this was the main reason for this segment's outperformance.

The online marketing services business was also the star for Youdao relating to the company's better-than-expected gross profit margin and bottom line. Gross margin for DAO's online marketing services segment increased by +480 basis points YoY to 31.9% in Q3 2023, which Youdao credited to "improved gross margin profile of performance-based advertisements" in its Q3 results press release. Youdao's gross margin expansion for the recent quarter also benefited from positive operating leverage for the learning services business segment, and the introduction of higher-margin products for the smart devices business segment.

DAO's third quarter bottom line was also boosted by excellent cost management. Notwithstanding the company's +9.7% YoY top line growth in the latest quarter, Youdao's S&M (Sales and Marketing) and R&D (Research and Development) costs decreased by -5.0% and -12.0%, respectively on a YoY basis in Q3.

I noted in my previous late-July write-up that "DAO can ride the generative AI wave without increasing R&D (Research & Development) spending in a big way", and this is reflected in Youdao's most recent set of above-expectations quarterly results.

Youdao Has Made Good Progress With Its Share Buyback Plan

DAO has an existing $40 million share buyback plan that is in effect for the period between November 2022 and November 2025.

It is encouraging to know that Youdao has already completed close to half of the company's share repurchase program in less than a year since the initiation of the new share buyback program. DAO revealed in its Q3 2023 results release that it has spent $18.3 million repurchasing its own shares between November 17, 2022 and September 30, 2023. It is fair to say that Youdao has engaged in accelerated share repurchases.

Youdao's cash and investments amounted to RMB360.1 million or $49.4 million at the end of September this year, which represents about 9% of the company's current market capitalization. In other words, the company has the financial strength to execute on its current share repurchase plan.

Based on its closing price of $4.36 at the end of the November 15, 2023 trading day, DAO is now trading at consensus forward next twelve months' Enterprise Value-to-Revenue and Price-to-Sales multiples of 0.83 times and 0.68 times (source: S&P Capital IQ ), respectively. It is reasonable to deem Youdao's shares as undervalued, as the market is currently valuing the stock at less than 1x revenue. As such, it is value-accretive for DAO to do accelerated share buybacks at its current price levels. This also sends a clear message that Youdao recognizes the undervaluation of its stock and it is doing the right thing by purchasing its own shares at a discount to fair value.

Closing Thoughts

A Buy rating for DAO is maintained. I made the decision after taking into account Youdao's third quarter results beat and its accelerated share buybacks.

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