DAO - Youdao: Staying Bullish On AI Growth Opportunities And Valuations

2023-07-25 11:48:35 ET

Summary

• Youdao, Inc.'s intermediate-term financial prospects are good, considering that the company can leverage on the rise of AI without investing heavily in R&D going forward.
• DAO's consensus forward price-to-sales and normalized P/E multiples have come down to pretty attractive levels, as the company's share price declined by -23.9% in the last three months.
• I leave my Buy rating for Youdao unchanged following an assessment of DAO's growth opportunities relating to AI and its current valuation metrics.

Elevator Pitch

My Buy investment rating for Youdao, Inc. ( DAO ) shares stays unchanged. Earlier, I evaluated DAO's financial prospects for FY 2023 with my May 11, 2023 write-up for the company.

With this latest article, I assess Youdao's medium-term growth outlook in view of new growth opportunities emerging as a result of the rise of generative AI. My analysis leads me to the conclusion that DAO can ride the generative AI wave without increasing R&D (Research & Development) spending in a big way. Also, Youdao's share price weakness in recent months means that DAO is now attractively valued with consensus forward price-to-sales and P/E valuations below 1 times and 10 times, respectively. Therefore, I choose to maintain a Buy rating for Youdao.

Youdao Is A Play On Generative AI

The current sell-side analysts' consensus financial projections (Source: S&P Capital IQ ) for Youdao suggest that the company is expected to deliver solid revenue growth and a meaningful improvement in profitability for the intermediate term. Specifically, DAO's top line in RMB or local currency terms is estimated to expand by a +20.1% CAGR for the FY 2022-2025 period. Also, Youdao is forecasted to witness narrowing losses for FY 2023 and FY 2024 prior to turning profitable in FY 2025.

In my view, Youdao's ability to capitalize on the rise of generative AI while keeping a lid on costs is the major factor contributing to its excellent medium-term financial outlook.

I cited a Chinese news article referring to Youdao as "one of the first few companies in China to implement AIGC (AI-generated Content) technology in the Chinese education industry" in my prior May 2023 update for DAO. Youdao has rolled out a couple of new AI-related products recently, and one of them is Youdao Desktop Translation as detailed in the chart below.

An Overview Of The Key Features Of DAO's New AI Offering, Youdao Desktop Translation

At its Q1 2023 results call , DAO shared that "the AI Box feature" incorporated into Youdao Desktop Translation drove a "200% year-over-year increase in translation subscription fees" for the company in the recent quarter.

Youdao also revealed at the company's most recent quarterly results briefing that its other new AI offerings include "Youdao AI Speaking in Youdao Dictionary Pen" and a "generative AI-based Go game review." DAO indicated that the monthly active users or MAUs for its Youdao Dictionary Pen rose by +40% YoY in Q1 2023, as the new "AI speaking" feature gained traction with users.

I have a positive opinion of the significant growth in translation subscription fees and MAUs for the dictionary pen for DAO with the introduction of new AI offerings. This implies that the launch of new products and services powered by generative AI could provide a substantial boost to DAO's future top line expansion in the mid-to-long term.

DAO Can Leverage On AI Without Incurring Substantial Costs In The Future

Interestingly, Youdao's roll-out of new AI offerings and the resulting growth in translation subscription revenue and dictionary pen MAUs haven't come at the expense of higher research & development or R&D costs.

In fact, DAO's R&D costs decreased by -10% YoY from RMB203 million for Q1 2022 to RMB183 million in Q1 2023. Youdao explained at its first quarter results call that it doesn't "need to increase overall R&D expenses to deploy generative AI", as it "will be leveraging our existing investments." DAO noted in its most recent quarterly results briefing that it has begun investing in AI-related research since "2017 with the release of the Youdao Neural Machine Translation technology."

DAO's recent quarterly metrics and management commentary provide support for the market's view that the company's profitability is expected to improve in the years ahead, even though it will be leveraging on AI to register strong top line growth.

Recent Share Price Correction Offers Buying Opportunity

Youdao's shares have almost lost a quarter of their value in the past three months, with the company's stock price pulling back by -23.9% for this time period.

DAO's valuations have become more enticing with the recent correction in the company's share price.

Youdao currently trades at 0.64 times consensus forward the next twelve months' price-to-sales as per S&P Capital IQ data, which is much lower than DAO's three-year average price-to-sales ratio of 2.23 times. The market also values DAO at a consensus forward FY 2025 (the year where Youdao is expected to turn profitable) normalized P/E multiple of 9.8 times now.

The stock is valued by the market at below 1 times price-to-sales, even though the company's consensus FY 2022-2025 top line CAGR is pretty good at +20.1%. Separately, a P/E ratio of under 10 times seems too low for an AI play such as Youdao.

As such, it is reasonably fair to label Youdao's shares as undervalued. This suggests that the recent pullback in DAO's stock price represents an attractive investment opportunity for investors.

Concluding Thoughts

I retain my Buy rating for DAO. The market has yet to price in Youdao's positive growth outlook supported by new AI offerings into its stock price and valuations. This explains why I still have a bullish view of Youdao's shares.

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