►Youdao's first full-year financial report since listing shows soaring costs, increasing incomes and no profits.
►The firm's revenue source shifting from online marketing services to education.

Recently, NetEase Youdao (DAO:NYSE) released its first annual financial report since its listing on October 25, 2019. According to disclosed figures, the online education arm of NetEase achieved an annual operating income of CNY 1.305 billion, an increase of 78.28% YoY. Gross profit was CNY 370.6 million, an increase of 71.17% YoY, the gross profit margin was 28.4%, a decrease from 29.6% during the same period the year before. The net loss increased from CNY 239 million to CNY 647 million.

Soaring costs, increasing incomes and no profits

While operating income increased by nearly 80%, Netease Youdao’s net losses are still expanding. The net loss in 2019 exceeded CNY 600 million, with an increase in income and no increase in profit.

As we can see from the data above, Netease Youdao’s operating costs have been increasing year after year. In 2018 and 2019, operating costs accounted for about 70% of operating income, of which the operating costs of learning services and product business increased from CNY 335.1 million in 2018 to CNY 620.7 million in 2019, accounting for two-thirds of overall operating cost.

According to the report, cost mainly comes from the salary cost of expanding the faculty team. As of December 31, 2019, the total number of Netease Youdao lecturers and teaching assistants increased from 189 in 2018 to 671. Secondly, due to the growth of smart hardware sales, the cost of learning products has also increased by 424.9%, from CNY 20.5 million in 2018 to CNY 107.6 million in 2019.

On the one hand, the operating costs remain high, and the profit margin is compressed. On the other hand, in order to have a place in the crowded online education track, Netease Youdao has to invest more marketing expenses to obtain more users, due to which expenses have increased sharply.

The firm’s three-fee expenditures increased significantly in 2019, of which the growth in marketing expenses was the most prominent, rising from CNY 213 million in 2018 to CNY 622 million, accounting for 47.7% of the operating income, which means that in 2019 NetEase Youdao had invested nearly half of its annual revenue in marketing.

Amid the fierce competition in the entire online education industry, in order to acquire more users, almost all online education companies began to spend their efforts/resources on marketing. In order to maintain the position of the industry and expand the market scale, Netease Youdao also followed the same trend. 

The cost of acquiring customers is high, and of course, the effect is also there. In 2019, the number of paid students on the platform increased from 645,600 in 2018 to 833,400, an increase of 29.08% year-on-year. So even if the current situation is not enough, the determination of Netease Youdao to increase its marketing strategy cannot be changed. Netease Youdao has said that it will continue to invest a lot of money in sales, marketing and brand promotion.

At the same time, NetEase's gross profit margin in 2019 decreased from 29.6% in 2018 to 28.4%. Obviously, the gross profit margin of 28.4% cannot offset the rising expenses. NetEase Youdao CEO Zhou Feng's understanding of the education industry goes as follows: "The education industry is a 'reverse cycle' industry – we may not be able to generate sufficient revenue to achieve profitability.” NetEase Youdao is unlikely to get rid of the negative net profit any time soon. 

However, only stocks with profit expectations tend to win the favor of investors. Therefore, in order to increase investor confidence, Netease Youdao has been actively planning some measures to help boost profit, such as expanding online courses to increase the total number of paying students and the total bill for each paying student, providing more paid content and sales of smart devices through Youdao interactive learning applications and further controlling costs and expenses. 

Looking at Netease Youdao ’s plan to continuously update existing products and services and develop new ones to meet the needs of users and students and follow evolving market trends, it is clear that product development and marketing is where a lot of money will be invested.

Youdao’s business spectrum

Youdao, a search engine and an online education platform, was launched by NetEase back in 2006. It operates China’s most popular dictionary and translation app. It counted more than 700 million users at the start of the year, according to 36Kr, and raised its Series A financing round at a CNY 7.58 billion valuation in April 2018.

Meanwhile, Netease, the parent company of Youdao, is listed on NASDAQ and is one of China’s largest internet companies.

Youdao’s business spectrum comprises four types of products:

Online knowledge tools include the Youdao Dictionary, which was China’s top language app in terms of monthly active users in the first half of 2019. Youdao uses these free online tools to let people know about the company and attract traffic to the other businesses it has, such as online courses. 

Online courses, meanwhile, include Youdao Premium Courses, focusing on K12 students, NetEase Cloud Classroom and China University MOOC. This part of the business generates the largest percentage of revenue for Youdao.

Interactive learning apps enable students to study maths, English and other subjects with a virtual teacher on their mobile devices. Through social media such as WeChat, users may access these apps and share their activities with friends. 

Smart devices constitute a hardware arm that includes the Youdao Smart Pen, Youdao Dictionary Pen and Youdao Pocket Translator. These devices connect with the Youdao interactive learning apps and online courses.

It is clear that Netease Youdao's core business mainly includes online market services, learning services and products.

Before 2018 the company’s revenue mainly relied on advertising from online market services. Since 2018, with the continuous growth of NetEase Youdao's online course business and the successful test of educational smart hardware products, learning services and products have gradually become NetEase Youdao's main revenue source. Last year, revenue from learning services and products reached CNY 852 million, a YoY increase of 98.7%, accounting for 65.28% of total revenue, while online market service revenue was CNY 453 million, accounting for only 34.7% of total revenue.

It is foreseeable that NetEase Youdao will find its way of making money in the education service track and product business in future, with revenue growth points coming from educational smart hardware products and online course business.

The firm said that in 2020 it will increase the offline distribution of smart hardware products through offline and online channels. 

In addition, NetEase Youdao will also focus on overseas markets, with the launch of overseas products U-Dictionary and the iCourse international MOOC platform widening its revenue streams. 

The Tencent challenger NetEase’s (NTES: NASDAQ) Youdao is set to release its Q1 2020 financial report after the closing of the US stock market on May 20, 2020 (Beijing time). We will have to wait and see the impact of the epidemic on the recently listed education platform. Will it have a similar tale as Liulishuo, which has not been able to generate any kind of profits over the years, or will we see it rise in this competitive market?

With Morgan Stanley, Credit Suisse, Citigroup, CICC and HSBC as its underwriters, Youdao went public on NYSE on October 25, 2019, and got the firm listed under the symbol ‘DAO.’ Since the listing, the stock has performed rather well. The share price started from USD 12.50 and, as of today, May 18, 2020 (10:45 am Beijing time) the price is USD 23.41. It is also worth mentioning that Simply Wall St analysts expect the firm to reach the breakeven point before 2023.