Youdao offers lesson in diversification as education crackdown hits peak
Key points to remember:
• Youdao’s revenue more than doubled in the second quarter compared to the previous year, with all business segments showing strong performance
• The results came as China cracked down on after-school tutoring services that account for less than half of Youdao’s income
By Warren Yang
Online tutoring service provider Youdao Inc. (DAO.US) offers a concrete lesson in the virtues of diversification, as many of its peers fall victim to China’s crackdown on extracurricular education for young students.
Net sales of the company, a unit of the online gaming giant NetEase, more than doubled to 1.3 billion yuan ($ 200 million) in the second quarter of 2021 from a year earlier, according to its latest results released last week. The gross margin jumped an even more 140% in the last reporting period, with its gross margin improving to 52.3% from 45.2% a year earlier.
The company posted general improvements in its three main business segments, although classes still account for more than two-thirds of its overall revenue.
A variety of growth drivers is more critical than ever for Youdao as Chinese regulators curb out-of-school tutoring services. At the end of July, authorities released sweeping changes to what is estimated at $ 100 billion in an effort to alleviate stress on students.
Under the new rules, all businesses offering after-school tutoring were required to re-register to operate as of September 1 and run these non-profit services. IPOs are out the window for those not yet made public, and classes on weekends, breaks or holidays are now banned. Beijing’s municipal government last month became the country’s first local administrative body to implement the new regulations.
Regulators’ growing unease with the proliferation of out-of-school tutoring was known long before the tough new rules became official. Various written documents signaling the official attitude and reports containing specific details surfaced as early as March, following the rumors of last year. As a result, tutoring company stocks came under pressure throughout the year before plunging after regulatory crackdown came true.
Youdao shares were not exempt. During its conference call to discuss its second quarter results, company management warned that its extracurricular tutoring activity for K-12 students would be “severely limited” in the coming quarters.
The new rules mean that after-school tutoring companies will not only lose revenue, but also incur costs to downsize their operations. Those costs could include compensation for laid-off staff, office rental cancellation fees and depreciation expenses for prepaid office equipment, Youdao management explained during the call.
But Youdao is rather well positioned compared to its peers due to its lower reliance on K-12 income. This activity represented a little over 40% of its turnover in the second quarter. In comparison, the industry leader New oriental education drew 85% of its income from extracurricular courses during the fiscal year ended May 31, 2020, and 17 Education and Technology Almost all of his income comes from K-12 classes.
The other courses offered by Youdao include courses for adults, which are not subject to the current repression. Enrollment in these online courses for people pursuing professional certificates and other interests increased by around 70% in the second quarter compared to the previous year, accounting for around 13% of enrollments for all types of courses.
This segment actually provided over 50% of Youdao’s revenue in the second quarter of 2019. But the percentage contribution declined significantly a year later, with enrollments in K-12 classes more than quadrupling while those in the adult classes were declining. This change reflected the surge in demand for after-school tutoring which was in part what attracted current unwanted attention from regulators.
Adult classes aren’t the only business Youdao can rely on. It also offers creativity classes for young children, which are also not part of the current regulatory exam. Then there are learning devices, such as the Youdao Dictionary Pen, which scans the English text and instantly translates it into Chinese. Net sales of these products jumped about 139% in the second quarter to represent about 16% of total sales in the three months.
Youdao is also looking to generate revenue by leveraging its technological expertise to help other education companies digitize their offerings, while online marketing services was another business that saw strong growth in the second quarter. .
Investors have gradually recognized the benefits of Youdao’s business diversification relative to its peers, boosting the company’s shares by more than 30% in the four trading days since the release of its second quarter results on the 31st. August.
Although Youdao stock still lost more than half of its value from the January peak and is around 19% lower than its 2019 IPO price, it is doing much better than its peers whose main focus is K-12 activities. Of these, New Oriental stocks have lost nearly 90% of their value this year, while 17 Education is down by a similar magnitude from its New York IPO stock price last December.
Youdao is still unprofitable and is burning cash, with its net loss increasing at a rate similar to its revenue growth in the second quarter. Its liquidity decreased slightly at the end of June compared to three months earlier, as it continued to record net cash outflows to finance its operations. But that’s less of a concern for the company since its wealthy parent company, NetEase, continues to provide financing in various forms, including a short-term loan that can be automatically extended.
NetEase also plans to purchase up to $ 50 million of outstanding U.S. Depository Shares (ADS) of Youdao over a period of up to three years from September 2, which could help support the stock. .
NetEase itself operates in an industry that is also the subject of regulatory criticism as the government seeks to control the time minors can spend playing online games. But in the same way that Youdao’s diverse clientele shields it from the crackdown on tutoring, children under 18 make up less than 1% of total gross billing at NetEase.
Ultimately, Youdao helps NetEase diversify outside of its core gaming business, so there are good reasons for the parent to want their education unit to thrive. The old saying “Don’t put all your eggs in one basket” is Business 101. Anyone looking for a classic example of this should look no further than Youdao as they navigate China’s volatile regulatory landscape.