To The Moon

Key takeaways:

•      Youdao’s revenue more than doubled in the second quarter from a year earlier, with all business segments performing strongly

•      The results came as China cracks down on after-school tutoring services that account for less than half of Youdao’s revenue

By Warren Yang

Online tutoring services provider Youdao Inc. (DAO.US) is offering a real-life lesson on the virtues of diversification, as many of its peers fall victim to China’s crackdown on extracurricular education for young students.

Net revenue at the company, a unit of 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. Gross profit surged by an even larger 140% during the latest reporting period, as its gross margin improved to 52.3% from 45.2% a year earlier.

The company posted broad-based improvements across all of its three main business segments, though classes still account for more than two-thirds of its overall revenue.

A diversity of growth drivers is more critical than ever for Youdao because Chinese regulators are reining in after-school tutoring services. In late July, authorities issued sweeping changes for what is estimated to be a $100 billion industry as they seek to ease stress for students.

Under the new rules, all companies offering after-school tutoring were required to re-register to operate as of Sept. 1 and run such services on a non-profit basis. IPOs are out the window for those that haven’t gone public yet, and classes on weekends, breaks or public holidays are now banned. The Beijing municipal government last month became the country’s first local administrative body to implement the new regulations. 

Regulators’ growing unease with the proliferation of after-school tutoring was known well before the stringent new rules became official. Various written documents signaling the official attitude and reports containing specific details surfaced as early as March, following rumors last year. As a result, tutoring companies’ stocks have been under pressure throughout the year before nosediving after the regulatory clampdown became reality.

Youdao shares haven’t been exempt. During its conference call to discuss its second-quarter results, company management warned its after-school tutoring business for kindergarten to 12th grade students will be “severely limited” in the coming quarters.

The new rules mean after-school tutoring companies will not only lose revenue, but will also incur costs for scaling down operations. Such costs could include compensation for laid off staff, fees for cancelling office rentals and impairment expenses for prepaid office materials, Youdao management explained on the call.

But Youdao is somewhat well positioned compared with its peers due to its lesser dependence on income from K-12 classes. That business accounted for a little more than 40% of its revenue in the second quarter. By comparison, industry leader New Oriental Education derived 85% of its revenue from after-school courses in the fiscal year ended May 31, 2020, and 17 Education & Technology earns pretty much all of its revenue from K-12 classes.

Youdao’s other class offerings include courses for adults, which are not subject to the ongoing crackdown. Enrolments in such online courses for people pursuing professional certificates and other interests increased about 70% in the second quarter from a year earlier, making up about 13% of registrations for all types of classes.

That segment actually provided more than 50% of Youdao’s revenue in the second quarter of 2019. But the percentage contribution shrank substantially a year later as enrolments in K-12 classes more than quadrupled while those in adult courses fell. That shift reflected the boom in demand for after-school tutoring that was partly what attracted the current unwanted attention from regulators.

Creativity Classes

Adults courses aren’t the only business Youdao can fall back on. It also offers creativity classes for young children, which also aren’t part of the current regulatory scrutiny. Then there are learning devices, such as Youdao Dictionary Pen, which scans English text and instantly translates it into Chinese. Net revenue from such products jumped some 139% in the second quarter to account for about 16% of total revenue during the three months.

Youdao is also looking to earn revenue by leveraging its technology expertise to help other education businesses digitalize their offerings, while online marketing services was yet another business that grew nicely in the second quarter.

Investors have gradually recognized the benefits of Youdao’s business diversification compared with its peers, sending the company’s shares surging more than 30% in the four trading days since it released its second-quarter results Aug. 31.

Although Youdao stock has still lost more than half of its value from a January peak and is about 19% below its 2019 IPO price, it is faring much better than peers whose main focus is the K-12 businesses. Among those, New Oriental shares have lost almost 90% of their value this year, while 17 Education is down by a similar magnitude from the price for its New York IPO shares last December. 

Youdao is still unprofitable and burning cash, with its net loss ballooning at a similar pace to its revenue growth in the second quarter. Its cash holdings decreased a bit at the end of June from three months earlier as it continued to experience net cash outflow to fund its operation. But that’s less of a concern for the company since its wealthy parent, NetEase, continues to provide funding in various forms, including a short-term loan that can be automatically extended. 

NetEase also plans to purchase as much as $50 million worth of Youdao’s outstanding American depository shares (ADSs) over a period of as long as three years from Sept. 2, which could help to prop up the stock.

NetEase itself operates in an industry that’s also coming under regulatory fire as the government seeks to control the amount of time minors can spend playing online games. But similar to how Youdao’s diversified customer base is shielding it from the crackdown on tutoring, children under 18 years old account for less than 1% of total gross billings at NetEase.

At the end of the day, Youdao is helping NetEase to diversify away from its main gaming business, so there is pretty good reason for the parent to want its education unit to prosper. The old proverb “Don’t put all your eggs in one basket” is Business 101. Anyone looking for a textbook example of this should look no further than Youdao as it navigates China’s volatile regulatory landscape.