Quick Take
Youdao (DAO) has filed to raise gross proceeds of $300 million from a U.S. IPO, according to an F-1 registration statement.
The firm provides online learning solutions to Chinese residents through a suite of apps, products and services.
DAO is growing quickly but producing large operating losses and cash burn.
When we learn more IPO information, I’ll provide a final opinion.
Company & Technology
Hangzhou, China-based Youdao was founded in 2006 as part of NetEase (NTES) to provide pre-school, K-12, college, and adult learning solutions through its suite of online learning products and services.
Management is headed by Director and CEO Feng Zhou, who has been with the firm since 2007 and was previously a software engineer at ChinaRen.
Youdao offers most of its products and services for free and profits primarily through online marketing services and advertising to its base of over 100 million monthly active users [MAUs].
Below is a brief overview graphic of the company’s products and services:
Source: Company registration statement
Management says that Youdao Dictionary, the company’s flagship product launched in 2007, is China’s number one language app in terms of MAUs (Monthly Active Users) in H1 2019 with more than 51.2 million MAUs for the period, according to a Frost & Sullivan report commissioned by the company.
The firm’s flagship online course brand Youdao Premium Courses focuses on K-12 education, delivered through a “dual-teacher” large classroom live streaming model to maximize teacher-student interaction and best utilize the available resources.
Through DAO’s apps, students are able to learn math, English and other subjects through a virtual AI-based teacher on their mobile devices to aid in the forming of personalized learning habits while social media interactions with platforms such as Weixin/WeChat enables users to access these apps and share their activity with friends.
The company is also invested in the production of learning-focused smart devices and its current portfolio include the Youdao Smart Pen, Youdao Dictionary Pen and Youdao Pocket Translator.
Investors in Youdao also include Legend Capital and Muhua Jinxin Investment Management. Source: Crunchbase
Customer/User Acquisition
Youdao’s business model – primarily free with advertisements – means that it relies heavily on organic growth through word-of-mouth.
The firm also employs mobile marketing strategies, such as advertisements and marketing campaigns on app stores, mobile news apps and social media, as well as through search engine optimization.
DAO also engages in offline marketing, such as through “fan meetings” where prospective students and their parents interact with instructors and teaching assistants that showcase the company’s faculty and encourage conversion into enrollments.
Sales and marketing expenses as a percentage of revenue have been uneven but increased in the most recent period, per the table below:
Sales & Marketing | Expenses vs. Revenue |
Period | Percentage |
To June 30, 2019 | 33.9% |
2018 | 29.2% |
2017 | 29.9% |
Source: Company registration statement
The sales & marketing efficiency rate, defined as how many dollars of additional new revenue are generated by each dollar of sales & marketing spend, was 1.2x in the most recent six month period, as shown in the table below:
Sales & Marketing | Efficiency Rate |
Period | Multiple |
To June 30, 2019 | 1.2 |
2018 | 1.3 |
Source: Company registration statement
Market & Competition
According to a 2019 market research report by iResearch, China’s online education market was valued at about $9.9 billion in 2012, reached $35.2 billion in 2018 and is expected to exceed $76 billion by 2025.
The number of China’s online education paying users reached an estimated 135.4 million in 2018, an increase of 23.3% year-over-year, as shown by the chart below:
The main factors driving forecast market growth include the increasing acceptance of online education among users, improving online service payment willingness and enhancements in online learning experience and effectiveness.
Youdao competes with providers of online dictionary and translation solutions, note-taking services, as well as manufacturers of hardware or smart devices.
Additionally, the firm competes for advertisers and their budgets, not only with internet companies, but also with other types of advertising media, such as newspapers, magazines, and television.
Financial Performance
DAO’s recent financial results can be summarized as follows:
Increasing and accelerating topline revenue growth
Sharply higher gross profit but reduced gross margin
Negative operating profit and fluctuating negative operating margin
Increasing cash used in operations
Below are relevant financial metrics derived from the firm’s registration statement:
Total Revenue | ||
Period | Total Revenue | % Variance vs. Prior |
To June 30, 2019 | $ 79,904,000 | 66.1% |
2018 | $ 106,570,000 | 59.0% |
2017 | $ 67,021,471 | |
Gross Profit (Loss) | ||
Period | Gross Profit (Loss) | % Variance vs. Prior |
To June 30, 2019 | $ 23,155,000 | 46.3% |
2018 | $ 31,532,000 | 32.4% |
2017 | $ 23,814,559 | |
Gross Margin | ||
Period | Gross Margin | |
To June 30, 2019 | 28.98% | |
2018 | 29.59% | |
2017 | 35.53% | |
Operating Profit (Loss) | ||
Period | Operating Profit (Loss) | Operating Margin |
To June 30, 2019 | $ (23,620,000) | -29.6% |
2018 | $ (31,921,000) | -30.0% |
2017 | $ (19,123,676) | -28.5% |
Net Income (Loss) | ||
Period | Net Income (Loss) | |
To June 30, 2019 | $ (24,458,000) | |
2018 | $ (30,487,000) | |
2017 | $ (24,107,647) | |
Cash Flow From Operations | ||
Period | Cash Flow From Operations | |
To June 30, 2019 | $ (29,252,000) | |
2018 | $ (14,615,000) | |
2017 | $ (12,814,412) |
Source: Company registration statement
As of June 30, 2019, the company had $43.8 million in cash and equivalents and $206.3 million in total liabilities, of which $127.9 million were short-term loans from NetEase. (Unaudited, interim)
Free cash flow during the twelve months ended June 30, 2019, was a negative ($40.2 million).
IPO Details
DAO has filed to raise $300 million in gross proceeds from an IPO of ADSs representing Class A ordinary shares.
Class A shareholders will be entitled to one vote per share and Class B shareholders, including senior management and NetEase, will be entitled to three votes per share.
The S&P 500 Index no longer admits firms with multiple classes of stock into its index.
Per the firm’s latest filing, the firm plans to use the net proceeds from the IPO as follows:
to further invest in technology and product development;
to expand our branding and marketing efforts;
to further grow our user base; and
to satisfy other general corporate purposes.
Management’s presentation of the company roadshow is not currently available.
Listed underwriters of the IPO are Citigroup, Morgan Stanley, CICC, Credit Suisse, and HSBC.
Commentary
Youdao is attempting to raise a large amount of investment capital in a difficult environment in U.S. markets.
Overall stock market volatility has put a damper on IPOs as institutional investors recalibrate their investment appetite for firms with significant operating losses.
DAO’s financials show strong revenue and gross profit growth but high operating losses and sharply increased cash burn from operations.
Sales and marketing expenses as a percentage of revenue has been uneven but higher in the most recent six months.
The market opportunity for online education services and related advertising in China is significant and the firm holds a prominent place in the market.
However, Chinese companies in the education space have been buffeted by regulatory changes as the government has cracked down on lower-quality operators and reduced the opportunity for public-private offline school transactions.
On the legal side, like many Chinese firms seeking to tap U.S. markets, the firm operates within a VIE structure or Variable Interest Entity. U.S. investors would only have an interest in an offshore firm with contractual rights to the firm’s operational results but would not own the underlying assets.
This is a legal gray area that brings the risk of management changing the terms of the contractual agreement or the Chinese government altering the legality of such arrangements. Prospective investors in the IPO would need to factor in this important structural uncertainty.
Management’s valuation assumptions will be interesting to learn, and I’ll provide an update when we find out that information.
Expected IPO Pricing Date: To be announced.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.