Youdao: The Way To Play Chinese Digital Education (NYSE:DAO)

Investment Thesis

Youdao (DAO), a subsidiary of NetEase (NTES), is an online education platform focused on the China market. From a macro perspective, online education is seeing strong tailwinds given an easier engagement model vs. in-person tutoring centers as well as COVID-related shifts towards socially distant education models. This has driven strong performance YTD as illustrated below. Although the stock has come down quite a bit from August highs, it is still at a material premium to the IPO price in Q4 2019.

Data by YCharts

The company generates revenues from two core segments: online education which accounts for 66% of revenues and digital advertising which accounts for 33% of revenues. Online education specifically consists of online courses and online education tools (dictionary/notebook) with a focus on K-12 and a growing platform focused on continuing education for adults.

A unique technology offering that Youdao has is the Smart Pen offering. This Smart Pen technology allows for better direct student-teacher communication through real-time writing suggestions, explanations, and error correction. In addition, the company has a strong AI platform including AI tutoring/essay grader. This technology layer is a key differentiator as it helps drive increased engagement and separates the company from major competitors such as New Oriental, which are more traditional education plays with a minimal tech layer.

On top of this technology layer is the traditional instructor-led curriculum, which Youdao has built a reputation for quality. This combined with the strong tech layer has driven an almost Mid-Market SaaS retention rates of ~70%, which is exceptionally strong for a consumer-focused business.

The company has shown strong revenue growth over the past few quarters as interest in the Youdao platform has exploded in-line with increased demand for online education in general. To note, the company has a strong MAU of >100MM in 2019 of which <5% are currently paying users. This gives the company a strong base to upsell and grow efficiently.

ChartData by YCharts

The biggest risk facing the company is the competitive landscape as the TAM is still largely greenfield and growing. Here, competition is coming largely from both off-line tutoring platforms as well as digital-first platforms. TAL Education Group (NYSE:TAL) and New Oriental Education (NYSE:EDU) are examples of companies to watch in the space. As new entrants enter the space, given that the barriers to entry are quite low, I expect competition to heat up. This will have several knock-on impacts including (i) lower sales efficiency as the costs of many players marketing to the same customer base will likely increase and (ii) the threat of price competition which can reduce revenue growth and have a negative impact on margins.

Financial Summary

The company has grown significantly with a nearly 62% YoY revenue growth. However, burn has accelerated faster than revenue growth as the company invests in new content, technology, and new customer acquisition strategies. The company has seen significant growth over the summer months with K-12 paid users up nearly 500% YoY. I expect this outperformance to continue as the adoption of digital education platforms continues and as the company grows its technological leadership in the space.

(Source: Youdao Q2 Results)

Valuation

To be conservative, I am using a 12x EV/revenue run-rate multiple on the company. This translates to nearly 47% upside from today’s levels. As seen below, this 12x multiple is at a slight premium to where the company is trading at today but still within bounds of historical trends. Just given the company’s strong growth and proprietary tech layer, I do think there is a strong possibility for the company to re-rate in the near future.

ChartData by YCharts

Conclusion

Overall, the company is a leading player in the Chinese digital education market with a strong quality-first curriculum coupled with an innovative tech layer. The company has demonstrated strong growth since going public and the valuation currently is undemanding. With 47% potential upside from current levels based on a relatively conservative 12x EV/revenue multiple, I recommend a buy.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DAO over 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.

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