China Demographics And Regulatory Hurdles Will Limit Expansion

Key Takeaways

• Long-term growth is challenged by demographic shifts, regulatory pressures, and heavy dependence on parent company support.
  
• Rapid hardware expansion and commoditization of AI services raise risks to margins, competitive positioning, and revenue stability.
  
• Strong performance in AI-powered learning and smart devices, international expansion, disciplined cost management, and proprietary technologies position the company for sustained growth and profitability.

Catalysts

An internet technology company, provides online services in the fields of content, community, communication, and commerce in China.

• Despite near-term gains from AI-powered services and improvements in profitability, Youdao faces structural challenges as demographic headwinds and a shrinking school-age population in China will limit the long-term expansion of its core user base and constrain revenue growth.
  
• The company's ability to leverage data-driven education technology is threatened by intensifying regulatory scrutiny in China, which will result in higher compliance costs and directly limit the scope of product innovation, putting downward pressure on margins and earnings.
  
• Persistent reliance on rapid development of new hardware categories such as tutoring pens introduces concentration and execution risk, as any failure to maintain meaningful differentiation or respond to fast-changing consumer preferences could lead to sharp declines in smart device revenues over the long term.
  
• Heavy dependence on parent company NetEase for client acquisition, brand trust, and funding creates potential vulnerabilities; strategic shifts or any reduction in support from NetEase could severely disrupt operations, impairing both revenue stability and the ability to maintain or grow net margins.
  
• Proliferation of generative AI is likely to commoditize content and language services, eroding Youdao's competitive advantage and pricing power while simultaneously exposing the company to intensified competition from larger technology players, forcing down gross margins and restraining future earnings growth.

Youdao Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Youdao compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Youdao's revenue will grow by 11.7% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 4.1% today to 4.3% in 3 years time.
• The bearish analysts expect earnings to reach CN¥336.3 million (and earnings per share of CN¥3.01) by about August 2028, up from CN¥228.2 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 31.4x on those 2028 earnings, down from 37.8x today. This future PE is greater than the current PE for the US Consumer Services industry at 19.1x.
• Analysts expect the number of shares outstanding to grow by 0.59% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 8.08%, as per the Simply Wall St company report.

Youdao Future Earnings Per Share Growth

Risks

• Continued strong growth in AI-powered learning products such as Youdao Lingshi, driven by high retention rates over 75% and positive user feedback, signals long-term user base expansion, supporting revenue and earnings growth.
  
• The company is leveraging its proprietary large language models, such as Confucius 3 and Confucius 3-Math, to deliver differentiated learning, tutoring, and smart hardware offerings with state-of-the-art cost efficiency, which could drive margin improvement and competitive advantage.
  
• Smart devices, particularly Dictionary Pens and the newly launched Tutoring Pens, maintain clear market leadership and are positioned to benefit from secular trends in AI-powered educational hardware, potentially creating new high-margin revenue streams and cross-selling opportunities that boost both revenue and net income.
  
• Online marketing services are experiencing rapid growth from gaming and overseas markets, with advertising revenue rising more than 50% year-over-year in gaming and partnerships with major global platforms like TikTok and Google multiplying international revenues, which could result in long-term top-line and cash flow gains.
  
• The company demonstrates ongoing improvements in profitability, with a turnaround to operating income, disciplined cost management (lower sales and R&D expenses as a share of revenue), and continued share buybacks, collectively setting the stage for sustained earnings growth and enhanced shareholder value.

Valuation

• The assumed bearish price target for Youdao is $9.63, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of Youdao's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $18.2, and the most bearish reporting a price target of just $9.63.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be CN¥7.8 billion, earnings will come to CN¥336.3 million, and it would be trading on a PE ratio of 31.4x, assuming you use a discount rate of 8.1%.
  
• Given the current share price of $10.05, the bearish analyst price target of $9.63 is 4.3% lower. The relatively low difference between the current share price and the analyst bearish price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.