Is Youdao the Best Buy in China's Competitive Online Education Space?

Amid fierce competition, Youdao focuses on quality, innovation, and technology.
Feb. 24, 2021 21:00
Is Youdao the Best Buy in China's Competitive Online Education Space?

The year 2020 was breakthrough for online education in China as Covid-19 shattered conventional schooling. Classes moved from in-person to online—and many stocks in the sector saw appreciation.

Education has been one of China's fastest-growing industries, boosted by wild fundraisings, rising household income and government incentives. Above all, parents in China have traditionally been eager to spend on their children's studies thanks to the belief that education is one of the most life-changing factors, helping a family rise to a higher social status. Scoring high on Gaokao, the college entrance exams, is the key milestone for many teens on a path to a successful career. For this purpose, parents have been willing to pay for afterschool tutoring and additional test preparation courses.

In 2020, the crowded education space has lured even more newcomers, intensifying competition. Now, as China recovers from the pandemic and reopens its economy and its schools, where is the online education sector heading?

The Lunar New Year holidays are now over and the earnings season is in full swing. As we await the financial reports for the year-end quarter of e-learning companies Youdao Inc. (NYSE: DAO), iHuman Inc. (NYSE: IH), GSX Techedu Inc. (NYSE: GSX), and others, let's weigh the opportunities in this fast-growing sector.

Youdao Enjoys Non-stop Growth in 2020

The industry was among the few to thrive amid the raging Covid-19 outbreak. All schools locked down for the Chinese New Year and did not reopen for months. In some cities, reopenings began in late April, while schools in others remained closed until August. All of a sudden, companies in both online and offline education rushed to accelerate their online offerings as e-learning became mandatory and the demand skyrocketed. And Youdao, intelligent learning platform and gadget maker backed by technology giant NetEase (Nasdaq: NTES; HKEX: 9999), was among those who thrived in the new environment, already steps ahead of newcomers in the market.

Youdao's user-centric focus on quality, innovation, and technology—along with its proven financial capability—positions the company on a remarkable growth trajectory relative to its peers in this highly competitive market.

For the first three months of 2020, Youdao posted an increase of 359% in the number of K-12 paid student enrollments and a 60% increase across all paid premium course enrollments. Gross billings of online courses grew nearly fourfold year-over-year.

In the second quarter, Youdao's overall student count did not slow down, again showing 359% increase in K-12 enrollments and a 143% rise in paid enrollments overall, with just the adult student number declining at 22%. Gross billings of online courses were 223% higher from the same period in 2019.

The growth even picked up in the third quarter of 2020. The company reported a 438% rise in K-12 paid student count and 163% year-over-year improvement across paid premium courses. The adult segment improved from the second quarter, showing a 14% decline year-over-year. Gross billings of online courses were 228% higher. To note, all offline schools in China, including those in the hardest-hit regions, have reopened as of late August, as Reuters reported.

In the interim, Youdao also provided a summer update for July and August, showing 500% year-over-year increase in paid K-12 enrollments for the two months.

In terms of revenue, Youdao posted significant year-over-year improvement, seeing 140% growth in Q1, 93% growth in Q2, and 159% growth in Q3 to $132 million, scoring consistent quarter-over-quarter increase. Losses, however, widened, as Youdao continued investing in sales and marketing, R&D, and faculty.

Over the past year, the stock in Youdao has trended upwards, from $16 in January 2020 to $47.70 per share in early August, boosted each time by positive earnings reports. DAO stock stayed mostly under the $30 level from September to mid-January 2021, when it shifted higher, averaging about $37 per share. In mid-February, its shares have slipped to as low as $31 per share following a dilution after a capital raise.

Last week, Youdao raised additional funds of $238 million through a follow-on public offering to boost technology and product development, among other purposes. The company sold 7 million ADSs at $34 per share in an offering underwritten by Citigroup, Credit Suisse, J.P. Morgan, and CICC. The deal is yet another sign that investors see a continued upside for China's e-learning market.

In January, Macquarie initiated coverage of Youdao with an "outperform" and a $38 price target. Analyst Linda Huang saw the company's high spending on ads pay off as its user base widened and showed "fast-growing momentum." Meanwhile, CNN Business sees a median target of $42.32 per share among 11 analysts offering 12-month forecasts on Youdao stock.

Rivalry for Student Interest

Among online educators in China, Youdao is well-positioned to be among the consolidators in the fragmented market. The offline school sector in China is dominated by two major players with many smaller rivals, whereas in the online space, the leaders are just emerging, and there are few that have come as far as Youdao.

In addition to online courses for K-12 and the adult segment, Youdao develops education apps and makes smart learning devices like the Dictionary Pen, its third generation released in December. Its courses are supercharged with innovative features such as interaction, tailored curriculum and exercises, vertical strategy playbook, and even role-play games.

For Youdao's chief executive, Feng Zhou, "Quality content and innovation are keys to success in e-learning."

Few other e-learning companies in China have reached the same scale. GSX Techedu, which became listed in New York in 2019 like Youdao, has also been enjoying significant user growth and booked approximately $305 million in revenue for Q3. In contrast to Youdao, however, its student count has slowed its pace of growth from over 300% in the first two quarters to 133% in the third quarter of 2020. GSX provides K-12 large-class afterschool tutoring services and has been pumping capital into traffic acquisition.

However, the reputation of GSX was tainted by allegations of fraud and, specifically, faking its student numbers. GSX has repeatedly denied the allegations and in spite of the claims its stock has enjoyed a wild ride in 2020, trading near $105 per share as of late January. Investors now await the results of the probe launched by the U.S. Securities and Exchange Commission in September.

Goldman Sachs analyst Christine Cho recently downgraded GSX Techedu to "sell." The valuation "looks stretched" with the share price up 103% year-to-date, Cho tells investors in a research note. JPMorgan also recently downgraded GSX to "underweight" from "neutral."

Among other strictly online learning platforms publicly traded in New York are China Online Education Group (NYSE: COE), which focuses on one-on-one English tutoring, and recently-listed iHuman, which merges education and entertainment on its apps and learning devices. Skillful Craftsman Education Technology Ltd. (Nasdaq: EDTK) provides vocational training and virtual simulation courses. All three companies are focusing on niche markets in contrast to Youdao.

While NetEase's education arm had a head start, other tech giants also sought to cash in on their online users. China Money Network notes that Alibaba Group (NYSE: BABA; HKEX: 9988), Tencent Holdings (HKEX: 0700; OTC: TCEHY), and ByteDance have made investments into the sector over the past year, intensifying competition in certain areas.

Among companies not publicly traded is Yuanfudao, backed by Tencent. In October, the company, which provides K-12 afterschool tutoring, as well as pre-school and adult courses, closed its G rounds of financing, which brought its valuation to $15.5 billion. According to the company's press release, in October, Yuanfudao counted 3.7 million students and was the largest in China.

Another e-learning provider in China, backed by both Tencent and Yuanfudao, is Huohua Siwei, a.k.a. Spark Education. Bloomberg wrote last week that Spark Education is in talks with banks for a U.S. IPO, expected as soon as this year. The company provides online courses for ages 3 to 12 in China.

The Future of Online Education in China

Research and Markets forecasts China's K-12 and STEAM education (science, technology, engineering, arts, and mathematics) market to reach $100 billion by 2026. Factors driving growth in this sector are increasing government spending on education and favorable policies, continued influx of investment capital, shift from PC to mobile learning, and sector-specific innovations.

Covid-19 also remains a factor. Students and parents have gotten a feel of the online learning benefits, the option becoming more widely accepted. Many are still worrying about the pandemic, while children have quickly adapted to learning from the screen and the technology pushing forward with new improvements and smart capabilities.

Among risk factors, Research and Markets names lack of supervision of online platforms. Another setback is the intense competition, with e-learning providers and the tech titans behind them fighting fiercely for market dominance.

As Caixin Global wrote earlier, analysts forecast a few dominant players to emerge as the weaker get weaker. Currently, the majority of investment in the industry is burned on user acquisition and retention rate, but the winner may be the one who aims to deliver high-quality e-learning through innovation and technology and puts the student first.

In a recent filing, Youdao wrote: "Today, for tens of millions of people, Youdao is the go-to destination for looking up a word, translating a foreign language, preparing for an exam, or picking up a new skill. Through technology, we enrich the lives of people of all ages every day, guiding them on their journey of pursuing knowledge and sharing ideas."

In October, Youdao celebrated one year of being a publicly traded company. Its CEO Zhou has said: "After 2020, there won't be any new players entering the market. The bar for online K-12 education is very high and the entry barrier has heightened over the past few years."

In other words, the big and strong will get bigger and stronger, and the small will get eaten up in the new market. Big companies like NetEase-backed Youdao, it seems, stand to benefit in such an environment.

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