Qutoutiao's (QTT) CEO Eric Tan on Q1 2020 Results - Earnings Call Transcript

Qutoutiao, Inc. (NASDAQ:QTT) Q1 2020 Earnings Conference Call June 4, 2020 7:00 AM ET

Company Participants

Sai Chi Du – Investor Relations

Xiaolu Zhu – Chief Financial Officer

Eric Tan – Chief Executive Officer

Conference Call Participants

Vicky Wei – Citi

Thomas Chong – Jefferies

Miranda Zhuang – Bank of America

Operator

Hello, ladies and gentlemen, thank you for standing by for the First Quarter 2020 Earnings Conference Call for Qutoutiao, Inc. At this time all participants are in a listen-only mode. After management’s remarks, there will be a question-and-answer session. Today's conference call is being recorded.

I'd now like to turn the call over to your host, Sai Chi Du. Please go ahead, Sai Chi.

Sai Chi Du

Thank you very much. Welcome, everyone, to the first quarter of 2020 earnings conference call of Qutoutiao, Inc. The company's financial and operational results were released via Newswire Services earlier today and have been made available online. You can also view the earnings press release by visiting the IR section of our website at ir.qutoutiao.net.

Participants on today's call will include our CEO, Mr. Eric Tan; and our CFO, Mr. Xiaolu Zhu. Before we continue, please note that today's discussion will contain forward-looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the company's results may be materially different from the views expressed today. Further information regarding these and other risks and uncertainties is included in the company's prospectus and other public filings as filed with the U.S. Securities and Exchange Commission. The company does not assume any obligation to update any forward-looking statements, except as required under applicable law.

Please note that the Qutoutiao's earnings press release and this conference call include discussions of unaudited GAAP financial measures as well as unaudited non-GAAP financial measures. Qutoutiao's press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited GAAP measures. I will start by reading out Eric's commentary on the business first.

I will review key business developments since we last talked back in March before providing an outlook for the foreseeable future. In the end, I will share with you my thinking on the long-term objectives and strategy. COVID-19 continues to impact the wider economy and the real economy in two ways. On the one hand, the reopening of the offline businesses has been very gradual and controlled, along with that, the equally gradual recovery of marketing activities. On the other hand, but partly induced by the cautiously paced recovery, the outlook for business activities and the demand environment remain tame for a variety of sectors and industries.

As a result, we expect the current more conservative budgeting practice by advertising customers to continue until more material brightening of the general economic prospect. However, we executed strongly in the first quarter of 2020 against the strong industry-wide headwinds by growing our revenues 26% year-on-year to reach north of RMB1.4 billion, well within our previously guided range. The growth has been supported by continued user base expansion, with DAU increasing 22% year-on-year to reach almost 46 million.

With our daily user time spend flat, the inherent improvement in ARPU year-on-year is a strong testament to our commitment and ongoing effort in enhancing the core capabilities of our platform, especially given the unprecedented challenges facing our economy and the industry in the recent past in stark contrast to the market conditions a year ago. Being a young franchise, growth has naturally been an important part of our identity and strategy. We have taken a balanced approach to growing our business, appreciating the fact that the growth is not an end in itself.

As much as we would like to grow and become multiple times larger as a platform, given the market potentials we are facing, we have always emphasized unit economics when it comes to budgeting and spending, which is a function of the lifetime value of each new user and the acquisition costs associated with recruiting each new user. We have been patient in executing our growth strategies while navigating market vagaries in the past couple of years, aiming at profitable and a sustainable growth.

We are pleased to see significant operating margin improvement in the past quarter as our quarterly net loss has shrunk to a little more than half of the level a year ago while we achieved a healthy top line growth. Investing into the business has been a recurring topic in our discussions, but has never been more relevant. Since we established our proprietary machine learning platform, we have been able to accelerate R&D on algorithms, which are fundamental to improving both user experience and monetization. Being able to process and test large quantities of data has meant a steepening of the learning curve for task-specific algorithms, which lead to much better tailored push of high-quality content as well as adverts.

This enables an overall upgrade of user experience because if both the actual content and the adverts can be interesting and relevant for the user and the interchange between the two is seamless and well timed, the whole experience can feel very smooth and enjoyable as opposed to feeling intruded or interrupted. This makes a material difference in today's world where competition for Internet users' attention and time spent is fierce. Machine learning capabilities also underpin the development of our OCPC system which relies on the ability to estimate and manage performance metrics along the ad conversion value chain.

In an OCPC system where the customer bids for results further downstream, taking on less ad performance risk, the full capability of the system is to translate the bid into variables further upstream and leverage the intelligence gathered from large quantities of data to more precisely allocate ad inventories to where they can deliver maximum ultimate utility. For the system to do a good job, it needs to be capable of analyzing and understanding each and every piece of ad inventory as well as follow intermediary links and steps leading to the fulfillment of the end customer request.

Essentially, the OCPC system plays the role of a super agent bidding on behalf of advertising customers, delivering optimal end results at lower and more stable costs. We have driven deeper coverage of customer spending with second degree OCPC realization which is now at 50% plus in comparison to 30% earlier this year. We believe our head start in this field will enhance our competitive advantage over the long term. And we are confident about the long-term prospects of performance-based adverts overall and see tremendous room for us to grow.

On the Midu side, we continue to strengthen our lead on content offerings. We are now collaborating with more than 80% of online literature content providers in the entire industry. Our unique advantage of proprietary content development, supported by real-time user feedback and powerful data analytics, is already producing positive results as now we have almost 30% of the most popular titles being in-house productions despite the fact that in-house production started less than a year ago.

Given the reach of our platform, our diverse user base and our ability to match the right books with the right audience, great writers increasingly initiated conversations with us and our team to explore areas of development and collaboration not possible for them previously. Our vision is to create a healthy and thriving content ecosystem that will bring huge value to both readers and authors. And our platform will play a vital role in supporting the expansion of the reading population, which currently is estimated to be close to 500 million and growing steadily.

Now in terms of the outlook, there are still plenty of uncertainties in the ad market which present a challenge to everyone. By sticking to what we believe will create value and strengthen our core over the long-term, as and when the market normalizes, we will emerge much stronger. We expect to see both revenue and user base expansion in the second half of this year. We'll continue to improve our operating efficiency by holding a higher bar for capital allocation, especially with regard to user engagement and acquisition.

We aim to achieve quarterly breakeven in the second half of this year and the progress we have seen and achieving year-to-date has given us more conviction. Our long-term vision is to build a platform delivering quality online content to millions of households across the country, bringing entertainment and joy, knowledge and information to everyone. We see huge growth potential, especially in the lower-tier cities in China, where the vast majority of the population is located, and where, historically, there has been a significant lack of online products and services tailored to local needs.

There is a strong and growing appetite for online entertainment and activities unsatisfied despite a wealth of Internet offerings because such offerings have mostly been created to look after consumer preferences and the lifestyles of the developed regions of China. We are amongst the first to see this supply demand gap and subsequently set out to make it our mission to bridge the gap by really investing time and effort to understand this user group and to respond to their requirements.

We believe this is an extremely fulfilling endeavor, and that we will be recognized for the long-term value we bring to our users over time. The COVID-19 pandemic has caused significant disruptions to our society and lifestyles. Among many things, it rereminds us of the value to society technology could create. Balancing between growth and profitability, we will continue to invest into building out technological capabilities at all levels, accelerating the upgrade of our platform, building a rich and high-quality content reserve along with first-class AI distribution capabilities to become an indispensable part of hundreds of millions of people's daily lives.

Thank you very much. That concludes Eric's remarks, and I will now turn the call to our CFO, Xiaolu Zhu.

Xiaolu Zhu

Thank you, Eric and Sai Chi. And again, thank you, everyone, for joining today's call. Let me first go through the financial highlights of the first quarter of 2020 before discussing in a bit more detail our financial strategy and providing outlook for the rest of the year. Our net revenues grew 26% year-on-year during the quarter and reached RMB 1.410 billion, the exact figure of which is slightly above the midpoint of our guided range. The growth can be broken down to a 22% user base expansion in terms of DAU, which grew from 38 million to 46 million and a 4% improvement in monetization in terms of ARPU, which increased from RMB0.33 to RMB0.34.

Given the extraordinary environment we are in this year, what we have achieved so far has not come easily. As Eric has already explained, the increase in ARPU during these trying times are a testament to the investment that we have made in advancing our technological capabilities. This has given us an edge in delivering better results to our customers at a time when everyone is taking a more cautious approach towards marketing and are actively looking for more measurable advertising channels.

The results from the last few quarters give us the confidence in the effectiveness of our OCPC system, and we are also confident that we will continue to see better monetization efficiencies in the coming quarters, especially when advertising market in China recovers from the pandemic.

Moving on to expenses. Please note, I will focus on non-GAAP measures, which excludes stock-based compensation. Our gross margin stood at 68% in comparison to 75% in the same period last year. The change is a result of a number of factors, mostly driven by our investment in content and tech infrastructure as well as revenue mix change.

From a revenue mix cost structure perspective, our gross margin in Q1 2020 is much more comparable to Q4 2019, which was only 2% higher at 70% although seasonality in our business would usually main a noticeable sequential decline in revenue and margin going from Q4 to Q1 the following year, all else being equal. Therefore, the underlying trend is, in fact, rather positive. Our user engagement expenses on a per DAU per day basis decreased to RMB 0.12, which is nearly the lowest level on record.

Our user acquisition expenses per new installed users was RMB 4.6, which is a 26% decline year-on-year and a 17% decline quarter-on-quarter, partially reflecting our budgeting discipline and partly reflecting the weak advertising market environment.

Our total sales and marketing expenses in absolute terms are down 18% year-on-year despite the expansion in our user base and top line. As a percentage of revenue, sales and marketing expenses were 75%, which represented a 40 percentage points improvement versus the same period a year ago.

R&D expenses as a percentage of revenue stood at 15% versus 12% in the same period last year. In absolute terms, it increased by 54%, reflecting our commitment to ongoing investment into talent and to grow technological capabilities. G&A expenses were 4% of revenue, in line with history.

Overall, our non-GAAP net loss was RMB 388 million with non-GAAP net loss ratio at 28%. This represents a significant improvement from Q1 2019 while net loss in absolute terms was 59% larger and the net loss ratio was double the current level.

As of March 2020, we had cash, cash equivalents, restricted cash and short-term investments of RMB 1.2 billion or US$163 million. Three months ago, we said our financial objectives this year would be to break even on a non-GAAP quarterly basis by the end of the year. That remains unchanged and well on track. We will achieve it by leveraging top line growth and margin improvement. We will focus on three areas to drive margin expansion.

The first is better monetization, which will be the product of better business economics and the new incremental revenue streams. With enhanced machine learning capability, as Eric mentioned earlier, we will be able to further fine-tune the ad conversion and the user retention process to meet our various threshold requirement for economics. Meanwhile, we will keep exploring alternative ways to monetize the significant user traffic our platform has attracted.

Games and live streaming are some of the successful initiatives lately, which we believe will produce long-term benefits for us as users grow increasingly comfortable with spending money on our platform as opposed to the traditional way of earning rewards in addition to getting everything for free. Paid membership on Midu is also a step in that direction and makes the Midu product offerings more inclusive.

Despite a weak market impact by COVID-19, we managed to grow not only total revenue but also ARPU in Q1. The second is improving algorithm to drive better content recommendation while optimizing the loyalty points reward system. Ultimately, users spend time on our platform for quality and interesting content. The more they enjoy our content, the less they would pay attention to the loyalty points earned and the more there is the potential to reduce loyalty points being handed out.

Algorithm plays an important role in identifying the excess loyalty points and subsequently cutting down costs without affecting overall user experience. Our user engagement expenses per DAU per day since peaking in mid-2018 has more than halved as of Q1 2020. The third is smart user acquisition strategy. We don't look at user acquisition in isolation, rather we consider the effect and the impact of it in conjunction with our overall user base growth and quality. We have, over time, reduced customer acquisition costs considerably while growing our user base and maintaining its stability.

Looking ahead, as the economy recovers from pandemic and potentially the end market picks up, user acquisition budget could increase. But as a percentage of revenue, we expect it to be firmly below the levels we have experienced in 2019. Last but not least, in terms of the outlook, we expect Q2 2020 net revenues to be between RMB 1.41 billion and RMB 1.43 billion, which represents a 2% to 3% increase year-on-year with net loss margin to see at least a 10 percentage point improvement sequentially.

Our stance on sales and marketing spending has been conservative so far this year, given the uncertainties in the market. However, we will continue to invest in content and technology, as evidenced in our Q1 results. We believe these areas are vital to our success over the long run. We also plan to increase our marketing budget if the current market recovery we have witnessed in late May and June can be sustained throughout the year. But given better operating efficiency, we will continue to see improved margins in the coming quarters.

Looking at our operational and financial performance year-to-date and considering the various possibilities for the remainder of the year, we are confident about achieving quarterly breakeven during the second half, while maintaining a reasonable pace of revenue and user base expansion. Of course, this assumes that there will be no further disruption from the pandemic, at least in the domestic market.

So that concludes today's prepared remarks. Again, thank you all very much. And operator, we are now open for questions. Please proceed.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session [Operator Instructions] Your first question comes from the line of Vicky Wei from Citi. Please go ahead.

Vicky Wei

Good evening, management. Thanks for taking my questions. I have two questions. So could the management elaborate a bit more on the impact to the second quarter revenue guidance? We see that the first quarter was relatively resilient despite COVID-19 impact and seasonally soft quarter and directionally and judging from other Internet companies, with business activities resume, the second quarter should see decent quarter-over-quarter growth.

And what are the factors that affect QTT's ability to capture the advertising dollars that is different from other companies? Is that related to substantial cutback of user acquisition and engagement spend in the first quarter? And would management please provide some breakdown of major ad categories' contribution? And I have another question about cost of revenue. And it seems like content cost for reading will continue to capture a larger portion. Is the first quarter gross margins a new norm and we could see further pressure from here? Thank you.

Xiaolu Zhu

Thank you, Vicky. So to your first question regarding the advertising revenue trend so far this year, I think we did have a very strong performance before the Chinese New Year and before the pandemic and it looks like for us, March and April were the bottom, as most of our customers were quite conservative at the time, but we have seen the market start to pick up in late May and in June so far. It's still not back to the level we have seen before the pandemic but the trend for the last three or four weeks looks quite promising.

So in terms of breakdowns, we have seen strong demand from our e-commerce partners for the June 18 events recently. App downloads, which is a top category for us in last Q4 and Q1 this year is relatively weak as everyone is still taking a more cautious approach towards marketing and user based expansion so far this year. Branding is another area that remains weak. However, given our lack of exposure in this area in previous years, we have made some breakthroughs in Q1 this year with new advertising customers like China Mobile, Yum China and Evergrande to name a few.

So this will be an area where we can further enhance our monetization, but an overall weakness in branding means, this will not contribute significantly in terms of revenue in 2020 for us. So – but as we have said before, our strength in performance-based ads will help us to get through difficult times as our customers are increasingly looking for direct and more measurable results.

So all in all, I think the weakness in – from March to May probably explains the guidance for Q2, but we do see that our result is quite resilient in Q1, as you have already said. And also, we think that this – things were getting better starting from now as we have seen the trend for the last few weeks. And also in terms of marketing and investment, yes, we are – we have been quite cautious in terms of investments for marketing so far this year.

And as I said in our prepared remarks, on top of revenue growth, we will see at least a 10 percentage point improvement in non-GAAP operating margins in Q2 sequentially compared to Q1, which is already a big improvement compared to previous quarters. So overall, I think we are right on track towards what we have set, what targeted at the beginning of the year, which is a relatively gradual growth of user base and revenue, but to hit breakeven in the second half of this year.

Eric Tan

To your second question regarding gross margin and cost of revenues. I think as we have explained in the prepared remarks, there's several reasons for that. So to give you a little bit more detail, I think there are several things. First is obviously the investment for content. We make a big investment for online literature content for Midu starting from Q3 last year. And we also are starting our own proprietary content platform, which is also something we started in the second half of last year.

The other thing is that, for bandwidth and servers, obviously, more and more content are delivered in the form of video through our different apps for our users, which means that we need more bandwidth and servers. And also, we want to use algorithms to – for content recommendation, which means we also need more servers. As we have said, content and technology are two things that we believe that is very important for our future success, and we will continue to make investments in these areas. The other thing to note is the content review team, which makes sure the content compliance of our platform.

So all in all, I think we have a relatively stable cost of revenues. If you look at previous quarter numbers, the cost of content for Q1 is actually smaller compared to Q4 and Q3. So I think the margin is really depending on how fast we can grow our revenue. And I don't think that the level we have here in Q1 will be the new norm. Thank you.

Vicky Wei

Thank you.

Operator

Thank you. Our next question comes from the line of Hans Chung from KeyBanc. Please go ahead.

Unidentified Analyst

I'm asking on behalf of Hans. And – so I just want to know what's the management's view on the competition in online literature or the recent implications on China literature restructuring and what's the company's guidance about Midu in Q2 and beyond? Thank you.

Xiaolu Zhu

Thank you. So for Midu, I think we have seen a stable user base and monetization in Q1 and Q2 so far as we took a more balanced approach for the entire company between growth and profitability. This applies to Midu as well. The year-end target for Midu is still to get over 10 million in terms of DAU and a stable ARPU in line with the rest of the company. So we have made significant investment in content, especially our proprietary content, and we plan to keep investing in this area as we believe that only a healthy content ecosystem can retain the users over the long term, and a proprietary platform enables us to further interact with our users and to use real-time user data for quality analysis and to give real-time feedback to the authors.

The quality of the content and the right match of authors, content and readers are the key to long-term success for any content based business. So the proprietary program was launched less than nine months ago. And as we said, already six of the top 20 novels are Midu-owned. Competition wise, we see ByteDance and Baidu making – getting to this marketing strike and making several investment announcement. And also, there's a recent management reshuffling at China Literature. So you are definitely seeing more players making plans into the free literature market. But I think this further proves the value of this sector, and we welcome more players to make this a robust and healthy industry.

As we have said before, we believe the free literature market is much bigger compared to the traditional pay-to-read model. So there will always be competition from incumbents as well as newcomers. However, our head start and experience in user acquisition, monetization and a healthy content ecosystem makes us uniquely positioned in this market, and we will continue to be one of the leading players in this market. Thank you.

Unidentified Analyst

Thank you.

Operator

Thank you. Our next question comes from the line of Thomas Chong from Jefferies. Please go ahead.

Thomas Chong

Hi. Thanks management for taking my questions. I have – I will go back to the advertising side. I just want to get a sense about informing our Q2 guidance. What is the month-on-month – on a month, April, May and June, can you talk about the year-on-year growth or decline in each month so that we can better form the expectation for the second half?

And my second question is about the competitive landscape in advertising. How should we think about the impact of social media or other medium channels in getting the budget from advertisers? Thank you.

Xiaolu Zhu

Thank you, Thomas. So to your first question, yes, we have seen a gradual pickup in terms of revenue for us in the last few quarters. So to give you a sense, I think the revenues we get from the second half of May is about 15% higher compared to the first half of May. So you probably will get a sense of the speed of the pickup.

So in terms of your second question regarding different content format getting ad budgets and user times, I think if you look at our offerings on the QTT side, we started as a news feed app, but eventually, evolves into a content aggregator. So we have all kinds of different content formats on QTT, video included, we also have games, live streaming, so which help us to further expand our user base and also to increase our ARPU, even dealing the difficult times as we have witness – just witnessed in Q1 during the pandemic.

So I think for us, we are really trying to offer our users whatever content they want in whatever forms that is suitable to deliver. And also, if you look at our offerings, we also have two new short video apps with a combined DAU of close to 5 million in the last month, in May. So I think we are making different experiments, making different innovations in different fronts to make sure that we have the right offerings for our users in whatever format they want. Thank you.

Thomas Chong

Thank you.

Operator

Thank you. [Operator Instructions] Our next question comes from the line of Miranda Zhuang from Bank of America. Please go ahead.

Miranda Zhuang

Thank you, operator, and good evening all management. So my first question is about the OCPC system. So can you imagine an update about like what's the improvement to advertisers' ROI driven by this OCPC system? And then how is this OCPC system improve the, for example, the budget or ARPU per advertiser for us? And if I may further ask so I mean that there are a lot of advertising companies in China, they are all implementing the OCPX advertising system, like Total and like WIPO, Baidu, et cetera. So I'm wondering how do management view your OCPC system when you benchmark that with all the other competing advertising platforms?

And then my second question is about the user expenses. So management mentioned about trying to keep a gradual improvement in users, so how should we think about the overall user base growth for the second half of the year? And how should we think about the user engagement and acquisition costs? Thank you.

Xiaolu Zhu

Thank you, Miranda. So to your first question regarding OCPC, I think we started relatively earlier compared to our peers. I think we said during our last quarterly earnings that over 90% of our advertising are delivered through OCPC. This quarter, we said that over close to half our ads are now in second-degree OCPC, which means we can offer more detailed measurable results for the performance of our ads. That means that our customers can measure the retention, the eventual performance of the users they acquired from our platform.

So in terms of comparison with others, as I already explained that we are one of the leading players to get into this field, I think we are definitely among the first tier players in terms of the percentage of OCPC delivered and also in terms of the technologies we have so far explored. So we do believe that performance in the form of OCPC or OCPX is the right direction for the future of the advertising market, especially online.

In terms of your second question regarding user growth, I mean, as we have said, we want to take a more balanced approach between profitability and user base expansion. Overall, I think we will continue to invest for the long-term success of the business in terms of content and technology, which we believe is vital to the long-term success. And so it probably – we probably will keep a similar level of investment in absolute RMB terms. But as revenues grow in the second half, we will see a better gross margin and R&D as a percentage of revenue will also decrease.

In terms of your question regarding sales and marketing expenses, especially user engagement expense and user traffic acquisition. On the user engagement side, I think, as we have said, a better algorithm and better content will help us to further reduce user engagement expense. Last quarter is at RMB0.12 per user per day, about half the level from the peak two years ago. And we plan to keep the per user per day figure at a similar level or even lower for the coming quarters. So as a percentage of revenue, it will also decrease as we're getting out of the pandemic from numbers in Q1. And we will definitely see a higher ARPU in the second half.

In terms of TAC, we probably will increase TAC in coming quarters in absolute terms as we have been very conservative so far this year, especially since February. But as the market starts to recover and as we have more confidence in improving our operating efficiency from every aspect of our business, we are confident that we can achieve our target for both revenue and user growth as well as breakeven in the second half. So I think traffic acquisition as a percentage of revenue will also decrease despite the increase in absolute terms.

So overall, I think, as I said, we believe that on top of Q1 non-GAAP operating gross margin at 27%, we will see at least a 10 percentage points improvement in Q2, if not more. And we are very confident to get to non-GAAP breakeven by Q4 this year, and maybe even in Q3, if the market recovery continues and if we choose to more – with a more disciplined investment approach. Thank you.

Miranda Zhuang

Thank you, Xiaolu Zhu.

Operator

Thank you. [Operator Instructions] Great. As there are no further questions, I'd like to turn the call back to the company for closing remarks.

Sai Chi Du

Thank you all very much for joining us for today's call. And that concludes the call for today. If you have any further questions, please don't hesitate to contact the Investor Relations team at QTT. Thank you all very much. And we look forward to speaking to you next time.

Operator

Thank you. This concludes today's conference call. You may now disconnect your line. Thank you.