Executive Summary / Key Takeaways

• Youdao, Inc. (NASDAQ:DAO) has achieved a significant financial turnaround, marked by its first full-year operating profit in 2024 and its first profitable second quarter in Q2 2025, driven by a focused AI-native strategy.
• The company's proprietary Confucius Large Language Model (LLM) and strategic integration of open-source models like DeepSeek-R1 provide a robust technological advantage, delivering superior performance and cost efficiency in specialized education and advertising applications.
• Growth is propelled by strong performance in Youdao Lingshi within learning services, which saw approximately 30% year-over-year revenue growth in Q2 2025 and a retention rate exceeding 75%, alongside robust expansion in online marketing services, which surged 23.8% year-over-year in Q2 2025, fueled by the gaming industry and overseas markets.
• Management targets moderate revenue growth and accelerated profit growth for the full year 2025, aiming for operating cash flow breakeven, while continuing strategic investments in AI innovation and product development.
• Despite macroeconomic uncertainties and intense competition from established players like New Oriental Education & Technology Group Inc. and TAL Education Group , Youdao's differentiated technology, strategic partnerships, and affiliation with NetEase, Inc. offer a compelling competitive edge.

Youdao's AI-Native Core: A Strategic Transformation

Youdao, Inc., a subsidiary of NetEase, Inc. , has strategically positioned itself at the forefront of AI-powered solutions in China's dynamic education and advertising sectors. Founded in 2006, the company initially built its foundation on online knowledge tools, most notably the Youdao Dictionary. This historical emphasis on technology and user utility laid the groundwork for its current "AI Native Strategy," which involves deeply embedding large language models (LLMs) across its business lines to enhance user experience and drive growth.

The broader industry landscape is undergoing a profound transformation, with artificial intelligence emerging as a pivotal force. China's AI hardware market, excluding smartphones and cars, is projected to exceed RMB 1 trillion for the first time in 2025, with the educational smart device segment alone expected to reach RMB 34 billion. This trend, coupled with a significant shift in the multi-trillion yuan advertising industry towards performance-based models and the increasing application of LLMs, presents substantial opportunities for Youdao. The company's strategy is to capitalize on these shifts by applying LLM technology to critical learning and advertisement scenarios, addressing real-world challenges, and ultimately driving user satisfaction and business expansion.

Youdao operates in a highly competitive environment, facing established players such as New Oriental Education & Technology Group Inc. , TAL Education Group , and Gaotu Techedu Inc. , as well as indirect competitors ranging from free online resources to large tech platforms like ByteDance and Alibaba (BABA). Youdao's foundational strengths, including its technological differentiation and its strategic affiliation with NetEase, Inc. , are crucial in this landscape. The company's ability to innovate rapidly and integrate advanced AI into its offerings provides a distinct competitive advantage, particularly in specialized domains.

Technological Moat: The Power of Confucius and DeepSeek Integration

Youdao's core competitive advantage stems from its advanced proprietary AI technology, particularly its Confucius Large Language Model, and its strategic integration with leading open-source models like DeepSeek-R1. This dual approach allows Youdao to develop highly specialized and efficient AI solutions across its product portfolio.

The company's Confucius 3-Math, China's first reasoning model dedicated to math education, exemplifies this technological edge. It delivers state-of-the-art accuracy with exceptional cost efficiency, boasting 15 times the inference performance of DeepSeek-R1 at just USD 0.15 per million tokens, significantly below typical LLM costs. This enables the low-cost deployment of professional-grade math AI applications. Furthermore, Confucius-o1, an open-sourced, lightweight 14-billion-parameter reasoning model, offers competitive K-12 performance while being more cost-effective and easier to deploy than larger alternatives. It has demonstrated superior effectiveness in math tasks compared to DeepSeek R1 of the same size.

Youdao's commitment to technological innovation extends to its translation capabilities. The Confucius translation model operates with just 10% of the parameters of larger general models while maintaining industry-leading accuracy. An edge-based Confucius model, with fewer than one billion parameters, even delivers offline translation quality surpassing many online neural machine translation (NMT) models. These advancements translate into tangible benefits for users, such as faster responses from Confucius models for quick checks and more comprehensive answers from DeepSeek R1 for in-depth explanations.

The impact of these technological differentiators is evident across Youdao's product lines. The Mr. P AI Tutor, powered by Confucius 3-Math, has achieved over 95% accuracy for K-12 math problem solving and tutoring. Its multi-model visual system boasts over 92% accuracy for K-12 problem solving, a 7 percentage point improvement from the previous year. In Q2 2025, the newly introduced AI Essay Grading feature, designed in line with exam grading standards, drove retention rates for Youdao Lingshi above 75%, a historical high. For online marketing, the AI ad placement optimizer, launched in Q2 2025, is an end-to-end AI-driven agentic solution that covers demand analysis, strategy formation, data analytics, and iterative optimizations, operating 24/7 with data processing capacity significantly exceeding human capabilities.

These technological advancements contribute directly to Youdao's competitive moat, enabling higher user satisfaction, improved operational efficiency, and a stronger market position. The ability to develop specialized, cost-effective, and high-performing AI models for specific educational and advertising scenarios provides Youdao with a distinct edge against more generalized AI offerings and traditional competitors.

Strategic Pillars and Operational Excellence

Youdao's strategic execution is evident across its three core business segments: Learning Services, Online Marketing Services, and Smart Devices. Each segment is being transformed by the company's AI-native strategy, driving both operational efficiency and financial performance.

Learning Services: Focused Growth and AI Enhancement

The Learning Services segment, which includes offerings like Youdao Lingshi, digital content services, and AI-driven subscriptions, has undergone a strategic restructuring to prioritize high-return-on-investment engagements. While this led to a 16.1% year-over-year revenue decline in Q1 2025, the rate of decline narrowed, and the segment's revenues covered costs and operating expenses, yielding meaningful profits. In Q2 2025, net revenues from learning services rose 2.2% year-over-year to RMB 657.8 million, primarily driven by the strong performance of Youdao Lingshi.

Youdao Lingshi is a strategic priority, with its AI college admission advisers, powered by the Confucius LLM, contributing to over 25% year-over-year gross billing growth in Q1 2025. User satisfaction is high, with Q2 2025 retention rates exceeding 75%, a historical high, following the introduction of AI Essay Grading and personalized learning plans. AI-driven subscription services have also demonstrated robust growth, with sales reaching nearly RMB 80 million in Q2 2025, an approximately 30% year-over-year increase, setting a new record. For STEAM courses, programming gross billings increased roughly 15% year-over-year in Q2 2025, with retention rates also exceeding 75%. Management expects the segment restructuring to conclude in the second half of 2025, with revenue stabilization and Youdao Lingshi projected to achieve year-over-year growth in both revenue and profit for the full year. Future plans include expanding AI Essay Grading to English and launching AI tutoring powered by Confucius 3.0.

Online Marketing Services: AI-Driven Expansion

The Online Marketing Services segment has been a significant growth driver, achieving record net revenues of RMB 632.9 million in Q2 2025, a 23.8% increase year-over-year. This growth is primarily fueled by strong demand from the gaming industry, with gaming ad revenue increasing over 50% year-over-year in Q2 2025, and expansion into overseas markets. Youdao has deepened its collaboration with NetEase Games and other gaming advertisers, and its partnerships with TikTok and Google have contributed to significant overseas growth, including triple-digit percentage revenue growth with Google .

The company's investment in GenAI-powered advertising technologies, such as the AI ad placement optimizer and iMagicBox (an AI creative generation product), is central to its strategy. These tools provide end-to-end AI decision-making across the advertising workflow, from creative development to post-campaign analytics. While the gross margin for online marketing services in Q2 2025 was 25.8%, down 13 percentage points year-over-year due to the initial onboarding of new clients, management anticipates it will stabilize in the 25% to 35% range over the medium to long term. Stronger growth momentum is expected in the second half of 2025, driven by accelerated overseas advertising expansion, updated AI-powered solutions, and deeper collaboration with NetEase Group .

Smart Devices: Innovation and Market Leadership

Youdao's Smart Devices segment, known for its Youdao Dictionary Pen, has demonstrated resilience and innovation. While net revenues declined 23.9% year-over-year to RMB 126.8 million in Q2 2025, primarily due to certain high-end Dictionary Pen models reaching the end of their product life cycles and reduced marketing expenditure, the business health of the segment improved in Q1 and Q2 2025. The Youdao Dictionary Pen has maintained its market leadership, securing the #1 spot in sales on JD.com (JD) and Tmall during the 618 shopping festival for the sixth consecutive year. Cumulative sales of the Dictionary Pen have surpassed 10 million units since its market debut.

The company continues to innovate in this space, launching the SpaceOne, an AI-powered large-screen tutoring pen, in Q1 2025, featuring the Confucius multi-model LLM. A new AI-powered smart device, a new Tutoring Pen product, was expected to be unveiled shortly after the Q2 2025 earnings call, with its enhanced user experience projected to drive improvements in the segment's metrics in the second half of 2025. Management remains optimistic about the long-term potential of AI-powered devices, citing the projected RMB 34 billion market size for educational smart devices in China for 2025. The deepening synergy between hardware and learning services is also expected to unlock cross-selling opportunities and reduce sales and marketing expenses.

Financial Performance: A Turnaround Story

Youdao has undergone a remarkable financial transformation, shifting from significant losses to sustained profitability. For the full year 2024, the company achieved its first-ever operating profit, reaching RMB 148.8 million, a substantial turnaround from an operating loss of RMB 466.3 million in 2023. This positive trajectory continued into 2025, with operating income surging to a Q1 record of RMB 104.0 million, a 247.7% increase year-over-year, despite a 6.7% decline in net revenues to RMB 1.3 billion.

The second quarter of 2025 marked another significant milestone, as Youdao reported its first profitable second quarter, with operating income of RMB 28.8 million, a notable improvement from an operating loss of RMB 72.6 million in the same period last year. Net revenues for Q2 2025 increased by 7.2% year-over-year to RMB 1.4 billion. For the first half of 2025, total net revenue reached RMB 2.7 billion, a slight increase year-over-year, while operating income surged to a record RMB 132.8 million from a loss of RMB 42.6 million a year ago.

Gross profit for Q2 2025 was RMB 609.4 million, a 4.3% decrease year-over-year. Segment-wise, learning services maintained a gross margin of 59.8%, smart devices saw an increase to 41.5% (from 30.3% in Q2 2024, driven by newly launched Dictionary Pens), and online marketing services recorded 25.8%. The decline in online marketing services gross margin was attributed to the initial onboarding of new clients.

Youdao has also demonstrated disciplined cost management, with total operating expenses reduced to RMB 580.6 million in Q2 2025, compared with RMB 709.3 million in the same period last year. Sales and marketing expenses declined to RMB 401.8 million, and research and development expenses decreased to RMB 128.3 million. This cost optimization, coupled with AI integration, has been crucial for improving profitability. The net loss attributable to ordinary shareholders in Q2 2025 was RMB 17.8 million, a significant improvement from RMB 99.5 million in the prior year period. Non-GAAP net income for the quarter was RMB 12.5 million, compared to a non-GAAP net loss of RMB 96.0 million in Q2 2024.

From a liquidity perspective, operating cash inflow in Q2 2025 was RMB 185 million, although this represented a 26.1% decrease year-over-year, primarily due to the strategic scaling back of certain STEAM and adult courses. However, for the first half of 2025, net cash provided by operating activities was approximately RMB 70 million, an improvement of around 50% compared to an operating cash outflow of RMB 140.8 million in the first half of 2024. As of June 30, 2025, cash, cash equivalents, current and noncurrent restricted cash, and short-term investments totaled RMB 617 million.

Competitive Positioning and Strategic Responses

Youdao operates in a highly competitive landscape, with direct rivals including New Oriental Education & Technology Group Inc. , TAL Education Group , and Gaotu Techedu Inc. (GOTU). While these competitors have established brand presence and diversified operations, Youdao differentiates itself through its deep AI integration and specialized product offerings.

Youdao's technological leadership, particularly with its Confucius LLM and its strategic blend with DeepSeek-R1, provides a significant competitive advantage. For instance, Confucius-o1 outperforms DeepSeek R1 of the same size in math tasks, and Confucius 3-Math offers superior inference performance at a fraction of the cost. This specialized AI capability allows Youdao to deliver highly accurate and cost-efficient learning solutions like the Mr. P AI Tutor, which achieves over 95% accuracy in K-12 math problem solving. This contrasts with competitors who may rely on more generalized AI or traditional teaching methods.

In the smart devices market, Youdao's Dictionary Pen maintains clear market leadership, securing the top sales position on major e-commerce platforms for six consecutive years. This dominance is further strengthened by the integration of LLM features, such as offline large language model translation with accuracy surpassing online neural machine translation in the X7 series. While New Oriental (EDU) and TAL (TAL) have broader market reach and often stronger cash flow generation due to their scale, Youdao's focus on AI-driven innovation in niche, high-demand segments allows it to carve out a distinct value proposition.

The online marketing services segment demonstrates Youdao's ability to compete effectively by leveraging AI. The AI ad placement optimizer and iMagicBox provide end-to-end AI-powered advertising solutions, enhancing efficiency and advertiser ROI. This technological edge helps Youdao attract clients in growing sectors like gaming and expand its overseas presence through partnerships with global platforms like TikTok and Google (GOOGL).

However, Youdao faces vulnerabilities, including its dependence on the evolving Chinese regulatory environment and the intense competition from free alternatives in the AI space. The company's balance sheet has also shown negative equity in the past, a concern that improved profitability is now addressing. Youdao's strategic response involves deepening collaboration with NetEase Group , expanding globally, and continuously enhancing its AI tech stack to maintain its competitive edge and drive sustainable growth.

Outlook and Risks

Youdao's management is confident in its strategic direction, targeting moderate revenue growth and accelerated profit growth for the full year 2025. The company aims to achieve operating cash flow breakeven for 2025, building on the significant financial improvements seen in 2024 and the first half of 2025. Key assumptions underpinning this outlook include stable macroeconomic conditions and the continued maturation and cost-effectiveness of AI technology.

Specific guidance highlights include the expectation for Youdao Lingshi to maintain momentum and achieve year-over-year growth in both revenue and profit for 2025. The online marketing services segment is projected to show stronger growth momentum in the second half of 2025, driven by accelerated overseas advertising expansion, advanced AI-powered solutions, and deeper collaboration with NetEase Group (NTES). The Smart Devices segment is also expected to see improvements in metrics in the second half of 2025, fueled by new AI-powered product launches.

Despite this optimistic outlook, several risks warrant investor attention. Macroeconomic uncertainties, both domestically and internationally, could introduce operational variabilities and impact demand for Youdao's services. Intense competition, particularly from free AI alternatives and well-capitalized established players, could limit monetization potential and necessitate ongoing high investment in R&D and marketing. Regulatory changes in China's education sector also remain a perennial risk.

Youdao has demonstrated a commitment to shareholder returns, with plans to utilize the remaining budget from its $40 million share buyback authorization. With improved profitability, management has indicated the potential for a new buyback plan in future quarters, balancing this with strategic investments in technology.

Conclusion

Youdao, Inc. stands at a pivotal juncture, having successfully executed an AI-native transformation that has reversed historical losses and ushered in a new era of profitability. The company's strategic focus on high-margin learning services like Youdao Lingshi, its rapidly expanding AI-driven online marketing, and its innovative smart devices, all powered by a differentiated AI technology stack, form a compelling investment thesis. The proprietary Confucius LLM, with its demonstrated superior performance and cost efficiency in specialized educational applications, provides a robust competitive moat against both traditional and emerging rivals.

While macroeconomic headwinds and intense competition present ongoing challenges, Youdao's disciplined operational execution, strategic partnerships, and continuous investment in AI innovation position it for sustained growth. The company's achievement of its first full-year operating profit in 2024 and its first profitable second quarter in Q2 2025 underscore the effectiveness of its strategy. As Youdao continues to enhance learner productivity and deliver higher returns on advertising through its advanced AI capabilities, it is well-positioned to unlock further value for investors in China's evolving digital landscape.