Qutoutiao Inc (NASDAQ: QTT) Q2 2020 earnings call dated Sep. 21, 2020
Corporate Participants:
Sai Chi Du — Investor Relations
Xiaolu Zhu — Chief Financial Officer
Analysts:
Zheqian Deng — KeyBanc Capital Markets — Analyst
Vicky Wei — Citigroup — Analyst
Thomas Chong — Jefferies — Analyst
Presentation:
Operator
Hello, ladies and gentlemen, thank you for standing by for the Second Quarter 2020 Earnings Conference Call for Qutoutiao Incorporated. 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 will now turn the call over to your host, Sai Chi Du. Please go ahead, Sai Chi.
Sai Chi Du — Investor Relations
Thank you very much. Welcome everyone to the second 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 US 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 US 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 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. So far this year, strategically, we are maintaining a good balance between growth and profitability. In other words, sustainability and healthy growth have been playing a very important role in our thinking, as COVID-19 put a damper on the general economy in the first half. We have taken a relatively cautious approach to managing the overall business. Despite the generally weak market and the slow recovery for the first half of this year, our business expanded at mid-teens rate in comparison to a year ago. In terms of sales, this is the result of all our hard work and unwavering investment, it’s a demonstration of the value we create for advertising customers as well as our loyal users who have been the biggest of support for us during challenging times like this.
Our operational efficiency has improved tremendously as we have kept overall costs well under control as the business expands. We managed to operate on a smaller sales and marketing budget, while maintaining a larger user base, which has very positively impacted our profitability. At the same time, we invested more into areas we deem to be strategically important over the long-term, mainly technology, algorithms, and content. We have been selective, i.e. not as plain straightforward as just adding headcount everywhere. Instead we are trying to gain a better picture of what we need to drive better growth for the business longer term and prioritize strengthening different segments of our capabilities accordingly.
To achieve our long-term objectives, we will continue to focus on content and technology. Since we started to directly sign up writers for Midu Novels, we have been increasingly seeing this strategy paying off as their share of the most popular novels keeps increasing and most recently reached 50%. That has been an important part of our content strategy as we integrate vertically. We will be able to extract much more value from the same IPs. Most recently, our Midu Novels also formed a strategic cooperation with Kuaishou in short video series, which will leverage Midu’s content and Kuaishou’s user traffic. This will raise the profile of Midu Novels original content and create a much stronger basis for the longer term harvesting of derivative IP value. Coupled with continued improvement in our recommendation engine, we see enhanced monetization efficiency, which has allowed us to drive down user engagement costs while increasing ARPU.
We feel encouraged by the strategic progress we have been making, especially with respect to content and technology and we expect them to be the key pillars supporting our future development. Our financial performance is also trending in the right direction, which gives us further confidence that we are taking the right steps. On July 16, 2020, China Central Television reported in its Annual Consumer Rights Show that certain advertisements placed by third-party advertising agents on Qutoutiao exaggerated the health benefits of certain food and diet products and promoted activities that may involve online-gambling. In response to the issues raised by the Report, the Company has promptly taken appropriate measures such as immediate suspension of all employees involved in these advertisements, including the person in-charge of advertising operations, stricter management of all third-party advertising agents, enhancement of content management capabilities in identifying misleading or inappropriate advertisements, and the launch of an easy-to-use and easy-to-find complaint channel on the home screen of Qutoutiao, so that users can file their complaints with us about any advertisement placed on our app. The Qutoutiao app was temporarily removed from several major Android-based app stores in China after the CCTV Report, but was reinstated on July 31, 2020.
It is our commitment to bring real value to our users, and it is against our ethos that less than 100% compliant content should appear. The ad industry itself comes with some inherent risks every player has to manage and which we are also fully aware of. We have always closely followed the rules and regulations of the industry and the country. We aim to build the best content ecosystem for every stakeholder on our platform. We would like to use this incident as a chance for us to further build on the content ecosystem on our advertising platform, which is part of our core strategy to establish a solid foundation for driving long-term growth and strengthening our competitive advantages. We have also taken the time to reflect on the current state of the advertising industry from both a seller and a buyer’s perspective as we calibrate our growth strategy.
Going forward, we will deemphasize close to spending marketing dollars and drive growth predominantly through engaging content, great recommendations and an excellent user experience overall. We remain motivated by and committed to our long-term vision of bringing rich and diversified online content to millions of users across the country. We started the business in the first place as we saw the lack of tailored online products and services for people in the low-tier cities, which accounted for the vast majority of China’s population and this gap remains large still as of today and will inevitably be filled as our society moves forward and urbanization drives disposable income growth. As the first Internet company to dedicate effort and resources to tackle this problem, we are well positioned to serve the great purpose and create significant value for all our users in the long run.
Thank you very much. That concludes Eric’s remarks and I will now turn the call over to our CFO, Xiaolu.
Xiaolu Zhu — Chief Financial Officer
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 second quarter of 2020 before touching on financial objectives for the remainder of this year.
Our revenues for the second quarter was RMB1,441 million, which represents an increase of 4% year-on-year and some moderate sequential growth as well. This has been driven by user base expansion as our DAU has increased by 11% year-on-year, albeit partially offset by the weaker ARPU, which saw a 6% decline, reflecting the difficult advertising market and the generally weaker economy in the second quarter.
We have been working hard to improve our operating efficiency and have seen greater results so far this year. Our operational loss ratio has narrowed to just under 10% in the second quarter of 2020, which is a record low and a significant improvement significant improvement both year-on-year and sequentially, continuing a very positive trend, we have delivered in recent quarters. This has been achieved with much more targeted and efficient marketing spending in terms of both acquiring new users and the user loyalty program. This testifies to the strength of our combination of core capabilities in content and technology, which we have invested into consistently. Now let’s look at the costs and expenses in more details. Unless otherwise stated, please note that I will be referring to non-GAAP measures, which means share-based compensation is excluded. Cost of revenues were RMB397 million in the second quarter, an increase of 10.4% from a year ago, primarily attributable to increases in content-related costs, reflecting the company’s long-term vision to build a platform, delivering high quality online content to our users. Gross profit was RMB1,044 [Phonetic] million in the second quarter, an increase of 1.7% from a year ago. Gross margin was 72.4% compared to 74% in the second quarter of 2019. The decrease of gross margin year-over-year was mainly driven by the growth of content-related costs. R&D expenses were RMB195 million in the second quarter, an increase of 6.1% from a year ago. Sales and marketing expenses were RMB922 million, a decrease of 29.6% year-over-year. Sales and marketing expenses as a percentage of net revenues was 64% in the second quarter of 2020 compared to 94.5% a year ago, continuing to hit record low. User engagement expenses were RMB457 million in the second quarter, a slight increase of 1.7% year-over-year and a decrease of 9.9% quarter-over-quarter. User engagement expenses per DAU per day were RMB0.12 in the second quarter of 2020 and compared to RMB0.13 in the second quarter of 2019. The decrease of user engagement expenses year-over-year was primarily due to the company’s ongoing efforts in optimizing user engagement expenses for its loyalty program as well as enhanced personalized reading experience facilitated by our AI platform and our enriched content library. User acquisition expenses were RMB436 million in the second quarter, a decrease of 44.7% year-over-year and 13.2% quarter-over-quarter. User acquisition expenses consist of the costs of both referrals and third-party marketing. The decrease mainly reflected the Company’s efforts in optimizing its traffic acquisition strategy, and to a lesser extent, the weak advertising market environment in the first half of this year. G&A expenses were RMB92 million in the second quarter. Non-GAAP loss from operations was RMB140.6 [Phonetic] million in the second quarter of 2020 compared to RMB506 million a year ago. Non-GAAP operating loss margin was 9.8% compared to 36.5% in the second quarter a year ago, an improvement of over 26%. Non-GAAP net loss was RMB173.3 million compared to net loss of RMB496.3 million in the second quarter of 2019 and the non-GAAP net loss margin was 12% compared to 35.8% in the second quarter of 2019. Now on to the outlook for Q3 and the second half of 2020. The CCTV Report, which Eric referred to earlier caused the Qutoutiao application to be taken off at app stores for short period of time in earlier Q3. The company has observed negative impacts on its business operation and financial performance due to this in this quarter and is still evaluating the extent of such impacts. Qutoutiao highly appreciates the importance of strict compliance with all applicable laws and regulations and believes the measures taken by the company are critical to protect the interests of its users and investors in the long-term. For the third quarter of 2020, the company currently expects net revenues to be between RMB1,130 million to RMB1,150 million. This outlook reflects Qutoutiao’s current and the preliminary view including preliminary assessment on the potential impact from the CCTV Report, which is subject to uncertainty. In terms of the bottom line, we expect our operating loss to be narrow significantly on a year-over-year basis and flat on a quarter-to-quarter basis in the third quarter and we remain committed to further improve our operational efficiency as we have achieved consistently over the past several quarters and we expect this trend to continue in the fourth quarter of 2020 and beyond. This concludes today’s prepared remarks. Again, thank you all very much and we are now open for questions. Operator, please proceed.
Questions and Answers:
Operator
Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from the line of Zoe Deng of KeyBanc Capital. Please ask your question.
Zheqian Deng — KeyBanc Capital Markets — Analyst
Thank you management for taking my questions. I’m asking the questions on behalf of Hans Chung. So I have two questions. My first question is about third quarter guidance. So the third quarter guidance is much lower than the consensus because of the CCTV Report issue. But even when we add back to two weeks run rate due to the temporary removal of Qutoutiao app on Android app stores, third quarter guided revenue is still well below consensus, so could you elaborate on the causes for that. Does ARPU get impacted because we clean-out those non-compliant ads.
And then my second question is, although this quarter revenue is guided down quite a bit from the second quarter, operating loss is still expected to be flat sequentially. So where are we cutting the most in expenses. Thank you.
Xiaolu Zhu — Chief Financial Officer
Thank you, Zoe. These are very important questions. So regarding your first question on Q3 guidance, I think as we have said in the prepared remarks, both us and our advertising partners are quite cautious post the CCTV Report and we took extraordinary measures to make sure that our content and ads are compliant. I would say that we went above and beyond what the laws and regulations as well as industry practice would normally require in China. And the second reason and I believe more important reason is, as we have said repeatedly in previous earnings calls is that we want to take a more balanced approach between profitability and growth.
So this means three things. Firstly that, because we took and will continue to take a modest prudent approach our investment, especially on the marketing side and we would require a good ROI for every marketing dollar we spent. So we are likely to see a more subdued growth trend in terms of both revenue increase and user base expansion in the near term rather than the neck-breaking speed we have experienced back in 2018. Second, we want to make sure that we get to a breakeven on some profitability by the end of this year and this is the key priority for us and we will continue to see topline growth going into Q4 and beyond, but the more important target for us right now is to get a positive bottom line. And the last but not least, we want to further shift the user base mix to our users attracted to our platform by content, be it newsfeeds, short videos or novels and etc, we want our loyalty program to stimulate and encourage our users to stay engaged with us, but we don’t want them to be on our platform purely for the loyalty points. So as we have said before, we believe content and recommendation algorithms are the key pillars for our future growth and the user base built out these would be a good foundation for our long-term sustainable growth.
So regarding your second question, ARPU and breakeven, I think we still target to be breakeven in Q4 on a non-GAAP operating basis. We are already very close to breakeven in June and despite the recent setbacks, we expect the operating loss in Q3 to be in line with Q2 and to improve significantly compared to the same period one year ago. So given the recent trends, the recovery of our revenues as well as the usual seasonality, which means that Q4 usually will be the best season for advertising of the year, we are very confident that it will continue to improve our operating efficiency in the rest of the year and to get to breakeven in Q4.
And if you look at the major line items, I think first that we will continue to invest in content and technology, which we believe is vital to our long-term success and we’ll keep a similar level of investment in absolute dollar terms for content and technology. Total sales and marketing expense was at like 64% of our revenue in Q2, over 30% improvement year-on-year, and we believe believe this trend will continue and we will definitely see further operating leverage from this end for the coming quarters and especially our savings from user engagement expenses with better algorithms and the better content as we have explained in the prepared remarks. So our user engagement expense at RMB0.12 per user per day and only about half the level from the peak two years ago and we plan to keep that figure at the similar level or even lower for the coming quarter. And in terms of TAC, we have been very conservative so far this year and we probably will continue this approach as well. So if you look at our bottom line, non-GAAP operating loss margin for Q2 was less than 10%. As we have said in our Q1 earnings call, we see at least 10 percentage point improvement in Q2 compared to Q1 and the actual improvement was over 15%. So in all, we are still very confident to get non-GAAP breakeven by Q4 and along the way, we will also have a better user mix with more users attracted to our platform by our content. Thank you.
Operator
Your next question comes from the line of Vicky way of Citi. Please ask your question.
Vicky Wei — Citigroup — Analyst
Thank you management for taking my questions. So you share a bit about the breakeven target for the second half. So may I ask what is the company’s strategy to maintain user growth and reduce cost to achieve profitability. So would you please elaborate about the user growth strategy and while you prioritize the profitability.
And my second question is, what does management think of the second half advertising market sentiment and what do you think how long the CCTV impact will last. Thank you.
Xiaolu Zhu — Chief Financial Officer
Thank you, Vicky. So for your first question regarding our user growth, I think as we have explained before that we do want to make sure that we will continue to have long-term sustainable growth and we want to take a approach balanced between profitability and growth. But obviously we want to be profitable at the DAU level of over 100 million rather than the current 40-plus million, but however we do want to make sure that we are on the right path for long-term growth and also want to prove the value of our users and our business model and we think to achieve profitability this year is the right choice, given the uncertainty in the market, but as said, we still plan for healthy user base expansion and the revenue growth for the coming years.
The other thing to note is that this is a result of a more disciplined spending instead of simply cutting the budget, which means that we are getting the results we want with good ROI for each marketing dollars we are spending and if the market recovery continues and if the ROI is right, which we believe it will, then we will not hesitate to invest for the future. The other thing that we have already said that we do want to have a better user mix, we want users that are attracted to our platform by content, be it newsfeed, short videos or novels and etc, we want our loyal program to encourage our users to stay to engage with us, but we don’t want them to be on our platform purely for the loyalty points. So we do want to make sure that along the way in our path towards profitability, we will get a better user base mix and this will be a good foundation for our long-term growth.
Regarding your second question on the overall markets, I think that we have seen the market start to pick up in the second half of Q2 and this trend continued in Q3. So it’s still not back to the levels we have seen before the pandemic, but the overall trend in the market looks promising. As we have said in the prepared remarks, the CCTV Report caused the Qutoutiao application to be taken off app stores for about two weeks. We have observed negative impacts on our business operation and financial performance due to this in Q3 and we are still evaluating the extent of such impacts. But as we have said, we have already seen a trend of recovery and we think the growth and recovery will continue in Q4. Thank you.
Vicky Wei — Citigroup — Analyst
Thank you.
Operator
Your next question comes from the line of Thomas Chong [Phonetic] of Jefferies. Please ask your question.
Thomas Chong — Jefferies — Analyst
Hi, management. Thank you for taking my question. I am asking on behalf of Thomas Chong. My first question is about the content cost trends. Exclusively is committed to deliver our high quality content to user and this will continue to be our goal to guide user engagement, so do you expect to see continue increase in content cost and could you also share the revenue sharing trend with the content creator.
And my second question is on the GP margin. So after talking about this cost content trend, how should we see its impact on the GP margin and we see the GP margin increase quarter-over-quarter in the second quarter. So should we continue to expect there will be a margin expansion. Thank you.
Xiaolu Zhu — Chief Financial Officer
Thank you. So regarding your first question in terms of content cost trend, yes, we have made significant investment on the content side, especially for Midu for the last few quarters or for the last one or two years. And in terms of our revenue sharing, I think as we have explained before, because there are lots of freelancers and other content contributors to our newsfeed business, I think the content sharing for the newsfeed side of the business will continue to be quite low, less than 10%.
On the Midu side, we usually share about 20% of our revenue with our content providers. But you know as we start to grow this business and as we make more investment and sign more contracts with different content providers, there will be different contractual arrangement here and there. So there might be some fluctuations, especially on the Midu side in terms of the content cost from quarter-to-quarter, but I think overall the trend will continue to be stable. So content cost as a percentage of revenue I think probably will fluctuate from quarter-to-quarter, but remain at a similar level over the longer term.
So in terms of GP margin, its basically the same question, because the main impact factor affecting our GP margin over the last two quarters are the content cost. And so if we increase our content costs a bit from quarter-to-quarter, there might be some fluctuation to our GP margin, but I think overall I think we’ll continue to see our GP margin around 70% or some quarters over 70%. Thank you.
Thomas Chong — Jefferies — Analyst
Thank you.
Operator
[Operator Instructions] As there are no further questions, now I’d like to turn the call back over to Sai Chi.
Sai Chi Du — Investor Relations
Thank you all very much for joining us for today’s call. And if you have any further questions, please don’t hesitate to contact us at Investor Relations department. Thank you all and have a good day.
Operator
[Operator Closing Remarks]