Earnings Call Transcript - KC Q1 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by and welcome to the Kingsoft Cloud’s First Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. Please be advised that this conference is being recorded today. I will now like to hand the conference over to your speaker today, Ms. Nicole Shan. Thank you. Please go ahead.

Nicole Shan, Speaker

Thank you, operator. Hello, everyone, and thank you all for joining us today. Kingsoft Cloud’s first quarter 2020 earnings release was distributed early today and is available on our IR website at ir.ksyun.com as well as on Globe Newswire Services. On the call today from Kingsoft Cloud we have Mr. Yulin Wang, Chief Executive Officer; and Mr. Haijian He, Chief Financial Officer. Mr. Wang will review business operations and company highlights, followed by Mr. He, who will discuss financials and guidance. They will be available to answer your questions during the Q&A session that follows. Before we begin, I like to remind you that this conference contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended and as defect in the U.S. Private Securities Litigation Reform Act of 1994. These forward-looking statements are based upon management’s current expectations and current market and operating conditions and are related to events that involve known or unknown risks and uncertainties and other factors of which are difficult to predict, and many of which are beyond the company’s control, which may cause the company’s actual results, performance, or achievements to differ materially from those in the forward-looking statements. Further information regarding this and other risks and uncertainties factors is included in the company’s filings with the U.S. SEC. The company doesn’t undertake any obligation to update any forward-looking statements as a result of new information, future events, or otherwise, except as required under the applicable law. Finally, please note that unless otherwise stated, our figures mentioned during this call are in renminbi. It’s now my pleasure to introduce our Chief Executive Officer, Mr. Yulin Wang. Please go ahead.

Yulin Wang, CEO

Thank you, Nicole, and thank you all for joining us for our first earnings call as a public company. We were successfully listed on NASDAQ on May 8, 2020, marking a significant milestone in our company history and a new chapter for us. Since our inception, we have been building strong relationships with enterprise customers through high-quality services. As a public company, we are now committed to creating value for our shareholders. We have established a solid foothold in the cloud-based game and video sectors and have strategically expanded our presence into financial and traditional enterprises. We focus on select fast-growing verticals, driving our business with a technology-driven approach, while providing cloud services and solutions to our primary customers. With our focus and commitment to our cloud business, we can avoid potential conflicts of interest and maintain a unique neutral position in the cloud industry. As enterprises pay more attention to data security and seek to avoid potential conflicts of interest, many leading enterprises are adopting multi-cloud strategies, further accelerating our rapid growth due to our neutral stance. I would like to express our deepest sympathies to all those affected by the current global pandemic. We will continue to support our clients and their communities. Our cloud-based services are critical to businesses during this challenging economic climate. The pandemic has increased the reliance on digital solutions and remote working capabilities. Many customers have approached us since the outbreak seeking more effective cloud service deployment and technological support, which reinforces our business development prospects in the mid to long term while elevating our profile in the cloud market. We had an outstanding quarter with total revenues reaching RMB1.39 billion, a 64.5% increase from the same period last year, primarily driven by our focus on select strategic verticals and primary customers. I will now share some highlights. In the video sector, our comprehensive AI-driven video cloud solutions have established our industry-leading edge computing platform, which continues to grow rapidly. The enhancement of our high-capacity elastic cloud delivery network is driving the adoption of our business applications. For instance, in January 2020, our platform provided backend technological support for the Spring Festival Gala, the most viewed TV show in China during the Chinese New Year holiday. We have numerous cloud broadcast stations and transcoding parameters with a disaster recovery system, achieving a second-level emergency response. Additionally, we were the first in the sector to support Quick UDP Internet Connections, or QUIC cloud streaming, which significantly reduces latency and improves the video streaming experience. In the gaming sector, we officially launched a cloud-based game trial platform in February, offering a full-stack cloud-based solution that includes IaaS and PaaS. In collaboration with game companies, we are providing players with cloud-based gaming experiences through this platform and expect more extensive adoption going forward. Moreover, we have begun to implement our go-to-market strategy for cloud-based game solutions this quarter, offering high-quality services across various sectors, including game developers, distributors, and operators. Beyond video and gaming, we have made solid progress in sub-verticals within the internet industry. For instance, in the education sector, we delivered a digital interactive classroom solution to a leading online education company this quarter, encompassing IaaS and PaaS services. This solution facilitates online live teaching and ensures a smooth transition for students from offline to online amid the pandemic. We continue to support traditional enterprises as they transition to cloud-based IT infrastructure. To address the increasing demand for cloud services from traditional companies during the COVID-19 outbreak, we launched eight dynamic mitigation solutions. These solutions pertain to sectors such as emergency supplies management, collaborative office systems, remote education, and remote healthcare. One example is our emergency supplies management system developed in January 2020, which we offered to public health organizations at the forefront of virus containment across 30 provinces and cities in China. This initiative reflects our commitment to corporate social responsibility. Additionally, our products and technologies are increasingly recognized by public service organizations and enterprises for their quality and reliability, allowing us to gain valuable service experience. Furthermore, we provided cloud technology to enhance the control room of a leading domestic utility infrastructure company during the quarter, including deep learning platforms and inherent identification model development services, which earned high praise from the customer. We will continue to actively invest in opportunities associated with constructing new infrastructure, including the fifth generation big data centers, the AI industry, and IoT. We are dedicated to empowering enterprises through our cloud services. In the financial services sector, we have bolstered our investment in the research and development of distributed databases to maintain our competitive edge. We continue to support financial institutions, internet companies, and traditional enterprises with our robust cloud capabilities. For example, during the quarter, we implemented Galaxy Stack, our premier public cloud architecture, within the client's internal IT infrastructure at a leading domestic internet bank. Now turning to our AIoT segment, launched in 2019 in collaboration with Xiaomi and their extensive IoT ecosystem. We have reached phase four of our IoT product and its capabilities. Liaoning Province is probably the first community project, which began delivery during the quarter. This represents the first local small community covering both indoor and outdoor environments. As enterprises, communities, and cities seek to adapt infrastructure enabled by interconnected devices and solutions, this field will create new market opportunities in the future. Moving forward, we will continue to focus on deepening our solution offerings across different workflows, improving operational efficiency, achieving sustainable growth, and increasing shareholder value. We firmly believe in the growth potential of cloud solutions and are confident in our ability to seize these opportunities. I will now turn the call over to Henry to discuss our financials for the quarter. Thank you.

Haijian He, CFO

Thank you, Yulin, and thank you, Nicole. Hello everyone. I will discuss the financial performance of this quarter. Please be reminded that all announced currency here will be in RMB. Please also refer to our earnings release for detailed information. Before we go through the details, I would like to highlight the following four points. First of all, in our F-1 prospectus, we provided revenue outlook for the first quarter of 2020, which ranged from RMB1.35 billion to RMB1.4 billion. The total revenue of this quarter finished at the top end of the range at RMB1.39 billion, representing an increase of 64.5% year-over-year and exceeding the growth of the public cloud industry in China in general. Second, we achieved positive gross profit for the third consecutive quarter, and adjusted gross margin has continued to improve gradually for seven quarters. As a result, the adjusted gross margin increased rapidly from negative 5.3% in Q1 2019 to positive 5.3% in Q1 2020, an improvement of 10.6 percentage points. Third, adjusted EBITDA margin increased as well, up from negative 12.9% in Q1 2019 to negative 2.8% in Q1 2020, an improvement of 10.1 percentage points. Adjusted EBITDA margin continued to improve steadily for seven consecutive quarters. Lastly, we have maintained a healthy balance sheet and sufficient liquidity. As of March 31, 2020, we had cash and cash equivalents, and term deposits of RMB1.97 billion. On May 8, we raised US$551.3 million of net proceeds from the IPO. Moving forward, we will continue to maintain a healthy balance sheet and ensure sufficient investments into R&D and IT infrastructure. To summarize, we are pleased to have maintained a high revenue growth rate and significantly improved our profitability. Growing economies of scale have already benefited our performance. Now I will go through the details of the financial results. Our public cloud service revenue increased by 58.4% year-over-year to RMB1.21 billion. The increase is primarily due to the increasing demand for cloud services from internal verticals. Our top-line performance has shown a good level of resilience due to the nature of our cloud business model in the middle of the challenging environment. Growth in users and time spent on those two verticals, including video and gaming verticals, as well as a growing demand for our technologies contributed to the revenue growth. Enterprise cost service revenue increased by 118.8% year-over-year to RMB181.6 million. Enterprise cost service revenue accounted for nearly 13.1% of our total revenue in the first quarter, up from 9.8% in the same period of 2019, indicating a more diversified revenue mix. We are pleased to see that traditional enterprises increasingly shift their on-premises IT budgets to the cloud. Our robust financial results this quarter reflect this trend and demonstrate that diversified revenue streams will continue to drive future growth for us. Cost of revenue increased by 48.2% year-over-year to RMB1.3 billion. IDC costs increased by 36.1% year-over-year to RMB920.2 million, but as a percentage of total revenue decreased from 80% during the same period last year to 66.2% in the first quarter of this year. D&A costs increased by 51.3% year-over-year to RMB204.8 million, but as a percentage of total revenue, D&A costs declined from 16% during the same period last year to 14.7% in the first quarter of this year. Staff costs were RMB13.1 million and other costs were RMB182.1 million during the quarter. As we continue to advance our cloud technology, we are seeing continuous improvement in the efficiency of our IT resources, and as a result, IDC costs and D&A expenses, as a percentage of total revenue will gradually decrease potentially. Adjusted gross profit reached RMB74.2 million, compared to adjusted gross loss of RMB44.6 million in the same quarter of 2019. Our adjusted gross margin turned positive in the third quarter of 2019, and it further improved to 5.3% this quarter. Thanks to economies of scale and operating leverage, we are pleased to see our profitability continue to improve. Total operating expenses increased to RMB359.6 million, up 69.4% from the same period in 2019. Operational leverage and efficiency improved during this quarter, and as operating expenses excluding the impact of share-based compensation have continued to decline. R&D expenses were RMB195.7 million, representing a 57.3% increase year-over-year. The increase was primarily due to our business development and increased headcount in R&D personnel. We have built our business around our core team of outstanding engineers. As of March 31, 2020, we had 1,213 R&D personnel accounting for approximately 60% of total employees. We believe our robust technology expertise and engineering focus will further enhance our position as the largest independent cloud service provider in China and drive greater operational leverage and efficiency over time. Selling and marketing expenses were RMB88 million, representing a 66.5% increase year-over-year. G&A expenses were RMB76 million, representing a 116.3% increase year-over-year, which was primarily driven by the increase in share-based compensation expenses. Adjusted EBITDA reached negative RMB39.4 million, compared to negative RMB108.8 million in the same quarter of 2019. Adjusted EBITDA margin also improved steadily, reaching negative 2.8% in the first quarter from negative 12.9% in the same quarter of 2019. Adjusted net loss, which excludes share-based compensation, foreign exchange impact and a change in the fair value of financial instruments and other income expenses, was negative RMB243.4 million, compared with negative RMB225.3 million in the same period of 2019. As of March 31, 2020, we had cash and cash equivalents, term deposits of RMB1.97 billion. We will maintain a prudent approach towards capital expenditure as a healthy balance sheet. In this quarter, our capital expenditure was RMB282 million. We received net proceeds of US$551.3 million from our IPO early last month. The proceeds will be mainly used for further investment in upgrading and expanding our infrastructure, technology and product development, expanding our ecosystem, and supplementing our working capital. Moving to the outlook, we’re currently expecting the revenue for the second quarter of 2020 to be between RMB1.5 billion and RMB1.54 billion, representing a year-over-year increase of 60% to 65%. Assuming our resource utilization and the benefits of economies of scale continue, we expect adjusted EBITDA margin to break even sometime at the end of this year, either in the fourth quarter or in December. However, the above outlook is based on the current market conditions and reflects the company’s preliminary estimates, which are all subject to change due to uncertainties around the enduring effects of COVID-19. Finally, before we conclude the prepared remarks, I would like to talk about a recent deal passed by the U.S. Senate. Our auditor Ernst & Young Hua Ming LLP is an independent public accounting firm registered with the Public Company Accounting Oversight Board or the PCAOB and is a part of the Ernst & Young global network, which shows the global common technology, tools, methodology, training, and quality assurance monitoring. Our financial statements are prepared in accordance with U.S. generally accepted accounting principles or U.S. GAAP. Ernst & Young Hua Ming LLP has conducted the audits of our consolidated financial statements, including our registration statements, in accordance with the standards of the PCAOB and issued a qualified opinion that our consolidated financial statements represent fairly in all material respects our financial positions, results of operations, and cash flows in conformity with U.S. GAAP. There is an existing framework for PCAOB to conduct detailed inspections of audit engagements of accounting firms registered with the PCAOB. The China Securities Regulatory Commission, SEC, and PCAOB are engaged in ongoing dialogue regarding the types of information permitted to be exchanged on issuers with Chinese operations, while maintaining compliance with applicable laws. We have a very solid track record since we founded the company in 2012. Before the completion of our listing as a subsidiary of Kingsoft Group, whose shares are listed on the Hong Kong stock exchange, our financials were fully consolidated by Kingsoft Group for the past eight years. During the IPO process, we communicated with the SEC auditing team who observed no material concerns on our registration statements where we have been compliant with security laws of the safe and met all the applicable filings and disclosure requirements with the SEC. We have also been in compliance with all other applicable laws and regulations in all material aspects. To conclude, we are committed to transparency and integrity to shareholders. We aim to meet high standards as a good citizen of the global capital markets.

Nicole Shan, Speaker

This concludes our prepared remarks. Thank you for your attention. We are now happy to take your questions. Operator, please go ahead.

Operator, Operator

Ladies and gentlemen, we will now begin the question-and-answer session. We have our first question from the line of Alexia Quadrani from JPMorgan. Please go ahead.

Alexia Quadrani, Analyst

Good evening, management. Thank you for taking my question and congratulations on a strong quarter following the IPO. My question is about the industry dynamics related to COVID-19 in China. As we move into a post-COVID-19 phase, could you share your insights on the industry dynamics in China’s current market? We are particularly interested in the demand for cloud consumption from video operators and the pricing trends for CDN in China. Additionally, we would like to know if you have noticed any changes in behavior among large enterprises regarding cloud demand post-COVID-19. Thank you.

Yulin Wang, CEO

Thank you. I will translate for Mr. Wang. Thanks for your question. We believe the pandemic has greatly affected our industry in two main ways: first in terms of utility and second with the rise of new demands. In the internet sector, the first quarter is usually not the busiest time of the year. However, the pandemic has led to an increase in demand from the video and gaming sectors, with usage skyrocketing in the first quarter. Furthermore, we have also seen new customer demands in other areas of the internet industry, such as e-commerce and online education. For enterprise cloud services, many organizations are recognizing the convenience and benefits of cloud solutions, which can help improve efficiency in public healthcare services. However, it takes some time for our customers' needs to translate into our revenues due to the nature of these transactions. As for enterprises, we generally follow a primary customer strategy. Our main customers prioritize the technology and stability of our services and are less sensitive to price, which has been evident considering the price fluctuations we've observed this quarter. Thank you.

Operator, Operator

Thank you. We have our next question from the line of Kenneth Fong from Credit Suisse. Please ask your question.

Kenneth Fong, Analyst

Congratulations on the very strong set of results. I have a question about the gross profit margin, as you have seen significant improvement over the past eight or nine quarters. How should we consider the drivers moving forward? Additionally, sectors like education and e-commerce, which usually have high data consumption during daytime, are experiencing strong demand. Will this further enhance existing capacity utilization and drive margin improvement? Thank you.

Haijian He, CFO

Thank you, Kenneth. This is Henry. I can address those questions. As we introduced in our prepared remarks, you probably noticed that both our gross margin and EBITDA margin have improved for seven consecutive quarters. These indicators not only measure the fundamental IT resource utilization rates but also our SG&A and internal operation management efficiency. To your question, we have just started to enjoy the benefits of economies of scale, which are evidenced by the gross margin turning positive since Q3 of last year. We believe we are in the early stages of experiencing these benefits, and there is definitely upside potential for further improvements in profitability from both gross margin and bottom-line perspectives. The fundamental drivers are influenced not only by the traffic data patterns but also by the technology that we are building in-house. As we mentioned, over 60% of our personnel are working on cutting-edge technologies that not only cater to today’s client needs but also to the technology demands for the future. This is why we believe that technology will primarily drive the profit margin expansion. We see potential uplift going forward. Regarding the diversification within the internet space, as you mentioned correctly, online education and other sectors, such as e-commerce, see data usage throughout the day. This shift could indeed contribute positively towards raising the profit margin and improving the margin profile. However, as I also mentioned, we are not merely a passive player waiting for further diversification of client demand; we also proactively approach clients by utilizing more and better technology to enhance efficiency. In conclusion, along with the supply/demand dynamics in the Chinese cloud market, we believe that trend favors independent cloud companies like ours, allowing us to deliver better services for our clients. Thank you, Kenneth.

Kenneth Fong, Analyst

Thank you, that was very clear. Congratulations again.

Operator, Operator

Thank you. We have our next question from the line of Thompson Wu from UBS. Please ask your question.

Thompson Wu, Analyst

Some of the larger cloud providers in China are making significant investments in the cloud over the next three to five years. Can you discuss your investments with this new influx of capital for your business in that timeframe? The second question is about the disclosures regarding the number of premium customers and ARPU. Will you be sharing that information moving forward?

Yulin Wang, CEO

Some of your larger cloud players in China are making substantial investments over the next three to five years, particularly in the cloud. Can you elaborate on your investments with this recent influx of capital for your business over the next three to five years? That's the first question. The second question is about some disclosures around the number of premium customers and ARPU. Will you be providing that information going forward?

Haijian He, CFO

Yes, thank you, Yulin. Just to compliment the second point, and then Nicole can help translate. Regarding capital expenditures, as mentioned, we currently have a solid balance sheet. We are almost debt-free, which allows us to have a great capital structure available for deployment. However, we want to take a prudent approach in managing our balance sheets given the market environment and the challenges we are aware of. At the same time, we will ensure that we make sufficient investments into key technology that will drive substantial conversations with our clients moving forward in a few areas that our CEO mentioned in the prepared remarks. Of the $515 million actually raised, we will focus around 50% on upgrading and expanding our IT infrastructure. About 25% will target key technologies, such as AIoT, big data, and cloud technologies. The remaining 15% will be potential investments to solidify our ecosystem players, and possibly looking into global expansions, with the last 10% allocated to supplement our working capital. Again, our focus will be on balancing the capital at hand while ensuring sufficient investment in technology, which is crucial for driving future revenue growth. Nicole, please translate. Thank you.

Nicole Shan, Speaker

Thank you, Henry. I will translate for Mr. Wang. We believe that the cloud business is a long-term investment theme. Most of our competitors are focused on building new infrastructure. However, we have been making consistent investments in this domain. The new infrastructure has defined clear objectives and given corporations a clear path towards cloud services. We have already invested in our infrastructure and technology. Henry has already shared our detailed plan. Regarding customer disclosures, we currently do not disclose data related to our number of customers, as we consider this an annual number and will be summarizing our 2020 outlook in April next year. However, from an operational level, we observe healthy growth among our customers. Thank you.

Operator, Operator

Thank you. We have our next question from the line of Leping Huang from CICC. Please ask your question.

Leping Huang, Analyst

I have two questions for management. The first pertains to competition. In recent years, Huawei has significantly increased its efforts in the cloud business. Will this competition from Huawei affect our ability to acquire enterprise clients? My second question is about our revenue growth and CapEx budget. With KC having around RMB6 billion in cash after the IPO, could management provide the current revenue growth target and CapEx budget? Thank you.

Yulin Wang, CEO

Thank you for the question. I will address the first question. We believe the cloud business market is clear and straightforward. The potential in this market is significant, and we mainly face competition from smaller players. There are only a few leading companies in the industry. Our data from the full year and the first quarter of 2020 shows strong revenue growth. Additionally, we are a technology-focused company with an emphasis on engineering. Our big data and video streaming technology has received high praise from our customers in the public cloud sector. We have not invested heavily in hardware industries. Therefore, we expect our revenue growth to persist, and I'll allow Henry to provide further insights on the second question. Thank you.

Haijian He, CFO

Thank you. I would like to provide some context regarding your inquiries about CapEx and top-line growth. In previous disclosures of our F-1 for the past two years, our capital expenditures averaged around RMB1 billion each year. Moving forward, to support our revenue growth and investment in key technology, we anticipate a rising trend in capital expenditures each year, basing this on the last two years as a baseline. We foresee potential increases in our capital expenditure levels. However, we will still take a prudent approach regarding how and where to allocate capital expenditures. Historically, we have invested CapEx mainly to improve and acquire IT infrastructures, for example, servers and users. Going forward, we expect to maintain a similar strategy regarding our spending. Regarding revenue expectations, we believe that for our second quarter, the revenue will range around RMB1.5 billion to RMB1.54 billion, implying approximately 60% to 65% year-over-year growth. This indicates a strong growth trajectory, aligning with our goal of maintaining our revenue growth pace faster than the overall public cloud market in China. We aim to strike a balance between top-line growth while ensuring profitability and expanding our cash position and balance sheet health. Our historical performance has proven our capability in managing our objectives effectively, and moving forward we intend to maintain the balance in our financial performance. Thank you.

Operator, Operator

Thank you. We have our next question from the line of Ziyi Chen from Goldman Sachs. Please ask your question.

Ziyi Chen, Analyst

My question is about enterprise cloud businesses. Can management provide more information on the seasonality of this segment and how we should view growth in the upcoming quarters? Can we anticipate an accelerated trend in the growth trajectory? Additionally, could you offer some insights on Kingsoft Cloud's long-term competitive advantage and opportunities? Thank you.

Haijian He, CFO

Thank you. This is Henry, happy to address your question. I appreciate your detailed attention to the results. For the first question, the fundamental demand from traditional enterprises to transition from on-premises IT to the cloud is strong, with no change about it. Especially in the context of COVID-19, many traditional enterprise clients have recognized how technology can address real-world issues. However, as we mentioned in our F-1 prospectus, we take a very cautious and conservative approach to revenue recognition, which is contingent upon the delivery and completion of projects before recognizing revenue from these enterprise cloud segments. Many cities in China reopened only after April, so even though our projects are largely on track and many commenced in Q3 and Q4 last year, the travel bans and logistical inconveniences prevented us from completing delivery checks by the March end cutoff. Consequently, we could not recognize revenue before March's end. Importantly, while the year-over-year growth rate for enterprise cloud is robust, the quarter-over-quarter performance might not appear as strong due to these recognition methods. Nonetheless, the diversification of revenue streams from enterprise cloud is improving and will positively influence the overall revenue growth. Looking forward, we still expect a strong revenue trajectory for Q2 as previously guided. We anticipate a favorable performance from enterprise cloud to persist in following quarters. We remain optimistic about this sector in the long term and the diverse requests and initiatives that will fuel our growth. Thank you.

Ziyi Chen, Analyst

Thank you.

Nicole Shan, Speaker

Thank you, operator. Thank you everyone for joining us today. If you have any further questions, please feel free to contact us. Our contact information for IR can be found on today’s press release. That’s all, have a good day. Thank you.

Operator, Operator

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect. Thank you.