Earnings Call Transcript - KC Q4 2023

Operator, Operator

Good day and thank you for standing by. Welcome to the Kingsoft Cloud's Fourth Quarter and Fiscal Year 2023 Earnings Conference Call and Webcast. At this time, all participants are in listen only mode. After the speakers' presentation, there will be a question-and-answer session. Please note that today's conference is being recorded. I would now like to turn the conference over to Nicole Shan, IR Manager of Kingsoft Cloud. Please go ahead.

Nicole Shan, IR Manager

Thank you, operator. Hello, everyone, and thank you for joining us today. Kingsoft Cloud's fourth quarter and fiscal year 2023 earnings release was distributed earlier today and is available on our IR website at ir.ksyun.com, as well as our GlobeNewswire services. On the call today from Kingsoft Cloud, we have our Vice Chairman and CEO, Mr. Zou Tao; and CFO, Mr. Haijian He. Mr. Zou will review our business strategies, operations and the company highlights followed by Mr. He, who will discuss the financials and guidance. They will be available to answer your questions during the Q&A session that follows. There will be consecutive interpretations. All interpretations are for your convenience and reference purposes only. In case of any discrepancy, the management's statement in the original language will prevail. Before we begin, I would like to remind you that this conference call contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended and as defined in the U.S. Private Securities Litigation Reform Act of 1995. These forward-looking statements are based upon management's current expectations and current market and operating conditions and relate to events that involve known or unknown risks, uncertainties and other factors, all 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, uncertainties or factors are included in the company's filings with the U.S. SEC. The company does not undertake any obligation to update any forward-looking statements as a result of new information, future events or otherwise, except as required under applicable law. Finally, please note that unless otherwise stated, all financial figures mentioned during this conference call are denominated in RMB. It's now my pleasure to introduce our Vice Chairman and CEO, Mr. Zou. Please go ahead.

Zou Tao, CEO

Hello, everyone, and thank you all for joining Kingsoft Cloud's fourth quarter fiscal year 2023 earnings call. In 2023, we continued to uphold the principle of high quality and sustainable development and accomplished significant achievements. For the full year of 2023, adjusted gross margin was 12.2%, a significant increase of 6.8 percentage points, up from 5.4% in 2022. Adjusted gross profit was RMB860 million almost doubling the amount of RMB445 million in 2022. Normalized adjusted EBITDA was negative 3.4%, another significant improvement from negative 8.9% in 2022. During the year, we started building our success based on technology and innovations, forging our reputation throughout the entire business process, enhancing our operations management and building strength. We have been strategically adjusting our business mix and proactively embracing the new AI era, therefore, laying solid foundations for long-term sustainable development in 2024 and beyond. Now, I will walk you through the business highlights for fourth quarter 2023. This quarter, we achieved dual improvement in both our revenue and profitability measures. In particular, total revenues reached RMB1.72 billion, increasing 6.0% quarter-over-quarter. Adjusted gross margin recorded a major increase of 3.1 percentage points quarter-over-quarter to 15.2%, marking the sixth quarter of consecutive improvement. Adjusted gross profit reached RMB262 million, increasing 55.8% year-over-year. Normalized adjusted EBITDA margin was negative 1.6%, representing a significant improvement of 8.5 percentage points year-over-year. In terms of public cloud services, revenues were RMB1.05 billion, representing an increase of 3.5% quarter-over-quarter. Excluding CDN business, public cloud revenue increased by 11.8% quarter-over-quarter, we bear fruits on our three priorities for public cloud services, namely the Xiaomi and Kingsoft ecosystem, AI business and CDN strategic adjustments. First of all, as the sole strategic cloud platform within the Xiaomi and Kingsoft ecosystem, we continue to serve the demand in the ecosystem well, especially with respect to the highly visible and tangible demand in training and inference from Xiaomi EV and WPS AI, seizing opportunities in structural industry trends. This quarter, revenues contributed by Xiaomi and Kingsoft ecosystem reached 16%, representing an increase of 5 percentage points year-over-year. Secondly, we vigorously developed our AI business with remarkable agility to emerging industry trends. Besides the AI opportunities from the Xiaomi and Kingsoft ecosystem, we have been fully penetrating leading independent AI companies in China, providing long-term secured high-performance computing power, which is highly sought after in the market. Our AI business represented approximately 8% of our public cloud revenues, or an increase of 82% quarter-over-quarter. Besides, we have signed a loan facility agreement with Kingsoft Corporation obtaining a credit line of RMB1.5 billion dedicated to the development of AI business. Thirdly, we continued to push forward our strategic adjustments of CDN business. This quarter, CDN revenue decreased by nearly 10% compared to last quarter and CDN revenue as a proportion of total revenue has decreased to approximately 23%. The revenue share of our largest CDN customer was 12% in the quarter. Top customer concentration has been fundamentally alleviated. Moving on to enterprise cloud services. Total revenues were RMB670 million, increasing by 10.2% quarter-over-quarter. In public service space, we actively seized opportunities of public services cloud and SASE cloud. We implemented standardized operation and maintenance with core components such as large language model, big data and workspace collaboration, targeting use cases in public service and enterprise application domains. With Beijing, Wuhan and Zhuhai as our basis, we have built benchmark projects radiating to other large and medium-sized cities. This quarter, we successfully joined hands with Tianjin state-owned assets cloud to facilitate the digitalization and intelligence evolution of local state-owned enterprises. In healthcare space, we continued to promote the five business models and make new breakthroughs, inheriting and developing experience from the cooperation with Shanghai rating hospital, we replicated and scaled our medical digital capabilities to more renowned hospitals, including Wuhan Union Hospital, Zhongnan Hospital affiliated to Wuhan University and the Fuwai Hospital affiliated to the Chinese Academy of Medical Sciences. In financial services space, we continued to deepen our business cooperation with large state-owned banks, improving our big data products and service capabilities and win the base of big data platform projects for leading state-owned banks and trusts. Turning to Camelot. During the quarter, Camelot exhibited stable and healthy revenue and profitability, signing up four new customers, while maintaining robust relationships with existing major clients. In terms of product and technology, we uphold our principle of building success based on technology and innovation, delivering best-in-class customer experience across our core product offerings. In computing space, we continued to upgrade our core products and focusing on improving stability and domestic environment compatibility. This quarter, we launched our elastic bare metal compute product, EPCX7, with significantly improved computing memory, network and storage performance. In storage space, to better serve high performance use cases such as decoupling of computing and storage, AI, computer graphic rendering, we have released the extreme version of object storage service equipped with high performance, dynamic scaling and out-of-the-box features. In big data space, we upgraded our cloud-native lake house platform with maximum throughput improvement by 4x for batch processing tasks, better supporting use cases of autonomous driving AI and data models. In enterprise cloud space, our Galaxy Stack platform ranked in the market leader quadrant of both the private cloud market and the private cloud system platform market. In the research report released by CCID Consulting, a great recognition of the products and services capabilities. This quarter, Galaxy Stack platform released another updated version, adding six cloud products and more than 100 functions, perfecting the comprehensive enterprise cloud system, which powers our end-to-end service of cloud building, cloud migration, cloud usage and cloud management. In terms of AI, our MassMutual Trust dedicated zone solution was awarded the Most Innovative AI Solution by China Internet Economy Forum 2023. Our AI product center deepened research cooperation with Kingsoft's office to strengthen model research capability and serve enterprise use cases. Moving on to talent strategy. Wuhan Research Center has been quickly expanded. By the end of 2023, total employees in Wuhan exceeded 500 accounting for one-third of total R&D teams and half of them hold graduate degrees. Our Beijing Wuhan dual R&D standard strategy attracts talent for our long-term development and ensures R&D intensity as we stick to our build success based on technology and innovation principle, while managing R&D expenses effectively. In summary, we have achieved great milestones in executing high quality and sustainable development strategy with our profitability measures improving continuously. Looking forward, we will keep our original aspiration and long-term strategy to create value for our customers and society through our business services, embrace AI opportunities and continue to improve our profitability. Leading with increasing management efficiency, we will keep imposing strict cost and expense control, enhanced talent training and expansion of Wuhan Research Center and further improve the company's operating efficiencies. I will now pass the call over to our CFO, Haijian, to go over our financials for the fourth quarter fiscal year 2023. Thank you.

Haijian He, CFO

Thank you and I welcome everyone for joining the call. Now, I will walk you through the financial results for the fourth quarter and fiscal year 2023. Upholding the strategy of high quality and sustainable development, we are pleased to close the year 2023 with meaningful milestones on enhancement of revenue quality, margin expansion and operating efficiency. For the fourth quarter, we delivered another quarter of steady profitability improvement. Our adjusted gross profit continued to grow for the sixth consecutive quarter and achieved RMB262.5 million, increased by 55.8% year-over-year, representing adjusted gross margin of 15.2%, which is a record high for the company and significantly improved 3.1 percentage points compared with last quarter. Our normalized adjusted EBITDA narrowed from negative RMB216.3 million in the same period of last year and a negative RMB44.1 million in the last quarter to negative RMB27.7 million this quarter. As a result, normalized adjusted EBITDA margin further narrowed from negative RMB10.2 in the same period last year and a negative 2.7% in the last quarter to negative 1.6% this quarter. Our total revenue was RMB1,722.5 million this quarter, increased by 6% sequentially, of which revenues from public cloud services were RMB1,052 million representing an increase of 3.5% compared with RMB1,016.6 million in the last quarter. The increase was primarily due to the expansion from AI-related revenues and partially offset by our strategic scaling down of our CDN business by approximately 10% quarter-over-quarter, contributing around 23% of total revenues. Revenues from enterprise cloud services were RMB670.3 million, representing an increase of 10.2% from RMB608.5 million in the last quarter. As more projects are scheduled for delivery towards the end of the year, we continue to enhance our cost control measures. Especially in Q4, we refined the procurement process of CDN business. Total cost of revenues decreased by 25.4% year-over-year to RMB1,469.3 million. IDC costs decreased significantly by 30% year-over-year from RMB1,057.6 million to RMB740.4 million this quarter. The decrease was in line with our adjustments with CDN services. Depreciation and amortization costs decreased by 39.2% from RMB241.7 million to RMB146.9 million, the decrease was mainly due to previous impairments of our long-lived assets. Solution development and services cost increased by 8% from RMB465.8 million to RMB502.9 million this quarter. This increase was mainly due to business expansion of Camelot. Fulfillment costs and other costs were RMB9.4 million and RMB69.7 million this quarter, which are in line with our enterprise cloud project quality control strategy. Adjusted gross profit of this quarter increased by 55.8% year-over-year to RMB262.5 million, representing adjusted gross margin of 15.2% this quarter compared with 7.9% in the same period of last year and 12.1% last quarter, making another record high as well as the sixth consecutive quarter of steady margin improvement. In terms of expenses, excluding share-based compensation and impairment of long-lived assets, our total adjusted operating expenses were RMB494.8 million, decreased by 32.2% year-over-year and 1.9% from last quarter, of which our adjusted R&D expenses were RMB162.5 million, decreased by 13.2% from last quarter. As we continue to focus on utilizing our Beijing, Wuhan dual research center and welcome new graduate campus recruiting employees. Adjusted selling and marketing expenses were RMB106.7 million, representing a decrease of 6.5% from RMB114.1 million last quarter. Adjusted G&A expenses increased by 11.1% from RMB203.1 million last quarter to RMB225.6 million, the increase was mainly due to the year-end payment to vendors. As of December 31, 2023, our cash and cash equivalents and the long-term investments amounted to RMB2.3 billion, providing us sufficient liquidity for operations. We have entered into a loan facility agreement with Kingsoft Corporation with a cap of RMB1.5 billion. It will dedicatedly support our AI business development and will demonstrate the confidence and commitment of our ecosystem embracing the future of AI. The capital expenditure for this quarter was RMB1,415.8 million, as we invested in our infrastructure to build a sustainable AI business. Our operating cash flow once again recorded a net inflow reaching RMB16.8 million. Since the second quarter this year, we have been generating net inflow for three consecutive quarters. It resulted from our margin improvements as well as our enhanced internal cash management. For the full year 2023, our total revenue was RMB7,047.5 million. Non-GAAP gross profit increased to RMB859.9 million in 2023, almost doubled from RMB445.2 million in 2022. Non-GAAP gross margin increased to 12.2% in 2023 from 5.4% in 2022. Such increases were primarily because of the elimination of revenue mix and our effective cost controls, testifying the success of our high quality and sustainable development strategy. Non-GAAP EBITDA was negative RMB242.1 million, compared with negative RMB726.2 million in 2022. Non-GAAP EBITDA margin was negative 3.4% compared with negative 8.9% in 2022. Looking ahead, we believe the positive trend in profitability will persist as we continue to pursue a high quality and sustainable development strategy and unlock synergies within the Xiaomi and Kingsoft Group ecosystems as well as integrate our AI technology and ecosystem in a new era. Thank you.

Nicole Shan, IR Manager

This concludes our prepared remarks. Thank you for your attention. And we are now happy to take your questions. Please ask your questions in both Mandarin and English if possible. Operator, please go ahead. Thank you.

Operator, Operator

And the questions come from the line of Xiaodan Zhang from CICC.

Xiaodan Zhang, Analyst

My first question is regarding the AI strategy. So the company has been actively investing in AI for the past year. So could management give us some color on the market competency of your AI related products and solutions as well as on this year's CapEx plan and revenue expectation? And my second question is on gross margin. So KC has achieved significant gross margin improvement last year, partially attributable to the change in your revenue mix. So as your CDN business adjustment is approaching the end, what do you think of the gross margin improvement pace going onward?

Haijian He, CFO

I think in terms of margin expansion, there are three fundamental drivers for the margins. I think you pointed out correctly. The first one, obviously, is the continuous mix change of the CDN business versus others. So as you'll see that the CDN business itself actually going through a cycle, but right now, we are in a more stable period that we are going to see a potential stability of the CDN revenue contribution as well as the client usage patterns that will contribute naturally to our margin expansion. I think that contributes one-third of the margin improvement. The second thing I also want to mention, probably you didn't notice or want to point out is our measures and the new management initiatives, for example, including renegotiation of supply chain contracts with our suppliers to cut down the cost basis, that actually has not happened in one day or a single month of the year, as you can expect. It actually spans over, for example, the full year from last year. And those contracts and the repricing on a cost basis will be effective on a rolling basis from January to December of last year. And you're actually extrapolating those trends towards 2024. Those good benefits and the positive impact from the renegotiation and the lower cost basis will actually carry continuous benefits to our margin and costs into 2024. I think that part will contribute to the second one-third of the margin expansion. The third is, also, you probably didn't notice, is really about we actually, as Zou Tao mentioned in the prepared remarks, is getting the better quality of the projects, not only about the cloud project itself, but also on the enterprise side as well as those verticals, including the financial service, healthcare and certain high-quality public cloud projects as well. And those projects, as we sign into the contract, some of them are still in the backlog and that will be unleashed and delivered in 2024. In history, especially in 2023, we're actually seeing the good experience and good trends that those enterprise cloud projects, the single-level contract revenue contribution has expanded from, let's say, mid-single-digits in history a few years ago to double-digits. And right now, we are seeing those trends actually continue to improve. So the enterprise cloud margin expansion and high-quality initiatives and strategies we've set since 2022 have already seen some good results. To conclude, I think we do see a positive trend, even though I understand, Xiaodan, your concern may be in Q4, you do see a very good Q-on-Q jump of the margin about 3 percentage points. But I think we are in very good momentum and in a confident way that in Q1 and going forward, given the three reasons I just mentioned, our gross margin will continue to show good results going forward.

Unidentified Company Representative, Company Representative

So allow me to also translate for Mr. Xiaodan for the first question. The first question is about the competitiveness of our AI products. So, as you correctly commented, indeed in the last year, we have comprehensively worked very hard on expanding our AI business. However, it would be hard and less prudent for me to directly comment on the competitiveness of our AI product versus other peers. However, I would say that because of our unique positioning of our neutrality and independence, we have, if you look at it from the results, become a preferred choice among a large number of independent AI companies. That is exactly because we don't do our large language model and build our large language model ourselves. Therefore, in this round of opportunities, we have seen as a result that we're already covering a significant number of independent AI companies becoming our customers. You also asked about the future investment in terms of CapEx. I would say that the rule of thumb is we will be continuing to invest based on the demand and the pipeline of the customers we have. However, the specifics as regards to the specific amount and tempo of such investments is relatively difficult for me to comment at this stage.

Operator, Operator

We are now going to proceed with our next question. And the questions come from the line of Daley Li from Bank of America Securities.

Daley Li, Analyst

I have two questions. First one is about the AI business. Could you share some color about the supply and demand trend recently? And how do we see the growth drivers for the AI, data center AI, public cloud business going forward, and the key drivers? And essentially, my second question is about the margin trend. Looking into 2024, how do we see the margins such as the adjusted EBITDA margin and some costs like share-based compensation cost trend?

Zou Tao, CEO

Yes, you mentioned the situation of demand for GPU chips exceeding supply, which has been the key factor for last year. That is why during the past year, we have also been trying our best to meet our clients' demands. While the situation this year shows no changes, right. On one hand, the production of some made-in-China chips has been alleviating to some extent. However, we have also seen other factors, especially geographic tension factors deteriorating the situation. Overall speaking, we see that since the AI market is still booming and demand continues to increase, the overall theme of the demand and supply balance is still that the demand is largely not exceeding that of the supply. We do not expect that kind of relationship to have any material change in the near-term future. Now, in terms of our responsive strategy to this situation, on one hand, we are working with some firms that have computing power within China to build dedicated computing power together. The second thing we do is to follow up with new products that are within compliance premises they're allowed to supply in the China market. In terms of growth drivers, there are basically two types. One is existing customers characterized by independent AI large language model customers that we have been serving recently. The second type is new customers, which are typically not independent AI large language model companies, but those companies that are ready to leverage the capability of large language models to empower their existing business, for example, the EV customers. Currently, we see that the growth driver coming from existing customers is taking a higher proportion. However, we do expect that in the future, the potential for new customers' demand has higher growth potential. Mr. Liu Tao, our SVP, also added that there are several types of growth drivers. One is internet companies training their own models and using their in-house models, utilizing the inference capability of the computing power. Secondly, the advance and launch of Zuora are leading to a surge of demand from the video sector. The third part would be new companies like Mr. Zou Tao mentioned, with demand in EV and autonomous driving.

Haijian He, CFO

I will take on the second question. I appreciate you noticing the margin expansion side. There are a few major directions we're trying to achieve going forward at the same time. First of all, we're aiming to keep Q-on-Q expansion on the gross margin side. This is driven by cost-cutting on the supply chains and better automation of our resources, cutting certain loss-making computing regions and disposing of equipment that we don't think will fit today's client requirements. All the combination of actions will contribute to the margin expansion of the gross margin. As I explained to the first question, those efforts are already in place, and we're going to see those impacts gradually delivered in the next year. The second aim is to improve the EBITDA margin on a continuous basis. We are confident that our EBITDA margin will approach breakeven in the short term. Lastly, we're also adding a KPI for ourselves in terms of internal management. We're trying not just to achieve breakeven in terms of EBITDA margin but also to ensure better quality of revenue. We will continuously optimize our revenue mix, selecting the right clients, and expanding our AI exposures. We will be in a very good position to see a favorable trend of OP margin expansion. While we are not in a position today to provide a clear guidance regarding the timing of EBITDA margin breakeven as well as profitability on OP margin side, we are confident that all the initiatives we've put in place will yield good results in the forthcoming quarters. To your question regarding share-based compensation costs, it is important to note that based on accounting rules, SBC costs are booked based on the share price at the time when the ESOP and the shares were granted to employees, not over a vesting period. When the share price is high, those costs will be booked and amortized over the following years. Given the volatility of the capital markets for many shares today, the SBC line does not accurately reflect the true value, or the market value of the ESOP value granted to the employees. Therefore, those values need to be revisited and recalculated if you wish to do a model. However, the company has adopted a prudent approach in granting and investing shares as you may notice from our announcements. We're extending the share vesting schedules to motivate employees for longer terms. From 2022 to 2023, our SBC costs decreased from roughly RMB360 million in 2022 to about RMB180 million in 2023. We have taken a prudent stance in issuing, granting, and investing shares.

Nicole Shan, IR Manager

Operator, the last question, please.

Operator, Operator

We are now going to proceed with our last question. And the question comes from the line of Yang Liu from Goldman Sachs.

Yang Liu, Analyst

Could management talk about the strategic planning for enterprise cloud in 2024? And the second question is, we have seen some news on peers' price competition in the public cloud in early 2024. Could management tell us more about the latest competitive landscape and also about Kingsoft Cloud's competitive advantages?

Zou Tao, CEO

I think this is a very good question. We have been conducting internal discussions around exactly the question you raised. A few opportunities I would like to share with you. The first is you might have noted that recently a large number of digital asset companies across China has been established and that basically led to a wave of state-owned asset companies migrating onto the cloud and utilizing more cloud services. The second, which I think is probably a large opportunity happening this year, is the measure of digital assets showing on the balance sheet. We should call 2024 the first year for this opportunity due to the recent government policy promulgated. We have also been making communications with the Shanghai Digital Asset Exchange and also with professional parties, such as auditing firms. We believe this represents a significant opportunity for cloud service companies and for us because all of these digital assets will be managed on cloud infrastructure. Digital assets and those data assets cannot run independently. Therefore, the integration of cloud services and digital assets creates opportunities for us. This isn't limited to a particular industry but presents a general large opportunity that we can expect in recent years. Regarding the price competition, I would like to share two core views. First, we have actually been experiencing price pressure since our founding day. Each year, we have seen different kinds of pricing pressure from various peers in different product categories. However, we do not really see any of those price cuts by our peers having any material or significant impact on the market. From our performance results, we have also achieved six consecutive quarters of profitability improvement. I would like to state that while pricing is an important factor for customers to consider, it is far from the most important factor. Our experiences and achievements in the past six quarters show that focusing on customer satisfaction is actually the most important element. I would also say that my view about this current round of price cuts by peers is more of a marketing and PR measure. Some of these price cuts are based on catalog prices. However, much of the transaction price that cloud service providers have agreed upon with potential customers is already deeply discounted and is below the current price cut levels we observe today. Additionally, Mr. Liu Tao, our SVP, also added that this recent round of price cuts from our peers mainly focus on relatively small-scale customers who are paying their cloud usage fees on an annual basis. This customer group does not overlap with the customers that Kingsoft Cloud serves, hence it does not materially impact our pricing strategy or business performance.

Nicole Shan, IR Manager

Thank you once again for joining us today. If you have any further questions, please feel free to contact us. We look forward to speaking with you again next quarter. Have a nice day. Thank you.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect your lines. Thank you and have a good day.