Earnings Call Transcript - KC Q3 2023

Wayne Wong, Investor Relations Manager

Thank you, operator. Hello, everyone, and thank you for joining us today. The Kingsoft Cloud's third quarter 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. Tao Zou; 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. And 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.

Tao Zou, Vice Chairman & CEO

Hello, everyone, and thank you all for joining Kingsoft Cloud's Third Quarter 2023 Earnings Call. During the quarter, we continued to uphold the principle of high quality and sustainable development, build success based on technology and innovation, and forged our reputation throughout the entire business process with customer centricity. We have enhanced our operations management and proactively embraced the new AI era. This quarter, our profitability further improved. Total revenues reached RMB1.63 billion. Adjusted gross margin increased steadily for the fifth consecutive quarter to 12.1%. Adjusted gross profit reached RMB196 million, increasing by 57.5% compared with the same quarter last year. Normalized adjusted EBITDA margin was negative 2.7%, which represents a significant improvement of 7.6 percentage points from the same quarter last year and 0.6 percentage points from the previous quarter. In terms of public cloud services, revenues were RMB1.02 billion with a gross margin of 4.7%, significantly higher than the negative 1.6% compared with the same quarter of last year. We continued to focus on three priorities for public cloud services, namely the Xiaomi and Kingsoft ecosystem, AI business, and CDN strategic adjustments. First of all, we continued to serve Xiaomi and Kingsoft ecosystem well and coordinate enterprises within the ecosystem to systematically sort out their cloud planning and fulfill their cloud demand. This quarter, Xiaomi and Kingsoft contributed 17% to our revenue, an increase of 2.2 percentage points quarter-on-quarter and 3.6 percentage points year-on-year. Among them, driven by Xiaomi business, the capacity of its dedicated cluster has expanded significantly, and Xiaomi has become our largest customer. Kingsoft Office's revenue in September increased by nearly 50% compared to January, driven by its AI business. Secondly, we proactively developed our AI business. Currently, there is a strong demand for AI business with tens of customers who have signed contracts with us or in the process of business discussions. AI-related capital expenditures in the quarter exceeded RMB400 million, exceeding the total of the previous three quarters and have increased for two consecutive quarters. With our continued investment and efficient execution, our AI business revenue surged by over 70% compared to last quarter, with a healthy gross profit margin. Thirdly, we continued to push forward our strategic adjustments in CDN business. This quarter, CDN revenue decreased by nearly 20% compared to last quarter, and CDN revenue as a proportion of total revenue has decreased to about 30%. The revenue share of our largest CDN customers has significantly decreased from 16.2% in the previous quarter to 12% in this quarter. Moving on to Enterprise Cloud Services. Total revenues were RMB609 million, while gross margin has maintained at a healthy level of more than 24%. In public services space, we opted to focus on core areas such as public services cloud, state-owned assets cloud, and education cloud, further improving the end-to-end model from cloud migration, cloud use to cloud management, forming a product matrix centered on big data, large models, as well as WPS collaboration. For example, we have been the partner for the Beijing Public Services cloud for nine consecutive years, winning a strong reputation to deliver secure, reliable, and easy-to-use systems and services, resulting in 24 contract renewals this quarter and forming a virtuous cycle. In digital health space, we continued to promote the five business models and make new breakthroughs. This quarter, as the only cloud service provider, we participated in the revision of a national level health care standard setting project, gaining a first-mover advantage as demonstrated by our business model, technical capabilities, and our concrete achievements in the regional health cloud space. We have collaborated with Kingsoft Office to develop an electronic medical record editor for the National Health Commission and successfully completed the task. While continuously delivering the rating hospital project, we have also successfully signed a contract for the information construction project of the People's Hospital of Zhuhai in the high-tech zone, making new progress in the hospital space. In the financial services space, we continued to deepen our business cooperation with large state-owned banks and complete the delivery of the existing projects as scheduled, while winning new projects. We also actively participated in the selection stage of AI models for large state-owned banks. Turning to Camelot. During the quarter, Camelot business is stable, signing up five new customers while maintaining robust relationships with the existing major clients. Its profitability has been rising again steadily. In terms of product and technology, we uphold our principle of building success based on technology and innovation by delivering best-in-class customer experience across our core product offerings. In computing space, we continued to upgrade our core products, focusing on improving stability and domestic environment compatibility. We have also identified eight major product and technology co-construction projects with key leading customers so as to accurately match customer demand, planning, and deepen collaborative developments. In storage space, we have released a new version of object storage, significantly optimizing performance under small IO scenarios, with an overall performance improvement of over 50%, approaching the theoretical limit. In big data space, our cloud-native big data platform has significantly improved its compatibility with Hadoop, effectively achieving a smooth migration of Hadoop text. In the enterprise cloud space, we focus on the end-to-end positioning of cloud migration, cloud use, and cloud management, continuously optimizing the user experience in terms of ease of use, openness, and efficiency, building a unified presentation of operational data in the management cockpit, and once again upgrading the one cloud multi-CPU compatibility to provide more domestic environment support capabilities. Our Galaxy Stack platform has obtained leadership grade designation, the highest level of certification in the national authoritative cloud benchmark evaluation, testifying that our dedicated cloud service capabilities are top-notch in China. We embraced the new AI era in a comprehensive approach. In terms of customers, we aim to fully align with AI cloud planning from Xiaomi and Kingsoft ecosystem; in the meantime, leveraging our neutral position to proactively meet the model training and inference demand from a large number of independent AI companies. In terms of business model, while the general AI computing service business is taking off, we preemptively explore one-stop AI cloud transformation services, aiming to become the AI enabler in select verticals. In terms of R&D, we make efforts in three directions: talent, products, and solutions, establishing our AI R&D center to support the research from three major capability areas including application, algorithm, and platform. We also upgraded our core storage database network and other products with AIGC-facing features and continue to perfect our MassMutual Trust dedicated zone solution. In terms of supply chain, facing the uncertainty of the international market, we actively explore domestic supply chain alternative channels. Moving on to talent strategy. Firstly, it's about building our Beijing, Wuhan dual R&D center. In less than a year since its founding last October, through voluntary relocation of key R&D staff from Beijing and Wuhan local recruitment, our Wuhan team has quickly grown to over 500 people, accounting for approximately 50% of our total R&D personnel. Secondly, we are promoting the implementation of the high potential talent program, which aims to identify and nurture the future backbone of our company. Thirdly, despite the uncertainties in the macro economy, we continued to increase campus recruitment efforts to forge a talent base as a foundation for the Company's long-term development. In summary, the continuous and steady improvement in our profitability over the past consecutive quarters have strengthened our belief in the strategies and the directions we have chosen. With both opportunities and challenges ahead of us, we will continue to uphold the strategy of high-quality and sustainable development, leverage technology, reputation, and operational management to drive progress, maintain our risk awareness, optimize business structure, embrace AI opportunities, and continue to improve profitability, thereby creating value for our customers, shareholders, employees, and society. I will now pass the call over to our CFO, Henry, to go over our financials for the third quarter of 2023. Thank you.

Haijian He, CFO

Thank you, Mr. Zou, and welcome, everyone, for joining the call. Now I will walk you through the financial results for the third quarter of 2023. Under the strategy of high-quality and sustainable development, we are pleased to deliver another quarter of steady profitability improvement. Our adjusted gross profit continued to grow for the fifth consecutive quarter and achieved RMB196.3 million, increased by 57.5% year-over-year, representing adjusted gross margin of 12.1%, which is a record high for the Company. Our normalized adjusted EBITDA narrowed from negative RMB202.0 million in the same period of last year and a negative RMB59.9 million in the last quarter to negative RMB44.1 million this quarter. As a result, normalized adjusted EBITDA margin further narrowed from negative 10.3% in the same period last year and a negative 3.3% in the last quarter to negative 2.7% this quarter, making another solid step towards EBITDA breakeven. Our total revenues were RMB1.625 billion this quarter, of which revenue from public cloud services was RMB1.0166 billion, representing a decrease of 9.5% compared with RMB1.1130 billion in the last quarter. This is primarily due to the strategic scaling down of our CDN business by approximately 20% quarter-over-quarter and partially offset by non-CDN public cloud services. Revenues from enterprise cloud services were RMB608.5 million, representing a slight decrease of 2.2% from RMB622.0 million in the same period of last year as we continued to be stringent on project selection. We continue to enhance our cost control measures. Total cost of revenue decreased by 22.6% year-over-year to RMB1.4290 billion. IDC costs decreased significantly by 31.6% year-over-year from RMB1.0783 billion to RMB737.7 million this quarter. Depreciation and amortization costs decreased by 21% from RMB253.7 million in the same period of last year to RMB200.4 million. Solution development and services costs decreased by 4% year-over-year from RMB443.1 million to RMB425.3 million this quarter. Fulfillment costs and other costs were RMB25.7 million and RMB39.9 million this quarter, respectively. Adjusted gross profit of this quarter increased by 57.5% to RMB196.3 million, representing adjusted gross margin of 12.1% this quarter compared with 6.3% in the same period of last year, making another record high as well as the fifth consecutive quarter of steady margin improvement. Each of our business lines achieved margin improvement on a year-over-year basis. Gross profit of public cloud services was RMB48.1 million, which was significantly improved from the gross loss of RMB22.1 million in the same period of last year. Gross margin of the public cloud services was 4.7% compared with negative 1.6% in the same period of last year. The improvement was mainly due to our success in AI business, proactive scaling down of the CDN services, and adjustments of our client structure. Gross profit of enterprise cloud services was RMB147.3 million compared with RMB143.8 million in the same period of last year. Gross margin of enterprise cloud services was 24.2%, representing a slight increase from the already healthy margin level of 23.1% in the same period of last year as we continued to carry out stringent project selection. In terms of expenses, excluding share-based compensation and impairment of long-lived assets, our total adjusted operating expenses were RMB504.5 million, decreased by 6.2% from RMB538.1 million last quarter, of which our adjusted R&D expenses were RMB187.2 million, increased by 2.7% from last quarter as we continue to focus on technology partners and welcome new graduate campus-recruiting employees. Adjusted selling and marketing expenses were RMB114.1 million, representing a decrease of 11% from RMB128.3 million last quarter. Adjusted G&A expenses also decreased by 10.7% from RMB227.5 million last quarter to RMB203.1 million. As of June 30, 2023, our cash and cash equivalents and short-term investments amounted to RMB2.6 billion, providing us sufficient liquidity for operations. The capital expenditures for this quarter were RMB415.3 million as we invested in our infrastructure to build a sustainable AI business. Our operating cash flow once again recorded a net inflow, recording RMB20.4 million. It resulted from our margin improvements as well as our enhanced internal cash management. Looking ahead, we will continue to pursue our high-quality and sustainable development strategy and unlock synergies within the Xiaomi and Kingsoft Group ecosystem while staying agile to capture new opportunities in the new era of AI. Thank you.

Unidentified Company Representative, Representative

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

Operator, Operator

Your first question comes from the line of Xiaodan Zhang from CICC.

Xiaodan Zhang, Analyst

So my first question is regarding our AI strategy. So Kingsoft Cloud has become the first choice for some of the industry-leading independent large language model providers when they select ICE vendors. So what is the growth trajectory for these type of clients in the recent quarters? And how would the recent supply constraints impact our AI strategy? And secondly, could management share your most recent guidance on the timing of adjusted EBITDA margin breakeven?

Tao Zou, Vice Chairman & CEO

The first part of the answer was provided by Mr. Zou Tao. In response to your question, the customers we have signed and are doing business with are prominent players in the AI market aside from BBAT, and they possess considerable capital strength and business scale. Typically, the initial stage of our business cooperation ranges from 128 to 256 server units, with the potential to expand to a group of 512 server units. Their ultimate aim is to advance to large language models, which typically require hundreds of billions of parameters; hence, the necessary computing power exceeds 512 server units. Regarding the uncertainties in the external environment that you mentioned, it’s clear that since October, U.S. export controls have significantly impacted the industry, including in China, and we are also affected. Fortunately, we anticipated this situation and took proactive measures. As a result of our forward planning, the impact from the export control has been limited for us. Looking at this from a medium to long-term perspective, it will depend on several factors, notably the performance of domestically produced GPUs and their production capacity. Overall, in the short term, say within the next one or two quarters, the impact on Kingsoft Cloud should be manageable. We believe it is relatively under control. In the longer term, we remain confident due to the positive strides the Chinese chip industry has made over the past year. As I noted earlier, we see both opportunities and challenges ahead. With a greater number of independent AI customers, we are quite comfortable regarding the potential impact.

Haijian He, CFO

I will take on the second question. So there are actually two different drivers. First of all, some of you may remember, we actually hit quite dramatically back then back in late part of 2021, right, given the slowdown of the Internet consumer business as well as the certain impact on the enterprise cloud sectors in the later part of 2021. So at that time, our gross margin was only 1.2%. As you all notice that today, the increase from 1.2% to 12% on the gross margin side. So that actually is the fundamental result of our collective efforts around improving the efficiency of the resources we have, improving the client selections and the client quality. So putting that aside, that gave us about 10x increase in gross margin percentage. So on top of that, as you probably also noticed, the spread between the gross margin and the EBITDA margin. I think the largest spread probably last year was around 19% to 20%. But this quarter, as you may see, the spread has also narrowed from about 20% to only 14%, which means on expenses control side we also reduce significantly in terms of how we spend on research, travel, and general management purposes. So putting everything together, the two fundamental drivers from the business as well as how we improve the operational efficiency have given us leading to today's improvements in the EBITDA margin improvement. And so to your question, I think given all the initiatives and the strategy we're already putting into place, those impacts and the results will gradually be released quarter by quarter. So it's not going to be a one-time occurrence for this quarter. It's going to be carried out for the next few quarters steadily. In our attention, we are hoping to improve both gross margin as well as narrowing the spread between the gross margin and EBITDA margin in the next few quarters. While as you may understand, the management team will not be giving guidance for the formal EBITDA margin breakeven at this moment. But as you can see, the trend has been steady for the past four quarters, and we hopefully can keep that trajectory and the pacing of improving the margin. Hopefully, we can report a breakeven not only on the EBITDA margin, but also on other items in the near future as well. So just give us a bit of time, and then we can probably deliver those results to your expectation.

Operator, Operator

Your next question comes from the line of Timothy Zhao from Goldman Sachs.

Timothy Zhao, Analyst

I have two questions related to the public cloud sector. The first pertains to the AI business. Can management provide more details on how much revenue the AI business contributes and its profitability in terms of gross profit margin or EBITDA margin? Additionally, in the third quarter, management indicated a CapEx of around RMB1 billion for the AI business. Could you also provide guidance on CapEx for the fourth quarter and next year, including for the AI business? My second question concerns the CDN business. Given the competitive landscape in China's cloud segment is quite dynamic, should we expect to see more adjustments in the CDN over the next few quarters? After these adjustments, what is management’s outlook for the midterm normalized gross profit margin of the public cloud business?

Haijian He, CFO

It's Henry here. I'll start with the first question and provide a brief translation before Zou comments. Regarding the contribution of the AI business, the first point is about our capital expenditures. Last quarter, we spent around RMB415 million, or roughly RMB400 million for the third quarter. Now, focusing on the contribution and revenue margins, there are a few key points to share. Firstly, as you know, this is fundamentally driven by two factors: the supply-demand balance and the technology and products we offer. Currently, it is a seller's market. If we have solid infrastructure and resources to deliver strong services and products to our clients, they are willing to pay for that. This also gives clients a competitive edge as they train their models to compete globally. This translates to better margins for us compared to traditional resource-driven services. We have also noticed that clients are willing to pay for value-added services, not just for basic resource usage. By providing best practices and additional services, we can create shared value that gets reflected in our pricing over time. These are two fundamental reasons we expect the higher margins from the AI business to continue into the future. Regarding the contribution, we didn't provide a percentage for this quarter because every day counts. Due to strong client demand and our sufficient resources, we are witnessing significant growth. However, looking at the third quarter, which spans from July 1 to September 30, today's situation is quite different from July 1. The tail impact of the third quarter shows a significant contribution to Kingsoft Cloud's total revenue on a weekly basis. However, if you only consider the entire third quarter, it may not accurately represent the AI business's full impact for us. On the topic of capital expenditures, as we mentioned last quarter, this spending is a crucial growth driver for us. The more we invest, the more revenue we expect to generate, along with better gross margins. Although we spent about RMB400 million this quarter on capital expenditures, we anticipate this will continue to rise in the next quarter and possibly early next year. There is a clear mathematical correlation between spending and new revenue generation for the coming year. While I won't provide specific numbers, the trend is evident. These are the three main points I wanted to share. Given the importance of this question, I will translate my remarks as well.

Tao Zou, Vice Chairman & CEO

We're observing a trend in capital expenditures for the upcoming quarter and possibly early next year, indicating that this figure is likely to rise. There is a clear mathematical connection between this spending and the revenue we expect to generate next year. While I won't provide a specific number, the trend is quite apparent. I wanted to share this insight, especially since this question is significant, so I will provide a translation myself.

Haijian He, CFO

Okay. So let me quickly translate. So in relation to your second question about the CDN strategic adjustments, we started the adjustment on October 31 this year, and we have an internal deadline of June 30, 2024. As I can see this, we're continuing to do some adjustment according to the market conditions. Currently, we're generating CDN revenue on a quarterly basis around RMB500 million. It might continue to scale down to somewhere between RMB300 million to RMB400 million per quarter, thereby reaching a relatively stable status till after June 30 next year. In relation to your question about the profit margins for the public cloud services business, it consists of two components: one is CDN and one is the so-called pan-Internet sector. For the CDN sector, as mentioned, we expect the strategic adjustments to be completed by the third quarter next year. By then, we hope the margin of this business line will revert to the relatively healthy level that was as of the fourth quarter of 2022. Now for the pan-Internet space, we are still seeing the margin, including both the GP margin and the operating profit margin steadily and gradually improving. I mentioned one of the uncertainties is the GPU supply. Obviously, in the AI space, the demand significantly outpaces the supply. If that supply chain issue can be completely resolved, the improvement in our business as well as margins in the AI and thus the pan-Internet space will be much faster. But even with that uncertainty, we are already seeing relatively good progress in terms of margin improvement and business scale expansion.

Operator, Operator

Your final question comes from the line of Katrina Chiu from Citi.

Katrina Chiu, Analyst

This is Katrina Chiu asking on behalf of Brian Gong from Citi. Can management share with us the overall revenue outlook in 2024 and whether we can expect positive revenue growth next year?

Haijian He, CFO

After our dual listing in Hong Kong, we chose not to publish management guidance. However, as we approach the end of 2023, I can share some insights. Currently, around 20% to 25% of our revenue comes from the CDN business, which our CEO Tao highlighted. We are in the process of adjusting our client mix and product offerings while managing costs and procuring bandwidth. Our primary objective is to improve the mix and structure of our client products. While we aim to keep things stable, we are changing the combination of clients and products within the business over the next two or three quarters. The second area to consider is our investment in AI and capital expenditures. We are building infrastructure for clients and developing model services and solutions, which will be a key focus for revenue growth next year. For every $2 or $3 we spend this year, we expect to see about $1 in additional revenue next year, illustrating how our spending on CapEx translates into products and revenue growth. The third aspect is our stable enterprise business. Our subsidiary, Camelot, has shown consistent revenue stability. With the improving macro environment, we anticipate revenue growth from Camelot, alongside growth in our healthcare public sectors and financial services enterprise cloud, as we replicate successful products from one client to another next year. We hope to maintain around a 30% gross profit contribution at the project level while expanding to more projects. When we combine these elements — a stable CDN with an improved mix, CapEx leading to incremental AI revenue, and growth in enterprise cloud — we are optimistic about achieving year-over-year and quarter-over-quarter revenue growth. We aim for our EBITDA to break even soon while also improving operating profit for our shareholders. Lastly, we are closely monitoring the competitive landscape, striving for superior quality compared to our peers. We believe we can improve our gross margins in the coming quarters and potentially outpace competitors in year-over-year growth. We've made significant strides since CEO Tao Zou took over, and our progress may be evident sooner than that of our main competitors.

Operator, Operator

I would now like to turn the conference back for closing remarks.

Wayne Wong, Investor Relations Manager

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

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect.