Earnings Call Transcript - KC Q2 2022

Operator, Operator

Good day and thank you for standing by. Welcome to Kingsoft Cloud's Second Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. Please be advised that today’s conference is being recorded. And now, I'd like to hand the conference over to Ms. Nicole Shan, IR Manager of Kingsoft Cloud. Thank you. Please go ahead.

Nicole Shan, IR Manager

Thank you, operator. Hello, everyone, and thank you for joining us today. Kingsoft Cloud's second quarter 2022 earnings release was distributed earlier today and is available on our IR website at ir.ksyun.com, as well as on GlobeNewswire services. On the call today from Kingsoft Cloud, we have our Vice Chairman and the CEO, Mr. Tao Zou; and the CFO, Mr. Haijian He. Mr. Zou will review our business strategy operations and the company highlights, followed by Mr. He, who will discuss the financials and the guidance. They will be available to answer your questions during the Q&A session that follows. There will be consecutive interpretations. Our interpretations are for your convenience and reference purpose only. In case of any discrepancy, 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 the Section 21-E 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 these 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. Thank you for joining Kingsoft Cloud's second quarter earnings call. I am pleased to be here today. As Vice Chairman, I have been involved in the overall management of the company and have gained a deep understanding of our strategy, business, and team. Since becoming CEO in August, I have maintained close communication with the Board of Directors, management, and core team to discuss our development strategy and evaluate our business under the current circumstances. I have also conducted thorough reviews of our frontline operations and visited our customers and partners. I am happy to report that the senior management team is stable and committed, and our daily operations continue as usual. I would like to share some insights on our business before reviewing our second quarter performance. Since Kingsoft Cloud's establishment, we have developed several core strategies. First, we focus on key industry verticals with strong potential, including the internet, finance, healthcare, and public services, to develop significant projects and tailored solutions. Secondly, we aim to advance our products and technologies, build long-term customer relationships through excellent service, and support our customers' growth. Third, we remain neutral to provide long-term trusted cloud services in a multi-cloud environment. Fourth, we strive to improve our solution and project deployment capabilities, integrating resources from Camelot and the broader ecosystem to offer one-stop digital transformation services. Through these strategies, we have achieved rapid growth, nearing annual revenues of RMB10 billion, and aim to be a leading cloud service provider. Despite a challenging operating environment since the second half of 2021, we have identified significant long-term opportunities stemming from digital transformation across industries. According to a recent McKinsey Report, China ranks as the second-largest cloud computing market globally, following the United States, with expectations for its public cloud market to grow to USD90 billion by 2025 from USD32 billion in 2021. The 14th Five-Year Plan emphasizes the need to build advantages in the digital economy and improve research and development in core software technologies, particularly in smart healthcare and public services. Additionally, the demand for end-to-end cloud solutions from enterprise customers continues to rise, serving as a strong driver for the cloud service market's long-term growth. We are facing current challenges head-on, while keeping our commitment to technology-led business growth in focus. Our technological strengths lead to strong products, which drive our sales and overall competitiveness. By excelling in our core technologies and products, we can maintain our position in a dynamic environment, ensuring the long-term sustainable development of the company and increased value for our customers, shareholders, and employees. Moving forward, we will focus more on the core technology areas of computing, storage, networks, and big data. We will enhance our product strength while emphasizing scalable and replicable solutions that provide exceptional customer experiences. In terms of business development, we will continue to delve into key industry verticals while cautiously exploring new opportunities. The internet, finance, healthcare, and public service sectors will remain our focus areas where we have gained substantial expertise. We will refine our replicable products and services and carefully manage the balance between scaling up and profitability. At the same time, we will explore new areas, leveraging the strengths of the Xiaomi and Kingsoft ecosystems alongside our replicable technologies to identify new growth areas following thorough strategic analysis of potential cloud computing prospects. In sales, we aim to engage customers through a model centered on integrated solutions. Unlike mature markets like the United States, many traditional industries in China face complex business challenges and have lagged in digitization. The cloud computing ecosystem still requires significant development. Customers cannot fulfill their business needs solely by purchasing cloud products. To address this, we adopt a customer-centered approach, moving away from a product-driven model to one that delivers turnkey solutions by integrating our proprietary products and technologies with those of our partners while leveraging Camelot's deployment capabilities. Moreover, we will enhance collaboration with our strategic shareholders as we navigate the digitalization trend. As a key part of both Xiaomi and Kingsoft Group, we have consistently delivered quality cloud services while receiving support from our strategic partners. Moving forward, we will explore collaboration opportunities in digitalization, research and development, and sales to foster thriving ecosystems for both Kingsoft and Xiaomi, ensuring mutual benefits. These represent our strategic perspectives. We will continue to improve and maintain effective communication with all stakeholders as we execute our strategy. I would like to thank our customers, shareholders, employees, and ecosystem partners for their ongoing support throughout our journey. We will stay focused on growth and dedicated to delivering long-term value to our stakeholders. Now, let me summarize our second quarter performance. Our total revenues reached RMB1.9 billion in the second quarter, with public cloud revenues at RMB1.3 billion, primarily due to a proactive reduction in CDN services. Excluding CDN services, computing and storage revenues increased by 5.3% year-over-year. Enterprise cloud revenues were RMB620 million in Q2, remaining stable compared to last year but below our expectations, largely due to the resurgence of COVID between April and June, which delayed project deployments. Our adjusted gross profit for this quarter was RMB68.4 million, with an adjusted gross margin of 3.6%. The adjusted EBITDA margin was negative 7.7%, largely due to the revenue impact of the COVID resurgence and other factors that were more significant than expected. While our cost-saving measures have produced impressive results, our profit margin contracted due to lower-than-anticipated revenues. Despite short-term pressures, our Board and management are dedicated to long-term development and are actively managing operations to address current challenges. In the internet sector, we provided a full range of cloud services for the JX3 origin season game's blockbuster MMO RPG, ensuring a smooth gaming experience. We utilized a multi-active architecture at our Tianjin data center to ensure reliable services. We also entered an agreement with a Chinese e-grocery platform for comprehensive cloud migration services and partnered with a smart mobility company to jointly develop a one-stop solution for the mobile industry. In the enterprise cloud sector, as part of the Dong Shu Xi Suan project, we took the lead in establishing a data platform for the Guangdong-Hong Kong-Macau Greater Bay Area, serving as foundational infrastructure for data processing and analytics. This platform offers numerous functionalities, enabling data cleaning, governance, quality assessment, and secure sharing. Additionally, we developed a computing power distribution platform and a resource scheduling center in Gansu Province, coordinating computing resources between regions while supporting local businesses. In public services, we provided vital assessment and storage resources to ensure uninterrupted education during COVID-related school closures. In finance, we deepened partnerships with top banks, providing products such as big data and storage solutions. For instance, our data lake product assists a leading commercial bank with data storage and analytics, significantly improving efficiency in data response. In healthcare, we continued to advance five models through our Lighthouse projects, demonstrating successful implementations at various levels from provincial to municipal healthcare systems. Overall, the challenging external environment has placed pressure on our short-term performance. Regardless of these headwinds, we firmly believe that cloud computing is essential to driving digital transformation. We remain committed to our all-in cloud strategy and maintain a positive outlook on our leading position in the cloud service industry.

Nicole Shan, IR Manager

I will now pass the call over to our CFO, Haijian He, to go through our financials for the quarter. Thank you.

Haijian He, CFO

Thank you all for joining today's call. I will now review the financial results for the past quarter. Our total revenue for Q2 was RMB1.91 billion, with public cloud revenues contributing RMB1.29 billion. The changes in our revenue were mainly due to our decision to proactively reduce our CDN business, which saw a gross billing decline of 30% year-over-year, while gross billing from computing and storage increased by 5% year-over-year. Revenues from enterprise cloud reached RMB616.6 million, and we managed to maintain stable revenues year-over-year despite the challenges presented by the COVID-19 resurgence, which slowed the bidding and deployment process for projects. The impact of COVID-19 on our business from April to June was more significant than we had initially estimated. New biddings and deployment processes for enterprise cloud projects slowed down, and several internet customers delayed their spending, which temporarily affected our revenue growth. However, our cost-saving measures were effective, resulting in total cost savings of RMB252.6 million and a decrease of RMB8.7 million in non-GAAP R&D and sales and marketing expenses. Our profit margin experienced a slight decrease due to slower-than-expected revenues, and we anticipate these effects will be largely evident in Q2 and Q3. As the market environment normalizes, we believe our business will begin to stabilize starting in Q4. In terms of costs, the total cost of revenue dropped by 12.1% quarter-over-quarter to RMB1.84 billion. The IDC costs decreased by RMB81.3 million from last quarter to RMB1.03 billion, primarily due to reductions in bandwidth and cabinet costs, aligning with our adjusted CDN services. Solution development and service costs increased slightly to RMB489.8 million, which includes payments to our personnel involved in solution design, development, and services. Depreciation and amortization costs remained stable at RMB249.1 million. Fulfillment costs were RMB24.7 million, consistent with the trend in enterprise cloud services revenue. The COVID lockdown has impacted offline deployment. Fulfillment costs represent the expenses related to purchasing technology and services from third parties to meet solution demands. Other costs totaled RMB48.6 million this quarter. The adjusted gross profit for the quarter was RMB68.4 million, resulting in an adjusted gross margin of 3.6%. The adjusted EBITDA margin was negative 7.7%, with the decline in margin attributed mainly to the revenue impacts from the COVID resurgence and other factors. Regarding expenses, excluding share-based compensation, total adjusted operating expenses were RMB507.0 million, down 3.1% from RMB523.2 million. Adjusted R&D expenses were RMB190.8 million compared to RMB221.7 million last quarter. Adjusted selling and marketing expenses were RMB120.1 million, while adjusted G&A expenses increased slightly from RMB174.0 million to RMB196.1 million, primarily due to one-time compensation expenses for personnel adjustments. As of June 30, 2022, we had cash and cash equivalents along with short-term investments totaling RMB5.4 billion, providing us with sufficient liquidity for our operations. Capital expenditure for this quarter was RMB450.9 million, largely consisting of cash payments for services ordered previously. For the full year of 2022, we expect to keep our total capital expenditure plan within RMB1.5 billion. In terms of our share repurchase program, we are pleased to announce our intention to adopt a share repurchase agreement with a potential size of up to US$30 million over a 90-day window, contingent on finalizing agreements with the repurchase agent. This initiative is part of the US$100 million repurchase program authorized by the Board and announced earlier in March 2022. The timing, structure, and amount of the repurchase program will depend on market conditions, agreed terms with the repurchase agent, trading prices of our ADS, and applicable securities regulations. We view this as a commitment to align our share price with the long-term value of our business. Finally, we are progressing with our Hong Kong Stock Exchange listing plan and submitted the prospectus and A1 filing on July 27. While we've seen positive developments in Sino-U.S. auditing cooperation negotiations, we continue to pursue primary listing status in Hong Kong and the U.S. to manage potential risks proactively. We will monitor market dynamics and proceed with caution at the right time, with the final listing decision and timelines dependent on regulatory approvals and market conditions. Looking ahead, we expect our total revenue to be between RMB1.95 billion and RMB2.15 billion for the third quarter of 2022, indicating a quarter-over-quarter increase of 2.3% to 12.8%. All these forecasts and comments are based on our current and preliminary views of the market and operational conditions, which may change.

Nicole Shan, IR Manager

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

Operator, Operator

Our first question comes from Brian Gong from Citi. Please go ahead with your questions.

Brian Gong, Analyst

I will translate myself. Thanks management for taking my questions. I have two questions. First is regarding our third quarter revenue guidance. Can management give the assumption of the revenue scale of public cloud and also the enterprise cloud? And secondly, management has just mentioned that you see the slower bidding process of enterprise cloud projects. How is the latest trend in recent months? And how do you expect the tendering pace in the rest of the year? And how would that impact your revenue ahead? Thank you.

Haijian He, CFO

Thank you, Brian. I'm happy to take on the first question. So to start with, as we explained, I think the Q2, especially the COVID impact in the city of Beijing, affected quite a lot of the business deployment process. So looking to Q3, I think there are some things unchanged. There are some things that we executed, on track, and there are some things still with some uncertainties. I have to kind of elaborate one by one. First of all, I think our plan to keep a relatively scaling down size of the CDN, this plan is no change, which we communicated earlier this year. So if you look at the dollar value and the total size of the business, I think, in Q3, our CDN business will keep a relatively stable, but on a year-over-year basis, will be still around about 30% or about 25% to 30% year-over-year decline for the CDN business. And for the core part of the public cloud, which actually we are providing services on storage and computing to key internet clients as well as some diversified non-internet clients who are using our cloud product, which also we are seeing as a very positive sign, I think, for that part, we are going to see a sequential increase of the public cloud usage on cloud computing and storage in Q3. I think that we will see some trends actually picking up. On the enterprise, we keep relatively prudent and cautious in Q3 as you probably understand. The public cloud or the enterprise cloud will need to have some phases to be deployed and finally executed. So when we look at our backlog, still very strong and robust. And the core part of the backlog for this year, given the timing and the pacing, I think the majority of that important projects will be completed in Q4 for this year. But even with that, I think, in Q3, our enterprise cloud will have gradually a sequential increase compared with Q2 for the enterprise cloud. So that's actually formed the basis of a sequential increase of the total revenue compared with Q2. The mix of the revenue will keep relatively stable. The CDN will be relatively lower. The Enterprise Cloud, robust on the backlog, and most of them will be delivered in Q4. So I think the execution is still on track and the revenue conversion will be taking some time for this year. Thank you, Brian.

Tao Zou, Vice Chairman & CEO

To briefly summarize for Mr. Zou, as noted in our prepared remarks, the COVID impact from April to June, particularly the lockdowns in key cities like Beijing and Shanghai, has caused delays in our enterprise cloud bidding and deployment activities. Currently, we can confirm that commercial and business activities are improving. For the third and fourth quarters, assuming no significant lockdown measures in major cities, we anticipate a recovery. However, it remains challenging to fully assess the ongoing and lasting effects of the COVID situation, especially given the weak and uncertain global macroeconomic environment. Since our business models are B2B, if our clients face difficulties due to the macroeconomic conditions, it will be hard for us to achieve much better results. Based on business activity observed in July and August, we honestly expect that pressure will persist for some time into the future. Thank you.

Operator, Operator

Thank you. Our next question comes from the line of Thomas Chong from Jefferies. Thomas, please ask your questions.

Thomas Chong, Analyst

Thanks management for taking my questions. My first question is about the competitive landscape in the public and enterprise cloud side. Do we see any changes in terms of the competitive landscape? For example, like we are seeing more new entrants? And my second question is about the pandemic outbreak and the global headwinds that we are facing. We have just talked about that the macro situation globally is still very challenging. So I just want to get some thoughts from management, qualitatively speaking, when should we expect business back to the pre-COVID level and back to normal situations? Any color would be great. And is that really impacting the ARPU or the number of customers? And my final question is about the timing that we should expect adjusted EBITDA to reach breakeven? Thank you.

Tao Zou, Vice Chairman & CEO

So let me briefly translate for Mr. Zou. So in terms of competitive landscape, my brief answer is that, from my perspective, during the past 10 years since our inception, we believe, fundamentally, there's no material change in terms of competition because as we started out, we were competing with Alibaba and Tencent Cloud business. And more recently, there are players joining the game, including giants like Huawei, but ultimately, all of them are giant companies, whereby, in any short period of time, it is not likely that our scale can actually match with theirs. However, the fact that we have developed and grown rapidly in the past 10 years has shown that we have considerable comparable advantages even in this market in playing with the giants. The one key reason is that the nature of the 2B service industry because the nature of this industry is that the selling of a single product does not really deliver value to the enterprise customers, but the company has to jointly develop solutions together with the customer to really develop and deliver value to those customers. And therefore, it is never a winner-takes-it-all market for the 2B service companies. So a metaphor would be a horse race whereby our competitor might have 20 to 30 horses, where we focus deeply on the 3 to 5 horses, which can race really well. I think in the past, especially 5 years, the growth of our businesses, in particular in financial services and in health care have been demonstrating this point. In particular, in the health care space, we believe our solutions and products are actually leading the game. So I think, in the future, we will continue to focus on a limited number of verticals and to deliver our value to customers. And to answer your second question, it's actually very difficult for me to answer when or if we are ever going to be able to revert to our status before the pandemic. It is quite apparent that the COVID has changed a lot of things, prevailing from our daily life to larger geopolitical struggles. However, if you only refer to the revenue and financial aspect of it, I would say that the largest impact of the COVID situation to the cloud service industry in China is that the players in the market are shifting swiftly from the rather aggressive pursuit of top line growth to the pursuit of more balanced growth and profitability. We have observed our competitors, for example, Alibaba Cloud and Tencent Cloud, to adopt such adjustments. And we have also reported in the prepared remarks that we are also adjusting to a more balanced growth rather than emphasizing on revenue only. We believe that this also gives more comfort to investors and other stakeholders as we are, by doing so, switching to a more sustainable development model.

Haijian He, CFO

I'll take on the third question regarding the profitability path. So we understand earlier this year, when we think about this year's total budget and the pacing of improving profit margin before the April and May of the COVID impact, our initial intention had two things. First of all, we wanted to actually improve efficiency and cut losses on certain nodes and regions, especially from the CDN business. Those are two major drivers that we were set earlier to see an improving sequential improvement of both gross margin and EBITDA margin. We budgeted for by Q4 on a single quarter basis, hopefully, our non-GAAP EBITDA margin will turn profit. However, the COVID happening this quarter obviously affected the pacing of implementing certain measures and also the market environment also reduced certain demand for certain high-quality products from certain customers. So I think, at this moment, we are seeing flat, especially on the gross margin side for this quarter. Hopefully, I think we are seeing improving gross margin, hopefully, for the next two quarters. And we understand that it is very important for ourselves, but also for the shareholders and the market to see our results quarter-over-quarter to improve gross margin. That reflects the quality of the products and the value of our technology. However, also on the product side, given our strategy today, as we discussed earlier by Mr. Zou, that we will continue and especially focus more on the investment into R&D and R&D personnel. So I think we will make some adjustments in terms of our internal budgets on some high-quality product investments and the people investment in the next two quarters that may affect certain R&D expenses and related expenses in those two items on a marginal basis. So I think the expenses, the budgets always follow the strategy and the business demand and the vision. And I think we explained earlier in the remarks today, we have laid out that clearly regarding the priorities we want to pursue in the next two quarters. So as a result, I think I will have two points as a summary. First of all, we will try our best to improve the gross margin on a quarter-over-quarter basis. This is no change. And point #2, we will make necessary investment into the R&D for the next two quarters and especially for high-quality products. So if that will have some impact, I think the timing of the EBITDA margin may be delayed or earlier or later. But again, I think it's only about the timing. And I think if we make the right investment in the products and the customers, our EBITDA margin will turn breakeven sooner or later.

Operator, Operator

We thank you very much for all your questions. We have now reached the end of the question-and-answer session. I'll now turn the conference back to Ms. Nicole Shan for closing remarks.

Nicole Shan, IR Manager

Thank you, operator. Thank you once again for joining us today. If you have any further questions, please feel free to contact us. Look forward to speaking with you again later.

Haijian He, CFO

Necessary investment into the R&D.

Operator, Operator

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