Earnings Call Transcript - KC Q4 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the Kingsoft Cloud Fourth Quarter and Full Year 2022 Earnings Conference Call. Please be advised today's conference is being recorded. I'd now like to hand the conference over to your first speaker today, Nicole Shan, IR Manager. 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 full year 2022 earnings release was distributed earlier today and is available on our IR website at ir.ksyun.com, as well as on the GlobalNewswire services. On the call today from Kingsoft Cloud, we have our Vice Chairman and CEO, Mr. Tao Zou; and our CFO, Mr. Henry 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 integration, our integrations are for your covenants and reference covers only. In case of any discrepancy, the management statement in our 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 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 related to well-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 is 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 by 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, CEO

Hello, everyone, and thank you all for joining Kingsoft Cloud's Fourth Quarter and Fiscal Year 2022 Earnings Call. 2022 was an extraordinary year in many ways, and we're pleased to have successfully navigated the various challenges we faced in the complex and dynamic environment. As I took on the CEO role, we have remained committed to our strategy for high-quality, sustainable growth while continuing to build success based on technology. We have also implemented cost reduction and efficiency initiatives, which have resulted in steady improvements to our profitability. I am pleased to highlight some of our notable results: In Q4, we saw a remarkable increase in our adjusted gross profit, reaching RMB 169 million, representing a fourfold increase year-over-year. Adjusted gross margin increased to 7.9%, rising by a significant 6.7% from the same period last year. Furthermore, our net operating cash inflow amounted to RMB 370 million, marking the third consecutive quarter of positive net operating cash flow since Q2 of last year. We also recorded a quarterly free cash inflow for the first time, which is an important milestone for us. These impressive results demonstrate our strong business resilience and provide a solid foundation for us to stabilize and emerge even stronger. Now I would like to provide some updates on our progress in three areas, namely public cloud, enterprise cloud and research and development. I'll start with public cloud services. In Q4, revenues from this business remained stable at RMB 1.35 billion, representing a slight increase from the third quarter. We fine-tuned our positioning and implemented differentiated strategies for key account customers and midsized customers. With key account partners, we strive to maintain a balance between revenue and profitability while delivering the ultimate service experience to establish a superior reputation for our full-stack solutions. We leveraged this strong reputation and the scalable core capabilities we have developed to serve key account customers to expand our cost business opportunities with midsized customers. This approach allowed us to gradually reduce our dependence on key account customers while driving revenue growth and profit enhancement in our public cloud business. During the past half year, we carried out a systematic review of more than 200 companies from over 10 industries and signed more than 30 new midsized customers with high growth potential. Thanks to these strategies, the revenue contribution from our top three public cloud partners has not declined while the revenue contribution from midsized customers continues to increase steadily. As a result, we have improved our customer mix while maintaining stable revenue growth in the public cloud business. Moving on to Enterprise Cloud Services. Revenue increased by 26.4% quarter-over-quarter to RMB 790 million in Q4. We remain focused on executing our high-quality and sustainable growth strategy and have further clarified and institutionalized our project management best practices, fundamentally enhancing our enterprise cloud business quality. This effort centers on four key initiatives: First, we focus on accumulating and enriching our core offering of proprietary products and solutions capabilities. Second, we continued to enhance the revenue share of our proprietary products and solutions across our projects. Third, we targeted industries and customers with high potential lifetime value, catering to their evolving needs and growing with them. Lastly, we further enhanced our project execution to improve customer experience and reduce costs. These initiatives not only generated a relatively high estimated margin for enterprise cloud projects in the current financial period, but will also drive sustainable margin expansion in the long run. Taking the public services sector as an example, we focus on the public service cloud model and developed a benchmark system consisting of cloud products, services and operations. In Q4, we completed a smart city upgrade project for the Public Services and Big Data Management Bureau of the city municipality, in which we deployed our core proprietary enterprise cloud solution, Galaxy Cloud. We are also carrying out a number of other projects, including the Beijing Water Authority Public Services Cloud, further sharpening our competitive advantages and business scale in public services. In the health care sector, we continued to enhance our five major models, namely the regional healthcare cloud model, medical image cloud model, integrated healthcare organization model, regional integrated model and smart capital model. During the quarter, we completed the second phase capacity expansion projects for the healthcare cloud in the new area and the medical image file of the Health Commission. This showcases our ability to provide continuous ongoing support for enterprise cloud partners using our market-leading products, solutions and services. In the financial services sector, we further deepened cooperation with state-owned banks and major commercial banks by focusing on providing financial big data support and operational capabilities. In addition, while retaining a stable existing customer base, we strengthened our project deployment partnership with key players, particularly enhancing our synergies and cross-selling in the banking segment. In terms of technology, we continued to advance our core strategy of building success based on technology. In the third quarter of 2022, we developed the Beijing-Wuhan dual research center strategy, and we executed it well in the fourth quarter. We aim to sustainably enhance our R&D capabilities while maintaining a disciplined R&D budget. We doubled the number of R&D funds in the Wuhan Research Center within just three months of its launch in December 2022, and we expect to grow the headcount there to more than 1,000 over the next three years, injecting momentum into our R&D initiatives and helping cement our industry leadership. We strive to deliver the ultimate user experience across our core products and technology categories, including cloud host, cloud-native enterprise cloud infrastructure, enterprise storage and big data cloud platforms, and we benchmark ourselves against the top-tier players in the cloud industry. For example, we recently launched our seventh-generation cloud host, as well as new versions of our container services and serverless cloud functions, delivering significant performance improvements. We added 79 key operating features, including various enhancements, test solutions and operational management assumptions to the upgraded version of Galaxy Cloud, significantly enhancing the competitiveness of our flagship enterprise cloud product. We also upgraded the data collection, data integration and hybrid architecture deployment capabilities of our big data cloud platforms and engine solutions. In addition, we significantly enhanced our product compatibility with various operating systems, databases and chips. Since the debut of GPT 3.5, we have been closely following its development and actively exploring relevant business opportunities. First, GPT models require massive computing power and vast amounts of data, making cloud computing a natural fit for this technology and an essential enabler for use cases, including both training AI models and applying them to various scenarios. Our years of collaboration with leading AI companies have allowed us to develop a market-tested solution that can be rapidly deployed on demand. Second, major Internet cloud service providers are generally developing their own cloud businesses, whereas we remain a neutral player. This means we can serve a wider range of partners, which is an advantage that the market is beginning to recognize. Third, the application of GPT models, especially in traditional industries, which have relatively underdeveloped IT capabilities, will require extensive preparation work unique to each company, including consulting and planning, process re-engineering, customized development, installation and deployment, and ongoing maintenance. Our strong and wide-ranging IT support and deployment capabilities will enable us to capitalize on the vast opportunities in this market. Overall, looking back at the challenges we faced in 2022, we are gratified that our proactive strategic adjustments enabled us to achieve positive initial results and strengthen our conviction that we are on the right track. Looking ahead, in the face of new challenges and opportunities, we will pursue high-quality and sustainable development no matter how the environment changes and roll up our sleeves to create sustainable 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 quarter and full year 2022. Thank you.

Henry He, CFO

Thank you, Tao Zou, and welcome, everyone, for joining the call. Before diving into the financial details, I will walk you through a quick summary for the fourth quarter of 2022. First of all, with our strong commitment to improve profitability, we have taken comprehensive measures from all sectors, including proactive adjustments to our CDN services, strategic restructuring of customer mix, prudent cloud selection and strict control of fixed assets and operational expenses. Since the third quarter of 2022, our adjusted gross margin has increased for five consecutive quarters, increasing from 1.2% in the fourth quarter of 2022 to 3.6% in the second quarter last year, 6.3% in the third quarter and further to 7.9% this quarter. Adjusted gross profit increased by 408% year-over-year to RMB 168.5 million this quarter. We disposed of certain underutilized services based on current customer demand and recorded a loss on disposal of properties and equipment. However, we believe this is helpful for our long-term development and gross margin expansion. Non-GAAP EBITDA margin profit was negative RMB 245.1 million, impacted by nonrecurring Hong Kong IPO listing expenses of RMB 94.9 million and a loss on disposal of properties and equipment of RMB 208.8 million. Non-GAAP EBITDA margin was negative 11.5%. However, excluding the IPO expenses and the loss on disposal of properties and equipment, our non-GAAP EBITDA margin would have been negative 5.7%, compared with negative 10.3% last quarter and negative 4.7% in the same period of 2021. Second, our operating cash flow has been positive for the past three quarters consecutively, and we achieved RMB 370.4 million net operating cash inflow this quarter. Thanks to our prudent control over capital expenditures, free cash flow, as measured in net cash generated from operating activities minus capital expenditures, was RMB 259.6 million, marking the first quarter of positive free cash flow. This demonstrates our strong commitment and successful execution of our cash management. Third, our cash and cash equivalents and short-term investments stood at RMB 4.7 billion by December 2022. Considering the improvement of our profitability, our scaling down of capital expenditures and cash inflow from operating cash flow, our cash reserves are well positioned and sufficient to support us in navigating challenges and provide flexibility for further business development. Lastly, our total revenue was RMB 2,131 million this quarter. Revenue from public cloud services was RMB 1.34 billion, remaining stable compared with last quarter. Revenue from enterprise cloud was RMB 785.9 million, increasing by 26.4% quarter-over-quarter. With a more balanced and healthy business mix, we believe we are well-positioned to start a new journey for our sustainable long-term development, being able to allocate more resources to expand our mid- to long-tail customer base and high-quality non-Internet companies. Now I will go through our financial details. Our total cost of revenue decreased by 25.2% year-over-year to RMB 1,969.1 million. IDC costs decreased significantly by 20% year-over-year from RMB 1,321.9 million to RMB 1,057.6 million this quarter. Depreciation and amortization costs increased by 6.4% from RMB 227.2 million in the same period last year to RMB 241.7 million this quarter. Solution development and services costs decreased from RMB 497.2 million to RMB 465.8 million this quarter. The decrease was mainly due to the synergies from overlapping headcount reduction and the COVID-19 impact and other synergy initiatives last December. Fulfillment costs and other costs were RMB 155.6 million and RMB 48.3 million this quarter. Adjusted gross profit of this quarter increased by 400.08% to RMB 168.5 million, representing an adjusted gross margin of 7.9%. The significant gross margin improvement was mainly due to the impact of cost-control measures and the strategic adjustments of our revenue mix. In terms of expenses, excluding share-based compensation, our total adjusted operational expenses were RMB 729.7 million; however, we were still impacted by Hong Kong IPO exit expenses of RMB 94.4 million and the disposal of fixed assets of RMB 28.8 million. Within that, adjusted R&D expenses were RMB 239.4 million, remaining relatively stable compared with RMB 231.6 million from last quarter. Adjusted selling and marketing expenses were RMB 118.4 million, compared with RMB 125.5 million last quarter. Excluding the lifting expenses and disposal of fixed assets of RMB 123.7 million, adjusted G&A expenses increased slightly from RMB 219.9 million last quarter to RMB 248.2 million. We have taken various measures to cut down expenses, including but not limited to the following aspects. First of all, we will review variable operational expenses weekly, especially in marketing and administrative expenses. Second, we streamlined headcount management within the firm and reviewed our cost strategy and adjusted fees and other structures of personnel. Third, along with the scaling down of certain customer services, we improved the efficiency of underlying resources. We also disposed of certain fixed assets and reduced benefit costs. Net loss margin was negative 24.5% this quarter, and adjusted net loss margin was negative 25.9%. The adjustment was mainly due to the foreign exchange gain of RMB 132.3 million caused by fluctuations in the U.S. dollar-RMB exchange rates, which is a noncash impact. As of December end 2022, our cash and cash equivalents and short-term investments were RMB 4.7 billion, providing us with sufficient liquidity for operations. During the fourth quarter, we have repaid certain loans within the group and to banks to reduce our interest costs. The capital expenditure for this quarter was RMB 110.8 million, which primarily consists of payments for services. In terms of share repurchase, regarding our USD 100 million share repurchase program within a 12-month period as approved by the Board of Directors announced in March 2022, since the release of our second quarter results up to the year-end of 2022, we bought a total of 12.3 million ADR shares for the cost of roughly USD 29.2 million. Going forward, we still have authorization from the Board of Directors and the flexibility to continue execution from time to time of the repurchase program. These efforts fully demonstrate our Board and management's strong commitment and confidence in the long-term business development of the company. Lastly, we have successfully finished the new primary listing on the main board of Hong Kong Stock Exchange by way of introduction on December 30, 2022. In March 2023, we have been selected and included in the Hong Kong Composite Index, Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect at the same time. Our primary listing in Hong Kong has helped us broaden our investor base and open up new investment channels. Our teams have been communicating more frequently and broadly with domestic investors, and we have seen more active trading patterns since we joined the Hong Kong stock market. Looking ahead, although we are still implementing our strategic initiatives, including business repositioning and cost control efforts on an ongoing basis, such adjustments have already yielded positive preliminary results as reflected in the clear improvement of profit margins in Q3 and Q4. We expect our total revenue to be between RMB 1.85 billion and RMB 2.05 billion for the fourth quarter of 2023. While the forecast and comments are based on our current and preliminary views on the market and operational conditions, which are subject to change, we firmly believe that given time, the potential positive impact of our ongoing strategic initiatives will continue to amplify and reflect in our financials in the mid- to long term. Thank you.

Nicole Shan, IR Manager

This concludes our prepared remarks. This answer contains both Mandarin and English, if possible. Operator, please go ahead.

Operator, Operator

We'll now take our first question. This is from Brian Gong from Citi.

Brian Gong, Analyst

I have two questions. First, regarding the enterprise cloud and the three verticals, how should we expect demand this year? Last year's delivery was affected by the cold wave. Should we anticipate faster growth this year, and how should we balance revenue growth with margin? My second question is about China GBT. The total trust mentioned regarding individual cloud providers indicates we have some advantages in China. However, many of the internet giants in China, capable of developing large language models, also have their own cloud services. If auto price users utilize their large language model, will they be more inclined to use those cloud services?

Tao Zou, CEO

We are currently experiencing a recovery phase following the COVID period, and the country is shifting back to its business development model. The COVID situation and related restrictions did affect our ability to deploy and deliver our enterprise cloud services, causing delays in some planned deployments that were supposed to occur in Q4 of last year. However, at this point, while we have not provided specific details or figures for the three verticals mentioned, we are very confident in our operating metrics for our enterprise cloud, particularly in terms of revenue, gross profit, and operating margin. We anticipate significant improvements in these areas. Secondly, I would like to clarify that our pursuit of high-quality and sustainable growth does not mean we do not pursue growth. For every customer and project, we evaluate whether that customer and project aligns with our core business and profitability. In other words, if some of the customers and projects do not bring profitability to the company, that is not a high-quality project and not a valuable development. We have been overly emphasizing growth in the past; now we need to shift that emphasis to high-quality and sustainable growth, which carries strategic value for us. Just to briefly hand over the CEO perspective, we have announced in the sense of various facilities and companies that we will not deploy many resources working on the big language model ourselves. Our clear value proposition is to provide solutions to our customers; therefore, working solely on cash models holds no significant strategic value for us. However, regarding the question of who uses our services and products, I have two main thoughts. One is that although the larger technology companies have relative advantages, it does not mean that those models developed by these giants are superior. OpenAI is a good example of this, which is not a technology giant but has developed a leading model. The second point is that despite the short-term outlook, we believe it is unlikely that large language models, such as GPT in China, will develop to a level similar to GPT 4.0 in the United States. However, smaller models can present real value and applications across various industries in China. For example, we are already seeing small models with billions of parameters yielding vivid and impactful applications in different sectors. These application scenarios represent potential business opportunities for us. To sum up, two potential business opportunities we see are venture teams from smaller companies working on these models, and the application of such smaller models in traditional companies with relatively underdeveloped IT capabilities.

Henry He, CFO

Hello, Brian. The first question you're asking about likely pertains to a specific sector. If we look at our quarter-on-quarter growth, last quarter we reported approximately RMB 600 million in revenue across the three verticals combined. In Q4, we achieved around RMB 784 million in revenue, marking a net increase of about RMB 180 million compared to the previous quarter. As a reminder, in December of last year, there were COVID-19 restrictions in Beijing that impacted our performance. Nevertheless, despite those challenges, we managed to achieve a revenue increase, demonstrating our ability to execute and deliver even under difficult circumstances. The second point regarding the backlog: while we didn't provide specifics on our backlog, we hope to disclose more information going forward, especially regarding new signings on the contracts for enterprise cloud revenues. I can share that the current backlog fully covers our potential budget for the NPS Cloud in 2023, and we're hopeful of increasing the backlog this year. We have confidence moving toward a balanced growth and quality model, and the growth potential is tangible. Additionally, the percentage of repeat customers has significantly increased, indicating that while we posted revenue of around RMB 700 million this quarter, a large portion came from existing customers with different phases of projects, providing us a solid foundation for growth in the following year.

Operator, Operator

We'll take our next question. This is from the line of Timothy Zao from Goldman Sachs.

Timothy Zao, Analyst

I have two questions. First, could management provide your outlook on public cloud demand in 2023? Between large enterprise companies and small SMEs, which type do you expect will demonstrate greater demand for public cloud this year? Secondly, we noticed that last year, the company performed exceptionally well in terms of profitability, both in gross margin and EBITDA margin. Could management update us on your expectations for gross margin and EBITDA margin?

Tao Zou, CEO

Regarding your first question, the demand for public cloud services and products focuses on core components such as computing, storage, and networking, meaning that demand does not significantly vary by the size of the enterprise we serve. What really influences demand is the application scenario and the specific business needs of our customer enterprises. For example, we have video company customers whose primary demand comes from our CDN and storage business, while customers in the AI industry may place more importance on computing capabilities.

Henry He, CFO

Thank you. I'll address your second question. Before discussing the target for 2023, I want to explain some reasons for our performance in 2022. First, regarding property, plant, and equipment (PP&E), we have made efforts to reduce redundancies and avoid misallocation of resources. These efforts have been ongoing for two to three quarters since mid-2022, and we expect the benefits to be gradual in the coming months. Second, we changed the combination of our customer base, with our mid-sized clients increasing their revenue share, which has a more favorable impact on profitability compared to serving larger clients. Third, we effectively controlled variable expenses, including travel expenses, accommodation, staff compensation structures, etc. As a result, some benefits were reflected in the Q4 numbers, with expectations for improved expenses to show in Q1 and Q2 of 2023. Though I can't provide a precise numerical target for the EBITDA margin and operating profits this year, I can say that we aim to increase our gross margin percentage on a quarter-over-quarter basis. We hope to see stable expansion in the next two quarters. Moreover, as we control expenses and reduce variable costs, we can reach breakeven sooner in terms of EBITDA margin this year. These are our two primary objectives. That said, regarding operational margins and breakeven points, I expect to maintain balance between growth and investments in CapEx while serving high-quality customers.

Operator, Operator

We will now take our next question. Please stand by. This is from Allen Li from JPMorgan.

Allen Li, Analyst

Let me quickly translate my question. My question is about capital expenditures. We made pre-investments in capital expenditures over the past few years. However, due to various macro challenges, our overall utilization rate appears to be low, which has negatively affected our margins. Looking ahead to this year, considering the significant opportunities created by AI industries, how should we approach our capital expenditure plan for 2023? Will we adopt a more proactive or reactive stance regarding AI-related capital expenditure investments?

Tao Zou, CEO

As we have noted, with the emergence of new AI technology like GPT, we have already started to allocate both technology and resources. However, I would describe our perspective as cautiously optimistic instead of eagerly chasing this potential opportunity. Given our insights into the AI industry's evolution, we feel that the market appears to be overheated and we anticipate a more sustainable but slower growth pattern. We will maintain a careful approach with gradual steps and swift iterations. Additionally, I want to emphasize that we will primarily discontinue developments and upgrades related to the previous generation of hardware.

Henry He, CFO

I'd like to add some additional context as well. If you remember from our IPO in 2020, we spent about RMB 1 billion on CapEx. As a company, we possess the capacity and experience to manage spending effectively, and our team is well-acquainted with the supply chain. Our good partnerships with ecosystem partners, including Xiaomi, have helped us manage the complexity of purchasing significant assets at reasonable prices given past experiences. The second point I want to make relates to investment decisions. We are investing in two key areas: team and technology. Our senior management oversees these areas, and we invest heavily in R&D, exceeding RMB 1 billion annually on R&D expenses. We are assured in our investment in products and technology. However, regarding cash flow for capital expenditures, our approach will differ. As previously mentioned, we see significant financial opportunities arising from Internet clients as well as applications from diversified and non-Internet clients. These business models will require less capital expenditure from Kingsoft Cloud, as customers develop their own environments. It's important for us to balance our investments and select the right clients to match our criteria. For partners like Xiaomi and others, we will fully invest and incur CapEx, while for other customers not meeting our criteria, we may taper our spending.

Operator, Operator

Thank you. And at this point, I would now hand back to Nicole Shan for closing remarks.

Nicole Shan, IR Manager

Thank you, operator. Thanks, everyone. This concludes our earnings call. Thank you again for joining us today. If you have any other questions, please feel free to contact us. We look forward to speaking with you next quarter. Have a nice day. Bye-bye.

Operator, Operator

This does conclude the conference for today. Thank you for participating, and you may now disconnect.