VNET Group, Inc. Q1 FY2023 Earnings Call

Hello, ladies and gentlemen. Thank you for standing by for the First Quarter 2023 Earnings Conference Call for VNET Group Inc. Participants from our management include Mr. Jeff Dong, Chief Executive Officer; Mr. Tim Chen, Chief Financial Officer; and Ms. Xinyuan Liu, Investor Relations Director of the company. Please note that today's conference call is being recorded. I would now like to turn the call over to the first speaker today, Ms. Xinyuan Liu. Please go ahead.

Thank you, operator. Hello, everyone, and welcome to our first quarter 2023 earnings conference call. Our earnings release was distributed earlier today, and you can find a copy on our website, as well as on Newswire services. Please note that the discussion today will contain forward-looking statements made under the Safe Harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. For detailed discussions of these risks and uncertainties, please refer to our latest annual report and other documents filed with the SEC. VNET does not undertake any obligation to update any forward-looking statements, except as required under applicable laws. Please also note that VNET's earnings press release and this conference call include the disclosure of unaudited GAAP financial matters as well as audited non-GAAP financial matters. VNET's earnings press release contains a reconciliation of the unaudited non-GAAP measures to the audited GAAP matters. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will also be available on our website at ir.vnet.com. I will now turn the call over to our CEO, Jeff.

Thank you, Xinyuan. Good morning, and good evening, everyone. Thank you for joining our call today. I will start with an overview of our first quarter results. After that, I will turn the call over to Tim, our CFO, who will discuss our financial results and outlook in more detail. We got off to a great start in 2023 with a solid first quarter performance, thanks to our effective dual core growth strategy and competitive service offerings. In the first quarter, we officially ended 1,300 utilized cabinets, growing our overall utilization rate to 56.5% from 55% last quarter. Total companies under management reached 87,310 by the end of the first quarter compared with approximately 78,960 one year ago. Notably, our retail MRR per cabinet reached a record high of RMB 9,486 during this quarter, up from RMB 9,371 million in the previous quarter. First quarter revenue of RMB 1.81 billion represents an increase of 9.7% year-over-year and adjusted EBITDA grew about 10% year-over-year to reach RMB 756.2 million, demonstrating our ability to drive stable growth amid China's steady post-pandemic recovery. Before I talk more about our business results, I want to share some color on the broader economic climate. Official statistics show China's GDP grew 4.5% year-over-year for the first quarter, indicating a clear post-pandemic recovery path with the digital economy poised to become China's key growth driver in the coming years. China's government is diligently advancing its Digital China vision. Its strategic efforts, including taking forward-looking steps in building digital infrastructure, fostering more innovation and value creation in the platform economy, and accelerating digital transformation across various sectors and the general population, according to the NDRC. Given this context, advanced infrastructure facilities such as 5G connectivity and data centers will serve as strategic cornerstones for the development of the digital economy, fulfilling growing demand from a broad spectrum of industries, including Internet players, as well as traditional industries. As a leading player in China's IDC space, we are well-positioned to provide ever-improving services to customers and seize opportunities arising from the favorable policy landscape and digital economic boom. Now let's take a closer look at our first quarter business updates. Execution of our dual core strategy continues to prove strongly effective in both the wholesale and retail IDC markets. Our wholesale service offerings continue to gain traction among leading Internet players during the quarter. As we mentioned during the last earnings call, in the first quarter, we won a bid for a new customer, one of China's Internet giants, to deploy IDC services to support its business expansion through our IDC assets located in the Yangtze River Delta Region. The overall project will total more than 100 megawatts and be delivered in multiple phases. The project is now progressing smoothly, and the initial phase of the cabinets will be delivered by the end of this year as scheduled. This project once again exemplifies our compelling value proposition and service capabilities for wholesale customers. Moving on to our retail business, in today's business operating environment, companies of all sizes and sectors are pursuing digital transformation with increasing urgency. Our high-quality, scalable retail IDC service offerings are attracting more and more enterprise demanding fast, reliable and secure digital access to facilitate their digital transformation agendas. In the first quarter, growing demand from cloud services, media, and traditional sectors drove an expansion in our number of new customers. At the same time, we continue to win extended orders from existing customers across a variety of industries, including local services, IT services, online gaming, and financial services. Our comprehensive service offerings and customized solutions create an excellent service experience for customers, solidifying our customer loyalty and a boost in our overall competitiveness. Next, I want to share an update on the Blue Cloud business. In April, Microsoft and our Blue Cloud jointly launched Microsoft Teams, one of Microsoft 365's core modules for the Chinese market. Together with Office 365, Microsoft Teams will be operated under Microsoft 365 by our Blue Cloud in China, bringing more robust and efficient functionality supported by Blue Cloud's secure and reliable cloud services. As China's digital transformation accelerates, we'll leverage Blue Cloud's cloud operational expertise and decade-long strategic partnership with Microsoft to further unlock its unique value proposition. Last but not least, I'd like to provide an update on our ESG performance, which is an important part of our growth and long-term value creation philosophy. Last month, we released our third annual ESG report detailing our 2022 ESG initiatives and outcomes, including third-party verification of our carbon inventory results. We also highlight achievements such as our average annual PoE of 1.37, a green power purchase agreement with a supply guarantee of approximately 500 million kilowatt-hours over the next five years, and an increase in our percentage of female employees in management positions to 29%. Going forward, we will continue to deepen our ESG engagement and embrace our responsibility to deliver sustainable value to our shareholders. In summary, our solid first quarter performance underscores our core strengths and execution capabilities. With China's post-pandemic economic recovery well underway, alongside increasing demand designed to boost the digital economy, we are optimistic about the domestic IDC service industry's growth prospects for the rest of the year. We'll remain committed to our effective dual core growth strategy, focusing on our core business by providing our retail and wholesale customers with reliable and customizable services while fulfilling incremental digital demand to facilitate digital transformation across verticals. Thank you, everyone. I will now turn the call to Tim to discuss our financial performance for the quarter and our business outlook.

Thank you very much, Jeff. Good morning, and good evening, everyone. Before we start the detailed discussions of our financials, please note that we will present non-GAAP measures today. Our non-GAAP results exclude certain non-cash expenses, which are not part of our core operations. The details of these expenses may be found in the reconciliation tables included in our earnings press release. Please also note that unless otherwise stated, all the financials we present today are for the first quarter of 2023 and in renminbi terms. Now let me walk you through the first quarter financial results. Unless otherwise specified, the growth rates that we review are all on a year-over-year basis. We delivered solid results in the first quarter amidst a steady post-pandemic recovery in China. In the first quarter, our net revenues increased by 9.7% to RMB 1.81 billion from the same period last year, mainly driven by the continued growth of our IDC business, as well as our cloud and VPN services. Gross profit was RMB 352.4 million in the first quarter of 2023, representing a decrease of 0.9% from the same period of 2022. Gross margin was 19.5% in the first quarter of 2023 compared to 21.6% in the same period of 2022. Adjusted cash gross profit, which excludes depreciation, amortization, and share-based compensation expenses, was RMB 754.3 million in the first quarter of 2023, an increase of 10.1% from the same period of 2022. Adjusted cash gross margin in the first quarter of 2023 was 41.8% compared to 41.6% in the same period of 2022. Adjusted operating expenses, which exclude share-based compensation expenses, and compensation for post-combination employment in an acquisition were RMB 228.8 million in the first quarter of 2023 compared to RMB 200.8 million in the same period of 2022. As a percentage of net revenues, adjusted operating expenses in the first quarter of 2023 were 12.7% compared to 12.2% in the same period of 2022. Adjusted EBITDA in the first quarter of 2023 was RMB 556.2 million, representing an increase of 9.9% from the same period of 2022. Adjusted EBITDA in the first quarter of 2023 excluded share-based compensation expenses of RMB 8.3 million. Adjusted EBITDA margin was 30.8% in both the first quarter of 2023 and 2022. Our net income attributable to ordinary shareholders in the first quarter of 2023 was RMB 82.3 million compared to a net income of RMB 90.7 million in the same period of 2022. Basic and diluted earnings were 0.09 and 0.07 per ordinary share, respectively; and 0.54 and 0.42 per ADS, respectively. Each ADS represents 6 Class A ordinary shares. Turning to our balance sheet, as of March 31, 2023, the aggregate amount of the company's cash, cash equivalents and restricted cash was RMB 3.24 billion. Meanwhile, net cash generated from operating activities in the first quarter of 2023 was RMB 455 million compared to RMB 482.6 million in the same period of 2022. Our CapEx in the first quarter of 2023 was RMB 611 million. Next, moving to our outlook. For the full year of 2023, our outlook remains unchanged, with net revenues expected to be in the range of RMB 7,600 million to RMB 7,900 million, representing a year-over-year increase of 7.6% to 11.8%. And adjusted EBITDA to be in the range of RMB 2,025 million to RMB 2,125 million, representing a year-over-year increase of 8.1% to 13.5%. Looking forward, we will continue to explore new opportunities arising from the robust digital demand and to further strengthen our presence as a leading IDC player. As always, we are dedicated to delivering sustainable value to all of our stakeholders in the long run. This concludes our prepared remarks for today. Operator, we are now ready to take questions.

I have three questions here. The first one is about the demand and moving. We see a steady improvement in the utilization rate in the first quarter. Does management believe that overall customer demand will continue to improve further in the second quarter? And we have this question because of the overall macro data trending down a little bit in April. So that's why I think there are some concerns about the overall demand side. Can management share with us the latest observations in the operation? The second question is that we observed a few public cloud vendors are cutting their prices or unit prices recently in the market. What is the management's view in terms of this kind of pricing action transferring to data centers, whether from the volume demand perspective or from the pricing pressure or whatever this kind of commercial negotiation perspective? That's the second question. The third question is we are glad to see that the company introduced Microsoft Teams in China. What makes the market more excited is that Microsoft's launch of Office Copilot. Does VNET have any plans to introduce the new generation of AI products to China? Thank you.

Yang, it's Jeff. Let me give you some insights on the three questions you just asked. The first one is about the demand. We have seen a steady improvement, as we keep repeating, actually from the macro side, such as China reopening and favorable regulatory environments supporting the development of the platform economy and digital economy. We have seen a trend that is recovering in the market. However, to be honest, given the state of the real market, we need to be a bit more patient for the market to warm up to fully recover. And as we mentioned, we have already obtained a very large order from the market, which signals that we have the ability and the market has already been recovering, especially from customers like the short video players compared to other cloud service players. The second question regarding the cloud service players, you just mentioned price cuts. There are some observations we can share with you. First, we don't have any direct competition with cloud service players regarding their price cuts as we serve a different customer base. Second, companies in several sectors like financial services will only be able to use IDC instead of a public cloud to meet compliance requirements. For example, we recently signed contracts with Morgan Stanley, which is an example where we could only provide IDC services instead of cloud. Plus, in terms of pricing, all the pricing we have signed are already determined in the contracts, so we do not see any immediate or direct feedback from their price cuts. Yes, we think that will likely be true that their price cuts may generate more business volume to the overall public cloud and then transfer to IDC suppliers. In terms of Microsoft, I would say that Blue Cloud and Microsoft recently launched in China. We expect enterprises to build out integrated modern office management systems and intelligent, scalable collaboration platforms to help customers operate efficiently. That's what we're looking for. As for Teams, we will see what we can do in terms of income and also the further additional products from Teams going forward.

I got three questions. The first one is, in the first quarter, you added 1,400 utilized cabinets. Can you share with us the split between retail and wholesale, and what sort of demand you are seeing from retail versus wholesale so far? The second question is about the non-IDC business. Can you share some insights on the growth of the Microsoft business and the VPN business so far? And what is your outlook for the rest of the year? The third question is about your CB. That will be puttable next year. Can you discuss whether you have a plan or what are you considering in terms of the refinancing of the CB?

Edison, let me take a shot at this, and then I'll have Jeff add additional comments from his side as well. In terms of the additional billable cabinets, I would say that the majority of those additional cabinets are coming from the wholesale business. This is not surprising given that those customers ramp up in larger volumes in terms of cabinets compared to our smaller-scaled enterprise customers. So again, it's driven largely by wholesale customers. Jeff, earlier on I talked about and we've mentioned for the last few quarters, a bifurcation in the wholesale customer base between cloud service provider customers and the large Internet companies. We have seen more ramp-up with the large Internet companies, which comprises the wholesale side of that split. For the non-IDC business outlook, there is continued growth in that business. You've seen that Microsoft has launched new products, and we do expect that this will continue to grow. As that business grows, then obviously our Blue Cloud-related business will grow as well in a similar manner. Lastly, we are very much aware of market questions around the upcoming CB for next year, the 600 million CB. We have already received the requisite NDRC approvals. We have a number of both onshore renminbi and offshore U.S. dollar alternatives and solutions in progress. We will announce further details to the market as soon as we have them. Jeff, do you want to add anything else regarding the retail-wholesale growth or non-IDC business outlook?

Yes. I think the team has covered most of the points. I just want to add that the newly added billable cabinets were contributed mainly by the wholesale business as well. In terms of revenue percentage, we cover about 30% from wholesale and 70% from retail. For the capacity and the billable cabinets, AUM is about 40% from wholesale and 60% from retail. Regarding Microsoft and Teams related to ChatGPT, we view this as a very positive signal for us. We're seeing increased demand for AI-based solutions and will need computing power for training, especially from lower-tier areas where latency is not a critical issue. We believe this demand will boost data center requirements. Moreover, the higher level of intra-data center communication, known as cross-connection, gives us a unique advantage as enterprises utilize interconnects to reduce latency. As AI continuously trains on new data sets for improved accuracy, we believe that this is likely the next direction for data centers.

Is it possible to talk about the growth rate of the non-IDC business in the first quarter?

Sorry, you’re asking about the growth rate of the non-IDC businesses?

Yes, in the first quarter. Is it possible to provide some insight on that?

We don't provide the segment breakdown, but I would say the growth rate is probably somewhere in the high single digits. I see. And do you expect that to be similar for the rest of the year? It's difficult to say at this moment because if you're looking at the non-IDC business, you're looking at the VPN business but also the Microsoft side. The Microsoft side is something we do have less visibility on. While we do see growth in underlying businesses, we do not have a direct connection to end customers concerning Microsoft's final business. It's hard to determine right now. If you look at the overall trend, it’s still early. China is still recovering from COVID, so after another quarter or so, we will probably have a much better gauge on whether growth is accelerating, remaining stable, or decelerating. We will have a clearer idea probably next quarter.

I have one question. I note that your retail IDC MRR has been continuously increasing since the second quarter of last year and already reached around RMB 9,500. I'm curious about the drivers behind the sequential improvement in our retail MRR. Additionally, could management provide more insight on our wholesale IDC MRR and expectations for future pricing trends?

Let me take the first one and then I'll see if Jeff has some insight on the second. Regarding retail MRR, we've always expected it to be north of RMB 9,300. If you look at historical data, it's fluctuated over certain quarters. In this quarter, I would say there are two key factors. The first is that additional value-added services are being added by existing customers. For example, the increase in O&M services from customers effectively boosts revenue without increasing the total number of underlying cabinets. Therefore, the retail cabinet MRR will rise. Secondly, the new cabinets we are adding are higher MRR cabinets, reflecting demand for colocation and value-added services. I would say the first factor drives the increase more significantly this quarter. For further comments on the pricing side and expectations, I'll pass that to Jeff.

In terms of MRR on the wholesale side, I would address this from two aspects. One is from the supply side of the market. Many smaller players have cut back on their workforce recently, especially since last year, which has helped to slow down the supply side. Larger players like us, along with some of our peers, have also scaled back to align with supply conditions. There is a trend of pricing on the wholesale side trending slightly downwards, but we have also observed recovery signs since the start of 2023. Some smaller players in the market, particularly established leaders, have been cautious with cash spending. That being said, we do not bundle our offers at any cost, which helps maintain a stable pricing structure. Moving forward, we will focus on better cost control and improving efficiency to address fluctuations in the market.

I have two questions. The first is on ChatGPT. Have you seen any increasing customer demand or accelerated movement due to recent AI deployments in China? The second question is on EBITDA margin. I noticed your Q1 EBITDA margin remained stable year-over-year and would like to know the reasons behind that. Could you also share your expectations for EBITDA margin going forward?

Regarding your question on ChatGPT, yes, we have seen some movement in customer demand. However, it's still early stage in terms of direct impact. Some customers have announced they are developing relevant products linked to AI. However, it has not yet turned into tangible new tenders around this product, so I would still classify it as early stage. Regarding EBITDA margins for Q1, as mentioned in our earnings release, it did exceed our internal forecasts. Several key factors contributed to this. There is a seasonality aspect; in Q1, certain non-recurring revenues positively impacted EBITDA and margins. We also experienced some costs that were delayed from Q1 to Q2, which may lead to slightly higher margins in Q1 compared to your models but lower in Q2 due to timing issues. Furthermore, we've implemented strict cost controls on the utility side and cost management, which positively impacted margins. So while margins align with last year, there are multiple factors at play here.

Let me provide some insight on AI demand, as you mentioned. We are observing a trend from AI-based customers, primarily from our retail sector. For instance, we've received feedback from government agencies in Beijing regarding strong computing needs linked to AI. However, this demand is mainly coming from the retail side. We are maintaining dialogue with AI-based customers but have not seen significant demand from the wholesale side.

Thank you very much for all your questions. With that, ladies and gentlemen, we conclude our conference for today. Thank you.