Earnings Call Transcript - VNET Q2 2022

Operator, Operator

Hello, ladies and gentlemen. Thank you for joining the Second Quarter 2022 Earnings Conference Call for VNET Group, Inc. At this moment, all participants are in listen-only mode. Following the speakers' presentations and management's prepared remarks, there will be a question-and-answer session. Participants from our management team include Mr. Samuel Shen, Chief Executive Officer and Executive Chairman of Retail IDC; Mr. Tim Chen, Chief Financial Officer; and Ms. Xinyuan Liu, Investor Relations Director of the company. Please be aware that today's conference call is being recorded. Now, I will pass the call over to our first speaker, Ms. Xinyuan Liu. Please proceed.

Xinyuan Liu, Investor Relations Director

Thank you, operator. Hello, everyone, and welcome to our second quarter 2022 earnings conference call. Our earnings release was distributed earlier today, and you can find a copy on our IR 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 US 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 includes the disclosure of unaudited GAAP financial measures, as well as unaudited non-GAAP financial measures. VNET’s earnings press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited GAAP measures. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will also be available on our IR website at ir.vnet.com. I will now turn the call over to our CEO, Samuel.

Samuel Shen, CEO

All right. Thank you, Xinyuan. Good morning, and good evening, everyone. Thank you for joining our second quarter 2022 earnings conference call. During the second quarter, our focus remained on driving healthy results and delivering high-quality solutions and services to our customers. Our solid growth momentum across our business segments, amidst macro challenges, clearly reflects the effectiveness of our growth strategy and our strong execution capabilities. On the operations front, total cabinets under management increased to approximately 80,800 by the end of the second quarter, compared with approximately 62,900 one year ago. At the same time, cabinets utilized by customers increased sequentially by approximately 1,500 to 44,500 by the end of the second quarter, compared with approximately 36,600 one year ago. Accordingly, the overall utilization rate maintained a sequential ramp-up, reaching 55.1% by the end of the second quarter. Our retail MRR per cabinet reached RMB9,186, showing a healthy increase from the same period last year. On the financial front, we delivered a robust financial performance, with a year-over-year growth of 15.2% and 14.5% in revenue and adjusted EBITDA year-over-year, respectively. With the rapid growth of China's digital economy, we, as a leading IDT service provider, are in a good position to benefit from this growth momentum and local government supportive measures. This may be the National Committee of the Chinese People's Political Consultative Conference held a consultative session and called for stronger efforts to boost the development of the digital economy across a broad swath of industries. Technological empowerment was highlighted as a vital driver for higher quality economic growth. We believe this will carry immense potential to significantly amplify demand for IDC services. Within this environment, we are confident in our strength and our ability to capture exciting new growth opportunities. Next, let's take a closer look at the business update, starting with the recovery momentum from the impact of COVID resurgences. Encouragingly, in June, with the gradual easing of COVID-19 related lockdowns and mobility restrictions in Shanghai, Beijing, and Hebei province, we immediately resumed construction on new projects in these areas and have seen moving rates recovering steadily. Next, a review of our progress in key business segments during the quarter. Our wholesale business made solid progress in the second quarter. We once again extended our contract with an existing customer, a leading social platform in China, for building its network infrastructure in the northern region of China. This new order will generate total capacity of approximately 14 megawatts and further demonstrates our value proposition for this business segment. In addition, we recently signed a new contract of approximately 15 megawatts with the leading cloud service provider in China to build its network infrastructure in the Yangtze River Delta region. In the data center for this customer, aside from conventional air cooling, we will also offer liquid cooling solutions a more sustainable approach that will help reduce PUE and carbon emissions. Moving on to our retail business. Thanks to our diversified customer base, we are pleased to see our retail business growing steadily amid macro challenges. In the second quarter, we leveraged our technologies and expertise to cater to various vertical needs with a suite of value-added services, existing customer expansion, and new customer acquisition, both achieved impressive results, driven by rising digital demand from a wide variety of industries, such as local service, automobile, financial services, power manufacturing, and online gaming. Looking ahead, we plan to harvest our advanced engineering capabilities to enhance our service portfolios, creating more value for our customers and generating more diverse revenue streams. On the Blue Cloud business front, we continue exploring opportunities that will allow us to diversify our industry-specific cloud solutions during the second quarter. We extended our manufacturing execution system, aka MES, to a leading automotive seating manufacturer in China. Through the delivery of MES, we help the customer manage manufacturing flexibility, improve productivity, and maximize efficiency by deploying digitalization, automation, and new technologies that will provide real-time workflow visibility, flexibility, and insight into the entire manufacturing operations process from order release to ready-to-forge shipment. This system has been successfully implemented across all of our customer's production lines, and we're very pleased with the progress we have made in this area. In the meantime, we are actively accumulating more industry-specific expertise and look forward to tapping into greater opportunities in the cloud business sector in the future. Despite macro headwinds, the unprecedented COVID-19 resurgence and lockdowns in the first half of the year, our sustained growth highlighted our excellent business resilience and our ability to capture the rising demand for high-quality IDC services. However, in the near term, the uncertain economic outlook and threat of COVID-19 outbreaks may bring some short-term challenges to us. While the long-term demand trend is secure, taking into account the short-term challenges of the current slowdown environment and the impact of COVID-related disruptions, we are adjusting our outlook for the full year of 2022, revising our full year delivery plan to the range of 9,400 to 12,400 cabinets from the previously provided 14,400 to 17,400 cabinets. Going forward, we remain focused on our dual core growth strategy, leveraging our scalable service offerings to drive growth and building our customer base across verticals. As the industry frontrunner and the fundamental link in China's digitalization chain, we will seize the opportunities from the nation's rapidly expanding and evolving digital economy, creating sustainable value for our stakeholders in the long term. Thank you, everyone. With that, I will now turn the call over to our CFO, Tim Chen, to discuss our financial performance for the quarter and our business outlook.

Tim Chen, CFO

Thank you very much, Samuel. Good morning, and good evening, everyone. Before we start the detailed discussion 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 financials we present today are for the second quarter of 2022 and in renminbi terms. For the second quarter, again, we delivered a robust financial performance driven by rising demand from both our wholesale and retail businesses. Our solid financial position gives us a firm foundation to drive long-term and sustainable growth, as we continue to leverage our scalable service offerings and build our customer base across a wider variety of industries. Next, let me walk you through our second quarter financial results. Unless otherwise specified, the growth rates I will be reviewing are all on a year-over-year basis. In the second quarter, our net revenue increased by 15.2% to RMB1.72 billion from the same period last year, mainly due to increased customer demand for our highly scalable carrier and cloud-neutral IDC solutions from both wholesale and retail IDC customers, as well as the continued growth of our cloud business. Gross profit was RMB357.8 million in the second quarter of 2022, roughly flat compared with the same period of 2021. Gross margin was 20.7% in the second quarter of 2022, compared to 24% in the same period of 2021. Adjusted cash gross profit, which excludes depreciation, amortization, and share-based compensation expenses, was RMB713.7 million in the second quarter of 2022, an increase of 11.5% from the same period of 2021. Adjusted cash gross margin in the second quarter of 2022 was 41.4%, compared to 42.8% in the same period of 2021. Adjusted operating expenses were RMB250.7 million in the second quarter of 2022, compared to RMB235.6 million in the same period of 2021. As a percentage of net revenues, adjusted operating expenses in the second quarter of 2022 were 14.5%, compared to 15.7% in the same period of 2021. Adjusted EBITDA in the second quarter of 2022 was RMB486.9 million, representing an increase of 14.5% from the same period of 2021. Adjusted EBITDA in the second quarter of 2022 excluded share-based compensation expenses of RMB47.5 million. Adjusted EBITDA margin in the second quarter of 2022 was 28.2%, compared to 28.4% in the same period of 2021. Our net loss attributable to ordinary shareholders in the second quarter of 2022 was RMB377.2 million, compared to a net profit of RMB455.9 million in the same period of 2021. Basic and diluted loss were both RMB0.43 per ordinary share and both RMB2.58 per ADS. Each ADS represents six Class A ordinary shares. Turning to our balance sheet. As of June 30, 2022, the aggregate amount of the company's cash, cash equivalents, and restricted cash was RMB3.62 billion. Meanwhile, net cash generated from operating activities in the second quarter of 2022 was RMB942.7 million compared to RMB314.8 million in the same period of 2021. Our CapEx in the second quarter of 2022 was RMB540.6 million. And now on to our financial outlook. As Samuel mentioned, we faced the impact from COVID-related disruptions in the second quarter of 2022 on data center construction and customer moving schedules, and ongoing macroeconomic uncertainties as well. As a result, we adjusted our outlook for 2022. Based on our current estimates, we expect our net revenues to be in the range of RMB7,250 million to RMB7,550 million and adjusted EBITDA to be in the range of RMB1,800 million to RMB1,950 million. We always believe opportunities go alongside challenges. The COVID impacts are short-term in nature, and digitalization is rapidly advancing in the wider society. Looking ahead, we will remain committed to advancing our dual core growth strategy, broadening the spectrum of our services, increasing customer diversification, and capitalizing on the enormous opportunities presented by a thriving digital economy in China. This concludes our prepared remarks for today. Operator, we are now ready to take questions.

Operator, Operator

Thank you. We will now begin the question-and-answer session. The first question comes from Ethan Zhang from Nomura. Please proceed. Thank you.

Ethan Zhang, Analyst

Thank you, management for letting me ask the first question. So I have two questions. The first one is, given the current situation of the electricity supplies in China, especially the heat wave in and surrounding areas, how do you see the trend of the utility cost in the second half of this year and the impact on our EBITDA margin? And second question is regarding the CapEx trend. So I remember we guided around RMB5 billion CapEx for the full year 2022. But during the first half, since that we only completed a limited portion of our CapEx target. So I just wonder, if we maintain the previous guidance on our CapEx spending for this year and what would be our focus or target for CapEx spending in the second half of this year? Thank you.

Tim Chen, CFO

Thank you very much, Ethan. Let me take the first two questions. First, in terms of electricity, and impact of some of the areas switching-1 as an example, we do not expect to see a major increase in electricity tariffs. However, in the areas that are impacted by electricity shortages, similar to last year and early parts of this year, where some of the data centers would need to switch over to diesel or we would actually acquire diesel in preparation for potential shortfalls in terms of electricity supply. I think that will show up in the figures for the second half, especially for anything in the affected areas. As for the CapEx and whether there are any changes to the CapEx guidance, we still expect to spend roughly in the range of RMB4 billion and that's despite some of the capacity being pushed into 2023. As you know, these constructions do have a longer lead time. And so there will still be money being spent regarding the power infrastructure, the buildings, and so forth. It would just be a slowdown a little bit, but we still expect that it will be for the full year around RMB4 billion. I hope that answers your questions.

Ethan Zhang, Analyst

Thank you.

Operator, Operator

Thank you for the questions. Our next question comes from Edison Lee of Jefferies. Please proceed with your question.

Edison Lee, Analyst

Hi, Morning Samuel and Tim. Thank you very much for the presentation. I want to see what kind of power cost increases that you are assuming in your new guidance for the second half? And also, I want to know, what the two new wholesale projects? What is the timing in terms of service launch and EBITDA contribution? Thanks.

Tim Chen, CFO

Hi Edison, let me talk about the first one. So in terms of the second half, we've assumed small increases in terms of coming from the power side. As you know, some of the power increases already took place in the first half. We do expect a little bit of further increases, but not in the truly Tier 1 areas, but I would say the other areas will see some increases. We can go into some other details later on, but not a very large increase. I think the full year we had given to the market previously, it was about a 1% margin impact I'd say that this moves the needle a little bit in the second half, but nothing that would be very material. Let me pass to Samuel to talk a little bit about the two wholesale wins. Thanks.

Samuel Shen, CEO

Sure. Thank you, Tim. And also thank you, Edison, for the questions. Regarding the wholesale wins, that we announced today, the social platform is actually an existing customer, but with a new contract. And basically, a contract signed in the second quarter. And then, for another one, which is public cloud service providers, we're expecting to sign the contract in Q3. And we are very pleased, because we spent quite a bit of time working with the customers and finally secured a design win. So that's pretty encouraging for us.

Edison Lee, Analyst

Sorry, Samuel, can you talk about the timing of these contracts coming into service?

Samuel Shen, CEO

Oh, yes. As I said, the social platform wins would be second quarter, this quarter. And then for the public cloud service providers, the contract will be signed in Q3. We expect this to be serviced and the ramp-up starting from Q4 this year.

Tim Chen, CFO

Okay. So Edison, both of these are expected to contribute a small or negligible amount in 2022, but the ramp-ups should be within 2023.

Edison Lee, Analyst

So is the ramp-up period also two years for these two projects?

Tim Chen, CFO

They should actually ramp up quite quickly. Again, contractually, as you know, our customers will sign a commitment, but what we've seen at least from the customers that we've just talked about, they can actually ramp up extremely quickly. So I would say at the moment, probably assuming that most of the ramp-up should be within 2023 for these projects.

Edison Lee, Analyst

Okay. Thank you, Tim.

Tim Chen, CFO

Yeah. Most welcome.

Operator, Operator

Thank you for the questions. Our next question comes from the line of Alex Wang from Daiwa Capital Markets. Please proceed with your question.

Unidentified Analyst, Analyst

Thanks, management. So my first question is regarding our pipeline. I understood that we cut our capacity addition plan in the near term. But I understand that we currently forecast roughly 17,000 for 2023-2024 capacity addition. So I want to have more color on the spend? Do we have any change on two years guidance? And the second thing is about the utilization ramp-up, so how do you see ramp-up acceleration in exciting projects starting from June. So could we add more color on the current utilization rate for existing wholesale projects in service, and given current macro and the current situation, I want to have more sense about what's the typical period for this kind of capacity rate, normalized utilization rate? Thanks.

Tim Chen, CFO

Thank you, Alex. Let me take the first question in terms of the pipeline. You're correct. I think previously, we had a range from 14,400 to 17,400 in terms of the cabinet deliveries in 2022. We did revise down, down to a range of 9,400 to 12,400. You'll see the details that we've included in the IR PPT, that will be uploaded to our website. But so that is the range of guidance down from the 17,400 that you discussed earlier on. You'll see that the projects that we've taken out, again, some of these we expect to take place in 2023. There are some related to construction slowdowns and then others related to customer demand being pushed back. And so rather than have everything ramped up in terms of delivering the cabinets and then waiting for the customer, we decided to also then match our pace of delivery with the customer requirements as well. For the second question, maybe I'll pass to Samuel, and he can address that for you.

Samuel Shen, CEO

Yes. In terms of the ramp-up for our wholesale customers, what happened is most of the customers basically from the contract are committed to have two years to ramp up to hit the 90% or even higher utilization rates. But in reality, from our experiences and by talking to the customers, given their business growth normally will be within a year, they basically hit the 90% or even higher. And so for the two MOUs that we talked about today, including the social platform and public cloud service providers, we have a high expectation that they can ramp up to 90% or even higher within a year's period of time, given the current forecast. Separately, from a retail point of view, we're also seeing momentum from the customer digital transformation trend as well. I would say, given even though the macro conditions are a little bit uncertain, the business is pretty solid in the quarter ahead of time.

Unidentified Analyst, Analyst

Thank you.

Operator, Operator

Our next question comes from the line of Sara Wang from UBS. Please proceed.

Sara Wang, Analyst

Hi, Sam and team, thanks for the chance to ask a question. I have two inquiries. First, regarding the delivery target, could you clarify the split between wholesale and retail for the delivery target of cabinets? Secondly, what is the expected magnitude of the power tariff increase in the second quarter? I noticed that our adjusted EBITDA margin remained relatively stable compared to last year. Could you let me know if there are any other areas where we can reduce costs to counterbalance the power tariff increase? Thank you.

Samuel Shen, CEO

Hi, Sara. Can you repeat the first part of the question, please, again?

Sara Wang, Analyst

Hi. The first question is what's the split between wholesale and retail orders of our delivery target?

Samuel Shen, CEO

Okay. Thank you. Let me handle that first question. I'd say that right now, the split between the wholesale and retail, we're still looking at a similar split of around 60-40. So we've talked about, again, in the past 60-20, 20-60 being the wholesale and then scale retail and retail. So we still expect that to be the same in that range more than half being wholesale related, maybe up to two-thirds being wholesale related. In terms of the power increases, again, the vast majority of the increase that we saw were in the Tier 1 cities. Again, in the earlier part of the year, we saw them go up by anywhere from 10% to 20% in the Tier 1 cities. And so we factored in the impact to the full year margins. In quarter 1, we did have some tax rebates and other income, and then that's kind of some of the reasons behind why the margins in the first quarter weren't impacted as much. In the second quarter, there were some costs incurred there. But again, we have been quite focused on making sure we help to implement cost controls. So, we'll continue to do that in the third and fourth quarter, but there are going to be limits to how much we can do to offset increases in our operating costs in general. Hope that helps, Sara.

Sara Wang, Analyst

Got it. Thank you.

Operator, Operator

Thank you for the questions. The next question comes from the line of Albert Hung of JPMorgan. Please proceed with your question.

Albert Hung, Analyst

Hi, Samuel and Tim. Thank you for taking my question. My first question is, if I look at the 2022 new guidance, the EBITDA margin in the second half adjusted EBITDA could be like 22%, which is a multiyear low. Going now further on the one-off structural margin drag in the second half, how does it drive the margin recovery in the next year? And the second question is regarding the decline in revenue, is it mainly driven by wholesale or cloud-based IDC demand weakness? And from your point of view, how long did you expect that the downside will last? Historically, our spending will be the leading indicator for IDC, and right now, the average spending looks still quite weak in the second half. Does that imply that first half next year we'll also see the slowdown in IDC? Thank you.

Samuel Shen, CEO

Okay. Thank you, Albert. Let me take the first part of the question, and then maybe Tim can help to chime in with additional context. I think as Tim pointed out, the very first quarter of the year, because we did have the tax subsidies and annual reimbursement from the depository bank. And then so by removing the one-time thing and then the second quarter margin is pretty much on par. However, with the revised guidance, as you can see our second half EBITDA margin is going to be roughly about a 22% ratio. I would say in a nutshell, aside from the fact that some of the costs and expenses got delayed to the second half due to the COVID outbreak, the lockdown in the first half. We are also expecting some of the support revenue in the pipeline, basically, for new retail customer acquisition and then as well as some of the increased engineering costs, mainly focusing on the investment ahead of revenue type. And so that basically impacts our EBITDA margin in the second half. So a lot of the analysts are asking about the power tariffs or even our data center maintenance and upgrade, I think both electrical and mechanical parts, although not really material data center, but if we add it up, it is still a month in the P&L. So that basically impacts the EBITDA ratio in the second half. Are we expecting that will continue going on? We strongly doubt because a lot of the costs basically impacting the second half are more seasonal, and so we're expecting to have the improvement in 2023. And then Tim, do you want to take on the second question?

Tim Chen, CFO

In terms of the you're asking about how long this will last for, I think Samuel started to address that and kind of will this drag into 2023 in terms of leading indicators. I would say that in our shifting of some of the capacity deliveries through 2023, alongside or matching with the customer demands is that we already see some of the things that they had initially wanted by end of the year being pushed into the sort of first half of 2023. So there is that visibility that customers still intend to require these data centers, but it has been shifted backwards. In terms of which area we've seen, let's say, the slower ramp-ups, I would say, just given the sheer scale of the ramp-up pace of a wholesale customer versus a retail customer, I would say that it is more on the wholesale side. They are a sort of larger contributor in terms of billable cabinet ramp-up. But it's not to say that we've not seen a sort of similar slower pace during the times that there were lockdowns in place. We certainly hope that we see less and less of these steps of lockdowns in the second half. And so then customers can actually resume a more normal pace of ramp-up during the rest of this year and into next year.

Albert Hung, Analyst

Thank you.

Samuel Shen, CEO

Questions?

Operator, Operator

Our next question comes from the line of Clive Cheung from Credit Suisse. Please proceed with your question.

Clive Cheung, Analyst

Hi. Thank you, management, for taking my question. I have two questions. The first one is regarding wholesale demand. So for the move-ins you have seen for the existing customers we have had or existing orders. How different is that in terms of months required for ramp-up? Is it different from our previous expectations, say, previous guidance versus our new guidance? That's the number one question. The second question is the MSR. I see there is a small decline in retail MSR for two quarters running, and I was wondering if there are any trends we should pick up here or should we still expect them to be broadly in line or previously, you mentioned slightly upward in the longer term. Thank you. Two questions.

Samuel Shen, CEO

Thank you, Clive. From the perspective of our wholesale customers, Tim and I have been discussing two main types of customers we engage with almost weekly: public cloud service providers and social platforms, particularly those focused on video, who need substantial storage for their data. I'm not seeing any changes in their move-in rates, except for the effects of COVID-19 and lockdowns. Their businesses are still growing. When we communicate with them, they actively plan their demand forecasts and choose site locations. Winning a bid isn't just a one-time event; it signifies a long-term partnership. Thus, when Tim and I talk about the contractual commitment of two years to reach 90%, we are actually experiencing results that surpass that timeline. With the two MOUs mentioned earlier, we expect similar trends to continue. Tim, would you like to discuss the monthly recurring revenue for the retail segment?

Tim Chen, CFO

Yes, sure. In terms of the monthly recurring revenue, I think the main thing is quarter-to-quarter, you will see some fluctuations, and that's because the figure there is the total retail-related revenue divided by cabinets. We do expect that these levels will remain around 9,000. And Clive, you're absolutely correct in your second part of your statement, which is whether or not we expect this longer term to trend upwards. I think the answer is definitely yes. And that's going to be driven by some of the investments that Samuel mentioned earlier on. The investments on the retail services side will then allow us to provide again a larger suite of services to the customers and expand then the contribution of the value-added services to the overall MRR. So again, longer-term, it is expected to trend up, but I think quarter-to-quarter-to-quarter, it will fluctuate roughly around the 9,000 level. I hope that helps.

Clive Cheung, Analyst

Thank you very much, Samuel and Tim. Thank you.

Operator, Operator

Thank you for the questions. Your next question comes from the line of Hongjie Li of CICC. Please proceed with your question.

Hongjie Li, Analyst

Hi, management. Thanks for taking my questions. I have two questions. The first one is based on the current wholesale and retail demand, could you share more about the delivery pipeline and CapEx plan in recent years like in 2023? And my second question is regarding the utility cost. We're hearing some regions in China, there's a power supply shortage. Is there any material impact for us and traditional detail about the future trend you think of the utility costs and the impact on our margin? Thanks.

Tim Chen, CFO

Yes, I'll address both questions. Regarding CapEx and delivery plans for 2023, since some capacity originally scheduled for 2022 is now being moved to 2023, we anticipate a significant increase in capacity, measured in megawatts, for 2023 compared to 2022, especially as operations ramp up and construction delays are resolved, particularly with less COVID impact expected next year. We previously mentioned that we estimate CapEx spending will remain around RMB4 billion this year, with expectations for higher spending next year as we expand capacity, notably due to additional MOU wins, which will influence our spending in the latter part of this year and into next year with anticipated future tender wins as well. As for the second question regarding power costs, the situation remains consistent with previous instances of power shortages in China. These shortages have mainly resulted in short-term purchases of diesel fuel to ensure our data centers remain operational during uncertain power supply conditions. While these costs are not significant on a single data center basis, they could escalate if they become widespread across China. However, we believe we have already addressed our projections for the latter half of the year. I hope this provides clarity.

Hongjie Li, Analyst

Thank you.

Operator, Operator

Thank you, management, for the answers. Ladies and gentlemen, that concludes our conference for today. Thank you for joining.