Kingsoft Cloud Holdings Limited (NASDAQ:KC) Q3 2022 Earnings Conference Call November 23, 2022 7:00 AM ET

Company Participants

Nicole Shan - IR Manager
Tao Zou - Vice Chairman & CEO
Haijian He - CFO

Conference Call Participants

Thomas Chong - Jefferies
Xiaodan Zhang - CICC
Joel Ying - Nomura
Timothy Zhao - Goldman Sachs

Operator

Thank you for standing by, and welcome to the Kingsoft Cloud Holdings Third Quarter 2022 Earnings Conference Call. All participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session. [Operator Instructions]

I would now like to hand the conference over to Ms. Nicole Shan, IR Manager. Please go ahead.

Nicole Shan

Thank you, operator. Hello, everyone, and thank you for joining us today. Kingsoft Cloud's third 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 strategies, 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 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. Tao Zou. Please go ahead. Thank you.

Tao Zou

[Foreign Language]

[Interpreted] Hello, everyone. Thank you all for joining Kingsoft Cloud’s third quarter 2022 earnings call. Since taking on the CEO role in August, I have been leading the company through a systematic review of our strategy, business, and financials. And during the quarter, we continued to implement various initiatives in a solid and down to earth manner.

First, we continued to invest in technology, focus on our core businesses, and revise our original vision for cloud services. Second, we continued to review and evaluate our customer base and project portfolio, strengthen cost control, to achieve a better balance between revenue growth and profitability. At the same time, we continued to strengthen our ecosystem synergies explore high value business opportunities and pursue a path of high quality development.

We achieved solid financial performance in the quarter. Our total revenues were RMB1.97 billion, in line with our guidance. Adjusted gross margin improved significantly to 6.3% from 3.6% in the second quarter. And our operating cash flow has been positive for two consecutive quarters, indicating that our business adjustment and cost control efforts are starting to yield initial results.

In terms of business, we adhere to the conviction of building success based on technology, continued to focus on building key product capabilities on the IF and SaaS layers. These efforts were recognized by Frost & Sullivan Lead Leo Institute in China Data Management Solutions Market Report published in the third quarter this year, in which Kingsoft Cloud’s data management solutions ranks among the leaders of the market for innovation competency and growth performance. Meanwhile, IDC's latest addition of China's software defined storage tracker 2022 first half ranked our enterprise level storage solution, King storage, at top four in China's software defined object storage market.

In terms of ecosystem collaboration, we stepped up our technological cooperation with Kingsoft Office to achieve enhanced cloud document processing, including authentication, encryption and proof-reading. Leveraging our cloud computing capabilities, we helped Kingsoft Office strengthen the business logic layer for cloud document processing, and thereby further improve their end user experience.

In terms of different business scenarios, we continue to focus on our core industry verticals, replicating our successful lighthouse projects and apply to customers in their respective sectors. In public services space, we built a smart cloud solution for municipality leveraging our hybrid cloud and distributed cloud storage technology among others to enable and facilitate the management of economic affairs in a coordinated and integrated manner.

In financial services sector, we validated our data governance services capabilities, particularly in data lake and metadata management in various projects for major commercial banks. We will continue to replicate such success with more clients in the industry. In the healthcare sector, we are about to complete the capacity expansion projects for the medical image clouds in regions, including Sichuan and Chongqing. A testament of our ongoing support and monetization to address our customers' needs to expand and upgrade their existing projects.

Overall speaking, we will continue to invest in technology, focus on core businesses and enhance the foundation and the structure, which enables sustainable high quality development. Under the backdrop of the wave of digitalization, we aspire to penetrate deep in verticals of strategic choice and offer our customers safe, robust and efficient cloud computing services.

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

Haijian He

Thank you, Tao Zou, and welcome, everyone for joining the call. Now I will walk you through the financial results for the third quarter 2022. We have actively taken measures to improve efficiency demonstrating our strong commitment to pave the path for profitability. This quarter, our adjusted gross margin has improved considerably and continuously from the lowest point of 1.2% in the fourth quarter of 2022, to 3.6% in the second quarter this year and further to 6.3% in the third quarter.

Our operating cash flow has been positive for the past two quarters consecutively and we have achieved RMB100.9 million net operating cash flow this quarter. Our total revenue was nineteen RMB1,968.8 million in Q3. Within that, revenues from public cloud services was RMB1,349.0 million. While increased by 4.4% compared with Q2, it represents a 20.2% decrease compared to the same period in 2021. The change was primarily due to the company's proactive scaling down of CDN business, with its gross billing decreasing by about 28% on a Y-o-Y basis.

Revenues from enterprise cloud services was RMB622.0 million, which is relatively stable compared with Q2 2022 as we navigated a challenging operating environment, including the impact from resurgence of COVID-19 in China. While proactively applying more selective criteria to project screening to strive for better profitability and cash flow.

Our cost saving measures are well on track within our plan. Total cost of revenues decreased by 20.6% year-over-year and remained stable quarter-to-quarter at RMB1,846.4 million. IDC costs decreased significantly by 23.6% year-over-year from RMB1,410.9 million, to RMB1,087.3 (ph) million this quarter.

Depreciation and amortization costs increased by 26.9% from RMB200 million in the same period of last year to RMB253.7 million, while remained stable compared to last quarter. It is in line with our revenue mix adjustments as we moderated the procurement process of service of public cloud. Solution development and services costs increased from RMB160 million to RMB443.1 million this quarter. The increase was mainly due to the consolidation of Camelot since September last year. Fulfillment costs and other costs were RMB31.9 million and RMB39.3 million this quarter.

The adjusted gross profit of this quarter was RMB124.7 million, representing adjusted gross margin of 6.3%. The significant gross margin improvement was mainly due to the effect of cost control measures and strategic adjustments of our revenue mix. In terms of expenses excluding share-based compensation, total adjusted operating expenses was RMB577 million. Within that, adjusted R&D expenses was RMB231.6 million increase from RMB190.8 million from last quarter as we remain focused on our technology development.

Adjusted selling and marketing expenses was RMB125.5 million compared with RMB120.1 million last quarter. Adjusted G&A expenses increased slightly from RMB196.0 million last quarter to RMB219.9 million, which is partially due to the one-time of expenses of Hong Kong listing projects. Net loss margin was 40.7% this quarter and adjusted net loss margin was 24.8%. The adjustment was mainly due to the foreign exchange loss of RMB218.9 million, caused by the significant fluctuation of U.S. dollar RMB exchange rates, which is totally a non-cash item impact on the P&L items.

As of September 30, 2022, our cash and cash equivalents and short-term investments amounted to RMB5.3 billion, providing us sufficient liquidity for operations. The capital expenditures for the quarter was RMB253.3 million, which primarily consists of payment for service, which we ordered previously. The decrease of CapEx was in line with our proactively scaling down CDN business. We expect to keep our total CapEx within RMB1.5 billion for the full year of 2022.

In terms of share repurchase program, regarding our $100 million share repurchase program within a 12 month period as approved by the Board and announced in March this year. We have been duly executing since the release of our Q2 earnings results up to November 18, we bought a total of 10.41 million ADS shares for roughly about $23.92 million.

Going forward, supported by our ample cash reserve of about RMB5.3 billion. We expect to continue to execute from time to time with way to mandated repurchase program. These efforts fully demonstrate our Board and management's strong commitment and the full confidence in the long term business prospects of the company. As we strive to reward our shareholders for their support and we believe our share price will eventually reflect company true value.

Finally, we submitted the application for Hong Kong's due primary listing on July 27, 2022. As always, the listing and the potential timing is subject to regulatory approvals. Looking ahead, although, we are still implementing our strategy 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 the profit margin in Q3.

We expect our total revenue to be between RMB2 billion and RMB2.2 billion for the fourth quarter of 2022, representing a quarter-over-quarter increase of 1.6% to 11.7%. While these forecasts and comments above are based on our current and preliminary views of the market and operational environment, which are subject to change. We firmly believe that given the time the effects of our ongoing strategic initiatives, we will continue to amplify and reflect our financials in the mid to long-term. Thank you.

Nicole Shan

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

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Your first question today comes from Thomas Chong with Jefferies. Please go ahead.

Thomas Chong

[Foreign Language]

[Interpreted] Thanks, management for taking my questions. My first question is about the recent outbreak of COVID as well as the uncertainties of the macro environments. How should we think about the near term as well as 2023 outlook when we do the budgeting process? And number two is about the Q4 revenue guidance, can management comment about the trend for public and enterprise call during the quarter? Thank you.

Tao Zou

[Foreign Language]

[Interpreted] Thank you, Thomas. So on your second question regarding the Q4, so as we mentioned, we do see a third point, we do see a relatively expected recovery curve on the top line right, starting from last quarter, and carry from this quarter and Q4 sequentially. So the total revenue will be improving trend in Q4.

And in terms of the mix, given we have almost completed the initiatives on the CDN business adjustments on the priorities in terms of investments and the client mix. So I think that provides us with a relatively stable base to project the public cloud revenue in Q4. So because of that, I think in Q4, our public cloud -- as a total, we will see a sequential marginal improvement on the top line, but the profitability on the line of the public cloud will continue to see a positive contribution for the company's total gross margin in Q4.

And on enterprise cloud side, as we mentioned, I think if you're really looking back from Q1, Q2 and this quarter, and as Tao Zou mentioned, part of the due to the COVID measures in Beijing City that preventing us some of the project bidding and the deployments and execution in Q2, which was around about April and May, and sometime in part of July -- June and July. We do actually tried our best in Q3 this time to accelerate the deployment execution.

So hopefully, some of the flagship projects, including a few important projects that we discussed and disclosed earlier, for example, some of the provision-level healthcare cloud, hopefully, we can be deployed and fulfill the execution in Q4, and that will carry with the revenue booking in Q4. So with that, I think our enterprise cloud, you may see relatively a little step up of the revenue of enterprise cloud as part of the total revenue contribution.

So overall, my feeling is right now, I think the sequential improvement on both top line and the gross margin will be two important priorities for management team, while we will need to continue to make sure that our cost control measures of expenses lines will carry forward. Hopefully, will be -- have some benefits in Q4 and Q1, starting from next year as well. So it will take some time, but I think some of the initiatives were already implemented in place, just we need to have the time clock and see the benefits going forward. Thank you, Thomas.

Haijian He

Thank you. And I think it's just a quick translation of what Mr. Zou responded to the first question. So the COVID situation has been going on for years. And honestly speaking, it has been impacting the overall society significantly across all verticals, including us. And like you rightly pointed out, we are also observing and trying to see what the next step might be. As you might be aware, in recent days and weeks, the situation in Beijing is becoming more severe, to abide by the government rules. We have only 20% of the workforce currently working in the office.

And as you know, there has been one situation like this back in April and May. So it's really difficult to predict or to comment the situation. What we can do is to abide by the rules promulgated by the government. However, I think from a strategy perspective, in light of the uncertainty and potential uncertainty in future years. From a strategy perspective, what we can do is to maintain a robust and relatively defensive approach. And what I mean by that is exactly what we commented in the prepared remarks, which is no longer blindly pursuing top line growth and but to switch to our pursuit of sustainability and path to profitability.

And as you have seen, the gross margin in the third quarter has already improved quite a lot from 3.6% to 6.3%. So we believe that by abiding by that relatively conservative and robust strategy, we'll be able to navigate through the potential uncertainties in the years to come. As to your question of our budgeting, we are currently going through the process of making a comprehensive budgeting, currently going through the first round of review and compiling the numbers. We expect to have more clarity towards the end of December or the beginning of January. So unfortunately, we don't have much -- more data to share at this stage. Thank you.

Thomas Chong

Thank you.

Operator

Your next question comes from Xiaodan Zhang with CICC. Please go ahead.

Xiaodan Zhang

[Foreign Language]

[Interpreted] So my first question is regarding our non-GAAP EBITDA margin, as which dropped slightly quarter-on-quarter in Q3. So I just wonder, do you expect a delay in terms of the timing for non-GAAP EBITDA margin breakeven.

And secondly, what is our CapEx plan for the next two to three years? And are there any foreseeable plan to further extend the useful life service the some of the overseas peers have extended that from four to six years. Thank you.

Haijian He

Thank you. This is Henry. Happy to take all those three questions on the financial related matters. The first question is regarding the EBITDA breakeven, yeah, we do acknowledge that the EBITDA on a sequential basis, we actually dropped a little bit marginally. We noted that there are a few things on the line.

First of all, if you look at the total expenses on the dollar value, actually, our sales, marketing and R&D expenses actually was quite stable. So there's no major changes on that. However, the booking of certain G&A expenses due to, for example, the Hong Kong Dual Primary Listing projects that we actually need to pay certain fees, as you may understand, that actually also eating up the bills as well.

And also given this year, we do have certain cost-cutting, for example, the optimization of human capitals of the company. We need to pay certain compensations for the people they may choose other credit tracks for things like that. We did a batch of that arrangement in Q3. So especially towards the end of Q3. So the savings on the salary has not been reflected on expenses in Q3, while we need to pay even more for the compensation for the people that they choose other credit tracks.

So in and out, you see actually the fluctuation and even increasing on certain expenses items. But I think these are the right thing to do for the company and the benefits on the cost of savings and expenses will be gradually released in Q3, and I think for some time down from Q1 next year. So that's actually quite clear on online reasons. So we don't worry too much about that a little fluctuation, but the online -- or the normalized operational expenses in Q3 already kind of declined.

So given that, as you probably know that, our priority at this moment is improving the gross margin. As we mentioned, the gross margin has been improving from almost only 1% last Q3 -- Q4 last year to about 6.3% this quarter. That's actually a meaningful improvement. And if you look at the growth profit on a dollar value, we almost doubled from Q2 to Q3 from about RMB50 million to about RMB120 million for this quarter. So we do believe the improvement on the gross margin will be a first level of the driver of improving EBITDA and even -- and breakeven of EBITDA timing.

So given on that, we think sometime for next year, we do hope the EBITDA margin kind of improving at a little bit faster pace compared with the gross margin sometime point of next year. And on the other side, we do hope that after we complete all the necessary capital market transactions, our expenses ratio will further come down as well. So that's the first point.

The second point regarding the CapEx plan. I think this year, we're running relatively well. It's towards the low end of the capital budget for 2022. While we print the same level of the revenue target, I think which is a good sign. For the next two to three years, I think we may keep relatively the same level at around about RMB1 billion each year.

And you may remember, we discussed that we may need to hit a certain server replacement cycles, sometime around like '25, '26. But I think so far, we feel comfortable regarding about RMB1 billion on capital expenditures. But given we do have about RMB5 billion cash.

And right now, we have multiple access to the capital, not only from the stock market, for example, the long-term financing and the cheap leasing arrangements, et cetera. So we do hope over 90% of the capital expenditures we may find other ways to fund those capital expenditures outlay rather than tapping to our own net cash balance. I think that's going to be a good point on the capital structure, and we don't need to burn too much cash on hand.

And the third question regarding the service, I think you're right. We do notice that the major U.S. cloud company has revised the DNA policy from four years to five years, last year. And some of them are discussing the shifting to six years, which actually reflecting the nature of the technology as they evolve because most of the new servers starting from these two years, for example, some of the expensive ones, we actually -- the cost -- the price point is high, but they actually can use, for example, 2 times of the price point, but they can use like 3 times, 4 times of the life cycle.

So I think it does make sense for the U.S. peers to extend that. But given we do adopt a very conservative financial policy, we do not have any plan at this moment to extend our DNA policy, even though we understand extending from four years to five or even six years, we will have a relatively good impact on the gross margin because we have a lower G&A expenses. But at this moment, we do not any plan to revise that policy. But we may reserve that if we see other Chinese players change the policy. It's going to be an uplift to our gross margin, and reduce the D&A expenses. Thank you.

Xiaodan Zhang

Thank you. That’s very helpful.

Operator

[Operator Instructions] The next question comes from Joel Ying with Nomura. Please go ahead.

Joel Ying

[Foreign Language]

[Interpreted] I’ll transfer myself. So regarding the margin improvement, can management talk about situation, so where it comes from, public, cloud enterprise cloud and will it be sustainable into the first quarter and going forward? Thank you.

Haijian He

Thank you, Joel. Yeah. On the GP (ph) margin, you touched upon a few things. The improvements, the breakdown, the root causes and the sustainability. It's a very broad scope actually. So I think I'll start with the reasons, first, so there are a few things we actually start to work on since Q4 last year. So it's not actually happening only this quarter. There are a few things involved. As you may remember, first of all, is we're kind of cutting some losses for certain loss making clients.

Number two, we optimize the product mix, right? So try to make the computing, the storage, some of the big data solutions and certain more high value added products and more profitable products we invest a bit more, right? So I think these are the second reason. We start to do that from Q1 this year.

And the third reason is, the improvement and the screening of the projects. So as Tao Zou mentioned in the CEO remarks, we actually starting from this quarter, have adopted a very comprehensive approach to analyze returns on each projects and different ratings internally for different clients, et cetera. So we can prioritize and select the right projects we're working on, and some of that has already yield a good for this quarter as well.

And the last reason is actually, if you remember last year, we do kind of learn our experience and the lessons. We've bought -- a little bit (ph) too much of the service, and we ordered a bit too much of the bandwidth, and it cannot be returned. So the eating up on the gross margin last year, especially the second half.

So this year, we have changed our process to evaluate the procurement process to make sure that we do not over order it, and we can use them wisely. So I think these are the kind of four different things that help the gross margin can improve for this quarter to see the results. So even though we did something last year, but it's going to be a good time to see the results.

Speaking about the mix, I think that both public cloud and enterprise cloud has contributed to the incremental RMB60 million of the margin improvement. Because as you know, given the base of the public cloud and the enterprise cloud is actually quite balanced, and we cannot lose any of that. So it's both important.

And on the sustainability, I think the first-three reasons, as I mentioned, we will carry a long way. So it's going to be -- you see -- hopefully, we can see a better margin in Q4, and some time in -- carry over to next year as well. And certain enterprise cloud projects, as you know, we're booking the revenue only at completion, but some of the costs we already booked.

So hopefully, in Q4 as a peak time of enterprise cloud delivery, you will see additional step-up on enterprise cloud contribution. So if you want to break down the reason for Q4, let's say, going forward, I think enterprise cloud will be relatively more important private cloud in Q4 given the time delivery on that. Thank you, Joel.

Joel Ying

Thank you, Henry.

Operator

The next question comes from Timothy Zhao with Goldman Sachs. Please go ahead.

Timothy Zhao

[Foreign Language]

[Interpreted] Thank you, management for taking my question. My question will be about the outlook for 2023 as we understand this year is the transition year in terms of our business adjustment, and also there is impact from the macro environment as well as COVID. Could management share some thoughts on how we should look at the demand of overall cloud industry in China. And also for our revenue growth, when should we see an inflection point in terms of cloud revenue in your growth into 2023? Thank you.

Tao Zou

[Foreign Language]

[Interpreted] Okay. Just very quickly responding to your question. The first point is, as I commented previously, we're currently undergoing the first round of budgeting for the next year and we currently do not have a comprehensive picture which we will be able to have towards the end of this year to share more color to the market, and to the investors.

Now the second thing is, although that being said, I think I can share with you some of my thoughts towards the macro situation and our strategy in response to that. The first is, the -- given the dynamic situation and the control measures within China, we have been changing the guiding principle, as I commented, from revenue from the pursuit of revenue growth to profitability, which is also a change that we have been increasingly observing within the sectors.

The second point being the -- there still remains significant uncertainty to the COVID control measures that will come. And also including the uncertainties of what the country's overall economic planning after the two sessions in 2023 is going to be. So we all generally adopt a conservative and defensive approach. And this approach, including some of the falling measures, number one, we will exit some of the projects and customers and transactions that have not been profitable for a long time -- for the long-term.

And secondly, we will be looking at our customer base and adjust the customer base structure, in particular in the past that some of the largest customers have been commanding large share of revenue contribution, and has impacted to our financial performance. And we might decrease that revenue contribution and increase the revenue contribution coming from the waste and shoulder-level kind of customers.

And thirdly, in terms of enterprise cloud services, we will continue to dig deeper into the strategically selected verticals as we have done in the past, but also cautiously explore new verticals that are highly beneficial for the cloud industry, for example, the electric vehicle industry. That's some of the thoughts that I can share with you at the macro level. Thank you.

Haijian He

Yes. Thank you, Timothy. I also add one point as well, while we follow the market and client demands carefully, and while we are looking for -- as you do as well, for the next kind of acceleration or the v-shape acceleration of the demand from clients we have a capacity on the cash reserve as well. So as you can see that we already delivered a net positive on operating cash flow side this quarter. And hopefully, for next quarter and going forward, we can continue to do that.

So we remain relatively robust on the cash balance. And while we're investing carefully on the potential new verticals that will carry relatively faster growth, as Tao Zou mentioned, for example, the new energy EV cars and other verticals as well. So I think we do not worry too much about the timing because we have enough cash, and we can wait for the market to come back and work with the right clients. So I think that's actually one more point I just want to say as well. Thank you.

Timothy Zhao

Thank you, guys. Very helpful.

Operator

There are no further questions at this time. I will now hand the call back to Ms. Shan for any closing remarks.

Nicole Shan

Thank you, operator. Thank you all 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 next quarter. Have a nice day. Good-bye.

Operator

This does conclude our conference for today. Thank you for participating. You may now disconnect.