Kingsoft Cloud Holdings Limited (KC) Q3 2023 Earnings Report, Transcript and Summary

Good day and thank you for standing by. Welcome to Kingsoft Cloud's Third Quarter 2023 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Wayne Wong, Investor Relations Manager of Kingsoft Cloud. Please go ahead.

Thank you, operator. Hello, everyone, and thank you for joining us today. The Kingsoft Cloud's third quarter earnings release was distributed earlier today and is available on our IR website at ir.ksyun.com, as well as our GlobeNewswire services. On the call today from Kingsoft Cloud, we have our Vice Chairman and CEO, Mr. Tao Zou; and 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 guidance. They will be available to answer your questions during the Q&A session that follows. And there will be consecutive interpretations. All interpretations are for your convenience and reference purposes only. In case of any discrepancy, the 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 21E 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 this and other risks, uncertainties or factors are included in the Company's filings with the U.S. SEC. The Company does not undertake any obligation to update any forward-looking statements as a result of new information, future events or otherwise, except as required under applicable law. Finally, please note that unless otherwise stated, all financial figures mentioned during this conference call are denominated in RMB. It's now my pleasure to introduce our Vice Chairman and CEO, Mr. Zou. Please go ahead.

Hello, everyone, and thank you all for joining Kingsoft Cloud's Third Quarter 2023 Earnings Call. During the quarter, we continued to uphold the principle of high quality and sustainable development, build success based on technology and innovation and forged our reputation throughout the entire business process with customer centricity. We have enhanced our operation's management and proactively embraced the new AI era. This quarter, our profitability further improved. Total revenues reached RMB1.63 billion. Adjusted gross margin increased steadily for the fifth consecutive quarter to 12.1%. Adjusted gross profit reached RMB196 million, increasing by 57.5% compared with the same quarter last year. Normalized adjusted EBITDA margin was negative 2.7%, which represents a significant improvement of 7.6 percentage points from the same quarter last year and 0.6 percentage points from the previous quarter. In terms of public cloud services, revenues were RMB1.02 billion with a gross margin of 4.7%, significantly higher than the negative 1.6% compared with the same quarter of last year. We continued to focus on three priorities for public cloud services, namely the Xiaomi and Kingsoft ecosystem, AI business and CDN strategic adjustments. First of all, we continued to serve Xiaomi and Kingsoft ecosystem well and coordinate enterprises within the ecosystem to systematically sort out their cloud planning and fulfill their cloud demand. This quarter, Xiaomi and Kingsoft contributed 17% to our revenue, an increase of 2.2 percentage points quarter-on-quarter and 3.6 percentage points year-on-year. Among them, driven by Xiaomi business, the capacity of its dedicated cluster has expanded significantly and Xiaomi has become our largest customer. Kingsoft Office's revenue in September increased by nearly 50% compared to January, driven by its AI business. Secondly, we proactively developed our AI business. Currently, there is a strong demand for AI business with tens of customers who have signed contracts with us or in the process of business discussions. AI-related capital expenditures in the quarter exceeded RMB400 million, exceeding the total of the previous three quarters and have increased for two consecutive quarters. With our continued investment and efficient execution, our AI business revenue surged by over 70% compared to last quarter, with a healthy gross profit margin. Thirdly, we continued to push forward our strategic adjustments in CDN business. This quarter, CDN revenue decreased by nearly 20% compared to last quarter, and CDN revenue as a proportion of total revenue has decreased to about 30%. The revenue share of our largest CDN customers has significantly decreased from 16.2% in the previous quarter to 12% in this quarter. Moving on to Enterprise Cloud Services. Total revenues were RMB609 million, while gross margin has maintained at a healthy level of more than 24%. In public services space, we opted to focus on core areas such as public services cloud, state-owned assets cloud and education cloud, further improving the end-to-end model from cloud migration cloud use to cloud management, forming a product matrix centered on big data, large models, as well as WPS collaboration. For example, we have been the partner for the Beijing Public Services cloud for nine consecutive years, winning a strong reputation to deliver secure, reliable, and easy-to-use systems and services, resulting in 24 contract renewals this quarter and forming a virtuous cycle. In digital health space, we continued to promote the five business models and make new breakthroughs. This quarter, as the only cloud service provider, we participated in the revision of a national level health care standard setting project, gaining a first-mover advantage as demonstrated by our business model, technical capabilities, and our concrete achievements in the regional health cloud space. We have collaborated with Kingsoft Office to develop an electronic medical record editor for the National Health Commission and successfully completed the task. While continuously delivering the rating hospital project, we have also successfully signed a contract for the information construction project of the People's Hospital of Zhuhai in high-tech zone, making new progress in the hospital space. In the financial services space, we continued to deepen our business cooperation with large state-owned banks and complete the delivery of the existing projects as scheduled, while winning new projects. We also actively participated in the selection stage of AI models for large state-owned banks. Turning to Camelot. During the quarter, Camelot business is stable, signing up five new customers while maintaining robust relationships with the existing major clients. Its profitability has been rising again steadily. In terms of product and technology, we uphold our principle of building success based on technology and innovation by delivering best-in-class customer experience across our core product offerings. In computing space, we continued to upgrade our core products, focusing on improving stability and domestic environment compatibility. We have also identified eight major product and technology co-construction projects with key leading customers so as to accurately match customer demand, planning, and deepen collaborative developments. In storage space, we have released a new version of object storage, significantly optimizing reperformance under small IO scenarios, with an overall performance improvement of over 50%, approaching the theoretical limit. In big data space, our cloud-native big data platform has significantly improved its compatibility with Hadoop, effectively achieving a smooth migration of Hadoop text. In the enterprise cloud space, we focus on the end-to-end positioning of cloud migration, cloud use and cloud management, continuously optimizing the user experience in terms of ease of use, openness, and efficiency, building a unified presentation of operational data in the management cockpit, and once again upgrading the one cloud multi CPU compatibility to provide more domestic environment support capabilities. Our Galaxy Stack platform has obtained leadership grade designation, the highest level of certification in the national authoritative cloud benchmark evaluation, testifying that our dedicated cloud service capabilities are top-notch in China. We embraced the new AI era in a comprehensive approach. In terms of customers, we aim to fully align with AI cloud planning from Xiaomi and Kingsoft ecosystem, in the meantime, leveraging our neutral position to proactively meet the model training and inference demand from a large number of independent AI companies. In terms of business model, while the general AI computing service business is taking off, we preemptively explore one-stop AI cloud transformation services, aiming to become the AI enabler in select verticals. In terms of R&D, we make efforts in three directions: talent, products, and solutions, establishing our AI R&D center to support the research from three major capability areas, including application, algorithm, and platform. We also upgraded our core storage database network and other products with AIGC-facing features and continue to perfect our MassMutual Trust dedicated zone solution. In terms of supply chain, facing the uncertainty of the international market, we actively explore domestic supply chain alternative channels. Moving on to talent strategy. Firstly, it's about building our Beijing, Wuhan dual R&D center. In less than a year since its founding last October through voluntary relocation of key R&D staff from Beijing and Wuhan local recruitment, our Wuhan team has quickly grown to over 500 people, accounting for approximately 50% of our total R&D personnel. Secondly, we are promoting the implementation of the high potential talent program, which aims to identify and nurture the future backbone of our company. Thirdly, despite the uncertainties in macro economy, we continued to increase campus recruitment efforts to forge a talent base as a foundation for the Company's long-term development. In summary, the continuous and steady improvement in our profitability over the past consecutive quarters have strengthened our belief in the strategies and the directions we have chosen. With both opportunities and challenges ahead of us, we will continue to uphold the strategy of high-quality and sustainable development; leverage on technology, reputation, and operational management to drive progress; maintain our risk awareness; optimize business structure; embrace AI opportunities; and continue to improve profitability, thereby creating value for our customers, shareholders, employees, and the society. I will now pass the call over to our CFO, Henry, to go over our financials for the third quarter of 2023. Thank you.

Thank you, Mr. Zou, and welcome, everyone, for joining the call. Now I will walk you through the financial results for the third quarter of 2023. Under the strategy of high-quality and sustainable development, we are pleased to deliver another quarter of steady profitability improvement. Our adjusted gross profit continued to grow for the fifth consecutive quarter and achieved RMB196.3 million, increased by 57.5% year-over-year, representing adjusted gross margin of 12.1%, which is a record high for the Company. Our normalized adjusted EBITDA narrowed from negative RMB202.0 million in the same period of last year and a negative RMB59.9 million in the last quarter to negative RMB44.1 million this quarter. As a result, normalized adjusted EBITDA margin further narrowed from negative 10.3% in the same period last year and a negative 3.3% in the last quarter to negative 2.7% this quarter, making another solid step towards EBITDA breakeven. Our total revenue were RMB1.625.2 billion this quarter, of which revenue from public cloud services were RMB1.0166 billion, representing a decrease of 9.5% compared with RMB1.1130 billion in the last quarter. This is primarily due to the strategic scaling down of our CDN business by approximately 20% quarter-over-quarter and partially offset by non-CDN public cloud services. Revenues from enterprise cloud services were RMB608.5 million, representing a slight decrease of 2.2% from RMB622.0 million in the same period of last year as we continued to be stringent on project selection. We continue to enhance our cost control measures. Total cost of revenue decreased by 22.6% year-over-year to RMB1.4290 billion. IDC costs decreased significantly by 31.6% year-over-year from RMB1.0783 billion to RMB737.7 million this quarter. Depreciation and amortization costs decreased by 21% from RMB253.7 million in the same period of last year to RMB200.4 million. Solution development and services costs decreased by 4% year-over-year from RMB443.1 million to RMB425.3 million this quarter. Fulfillment costs and other costs were RMB25.7 million and RMB39.9 million this quarter, respectively. Adjusted gross profit of this quarter increased by 57.5% to RMB196.3 million, representing adjusted gross margin of 12.1% this quarter compared with 6.3% in the same period of last year, making another record high as well as the fifth consecutive quarter of steady margin improvement. Each of our business lines achieved margin improvement on a year-over-year basis. Gross profit of public cloud services were RMB48.1 million, which was significantly improved from the gross loss of RMB22.1 million in the same period of last year. Gross margin of the public cloud services were 4.7% compared with negative 1.6% in the same period of last year. The improvement was mainly due to our success in AI business, proactive scaling down of the CDN services, and adjustments of our client structure. Gross profit of enterprise cloud services were RMB147.3 million compared with RMB143.8 million in the same period of last year. Gross margin of enterprise cloud services was 24.2%, representing a slight increase from already healthy margin level of 23.1% in the same period of last year as we continued to carry out stringent project selection. In terms of expenses, excluding share-based compensation and impairment of long-lived assets, our total adjusted operating expenses were RMB504.5 million, decreased by 6.2% from RMB538.1 million last quarter, of which of our adjusted R&D expenses were RMB187.2 million, increased by 2.7% from last quarter as we continue to focus on technology partners and welcome new graduate campus-recruiting employees. Adjusted selling and marketing expenses were RMB114.1 million, representing a decrease of 11% from RMB128.3 million last quarter. Adjusted G&A expenses also decreased by 10.7% from RMB227.5 million last quarter to RMB203.1 million. As of June 30, 2023, our cash and cash equivalents and short-term investments amounted to RMB2.6 billion, providing us sufficient liquidity for operations. The capital expenditures for this quarter was RMB415.3 million as we invested in our infrastructure to build a sustainable AI business. Our operating cash flow once again recorded a net inflow, recording RMB20.4 million. It resulted from our margin improvements as well as our enhanced internal cash management. Looking ahead, we will continue to pursue our high-quality and sustainable development strategy and unlock synergies within the Xiaomi and Kingsoft Group ecosystem, while staying agile to capture new opportunities in the new era of AI. Thank you.

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

[Operator Instructions] Your first question comes from the line of Xiaodan Zhang from CICC.

So my first question is regarding our AI strategy. So Kingsoft Cloud has become the first choice for some of the industry-leading independent large language model providers when they select ICE vendors. So what is the growth trajectory for these type of clients in the recent quarters? And how would the recent supply constraints impact our AI strategy? And secondly, could management share your most recent guidance on the timing of adjusted EBITDA margin breakeven?

So the first part of the answer was provided by Mr. Zou Tao. And so the answer to your question. The customers that we have signed and engaging in business with are leading players in the AI market apart from BBAT, and they have relatively strong capital strength and business scale. Roughly, the starting point of the business cooperation usually start from 128 to 256 server units and likely to expand to 512 server units group of servers. And because their final goal is to move to the large language models and the parameters usually amounting to hundreds of billions, so the required resources of computing power are also at the level -- at the level that is above 512 server units and above. So for the uncertainties that you asked about the external environment, people have seen, as well as you have noted as well, that since October, the export control from the United States has created quite an impact to the industry, including that industry in China, and we are no exception. However, fortunately, we have foreseen -- we have actually foresaw this coming and have made some preemptive actions. So due to our preemptive planning, we have actually got only limited impact from that export control. However, how do we see this from the medium to long term? I think it depends on a couple of factors, including the performance of made in China's GPUs as well as the production capacity. So I think all in all, in the short term in the future, for example, in one or two quarters, the impact to Kingsoft Cloud should be limited. I think it's relatively under control. In the longer term, we are also actually relatively confident because we have seen some of the positive progress the Chinese chip industry has made during the past year. So as I mentioned in the prepared remarks, we are seeing both opportunities and challenges ahead in the future. Because we have obtained a larger number of independent AI customers, we are relatively comfortable with the potential impact.

I will take on the second question. So there are actually the two different drivers. First of all, some of you may remember, we actually hit quite dramatically back then back of late part of 2021, right, given the slowdown of the Internet consumer business as well as the certain impact on the enterprise cloud sectors in the later part of 2021. So at that time, our gross margin was only 1.2%. As you all notice that today, the increase from 1.2% to 12% on the gross margin side. So that actually is the fundamental result of our collective efforts around improving the efficiency of the resources we have, improving the client selections and the client quality. So putting that aside, that gave us about 10x up of the gross margin percentage. So on top of that, as you probably also noticed, that the spread between the gross margin and the EBITDA margin. I think the largest spread probably about last year were around about 19% to 20%. But this quarter, as you may see, the spread has been also narrowed from about 20% to only 14%, which means on expenses control side we also reduce significantly in terms of how we spend on research, how we spend on the travel, how we spend on the general management purposes. So putting everything together, the two fundamental driver from the business as well as how we improve the operational efficiency has given us leading to today's improvements on the EBITDA margin improvement. And so to your question, I think given all the initiatives and the strategy we're already putting to place, those impact and the results will gradually be released quarter-by-quarter. So it's not going to be a onetime off thing for this quarter. It's going to be carried out for the next few quarters steadily. And in our attention, we are hoping to improve both gross margin as well as narrowing the spread between the gross margin and EBITDA margin in the next few quarters. While as you may understand, the management team will not be giving a guidance for the formal EBITDA margin breakeven at this moment. But as you can see, the trend has been steady for the past four quarters, and we hopefully can keep that trajectory and the pacing of improving the margin. Hopefully, we can report a breakeven not only on the EBITDA margin, but also on other items in the near future as well. So just give us a bit of time, and then we can probably deliver those results to your expectation.

Your next question comes from the line of Timothy Zhao from Goldman Sachs.

I have two questions, both regarding the public cloud sector. First one is regarding the AI business. Could management share more color on the AI business in terms of its revenue contribution as well as the profitability level in either gross profit margin or EBITDA margin? And as you mentioned in the third quarter, you spent around RMB1 billion CapEx in the AI business. Just wondering if management has any guidance into your CapEx into fourth quarter and next year, including the AI business? And second question is regarding the CDN business. As we understand that there's a -- the overall competitive environment in China in the cloud segment is quite dynamic. Just wondering for the CDN, are we going to see more adjustments in the next few quarters? And after adjustment, what is management's view on the midterm normalized gross profit margin level of the public cloud business?

It's Henry here. I'll probably take on the first question and I'll translate myself briefly, and Zou can comment as well. So regarding the AI business contribution, the first point is on the CapEx. So last quarter, we spent -- in my script I mentioned it's about RMB415 million, or RMB400 million level on the third quarter. But I'll go back to your first point regarding the contribution and revenue margin, a few things to share. First of all, as you know, following very fundamental and basic economic principle, right, it's really driven by two things. One is the supply-demand balance, and the second is about the technology we offer and the products we offer, right? So as we all know that today really is about the buyers -- it's all a seller's market, right? So if you do have a very robust infrastructure and resources and can provide a very robust service and products to the clients, clients are definitely willing to pay. And for the clients, it's also giving them a cutting-edge advantage when they try to compete, training their model to a certain level, they can compete in a world-class stage. So that actually convert to a very good logic for us to have a better margin compared with other kind of resources-driven ICE services historically. So we also observed the second phenomenon is the client also willing to pay for a value-added part of the services, not only by charging them on a fundamental resource usage basis. So by giving them the best practice and giving them a value-added service and products, we can share certain value with the client, and that gets embedded into part of the pricing after a given time. So those are the two fundamental reasons that we believe the higher margin from AI business will carry out for the future as well. This is the second point. And the third point is really about contribution, right? So the reason we didn't give a percentage for this quarter is every day counts for this quarter. So given we have a strong client demand and given we also provided enough sufficient resources for our client -- and each quarter, we do see a very good growth trajectory at this moment. But when you look at -- because the third quarter means from 1st of July until the 30th of September. And right now, we're already end of November. So today's situation is very different with the 1st of July. And we do believe if we look at the tail impact of the third quarter, the growth trajectory and the incremental revenue even on a weekly basis is a very significant contribution to Kingsoft Cloud total revenue. But if you combine as a total quarter for the third quarter alone, I think this number will be really misleading to a certain way that definitely does not account the full credit of the AI business for us. So this is my second point. And third point regarding the CapEx direction and the guidance. So as we probably talked last quarter as well, we do believe this part of the CapEx is a very good growth driver for us. So the more we spend, the more incremental revenue will come for sure and the more and better gross margin will come to follow as well. So even you see we spent about RMB400 million in this quarter for CapEx, we're seeing the trend for next quarter and maybe the early part of next year, this number will continue to increase. And mathematically, you will have a direct linkage for those spending converted to a new revenue for next year. I think you can do the math, but -- I'm not going to give an answer, but you can see that trend is very visible as well. So I think these are the three parts. I just want to give you color. Given the importance of this question, I will translate myself as well.

[Foreign Language]

Okay. So let me quickly translate. So in relation to your second question about the CDN strategic adjustments, we have actually started the adjustment in October 31 this year, and we have an internal deadline of June 30, 2024. As I can see this, we're continuing to do some adjustment according to the market conditions. Currently, we're getting CDN revenue on a quarterly basis around RMB500 million. And it might continue to scale down to somewhere between RMB300 million to RMB400 million per quarter, and thereby reaching a relatively stable status till after June 30 next year. And in relation to your question about the profit margins for the public cloud services business, it's of two components: one is CDN and one is the so-called pan-Internet sector. For the CDN sector, as mentioned, as to the third quarter next year we expect the strategic adjustments to have completed. And by then, we would hope the margin of this business line to revert to the relatively healthy level that was as of the fourth quarter of 2022. Now for the pan-Internet space, we are still seeing the margin, including both the GP margin and as well as the operating profit margin steadily and gradually improving. I mentioned one of the uncertainties is the GPU supply. And obviously, in the AI space the demand significantly outpaces that of demand -- outpaces of supply. And if that can be -- if the supply chain issue can be resolved completely, obviously, the improvement of our business as well as margin in the AI and thereby the pan-Internet space will be much faster. But even with that uncertainty, we are already seeing relatively good progress in terms of margin improvement and business scale expansion.

Your final question comes from the line of Katrina Chiu from Citi.

This is Katrina Chiu asking on behalf of Brian Gong from Citi. Can management share with us the overall revenue outlook in 2024 and whether we can expect positive revenue growth next year?

So after we relisted -- or dual listing in Hong Kong, we actually didn't publish our kind of management guidance. But have to share some color as well as we're moving towards the year end of 2023. First of all, as you know, even today, right now, we have about 25% -- 20%, 25% by different quarter. The revenue is coming from the CDN business, our CEO Tao mentioned as well. So we're kind of in the phase of some adjustment from client mix from the products we offer. And as well as we control the cost, we procure the bandwidth as well. So -- but if you look at that business, the first priority is we try to change the mix and the structure of the client products. Right? So we try to remain relatively stable, but we just the combination of the clients and the products within the business. So that's actually what we're trying to do in the next two or three quarters. Right? So that's kind of the first factor you probably can consider. But we're not going to see the dramatic changes or swings from that business, but change the better structure of that. So this the first part. The second part is, as I mentioned, the new money and the capital expenditure were spending to the AI. Right? The infrastructure we built for clients and the mass, we call the model services, the solutions, and services with developed clients as well as the value-add part of the projects we do for the clients. So those are actually combined will be one of the -- probably the one priority for next year to grow the revenue. And if you do a quick math, I put this way as every $3 or $2 spend this year, you're going to see probably $1 or relatively around $1 of the incremental revenue you're going to see for the next year. So that's kind of mathematical connection given the CapEx converts to products and products convert to the incremental revenue. So that's the second part. So you can do a kind of analysis on that. And the third part is really about our very stable enterprise business. As you can see that our sub, Camelot, is delivering relatively stable revenue. And for next year, I think given the macro environment has been improving, so you're going to also see -- that revenue contribution of Camelot is going to see relatively growth as well. And our health care public sectors and the financial services enterprise cloud, we also see certain growth given we already have some flagship products in place for this year. And we can replicate that from city A to city B, right, from client A to client B going forward for next year. So we're hoping we can remain around 30% in terms of the GP contribution on the project level, but we replicate that to more projects for next year. So if you combine those three things, stable CDN, but better mix, spending our CapEx converted to incremental AI revenue for the public cloud Y-o-Y growth for Camelot as well as a stable revenue and profits, but growing revenue for enterprise cloud for financial services and so on and so forth. And putting it together, we are kind of confident to see without any big changes on the big environment our top line revenue for next year you may see kind of back to the Y-o-Y growth and the Q-on-Q growth as well. And Tim mentioned in the previous question as well, we're hoping to get into a certain point that not only the EBITDA will be breakeven in the near future, but also we're going to see the OP side is going to be put in our back pocket with the intention to bring a better profitability for the shareholders as well. But the last point I want to mention is, we also will keep a very close eye on the competitive landscape, means our peers and competitors. We are trying to do a better quality of the work compared with other peers, but also we are happy to see we may next quarter or two, we've been catching up on the gross margin side in the next few quarters. But also in the Y-o-Y on the growth side we can maybe catch even better than the competitors as well, because we did a few things since last year when CEO Tao Zou come to the office, and we actually have a few things in place. And those efforts are, I think, two or three quarters earlier than the major competitors. You will probably see the recovery we are doing probably sooner than the other groups as well.

I would now like to turn the conference back for closing remarks.

Thank you, operator. Thank you, once again for joining us today. If you have any further questions, please feel free to contact us. Looking forward to speaking with you again next quarter. Have a nice day.

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