VNET Group, Inc. (VNET) Q2 2012 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you, everyone, and welcome to 21Vianet Group's Second Quarter 2012 Earnings Conference Call. [Operator Instructions] Before we begin, I will read the forward-looking statement. This call may contain forward-looking statements made pursuant to the Safe Harbor provisions for the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management's current expectations and observations that involve known and unknown risks, uncertainties and other factors not under the company's control, which may cause actual results, performance or achievements of the company to be materially different from the results, performance or expectations implied by these forward-looking statements. All forward-looking statements are expressly qualified in their entirety by the cautionary statements, risk factors and details of the company's filings with the SEC. 21Vianet undertakes no duty to revise or update any forward-looking statements for selected events or circumstances after the date of this conference call. With us today are Josh Chen, 21 Vianet's Co-Founder; Chairman and CEO; Jun Zhang, our Chief Operating Officer; and Mr. Shang Hsiao, President and CFO of 21Vianet. Following management's prepared remarks, we will conduct the Q&A. At this time, I would now like to turn the conference call over to Josh Chen, 21Vianet's Co-Founder, Chairman and CEO.

Thank you, operator. Good morning, and good evening, everyone, and welcome to 21Vianet Second Quarter 2012 Earnings Conference Call. We are very pleased to have achieved a new milestone at 21Vianet with the opening our new self-built data centers during the second quarter. This expansion dramatically increased our overall self-built cabinet by 2,280 to over 6,400 self-built cabinets. More importantly, this brings the total percentage of higher margin self-built cabinets to over 62% to -- of our 10,394 total cabinets, providing us additional control over the operational quality and efficiency in data transmission that our client demands. This help us to become further embedded with our clients as well strength -- strengthening their trust in our execution capabilities. We are also very excited to show you updates industry statistics flow IDC, verifying that 21Vianet have further solidified its market leadership during 2011 as China largest and the fastest growing carrier-neutral Internet data center service provider as measured by revenue. Moreover, our growth outpaced all data center operators in China, including both carrier and the carrier-neutral data center operators, resulting in our market share expanding to just over 10% for 2011. This third-party resulting clearly demonstrates the barrier of our customers finding utilizating our high-quality service offering in both data center hosting and broadband and connectivity the trust they're putting us to manage one of their most critical infrastructure component. Moving forward, despite having concerns over the macroeconomic softness in China, we believe that demand for high-quality, reliable and fast Internet connection will remain strong. IDC's new estimate also indicate faster growth than initial forecasted. Previously, IDC anticipated a 5-year component deal, annual growth rate of 24.1%, but now they have increased that growth rate to 25.1%. And by 2016, the market will reach USD 3.9 billion, driven by faster growth and adaption of Internet-based service. Looking ahead, we are targeting 13,000 cabinets of installed capacity by year-end 2012. We continue to believe that the trend discussed in IDC and Enodis [ph] will continue to drive China overall Internet growth and with that, demand for the stable, reliable and fast Internet connections that our customers have come to rely on 21Vianet for. With that, I will now turn the call over to our COO, Jun Zhang, for operational updates.

Thank you, Josh, good morning, and good evening, everyone. As Josh highlighted earlier, we are very excited to begin this new phase of expansion in our self-built data centers. In addition to our buildout of self-built data centers, we also continue to effectively grow and manage operations in our partner data centers, helping us to better accommodate additional customer demand. Having this mix of 62% of 6,400 and the 50% [ph] of our 10,394 cabinets being located in our self-built data centers. We are closing in on our stated optimum base of 65% self-built and 35% partner cabinets by year end. Even though this mix will largely fluctuate each quarter to accommodate customer's demand, we believe that the increased operational independence from the carriers will not only allow us to more efficient manage our customers' hosting and their connectivity needs, it will also result in improved end-user experience for our planned audiences. In addition, we are aiming to reach our year-end goal of 13,000 cabinets of installed capacity. We believe that this forthcoming capacity additions will continue to alleviate some of shortened capacity constraints that we were facing and will enable us to further capitalize on the strong industry demand. Moving onto our management network services front, we continue to see impressive financial result, driven by continuing demand for improved platform connections. The integrated network service capacity from both Mando [ph] and the Gehua acquisitions has resulted in increased efficiency in both network connections, as well as cross-selling opportunities within our customer base as was evident in our MRR improvement and high utilization. Customers continue to demand the enhanced data transmission capabilities that 21Vianet's network can provide, improving the reliability, stability and speed for their end users' network connections. At this time, I would like to turn the call over to Mr. Shang Hsiao, our President and CFO, who will discuss our financial performance as well as financial forecast for our recent initiatives in greater detail.

Thank you, Jun Zhang, and good evening, everyone. As you can tell, we are excited, okay, about our last quarter expansion. With the addition of 2,367 cabinets, we now total cabinet capacity to 10,394, which is nearly 2x the number of the cabinet since we went public last year. Even though there's a lot of our new data center on came online at the end of June, we're still managing to meet our revenue guidance. We were very pleased with included monthly recurring revenue for cabinets and high utilization rate, which was driven by the high demand from our customer. Now moving onto our financial result. I would like to state that we will present non-GAAP measure on today's conference call. Our non-GAAP result excludes certain non-cash expenses, which are not a part of our core operation. The detail on this expenses may be found in the reconciliation table included in our earlier release. Also note that all the financial number we are presenting today are in RMB amount unless otherwise noted. Now moving on to the detailed financial result. Our net revenue for the second quarter of 2012 increased by 58% to RMB 364.5 million. Our monthly recurring revenue or MRR defined as a revenue recognized on a fixed and recurring basis each month, one of our core charting metrics, grew to over RMB 124.4 million in June of 2012 from RMB 116.3 million in March 2012. The MRR per cabinet increased to RMB 10,053 from RMB 9,718 last quarter due to an increased demand for bandwidth especially in Tier 1 city. Going forward, we expect the MRR per cabinet to remain above RMB 10,000 per cabinet but may graduate it based on demand for interconnectivity service. Our utilization rate remains stable at 81.2% in the second quarter of 2012 compared to 82.4% last quarter. Net revenue from hosting and related service increased by 41% to RMB 205.1 million in the second quarter of 2012, primarily due to an increase in total cabinet under management in self-built and partnered data center attributable to growing customer demand. Net revenue from management network service increased 88% to RMB 159.4 million in the second quarter of 2012. This increase was primarily driven by network capacity demand for data transmission service. Excluding revenue contributed by Gehua during the second quarter of 2012, net revenue from management network service increased by 59% to RMB 134.8 million. The increase in management network service revenue was primarily driven by authentic network capacity growth for data transmission service. For the second quarter of 2012, adjusted gross profit increased by 59% to RMB 110.3 million. Adjusted gross profit margin increased to 30.3% from 30% in the second quarter of 2011. Adjusted operating expenses increased to RMB 62.1 million. As a percentage of net revenue, adjusted operation expenses was 17.1%. More specifically, adjusted sale and marketing expenses increased to RMB 22.4 million from RMB 17.1 million in the same period in 2011, primarily due to expansion of our sales and service support team. Adjusted general and administrative expenses increased to approximately RMB 24.2 million from RMB 11.5 million in the prior year period, primarily due to expansion of related headcount and office rental. Adjusted research and development expenses increased to RMB 15.6 million from RMB 7.4 million, which has reflected our effort to further strength our research and development capabilities and expand and improve our service offerings. The main difference between adjusted operating expenses and our higher GAAP total operating expenses amount is primarily due to the change in the fair value of contingent purchase consideration payable of RMB 2.2 million and share-based compensation expenses of RMB 10.6 million. The change in the fair value of contingent purchase consideration payable is primarily resulting from an increase in the present value of estimated cash and share consideration as of June 30, 2012, associated with the company acquisition of both the Management Network Entities and Gehua. From a profitability perspective, adjusted EBITDA for the second quarter of 2012 increased by 49% to RMB 70.4 million. Adjusted EBITDA margin for the quarter was 19.3% compared with 20.5% in the prior year period. More specifically, excluding additional spending on our Hong Kong special [ph] amortization and increased R&D spending on our new initiatives, adjusted EBITDA margin on authentic basis would have remained stable. Our adjusted net profit for the second quarter of 2012 increased 11% to RMB 37.6 million. Adjusted net profit margin was 10.3% compared with 14.8% in the prior year period. Adjusted diluted earnings per share for the second quarter of 2012 was RMB 0.11, which represents the equivalent of RMB 0.66 or USD 0.12 per ADS. The diluted share count is based upon a weighted average number of the company ordinary share. As of June 30, 2012, we had a total of 349.1 million basic share outstanding or the equivalent of 58.2 million ADS outstanding. As of June 30, 2012, our cash and cash equivalents and short-term investments was RMB 979.5 million, equivalent to USD 154.2 million, compared to RMB 1.3 billion as of December 31, 2011. Account receivable turnover date or days of sale outstanding was 58 days compared to 49 days in the first quarter of 2012 and full year of 2011 weighted average of 40 days. Regarding CapEx, okay, in the second quarter of 2012, we spent approximately RMB 127 million. For 2012, we plan to spend RMB 537.2 million CapEx on our infrastructure buildout as previously estimated, the CapEx spending also include additional data center we plan to build in 2012. Looking at our financial outlook for the third quarter of 2012, the company expect net revenue to be in the range of RMB 388 million to RMB 400 million. Adjusted EBITDA is expected to be in the range of RMB 74 million to RMB 83 million. This forecast reflects the company current and preliminary review, which is subject to change. As we continue to ramp up our overall capacity and explore new initiatives for the second half of 2012, we remain confident in the sustainability of our sector dynamics, revenue growth and margin expansion capability going forward. This conclude our prepared remark for today. Operator, we are now ready to take some questions.

[Operator Instructions] Your first question comes from the line of Chris Larsen from Piper Jaffray.

The first question I had was on the cabinets, the average cabinets building being down only 1%. Is that an average number in and therefore, down only 1%? Or have you already sold so many of the 2,280 cabinets that have come on that you're at 81% already by the end of the quarter? And then could you just repeat? I think, you said when those cabinets came on or you indicated that a lot of them came on towards the end of the quarter and I just want to make sure that was correct as well that I heard that correctly.

Thank you, Chris. This is Shang. The way we calculate it, okay, we use a weighted average to calculate something we call MRR per cabinet, okay? That's a monthly recurring revenue from our cabinet. The 2,300 around those are cabinet actually are deployed in the last 2 days of June, okay, in the second quarter. So when we calculate use weighted average, we calculate it, okay, the number we come out is MRR per cabinet actually was easy RMB 10,000, okay? That's our calculation. We always use weighted average.

That's very helpful. Can you just give us an update then on given that there wasn't a lot of sales in June on those new cabinets, how are sales progressing on those new facilities?

Okay. We--our goal, okay, because we deploy, okay, towards the end of June, our goal is by September 30, okay, we shall reach the 50% utilization rate for those 2,000 cabinets we just deployed, okay, towards the end of June, okay? So -- and our goal is 3 months reach 50%, and we plan to reach additional, to increase additional 30% by the end of this year. What I mean is, okay, for any cabinet, new cabinet, okay, we deploy, okay, the management will try to reach 80% of the utilization rate within 6 months.

And your next question comes from the line of James Breen from William Blair.

Just a couple of questions. One, I wonder if you'd give us any update. I know you talked over the course of the last few months about partnering with someone within the cloud business to maybe deliver some additional managed services on top of the co-location. And then second, with respect to the questions that Chris just asked, just trying to figure out, overall, what are you seeing in terms of pricing on a per cabinet basis. Has it been increasing on a sequential basis going forward? And do you expect that to continue? And then lastly with respect to margins, we talk about margins coming down in this quarter because of the costs associated with the launch and also a little bit of the slowdown of the broadband business, do you think that, that's going to rebound in the back of the year and you'll see margins improve?

Okay. Thank you, Jim. Regarding to the first one, okay, it's cloud computing business, okay, and we're still working on it, okay. One of the indication is if you guys pay attention to the company R&D expenses, actually, we did have the new hire and also put in certain platform, okay, to prepare for the cloud computing service, and hopefully, everything work out. And the management right now expect to deploy such service, okay, sometime, okay, in the first quarter, maybe second quarter of the 2013. So this one is coming. That's one of the reason our R&D expenses actually increased significantly, okay, quarter-over-quarter. That's question one. Question two, okay, based, okay -- actually, the pricing for our per cabinet right now actually they are increasing, okay? We show seasonal strength continue, okay? Because like I always mention each year, the company will increase the price, okay, especially, for on the pure co-location part, like to 5% to 10%. So that's one of the reasons the pricing will increase. Plus, another reason is sometimes the customer, okay, demands higher, okay, number quantity, okay, of the bandwidth. That will also helping the increase of the price. So right now, okay, the management expect, okay, the pricing will continue to increase, okay, for the next couple of quarters. And in terms of the company gross margin, right now our gross margin for the second quarter actually was 30.3% compared to 30% in the first quarter. Since we deployed, okay, so many self-built cabinet, okay, and so we expect, okay, we expect the gross margin will continue to increase. The only thing is, okay, maybe we were going to have a certain timing difference. Just say in the third quarter, since we just deployed 2,000 cabinets and a lot of depreciation were hit by the -- our utilization rate for those 2,000 cabinets maybe only reached 50%, so the gross margin, we may not be able to see that improvement, okay, in the third quarter. But by the time of the last quarter of this year since the utilization rate going to hit a very close to 80%, then we will see the meaningful, okay, gross margin increase.

I wanted to the follow up on the broadband business. It seems like the broadband business slowed down a little bit sequentially to about 2% -- sorry, yes, quarter-to-quarter 2% versus 9% in the first quarter. Is that tied to the cabinet utilization and the cabinet launch? Like as you launch more cabinets, does the broadband business ramp because you're connecting those cabinets to somewhere else.

Yes. Actually, at this moment, the China Internet traffic continues to increase, okay? And same thing, our customers continue to increase their demand, okay, on broadband, okay, on cabinet basis. So we expect that broadband, okay, demand will continue to increase. The reason, okay, the business, if you see the growth, somehow if you reference to the last year same period price and the second quarter of the 2011 actually for our network service revenue actually was flat, okay? And -- but this year, since we still have subsequent increase over here, but going forward for the third quarter and fourth quarter, we should be able to see those business continue to increase. Right now, we do not see any slowdown, okay, for the broadband business.

And our next question comes from the line of James Sullivan from JPMorgan.

I had 2 questions. You've already somewhat answered the R&D question. I was just wondering are there any components of the increase in R&D spend that aren't associated with cloud computing. And can you share what they are? And then second question, the guidance for third quarter revenue looks potentially quite conservative given that all the new cabinets really only came online at the end of June. So I was just wondering is that a signal of potentially weak pricing. Or how should we think about that guidance in light of the big cabinet ramp on the last day of June?

For the R&D expenses increase, okay, in second quarter, the major component actually is regarding to the new hire. And we are hiring the software engineer, platform engineer, okay, so that's a major expansion over there. And those people actually they are starting to work certain cloud-related development, okay? So that's a major one. And in terms of the second question, about our guidance, okay, the guidance we provide, okay, actually, we think it's a reasonable guidance, okay? And the reason we did not make even more aggressive, okay, because -- I just want to mention because everybody is talking about the China economy slowing down. Okay, the Internet company cuts down the -- their advertising revenue would be lower, so they plan to cut down the -- their CapEx spend [ph] . Although we have not faced that yet at this moment, okay, we just want to be more conservative given the economy slowdown, okay, in China. Okay, Jim?

I understand. Just to be clear, does the guidance mathematically imply lower pricing based upon utilization rates that you discussed? It seems like that would be the implication, so therefore, pricing is flat to up. Then, you could be potentially be above the guidance. Just mathematically, not asking for a guidance or anything.

Right. Actually, like I earlier mentioned, our pricing actually will be continue to increase, okay? We can see that already, okay? So the pricing should be able to increase. The only thing is since we deployed so many number of cabinet, okay, in second quarter, so I also can mention that probably our utilization rate will be lower, okay, compared to the second quarter, okay. Our utilization rate right now is estimate for the third quarter should be somewhere around 70% to 71% compared to 82.1% we have for the second quarter.

And your next question comes from the line of Chad Bartley from Pacific Crest.

I know you don't like to provide formal guidance for 2013, but can you talk about how you'll manage the business, how the capacity expansions will impact your gross margin, your EBITDA margin in 2013? Should we expect that to be relatively flat with 2012? Or could we see margin expansion?

Okay. So for the gross margin, okay, I can mention about more detail in this area. Our gross margin for the self-built cabinet actually should be somewhere around 33% to 34%. But for those leasing cabinet or what we call our partnered cabinet, actually our gross margin was only around like 21%, maybe 22%. Since right now it's a mix, okay, it's a mix, okay, already reached 62% versus 38%. And by the end of this year, we expect, okay, our mix of the self-built cabinet should be able to reach 65% or even higher. So we expect our gross margin will increase. But every time when we deploy the new cabinet, you probably will see the 1 quarter of the fact [ph] from the gross margin. But if you give them additional quarter, let's say 6 months after deployment, you shall be able to see more obviously increase on our gross margin. So by the end of, let's say we going forward looking forward for the year of 2013, we expect our gross margin will be a lot higher than we are today, okay? And the gross margin, I just don't want to comment, but just in case it's a company-deployed cloud computing-related service. Right now, we expect those gross margin will be even higher than our gross margin right now. That will also contribute to the increase of our company gross margin going forward to the 2013.

[Operator Instructions] Your next question comes from the line of James Ratcliffe from Barclays.

Two if I could. First of all, can you talk about what the incremental margin is on incremental managed services revenues? So what each individual dollar flows to the bottom line and to the EBITDA line? And secondly, what's the overlap at this point between managed network and hosting customers? Or what -- in other words, what share of hosting customers take managed network? Or alternatively, what share of managed network revenue is being generated by customers who are your hosting customers?

Okay. For the incremental margin from those EBITDA, okay, right now, let's talk about gross margin for the management network service. Actually, management network service right now produce higher gross margin than our hosting business. Their gross margin right now is around 33% to 34%, okay? But in terms of the incremental gross margin compared to -- because of -- for the management network service, okay, their biggest cost actually is bandwidth, okay? Bandwidth actually represents like 40% to 50% of their gross margin. And people, fixed cost over there only represent like 10% to -- and equipment another 5%, okay? So their gross margin actually was 34%, okay, for the second quarter. We expect our gross margin should be able to gradually increase, okay, towards the end of the year. And right now, some of our management network service, okay, they transfer into our hosting business. If you want to see the overlap, just on top of the information available to me, should be around 6% to 7% right now.

Right. So currently the large majority of the managed network services customers just take network service from you?

Yes. Okay. There is a reason for that, okay? Some of the management network service customer, they -- sometimes they already put the server, okay, in their own site for another service provider, okay, because they appreciate the company, the network efficiency, okay, and the speed, okay, we can deliver their data. So sometimes they are very clear they just want to utilize our network that's why they order such service, okay?

Great. And one follow-up if I could. Are you -- have you seen any change in the competitive environment following Equinix' acquisition of Asia Tone assets?

Okay. After last earnings call, actually, we have not heard any news, okay, from the Equinix in China market. But right now, the management, if you look at 2,000 -- more than 2,000 new cabinets we deployed, actually, 1 of the new data center that include 1 of the new data centers just deploy in Shanghai. Actually, it's in Shanghai Baoshan. We just deployed 870 cabinets in Shanghai, okay? And actually we are also very actively, okay, looking for new site in Shanghai, okay, to build a data center. So our strategy is we will continue, okay, to put more investment, okay, in Shanghai to build new cabinet.

[Operator Instructions] Your next question comes from the line of Eric Chu from Canaccord Genuity.

I have actually 3 quick ones if I may. Number one is on new cabinets, the 2,000 new cabinets. My understanding is that some of them, they offer a higher power capacity, which in terms translates into higher MRR per cabinet. I was just wondering how much of a factor you have built-in in terms of third quarter and fourth quarter going forward? And number two, I was wondering if you can expand a little bit about that cloud opportunity in China. And finally, R&D, I was just wondering in third quarter and fourth quarter, would the second quarter would be a good run rate to use or there should be sort of a more incremental spending there?

Okay. For the new 2,000 cabinets, right now, yes, you are right, okay, because right now we are building the higher power density cabinets. Higher power density cabinet normally mean our customer can put in more server in that particular cabinet. So that cabinet actually will -- can support more power. Under such logical thinking, we are going to build our customer more. So the revenue per cabinet, okay, will be more than the traditional high-power -- traditional power density cabinet we build. So that's why earlier I mentioned we should be able to continue to see MRR per cabinet, okay, to increase, okay, in the future, okay? One offer is like you say, okay, I can give you a statistic over here because I know average cabinet we build, okay, it's 4 kVA, okay, power density, okay. Compared to the previously, we only build 2.2 to 2.3 kVA power density cabinet. So that's why we continue to mention the -- our MRR per cabinet will continue to increase, okay? We also, okay, expect, okay, the high-power density cabinet will generate, okay, better gross margin compared to the traditional cabinet. And not only like that, high-power density cabinets, actually, they can offer to more customer demand. For example, the customer want to provide certain high calculation, more sophisticated server. Original, traditional 2.2 kVA cabinet cannot support that. Right now, we serve 4 kVA, maybe 6 kVA, okay, power density cabinet. Right now, they can provide those service. So that's number one answer to your question. For the number two, you mentioned about the cloud computing service and also asking me about R&D. The situation is like this. We already increased the headcount in the second quarter, and that trend will continue into the third quarter into also the fourth quarter, okay? We try to continue to increase certain engineer who can support, okay, our future power initiative, okay, in China. So that will continue. Right now, I can -- just basically very it's a ballpark estimate number, okay? In the third quarter, okay, we try to use somewhere around 1.2% of our revenue, okay, for the new hire. That's -- but we will cap those new hire in the R&D. And for the fourth quarter, we expect, okay, somewhere around 1.8%, okay, for the new hire -- of the revenue, okay, for the new hire. So this initiative, okay, could be very important for the company, okay? But when I say we increased 1.2% and also increased 1.8% but those increase, okay, because our revenue, okay, forecast continue to increase, our EBITDA we expect will be continuing to increase. Our existing business should be able to pick up, okay, those increase of the new hire from our R&D. The goal over here is use the current financial model to capture all the new hire for this year. Hopefully, next year, when we initiate the service, okay, deploy the service into the market, we can starting to generate the revenue to cover those costs, maybe provide a certain profit, okay, to the company. Okay, Eric?

On and quickly, the cloud computing opportunity?

For the cloud computing opportunity, okay, right now, because 21Vianet, we are a infrastructure player, okay? Our capability, okay, is very good, okay, in infrastructure as a service. But our management, actually, we are looking for, okay, full package of the service, okay, including the platform as a service and also other service. So the opportunity right now I cannot discuss too much. But I believe, by the time of the next earnings call, I should be able to provide more detail in this regard. Okay?

[Operator Instructions] Your next question comes from the line of Chris Larsen from Piper Jaffray.

I thought I'd just come back and ask one more question that often gets asked is bandwidth pricing, and the answer seems to be that it's fairly consistent. But I wonder if you can just give us any updates if there are any changes on pricing for bandwidth in China?

Okay. The bandwidth price in China actually -- I have to say, okay, we see the bandwidth pricing in Tier 1 city in China, actually they are increasing. Okay, but the bandwidth pricing in the Tier 2, Tier 3 cities, actually they are decreasing. Since the company right now have operation in 55 cities in China, overall, we use weighted average. That's why you see the -- our numbers, the bandwidth price still remains stable at this moment, okay? That's where we are right now, okay?

[Operator Instructions] Thank you, ladies and gentlemen. That does conclude our conference for today. Thank you for participating. You may all disconnect.