VNET Group, Inc. (VNET) Q3 2016 Earnings Report, Transcript and Summary

Good morning and good evening, ladies and gentlemen. Thank you, everyone, and welcome to 21Vianet Group's Third Quarter 2016 Earnings Conference Call. [Operator Instructions] Before we begin, I will read the safe harbor 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 Mr. Steve Zhang, the company's Chief Executive Officer; and Mr. Terry Wang, the company's Chief Financial Officer. At this time, I would now turn the call over to Mr. Steve Zhang. Please proceed, sir.

Good morning and good evening, everyone. Thank you for joining us for the earnings call today. Firstly, we are pleased to announce another solid quarter of healthy growth in our core business. 21Vianet continues to evolve with China's transforming Internet infrastructure industry as we see the continued rapid adoption of cloud solutions, increasing specialization of services as well as healthy demand for co-location services from Internet companies demanding expanded data applications as well as a variety of other industries, including financial institutions, which are seeking additional services -- which are seeking additional services like disaster recovery within our data centers. As more new cloud-based services emerge, like artificial intelligence, Internet of Things, Blockchain and big data, we believe the growing potential for computing capacity and storage as well as Internet traffic will grow exponentially in China. To strengthen the relationship in that IDC market, we have set a plan to build an unparalleled digital real estate platform, aiming to add 80,000 to 100,000 new cabinets over the next 5 to 7 years. Let me start by talking in a bit more detail about our recent move to form our strategic joint venture with Warburg Pincus to build a digital real estate platform in China. The data center industry as a whole is transforming quickly towards specializations. One side is a traditional retail co-location business, and the other side is a large-scale wholesale and a customized data center business like Digital Realty Trust model. These changes are the impetus behind several of our recent restructuring efforts and partnerships. Similar to the specialization we have seen in the U.S. market, our strategy is to focus on asset-light business, which will be separated from the capital intensive business. Our partnership with Warburg Pincus not only brings in extensive network resources but also brings in their expertise in the real estate industry. For 21Vianet, with our deep industry experience in data center operation, we see the separation of this full [ph] business as a solid strategic move, which will benefit us with a significant reduction in CapEx for future buildouts and a tremendous growth opportunities by more specifically focusing on both the wholesale data center and the retail market in China. Next, I would like to talk about the progresses we achieved in our hosting-related business. For our core IDC business, we added over 2,300 new cabinets in our self-built data centers during the quarter. The majority of the increase comes from our newest data center in Beijing, which opened towards the end of the third quarter. Supported by solid growth in billable cabinets, our data center utilization rate continued to increase to 77.9% despite this large additions. Our Cloud business showed continuous strength in terms of revenue and the profitability. We recently launched the IBM Bluemix services for general availability in October to all China-based users, which added services like artificial intelligence and Blockchain. CCTV.com was one of the early adopters of IBM Bluemix services. We have great expectations in this deepening partnership with IBM and believe it will facilitate a much wider range of cloud-related cooperation opportunities between the 2 companies and building a robust and comprehensive cloud ecosystem in China. I also want to touch upon our hybrid IT business strategy. Since we announced this strategy at the start of the year, we have welcomed more and more new partners into our ecosystems, including 2 newly added customers: one is Aetna, one of the 5 largest house insurance providers in the U.S.; and the other is Bupa, U.K.'s leading healthcare specialist. We provide a complete package of customized, secure and carrier-neutral IT solutions to them, enabling them to provide stable and safe services to their customers. Such high-profile partners are able to rely upon 21Vianet solution to help them achieve both flexibility and superior performance for their hybrid IT needs. I also like to talk a bit about our interconnection platform. As you are aware, this platform is similar to the Equinix cloud exchange model. We have been gradually rolling it out in our data center operations with several pilot projects. Our interconnection platform enables our data center customers to achieve stable, secure and fast data transmissions within our data center through interconnection technology, no matter where the business centers are located. It also allows for cloud exchange, which enables customers to establish more secure connections from their applications to the cloud. And the data exchange with Internet service providers. Our interconnection platform will significantly accelerate users' connections and the reduced customer bandwidth cost. We are so far very pleased with the progress of this pilot project and hope we can soon roll out this high-margin offering to all of our data center customers. For CDN and the MNS business, we continued to experience ongoing challenges as a result of the combination of the market competition and the regulatory restrictions. We see some early signs of stabilization, and we're working diligently to streamline our cost structure, which will help us begin to grow with steady margins as demand solidifies. In summary, we are pleased with the strong performance in our core IDC business and the closing of our joint venture with Warburg Pincus. This helps position us more strategically in terms of scope of service offerings, world-class partnerships, financial resources, capital structure and the industry expertise to capture this industry's solid, secular growth and aim to become the #1 player with the best-in-class data center facilities, serving both the wholesale and the retail co-location market in China going forward. With that, I would like to turn the call over to Terry, our CFO, to go through our financial results. Terry?

Thanks, Steve. And let me start with our third quarter of 2016 financial results. Before I begin, I would like to state that we will present the non-GAAP measures today. Our non-GAAP results exclude certain noncash expenses, which are not a part of our core operations. The details of these expenses may be found in the reconciliation tables included in our press release. Also note that all the financial numbers we are presenting today are in RMB and the percentage of change is year-over-year, unless otherwise stated. We're very glad that we -- third quarter 2016 results came in above our initial guidance, both for net revenues and EBITDA, driven by steady growth in our core businesses. We also began to see contribution from our core cost structure optimization and operating efficiency improvements started from first half of the year, especially in MNS and the CDN businesses. Our net revenues for the third quarter of 2016 increased by 4.8% to CNY 968 million, primarily driven by the year-over-year growth in IDS (sic) [ IDC ], cloud and VPN net revenues, partially offset by decline in MNS revenues. Net revenues from hosting and related services increased by 19% to CNY 928 million (sic) [ CNY 828 million ] in the third quarter of 2016 from CNY 696 million in the prior-year period, primarily due to the year-over-year increase in total number of billable cabinets and the improved utilization rate, partially offset by lower monthly recurring revenue per cabinet. Our monthly recurring revenue per cabinet for the third quarter was RMB 8,696 (sic) [ RMB 8,698 ] compared with RMB 8,793 in the second quarter of 2016. The decrease in the monthly recurring revenue per cabinet was mainly attributable to continued bandwidth pricing pressure as well as billable cabinets in certain markets with lower market prices, which is expected to be temporary. Net revenues from the Managed Network Services were CNY 140 million in the third quarter of 2016 compared with CNY 228 million in the prior-year period. The decrease was primarily due to the continued industry-wide decline in bandwidth prices and the intensified competition. Adjusted gross profit was CNY 225 million in the third quarter of 2016 compared with CNY 241 million in the prior-year period. Adjusted gross margin was 23% in the third quarter of 2016 compared with 26% in the prior-year period and 22% in the second quarter of 2016. The year-over-year decrease in gross margin was primarily due to continued softness in our MNS business. Adjusted operating expenses were CNY 294 million compared with CNY 231 million in the prior-year period. As a percentage of net revenues, adjusted operating expenses were 30% compared with 25% in the prior-year period and 34% in the second quarter of 2016. More specifically, sales and marketing expenses were CNY 100 million in the third quarter of 2016 compared to CNY 89 million in the prior-year period. The increase was primarily due to increased labor cost and outsourcing cost, which were partially offset by a decrease in agency fee. General and administrative expenses were CNY 190 million in the third quarter of 2016 compared to RMB 139 million in the prior-year period. The increase was primarily due to increased staff cost and bad debt provision. Research and development expenses were CNY 36 million in the third quarter of 2016, relatively stable compared to CNY 35 million in the prior-year period. Changes in fair value of contingent purchase consideration payable was a gain of CNY 12 million in the third quarter of 2016 compared with a loss of CNY 0.7 million in the prior-year period. Our adjusted EBITDA for third quarter of 2016 was CNY 68 million compared with CNY 122 million in the prior-year period. Adjusted EBITDA margin for the third quarter of 2016 was 7% compared with 13.2% in the prior-year period, and the 1.7% in the second quarter of 2016. Adjusted EBITDA for the third quarter of 2016 excludes share-based compensation expenses of CNY 33 million and changes in the fair value of contingent payable -- purchase consideration payable, which was a gain of CNY 12 million. Adjusted net loss for the third quarter of 2016 was CNY 84 million compared with adjusted net profit of CNY 15 million in the prior period. Adjusted net margin in the third quarter of 2016 was negative 3.7% compared with the net profit margin of 1.7% in the prior period, and negative 12% in the second quarter of 2016. Adjusted diluted loss per share for the third quarter of 2016 was RMB 0.02, which represents the equivalent of RMB 0.12 per ADS. As of September 30, 2016, our cash and cash equivalents and short-term investment were CNY 1.68 billion, equivalent to USD 252 million. Before I move on to financial guidance, I would like to briefly discuss our bond redemption in August to take advantage of the current low interest rate in the market. We have tendered about 79% of total bond with interest of 6.875% due in June 2017, which is RMB 1.5 billion in the principal amount. We lowered our interest rate from 6.875% level to below 5%, which we agreed [ph] lower our interest expenses. Now let me provide you with our guidance. For the fourth quarter of 2016, we expected our revenue to be in the range of RMB 900 million to RMB 940 million. Adjusted EBITDA is expected to be in the range of RMB 50 million to RMB 70 million. For the full year of 2016, the company now expects our net revenues to be in the range of RMB 3.64 billion to RMB 3.68 billion, revised from prior guidance of RMB 3.62 billion to RMB 3.66 billion. Adjusted EBITDA for the full year of 2016 is expected to be in the range of CNY 242 million to RMB 262 million, revised from prior guidance of RMB 240 million to RMB 260 million. This forecast reflects the company's current and preliminary review, which may be subject to change. This concludes our prepared remarks for today. Operator, we're now ready to take questions.

[Operator Instructions] Our first question today comes from the line of Matthew Heinz from Stifel.

One question on the cloud business. You briefly mentioned the IBM Bluemix launch. Just wondering if you could give us an update there in terms of total RMB in cloud revenue and the split between IBM and Microsoft cloud products. And then, secondarily, just a question on the interconnection platform pilot. I think from a few years back, there were some regulatory barriers to essentially earning revenues from interconnection related products or selling cross connects without the telecom license. And just wondering if there's been any progress made on that or if the venture is purely based on sort of a co-location product or whether there'll be incremental revenue opportunities from cross connects there.

First of all, let me first talk about the question related to the cloud. IBM Bluemix cloud was only launched in October. Their dedicated version was launched in July this year. The dedicated version basically enables their customers to build their private cloud using Bluemix technology. And their public cloud was only launched in last month, October. So their revenue is still relatively much smaller compared with Microsoft, but we see some enterprise customers are showing great interest in the IBM offering. Number two, talking about interconnection platform. We're seeing a lot of interest from our customers that they want to connect their applications, which are hosted in our data center with public clouds like Ali cloud, Tencent cloud, Microsoft cloud. And when we talk about interconnection platform, we're mostly talking about interconnections with a lot of the public cloud services.

Okay. I guess my question on the interconnect though: is there an opportunity to earn incremental revenue streams from selling cross connects to both the providers and the enterprise customers that may come into the facilities to interact with those clouds?

Yes, yes.

Okay. And then, just on the cloud business, are you still disclosing the revenue growth levels and overall sales levels in that business segment or is that something that you've discontinued?

We don't do the segmented reporting specifically related to the cloud business.

[Operator Instructions] Our next question today comes from the line of Tina Hou from Goldman Sachs.

I have 2 questions. First one is that Steve, you previously mentioned that you have seen the competition in CDN and MNS space stabilizing recently. I was wondering if you could share more colors on that. What kind of instances have you seen in terms of the competition stabilizing? And then the second one is Terry, you mentioned that the monthly recurring revenue per cabinet was down mainly due to the bandwidth -- the lower bandwidth prices. So I was wondering, excluding the bandwidth prices, what is the monthly recurring revenue per cabinet trend?

When we talk about the CDN and MNS business, first of all, on the CDN side, the competition on pricing is still intense. For the MNS business, we are seeing the pricing stabilize because of limited supply and also limited capability to meet the market demand. On the cost side, we're seeing some stabilization. And Terry, what's the second question?

Okay, let me answer the second question regarding the MRR slightly declined quarter-over-quarter. I think, Tina, that the bandwidth pricing is the factor that dragged the pricing MRR decline. That's the fact. But if you take that, exclude that fact, we will see regionally -- by each region, because different region have a different cabinet -- revenue per cabinet basis. So we still see that the price is not very stable -- I mean, it's very stable at -- we don't see any trend that pricing decline over time just on a cabinet basis.

Okay. And just a very quick follow-up. So how much percentage of the MRR is bandwidth?

Okay. We have, for example, a different region have a different percentage. But on a general basis, we have MRR for Beijing and regions about 10,000 a month. So within 10,000 a month, it's approximately about -- between 25% and 30% come from the bandwidth sales.

Great. And then just one more follow-up on the CDN side. So how much have you seen the CDN price declined this year so far?

About 20% to 30% drop.

Okay. So 20% to 30%. And then on a regular basis, the drop is about 15% to 20%, would you say?

Yes.

[Operator Instructions] Our next question today comes from the line of Yang Liu from Morgan Stanley.

I would like to ask the IDC pipeline in fourth quarter. Previously, management guided this year -- 21Vianet will deploy 3,500 new data centers. And now, we've seen pretty good progress up to third quarter. And could management share about the development of the fourth quarter data center new capital deployment.

Yes, I think so far this year, we have added over 3,000 new cabinets. And in the fourth quarter, it's about 300 new cabinets. And we have 2 major projects going on, but these 2 projects probably will be delayed until first quarter next year.

Okay. And I see CapEx so far third quarter is only CNY 140-something million versus a guidance of CNY 500 million CapEx. Is that slightly lower than run rate CapEx due to the delay of the 2 projects?

Partially, yes. And that new project will be delayed to next couple of quarters. So that was planned earlier.

Our next question today comes from the line of Matthew Heinz from Stifel.

Just one on the guidance for fourth quarter. Just would like to get some color on kind of what's driving the expected sequential decline in revenue. If that's primarily coming on the MNS side? Do you expect to see a sequential growth in the hosting business? And then on the margins, it looks like the margin guidance is kind of flat sequentially. I believe you talked last quarter about potentially being done with the cost initiatives as we turn into next year and just would appreciate any color you could add on when you expect to see some lift in the EBITDA margins?

Okay. This is Terry. On the revenue side, you see the guidance a little bit below than the third quarter's actual revenue. The reason for that is the -- we have separate 2 business. One in the hosting area, we continue to see the strong growth. I mean, that's the stabilized growth. But the things that drag us down is still the M&A -- M&A is the area, which is challenged by the pricing continue to fall, decline, and competition on the CDN side and also the -- on the Aipu, our residential Wi-Fi service area to C area has been compete to manage the pressure by the China mobile launch their strategy to get their target to get the customers promotion pricing by pricing cuts. So we have to be careful on that. So on that point of view, we have to be cautious about giving the guidance. For the margin and EBITDA portion, I think that is flat given that the revenue is relatively lower than the third quarter. I think that our total amount of EBITDA actually, if you talk -- if you talk on a percentage-wise, we actually come up a little bit. In other words that we have been initiated some of the cost control improvement and related to our procurement, our supplier, on the bandwidth side and also efficiency operation in our cabinets, reduce our inventory in our cabinets. Also the increase our -- the usage of the bandwidth that we purchase to be matched with demand so that give us some of the confidence that we can improve our margin a little bit. I think that what started, for next year, when you ask in the next year's trend, I think that next year is going to be good for us. We have the measure that we're taking for the efficiencies running operation by cutting the cost and reduce some of the expenses. I think that the margin will be going up next year. As we pointed out earlier, we will be reaching double-digit and no question about it.

[Operator Instructions] It seems there are no -- as there are no further questions on the line at this time, that does conclude today's conference. We thank you all for your participation. You may now disconnect.