Kingsoft Cloud: A Reasonably Priced Chinese Cloud Services Play (NASDAQ:KC)

Kingsoft Cloud (KC), a recent spin-off from Kingsoft Corp. (OTCPK:KSFTF), is a China-based cloud-service player primarily operating in the IaaS + PaaS (Infrastructure as a service + Platform as a service) cloud services space. The company also provides industry-specific solutions. Its latest quarterly report highlighted the underlying growth potential, with the company already on track for EBITDA breakeven at some point in FQ4. Longer term, Kingsoft Cloud is positioned to benefit from a structural digitalization tailwind across industries, with a benign competitive environment also boosting prospects. At current valuations, KC shares trade well below its US peers.

Growth Accelerates in FQ3

Kingsoft Cloud posted some impressive top line metrics for its latest quarter, with overall growth at +73% Y/Y in FQ3, driving the faster-than-expected improvement in margins. Public cloud revenue increased by 48% Y/Y, suggesting resilient cloud demand in the aftermath of COVID-19 in China. However, enterprise cloud revenue was the standout, growing at 257% Y/Y, and now contributing c. 24% of total revenues (up from 16% last quarter), on the back of pent-up demand in digitalization among corporate and public organizations and increased multi-cloud adoption across verticals.

3Q19

4Q19

1Q20

2Q20

3Q20

Public cloud services

885

945

1,209

1,287

1,310

Enterprise cloud services

114

220

182

246

409

Others

3

8

1

2

10

Total revenues

1,002

1,174

1,391

1,535

1,729

% Y/Y

67%

62%

64%

64%

73%

(Source: Company Data)

In addition, easing industry competition also helped the bottom line, with key product pricing remaining largely stable Y/Y. Improving operational efficiency in FQ3 was also key in driving the solid Y/Y margin improvement, with non-GAAP EBITDA margin now at -1.5%.

3Q19

4Q19

1Q20

2Q20

3Q20

Adjusted EBITDA

(102)

(89)

(34)

(27)

(26)

% Adjusted EBITDA margin

-10.2%

-7.6%

-2.5%

-1.7%

-1.5%

(Source: Company Data)

Looking ahead, Kingsoft Cloud management guides FQ4 revenue to reach the RMB 1.88-1.95 billion range, with fiscal 2021 revenue growth expected to outpace China’s public cloud industry average, supported by a premium customer base. As I discuss below, this has positive implications for margins as well.

On Track for Breakeven

While margins did improve in FQ3, it is worth noting that they were flattered by some one-off benefits. For instance, non-GAAP gross margins did improve to 6.6% (from 5.5% in FQ2), but this was partially due to changes in the depreciation policy. As disclosed in the Form 6-K filing, the useful life of certain electronic equipment was lengthened from three years to four years, which is generally in line with major industry peers like Amazon’s (AMZN) AWS.

“We review the useful lives of equipment on an ongoing basis, and effective July 1, 2020 we changed our estimate of the useful life for our certain electronic equipment from three to four years. The longer useful life is due to increasing purchase of high-end equipment, continuous improvements in our software and enhancements in our capability of operation.”

Excluding the D&A adjustment, FQ3 gross margin would have been lower Q/Q due to higher bandwidth and enterprise cloud deployment costs, as project implementation was accelerated following COVID-19-led delays in H1 ’20. As Kingsoft Cloud clears the backlog over time, gross margin should continue to improve alongside adjusted EBITDA margins into fiscal 2021. The current guidance is for EBITDA to hit breakeven at some point in FQ4, after which I expect margins will inflect higher on improved operating leverage.

Steady Outlook for Public Cloud

Kingsoft Cloud is unique in that it offers its comprehensive set of products primarily to premium customers in selected verticals. New customers include the likes of NetEase (NTES), Midea, and Xiaohongshu, all of which benefit from strong tailwinds and are large enough for the company to effectively serve using its R&D and marketing capabilities. The strategy seems to be working, with public cloud revenue (76% of overall revenue) growing 48% Y/Y to RMB 1.31 billion in FQ3. Within public cloud, c. 65% comes from the delivery business, c. 29% from cloud computing, and the remaining c. 6% from storage.

(Source: Kingsoft Cloud Prospectus Filing)

The near-term outlook is strong as well, with a near-term acceleration likely amid pent-up demand for public cloud following a nationwide work resumption in H2 ’20. Longer term, key growth tailwinds such as 5G and HD tech should continue to drive higher demand for video cloud, with online education and e-commerce also likely to drive demand for video content.

Enterprise Cloud Emerging as the Key Growth Driver

Thus far, Kingsoft Cloud has been successful in its initial penetration into selected enterprise verticals, and considering its strong enterprise service capability and brand image, I believe the company is equipped to strengthen its competitive position. With revenue contribution already rising rapidly to 24% in FQ3, management sees a robust near-term outlook as well, which has me bullish on the segment’s prospects.

Furthermore, the profitability of enterprise cloud should be higher than for computing and storage in the public cloud, as increased adoption of multi-cloud demand is mainly from verticals like finance and healthcare, which tend to be more willing to pay for projects with higher margins. Therefore, assuming management’s expectation (disclosed on the FQ3 conference call) for enterprise cloud to increase to 1/3rd in revenues by fiscal 2023/24 holds true, margins should expand further.

So to your second question regarding the revenue mix, I think, let’s say, in 2023 or 2024, I think our view is, as we see the increasing portion of the enterprise revenue, I think we are likely to reach, let’s say, around 1/3 of the revenue, roughly speaking, of the total revenue coming from enterprise cloud. And the remaining 2/3 will be the public cloud revenue.

Competitive Risks Remains

Thus far, public cloud has benefited from a stable competitive landscape and stable pricing trends as leading players continue to outgrow the industry. While the entry of major players such as ByteDance (BDNCE) into cloud services could be a concern longer term, there is limited product overlap with Kingsoft Cloud at present. The likes of AliCloud (BABA) and Tencent Cloud (TCEHY) are also a risk, as both players have aggressive plans to boost their market shares in the rapidly growing cloud market, and therefore, pricing could eventually come under pressure. Nonetheless, the current competitive landscape remains relatively benign, and Kingsoft Cloud is taking advantage, delivering persistent margin improvement.

Final Take

Overall, I am positive about Kingsoft Cloud considering its growth potential across public and enterprise cloud, along with its favorable progress on the margin improvement front. As short-term headwinds such as bandwidth costs normalize, and the company continues to benefit from operating leverage, the Kingsoft Cloud margin expansion story should gain traction in the upcoming quarters. Riding on the fast-growing cloud market in China, along with a reasonable valuation compared with US peers Cloudflare (NET) and Fastly (FSLY), which trade at c. 54x and c. 31x EV/Sales, respectively, I see plenty of upside potential for Kingsoft Cloud. Upcoming catalysts to keep an eye on include the addition of Kingsoft Cloud into the MSCI China Index on 30th November.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

(Excerpt) Read more Here | 2020-11-27 07:21:00
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