KC - Kingsoft Cloud: More Patience Is Required

2023-10-13 09:38:19 ET

Summary

• It will take a few more months for Kingsoft Cloud to downsize its CDN business, and recognize revenue from new AI-related projects.
• Kingsoft Cloud is expected to stay free cash flow negative this year, as management sees capital expenditures increasing in the second half of 2023.
• I maintain my Hold rating for KC, as it is premature to be bullish on the stock now.

Elevator Pitch

I continue to assign a Hold rating to Kingsoft Cloud Holdings (KC) [3896:HK] stock. Earlier, I assessed KC's key metrics and highlighted its CEO's purchase of the company's shares in my August 4, 2023, write-up .

In this article, I explain why investors need to have more patience when it comes to considering KC as a potential investment candidate. The absence of third quarter financial guidance for Kingsoft Cloud sends a message to investors that it will take time for the company to deliver a better set of financial results. As such, a Hold rating for Kingsoft Cloud is appropriate.

KC Didn't Provide Forward-Looking Q3 Guidance

Kingsoft Cloud always offered quarterly top line guidance in the "Business Outlook" section of the company's earnings releases in the past. But this wasn't the case for the most recent quarter.

In the company's Q2 2023 results press release issued in late August, KC's management didn't provide any forward-looking guidance, and this represents a significant departure from its past practices. As such, it is no surprise that the sell-side analysts have revised their sales estimates downward to reflect the uncertainty associated with the lack of guidance.

The market's consensus full-year fiscal 2023 revenue forecast for Kingsoft Cloud was lowered by -10% from RMB8,330 million before the second quarter results announcement to RMB7,535 million now as per S&P Capital IQ data. This implies that the sell-side sees KC's top line contracting by -8% in local currency or RMB terms for the current year.

The analysts' consensus financial projections also suggest that Kingsoft Cloud will register a negative free cash flow of -RMB1,379 million in FY 2023, which is worse than KC's FY 2022 negative free cash flow amounting to -RMB1,230 million.

In the subsequent sections of the current article, I highlight that an expected improvement in Kingsoft Cloud's financial performance could potentially be delayed, and this makes it clear why KC didn't offer Q3 top line guidance.

AI Revenue Contribution And CDN Business Optimization Will Take More Time

The two key earnings growth drivers for Kingsoft Cloud are new revenue contribution from businesses associated with Generative AI, and the gradual downsizing of the low margin Content Delivery Network (or CDN) business.

It seems that these two major drivers for KC will only be realized at a later time than was expected.

At the company's Q2 2023 results briefing , Kingsoft Cloud revealed that it is "in the process of signing up contracts with dozens" of "venture AI companies in China" as part of its efforts to ride on the Generative AI wave. KC was initially expecting to recognize revenue from these new deals in the third quarter of this year. But the timeline for AI revenue contribution has been pushed back to as late as Q1 2024 for Kingsoft Cloud due to chip supply constraints.

Separately, KC acknowledged at its second quarter earnings call that "the adjustment for the CDN business" will "continue for a while." In specific terms, Kingsoft Cloud requires another 6 to 12 months to conclude the restructuring of its CDN business. Kingsoft Cloud first mentioned about "adjusting our CDN services" at the Q4 2021 results call in March last year, so this has taken far longer than what was initially anticipated.

Focus On The Long-Term Could Come At The Expense Of Short-Term Underperformance

In the preceding section, I elaborated on how two major earnings drivers for KC might take a longer to come to fruition. In this section, I highlight that Kingsoft Cloud's emphasis on the long term might hurt its results in the near term.

One factor is that Kingsoft Cloud's Enterprise Cloud business has been more selective when it comes to taking on new projects.

KC noted at its most recent quarterly earnings briefing that it is now "more focused" on "high-quality projects" and those "that are more sustainable." In other words, Kingsoft Cloud is no longer thinking about maximizing revenue and earnings for the near term by signing up for as many as new projects as possible. Instead, KC wants to be working on projects that bolster the company's reputation and put it in a good position to be recognized as a leading player in the enterprise cloud space in the long run.

Another factor is that KC has shown a willingness to invest for the future, even if that translates into negative free cash flow in the short term.

As mentioned earlier, Kingsoft Cloud is expected to remain free cash flow negative in 2023 just like last year as per consensus estimates. Notably, KC highlighted at its second quarter results briefing that its Q2 2023 capital expenditures were lower than expected, because it was "saving our funds for high-performance AI services." Looking ahead, KC noted that the company's capital expenditures might potentially rise in 2H 2023 to capitalize on the growth potential of AI.

Closing Thoughts

More patience is required, as this isn't the best time to invest in KC. A turnaround for Kingsoft Cloud's businesses is unlikely to happen in the very near term, which means that it is fair to have a Hold rating for the stock.

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