KC - Kingsoft Cloud: Murky Outlook

Summary

• Kingsoft Cloud's consensus revenue projections for the FY 2022-2024 period have been reduced significantly, after the company issued disappointing third-quarter topline guidance.
• But there are expectations that KC can realize higher gross profit margins in the future, with the shift away from CDN services being a key factor.
• I retain my Hold rating for KC, as there is no certainty that KC's gross margin improvement will be able to offset a more moderate pace of revenue expansion going forward.

Elevator Pitch

My rating for Kingsoft Cloud Holdings Limited's ( KC ) stock is a Hold.

The focus of my prior June 21, 2022 update for Kingsoft Cloud was the company's "short-term headwinds." My attention turns to KC's financial outlook in the current article.

The outlook for KC is murky. The good news is that Kingsoft Cloud's gross profit margins should expand in the future in tandem with the pivot away from the CDN or Content Delivery Network business. The bad news is that KC is expected to generate slower topline growth in the next two years, and the reduced scale of the CDN business could also have a negative impact on its long-term revenue growth prospects. As such, my Hold rating for KC remains unchanged.

All Eyes On Management Guidance And Changes In Consensus Estimates

Kingsoft Cloud reported the company's financial results for the second quarter of this year on September 6, 2022. In its Q2 2022 results media release , KC disclosed its guidance of delivering a topline of between RMB1.95 billion and RMB2.15 billion for the third quarter. This translates into an expected Q3 2022 revenue of RMB2.05 billion for Kingsoft Cloud based on the mid-point of the company's guidance.

In other words, KC expects to see its topline contract by -15% YoY for Q3 2022 as compared to the company's Q3 2021 sales of RMB2,414 million. Assuming that the company's management is spot on with its guidance, Kingsoft Cloud will suffer from a larger topline drop in the third quarter vis-a-vis its -12% YoY revenue decline in Q2 2022.

To make things worse, the weak Q3 2022 revenue guidance offered by Kingsoft Cloud's management has led sell-side analysts to slash their financial forecasts for the company for full-year FY 2022, and the coming two years as well.

According to S&P Capital IQ data, Kingsoft Cloud's consensus revenue for FY 2022, FY 2023, and FY 2024 was lowered by -7%, -9%, and -11%, respectively, after its Q3 guidance was issued in early September.

The current market consensus financial projections for KC imply that the company's topline expansion will slow from +38% in fiscal 2021 to +0.2% for FY 2022. Although analysts expect Kingsoft Cloud's revenue growth to recover to +19% for FY 2023 and +20% in FY 2024, this would indicate that KC won't be growing as fast as it did in the past. As a reference, Kingsoft Cloud achieved revenue increases of +79%, +78% and +66% in FY 2018, FY 2019, and FY 2020, respectively.

Kingsoft Cloud attributed the YoY revenue contraction for Q3 2022 as implied by its management guidance to its "scaling down of CDN services" at its most recent Q2 2022 earnings briefing in September.

I have a mixed view of KC's strategic decision to shrink the company's CDN business operations, which is discussed in the subsequent sections.

Gross Margin Expectations

On the positive side of things, a lower sales contribution from CDN services might help to expand Kingsoft Cloud's future gross profit margins.

At its second-quarter investor call, KC revealed that it benefited from lower "IDC (Internet Data Center) costs" in tandem with the shrinkage of its CDN business. The company also emphasized at its recent quarterly results briefing that the reduced size of its CDN business operations supports its goal of "improving the efficiency and cutting loss on certain nodes and regions." This is reflected in the analysts' consensus profit margin forecasts for Kingsoft Cloud.

The sell-side estimates that KC's gross profit margin will improve from 3.9% for fiscal 2021 to 5.5% in FY 2022, before rising further to 9.3% for FY 2023 as per S&P Capital IQ data. As such, it will be reasonable to make the assumption that the decrease in revenue contributed by the CDN business is one of the main drivers for the company's expected gross margin improvement.

Topline Growth Prospects For Kingsoft Cloud

On the negative side of things, the pivot away from the CDN business might have long-term strategic implications for Kingsoft Cloud and potentially usher in a phase of slower revenue growth for the company.

Analysts from China Renaissance issued a July 4, 2022 research report (not publicly available) titled "Strategic Changes Unlikely To Spark A Catalyst". The analysts stressed that the reduced size of the CDN business could hinder "KC's efforts to promote its 'Video Cloud' PaaS (Platform as a Service) solutions" which "require availability of CDN services to ensure final delivery." In addition, China Renaissance's research noted that "customers demand one-stop solutions from an IaaS (Infrastructure as a Service) operator." In other words, Kingsoft Cloud might potentially be less competitive, as it scales down its CDN business.

China Renaissance isn't the only research firm to have a cautious view of KC's move to shrink the company's CDN business. A September 7, 2022 Seeking Alpha News article cited a report from Citigroup ( C ) refers to the shift away from CDN services as a "transition" which "may take some time to complete." Citi's analysts also highlight that Kingsoft Cloud "might become more selective on the quality of its customers" in a bid to "balance scale and profitability" as part of this "transition". This implies that it won't be easy for Kingsoft Cloud to compensate for lower CDN services revenue by either growing revenue contribution from other sources or significantly improving profitability in a very short period of time.

In summary, the consensus numbers for Kingsoft Cloud are indicative of the key challenge that the company is facing now.

By pulling back on CDN services, KC is in a good position to boost its gross profit margins in the short term, but this might come at the expense of slower revenue growth in the intermediate-to-long term. In an earlier section of this article, I specifically highlighted KC's slower topline growth expectations for FY 2023 and FY 2024.

Concluding Thoughts

Kingsoft Cloud's share price has fallen by -92% in the last year, and the stock currently trades at a consensus forward fiscal 2023 Enterprise Value-to-Revenue multiple of 0.20 times as per S&P Capital IQ's valuation data.

The company's shares have been penalized, because KC's revenue growth has slowed, and the company remains loss-making. Even though there are expectations of an improvement in Kingsoft Cloud's gross margins going forward, KC is likely to only turn EBITDA positive in FY 2024 as per management guidance and sell-side consensus numbers (source: S&P Capital IQ ). In that respect, a Hold rating for Kingsoft Cloud is justified, taking into account expectations of the company's future topline, EBITDA and gross margins.

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