KC - Kingsoft Cloud Seeks Balanced Growth But Operating Losses Remain Heavy

2023-05-10 12:27:23 ET

Summary

• Kingsoft Cloud Holdings Limited went public in early 2020, raising approximately $510 million in gross proceeds in a U.S. IPO.
• The firm provides Chinese and other Asian companies with a suite of cloud software services.
• Kingsoft Cloud Holdings has suffered reduced revenue and heavy operating losses.
• Until management can reignite growth and reduce operating losses, I'm Neutral [Hold] on Kingsoft Cloud Holdings Limited.

A Quick Take On Kingsoft Cloud Holdings

Kingsoft Cloud Holdings Limited ( KC ) went public in early 2020, raising approximately $510 million in gross proceeds from an IPO priced at $17.00 per share.

The firm provides enterprises in Asia with a suite of cloud-based service offerings.

KC continues to produce declining revenue and heavy operating losses even as China’s economic growth begins to improve.

For the near term, I’m Neutral [Hold] on KC.

Kingsoft Cloud Overview

Hong Kong, China-based Kingsoft was founded to provide enterprises with complementary cloud services as an alternative to their on-premise information technology systems. Kingsoft is a spinoff from Hong Kong-listed Kingsoft Corporation (HK:3888).

Management is headed by Vice Chairman and Chief Executive Officer Mr. Tao Zou, who was CEO of Seasun Holdings and has been responsible for the firm's entertainment software business since 2004.

The company’s primary offerings include:

• Compute

• Networking

• Storage & CDN

• Database

• Data Analysis

• Security.

Kingsoft Cloud’s Market & Competition

According to a 2020 market research report by Allied Market Research, the global market for cloud services of all types reached a value of $265 billion in 2019 and is expected to reach $928 billion by 2027.

This represents a forecast of 16.4% from 2020 to 2027.

The main drivers for this expected growth are a large and continued transition by enterprises worldwide from on-premises systems to cloud environments and ongoing innovation in cloud system offerings by service providers.

A Frost & Sullivan report commissioned by Kingsoft shows the expected growth of various sectors in China as shown in the chart below:

Kingsoft Cloud’s Recent Financial Trends

• Total revenue by quarter has produced the following trajectory:

• Gross profit margin by quarter has risen in recent months:

• Selling, G&A expenses as a percentage of total revenue by quarter have risen markedly recently, a negative signal indicating the firm is spending more to generate revenue:

• Operating losses by quarter have worsened substantially:

• Operating leverage by quarter has also deteriorated further into negative territory recently:

• Earnings per share (Diluted) have similarly worsened recently:

(All data in the above charts is GAAP.)

In the past 12 months, KC’s stock price has risen 79.54% vs. that of the iShares Expanded Tech-Software Sector ETF’s ( IGV ) rise of 9.44%, as the chart indicates below:

For the balance sheet , the firm ended the quarter with $677.5 million in cash, equivalents and short-term investments and $241.1 million in total debt, of which $181.2 million was categorized as short-term/current.

Over the trailing twelve months, free cash used was $178.3 million, of which capital expenditures accounted for $205.7 million. The company paid $52.2 million in stock-based compensation, or SBC, in the last four quarters.

Valuation And Other Metrics For Kingsoft Cloud

Below is a table of relevant capitalization and valuation figures for the company:

(Source - Seeking Alpha.)

The Rule of 40 is a software industry rule of thumb that says that as long as the combined revenue growth rate and EBITDA percentage rate equal or exceed 40%, the firm is on an acceptable growth/EBITDA trajectory.

KC’s most recent Rule of 40 calculation was negative (23.1%) as of Q4 2022’s results, so the firm has performed poorly in this regard, per the table below:

(Source - Seeking Alpha.)

Commentary On Kingsoft Cloud

In its last earnings call ( Source - Seeking Alpha ), covering Q4 2022’s results, management highlighted its focus on "high quality, sustainable growth" as it has implemented various cost reductions.

The firm produced operating cash flow for the quarter for the first time but continued to spend on capital expenditures and stock-based compensation.

Leadership says it strives to maintain a balance between growth and profitability, although operating losses continued to be heavy.

Total revenue for Q4 2022 dropped 26.2% year-over-year while gross profit margin rose a remarkable 6.6 percentage points.

Management did not disclose any company retention rate metrics.

SG&A as a percentage of revenue rose sharply during the quarter, showing the firm is spending more to obtain further revenue growth.

Operating leverage remained negative for the sixth quarter in a row.

Looking ahead, Kingsoft Cloud Holdings Limited management sees a burst of interest in AI technologies but also expects that interest surge to die down and produce a more steady stream of new opportunities.

Perhaps the "AI bump" is why the stock has both surged and fallen back in recent weeks.

The company's financial position is relatively strong, with ample liquidity and some debt, but the negative free cash flow burn will need to be reduced as it remains excessive, at least over a trailing twelve-month period.

Regarding valuation, the market is valuing KC at an EV/Sales multiple of around 0.9x.

The primary risk to Kingsoft Cloud Holdings Limited’s outlook is a macroeconomic slowdown that appears to be already underway, tightening credit conditions which may affect customer spending plans and lengthening sales cycles which may reduce its revenue trajectory.

From management’s most recent earnings call, I prepared a chart showing the frequency of key terms mentioned (or not) in the call, as shown below:

I’m most interested in the frequency of potentially negative terms, so management cited "Challeng[es][ing]" four times and "Macro" once in various contexts.

In the past twelve months, the firm's EV/Sales valuation multiple has risen nearly 5.5x, as the chart from Seeking Alpha shows below:

A potential upside catalyst to the stock could include further growth opportunities from within the AI segment as the company appears positioned to assist mid-sized businesses in China with their AI initiatives.

Chinese IT firms have been whipsawed by recent economic variations in the PRC as a result of the COVID-19 pandemic, lockdowns and removal of restrictions.

Some economists think that China’s "reopening" will usher in above-trend growth, and the chart below puts its current GDP growth in perspective:

While Kingsoft Cloud Holdings Limited growth is indeed faster now than at the nadir in the summer of 2022, I’m more cautious about its growth prospects, and I’m taking a "wait and see" approach.

Until management can reignite topline revenue growth and reduce heavy operating losses, I’m Neutral [Hold] for Kingsoft Cloud Holdings Limited in the near term.

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