KC - Kingsoft Cloud: Still In Transition

2023-12-26 20:34:33 ET

Summary

• I am concerned about the potential volatility in KC's financial performance for the short to intermediate term, as the company is still in the process of restructuring its CDN business.
• But I have a positive opinion of the enterprise cloud business' gross margin expansion and the AI business' strong QoQ revenue growth for the recent quarter.
• Kingsoft Cloud currently trades at a consensus forward next twelve months' price-to-sales ratio of 0.84 times and an FY 2025 EV/EBITDA multiple of 8.0 times.
• My Hold rating for KC stays unchanged in view of its prospects and valuations.

Elevator Pitch

Kingsoft Cloud Holdings ( KC ) [3896:HK] shares are awarded a Hold investment rating.

My prior October 13, 2023 update for Kingsoft Cloud highlighted that it was too early to turn positive on the stock. KC is still in the midst of optimizing the company's Content Delivery Network (or CDN) business operations. At the same time, the company is also currently executing on plans to realize the growth potential of its AI business and enhance the enterprise cloud services business' profitability. Therefore, it is fair to label KC as a company in transition, so the stock is deserving of a Hold rating.

KC Is Still In The Process Of Restructuring The CDN Business

At the company's most recent Q3 2023 earnings briefing last month, KC outlined expectations of returning to "Y-o-Y growth and Q-on-Q growth" in revenue for 2024 and achieving "EBITDA margin breakeven" for "the near future."

However, Kingsoft Cloud didn't offer specific guidance on the top line expansion rate in quantitative terms and the exact timing of delivering positive EBITDA. This implies there is significant uncertainty regarding how the company could potentially perform in the short to medium term.

The sell side's consensus FY 2024 and FY 2025 top line estimates for KC were cut by -5.8% and -6.0% (source: S&P Capital IQ ) to RMB7,684 million and RMB8,504 million, respectively in the one month following its Q3 results announcement . In addition, the FY 2025 EBIT loss forecast for Kingsoft Cloud was revised from -RMB854 million to -RMB965 million for the recent month. In other words, the analysts have lowered their expectations of KC's revenue growth and profitability for the coming years.

Kingsoft Cloud suffered from a -7.4% revenue miss (in local currency or RMB terms) for Q3 2023, while its actual third quarter EBIT loss of -RMB805 million was much wider than the consensus projection of -RMB342 million as per S&P Capital IQ data.

KC acknowledged at its third quarter results call that the company is still "in the phase of some adjustment" relating to "client mix" and "the products we offer." I had previously noted in my mid-October write-up that Kingsoft Cloud is executing on plans pertaining to "gradual downsizing of the low margin Content Delivery Network (or CDN) business." The top line derived from Kingsoft Cloud's CDN business contracted by close to -20% QoQ in Q3 2023. The sales generated from KC's biggest CDN client as a proportion of total revenue decreased from 16% for Q2 2023 to 12% for the latest quarter.

But Kingsoft Cloud has much more work to do when it comes to restructuring the company's CDN business. Notably, KC still earned 30% of its Q3 2023 top line from the CDN business. The company's target is to reduce the CDN business' quarterly sales contribution from approximately RMB0.5 billion to between RMB300 million and RMB400 million with the planned completion of the restructuring process in Q3 2024.

In a nutshell, KC's financial performance could possibly be volatile in the quarters ahead as the company continues with the optimization of its CDN business.

Bright Spots Relating To Enterprise Cloud And AI

It isn't all doom and gloom for Kingsoft Cloud, despite the Q3 2023 results miss and the downward revision in its consensus financial forecasts. There are certain bright spots for KC relating to the profitability improvement for the company's enterprise cloud services business segment (as opposed to the public cloud segment which includes the CDN business) and robust AI demand.

With my earlier October 2023 article, I mentioned that KC's "enterprise cloud business has been more selective when it comes to taking on new projects." This has paid off in the form of margin expansion for the enterprise cloud services segment. Kingsoft Cloud's enterprise cloud services business saw its segment gross profit margin increase by +110 basis points YoY from 23.1% for Q2 2023 to 24.2% in Q3 2023 at the expense of a minor -2.2% YoY segment revenue contraction.

Specifically, Camelot, a company that Kingsoft Cloud invested in 2021 , is expected to be a key growth driver for KC's enterprise cloud business. Camelot refers to itself as "the largest domestic provider of SAP-based Enterprise Resource Planning services in China" in its press releases . KC shared at its most recent quarterly earnings call that Camelot's "profitability has been rising again steadily" on the back of securing five new clients in Q3 2023.

Separately, Kingsoft Cloud revealed at the company's Q3 2023 results briefing that its AI-related sales increased by more than +70% QoQ for the recent quarter without disclosing the exact amount of AI revenue. It is also worthy of note that the company's AI business already achieved positive gross profit in the latest quarter.

As an indication of the long-term growth potential of KC's AI business, there was a substantial acceleration in investments for the recent quarter. Kingsoft Cloud's capital expenditures associated with the AI business were in excess of RMB400 million for the third quarter of 2023, which was higher than KC's total AI-related capital spending between Q4 2022 and Q2 2023.

KC Stock Is Fairly Valued

In the past six months, Kingsoft Cloud's shares have fallen by -34.1% as compared to a +10.3% increase for the S&P 500 over the same time period. But I think that the stock is at a fair valuation, rather than being undervalued.

The market values KC at a consensus forward next twelve months' price-to-sales multiple of 0.84 times as per S&P Capital IQ . It is justified that Kingsoft Cloud's market capitalization is at a discount to its revenue, as the company's consensus FY 2023-2025 revenue CAGR forecast is a modest +9.5% (assuming that 20% top line growth is a benchmark for fast-growing businesses).

Analysts see Kingsoft Cloud turning EBITDA positive in FY 2024 before generating a meaningful amount of EBITDA (RMB488 million to be exact) for FY 2025 as per S&P Capital IQ's consensus data. Kingsoft Cloud currently trades at 8.0 times consensus forward FY 2025 EV/EBITDA. According to Apollo Global Management's ( APO ) research , the median EV/EBITDA multiple for private equity buyouts in the 2010-2022 time frame was in the 8-12 times EV/EBITDA range. As such, it is reasonable to view KC's 8.0 times EV/EBITDA as a "fair" multiple.

Final Thoughts

KC's prospects are mixed. The restructuring of the company's CDN business is only expected to be completed in the third quarter of next year, although Kingsoft Cloud's AI and cloud enterprise services businesses hold promise. Moreover, KC's valuations are fair. These factors support a Hold rating for Kingsoft Cloud.

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