KC.US 3896.HK

The cloud services provider reported a sharp gross margin increase in the first quarter as it jettisoned less-profitable customers

Key Takeaways:

  • Kingsoft Cloud reported its first-quarter revenue fell 14.2%, but its gross margin improved significantly as it focused on customer quality over quantity
  • The company dismissed recent reports of a growing price war in China’s cloud services market as ‘more geared towards PR purposes’

  

By Doug Young  

Stormy times ahead, or just a passing drizzle?

That’s the big question on the horizon for Kingsoft Cloud Holdings Ltd. (KC.US; 3888.HK), which has just reported a mixed bag of quarterly results that may or may not reflect a widely reported growing price war in China’s cloud services sector. The company’s latest earnings report shows its revenue fell 14.2% year-on-year in the first quarter, which is never a good sign for a company in this kind of high-growth sector.

But Kingsoft Cloud executives were quick to downplay reports of a building price war in China’s highly competitive cloud services sector, with CEO Zou Tao saying the reports were “more geared towards PR purposes.”

“The tier players catalog price cut is actually limited, if we just take a close look at the specific products that are included in this action,” he said on the company’s earnings call this week. “And we also do not think that it has any material impact to the industry as of now.”

Investors didn’t seem too reassured by Zou’s assessment. Kingsoft Cloud’s New York-listed shares tumbled 15.7% in the two trading days after the release of its latest results, and have now lost more than half their value from a peak in early April. But we should also point out the April run-up looks like an anomaly based on speculative buying, and even after the latest sell-off the stock is still up slightly year-to-date.

China’s cloud services industry is very much a poster child for the kinds of freakish things that happen in sectors that Beijing has selected for strong promotion, and at the same time closes off to foreign participation. Both of those factors apply in this case.

Big global names like Amazon (AMZN.US) and Microsoft (MSFT.US) are only allowed to enter China’s lucrative cloud services business by working with local partners due to the ban on foreign ownership of such sensitive telecoms infrastructure. As a result, those global companies are largely marginal players in China, leaving the field open for domination by local companies that are often lured by strong government incentives.

In this case, nearly all of China’s major tech companies have jumped on the cloud bandwagon, with diverse names from internet giants Alibaba (BABA.US; 9988.HK), JD.com (JD.US; 9618.HK), Tencent (0700.HK) and Baidu (BIDU.US; 9888.HK), to telecoms titans like Huawei and China Mobile (0941.HK) all offering both public and enterprise cloud services. Alibaba, in particular, may be trying to boost its market share right now as it prepares to spin off and eventually separately list its cloud services unit, which is one of its few profitable divisions outside its core e-commerce business.

Alibaba was one of the first to slash its prices, announcing price cuts of up to 50% for some of its services last month. Tencent and China Mobile joined the fray last week by announcing their own cuts of up to 40% for the former and 60% for the latter. JD.com joined in this week by announcing its own cuts to some services.

Market share grab

Perhaps it’s all a PR exercise, as Zou indicated, since most of the reports indicate the cuts are only for select packages and may only be offered for limited times. But this kind of price war is quite common in China, especially during economically slow times like we’re seeing now.

Here, we should also point out that this price war really only dates back to April, meaning any impact for Kingsoft Cloud wouldn’t show up until its second-quarter results.

In that regard, the company seemed to indicate it wasn’t anticipating any big impact just yet, forecasting its second-quarter revenue would be roughly flat year-on-year. Specifically, it forecast its second-quarter revenue would land between 1.85 billion yuan and 2 billion yuan, which would represent anywhere from a 3% decline at the low end to a 5% gain from last year’s 1.91 billion yuan, and would be roughly flat at the midpoint of that range.

That would be a big improvement from the 14.2% first-quarter decline, which saw the company’s revenue fall to 1.86 billion yuan in the first three months of this year from 2.17 billion yuan a year earlier. Kingsoft Cloud attributed the decline to becoming more selective in choosing customers for both its public cloud services that account for about two-thirds of its revenue, and its enterprise services that make up the remainder.

Some cynics might say the company’s growing “selectiveness” may simply refer to the loss of customers who jumped ship for better deals from its rivals. But a look at Kingsoft Cloud’s improving margins appears to show it is serious about jettisoning lower-paying, less profitable customers in a bid to eventually earn a profit.

The company’s cost of revenue fell by 20% during the quarter, outpacing its revenue decline, though its operating expenses actually rose 30% during the period. Still, the former costs are a much larger percentage of the company’s total, and the big decline in that area helped the company significantly boost its gross margin to 10.4% from 3.7% a year earlier.

The bottom line for Kingsoft Cloud is that the company appears to be focused on quality over quantity, specifically aiming for higher-paying customers that can help it to operate profitably, and letting go of lower-paying ones that are simply good for market share. The problem, of course, is that even the higher-paying customers may also decide to jump ship if they can get better deals from big names like Alibaba and Tencent.

Concerns that such an exodus might happen, which might force Kingsoft Cloud to lower its own prices, were probably a factor behind the selloff in the company’s shares following the latest results announcement.

Following that selloff, Kingsoft Cloud’s stock trades at a price-to-sales (P/S) ratio of 1.17, which is hardly what you would expect for a company in such a high-growth sector. Even Ming Yuan Cloud (0909.HK), which offers cloud services to the embattled property sector, trades at a higher P/S of 3.24. Then again, Kingsoft Cloud isn’t exactly growing these days, and its revenue contraction could continue for at least the next few quarters if the recent price war doesn’t ease soon.

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