Kingsoft Cloud: China's Largest Independent Cloud Service Provider

Elevator Pitch

I have a Neutral rating on Chinese independent cloud service provider Kingsoft Cloud Holdings Limited (KC). I will consider upgrading the stock's rating in the future, if Kingsoft Cloud shows greater progress in penetrating the enterprise cloud market and diversifies its customer base to mitigate revenue concentration risks.

An increasing number of Chinese companies are adopting a multi-cloud strategy, and Kingsoft Cloud is a potential beneficiary as the largest independent cloud service provider in China. Kingsoft Cloud is also picking the right spots with its focus on premium customers and key verticals.

On the flip side, Kingsoft Cloud still derives the majority of its revenue from public cloud service, suggesting that more work has to be done to grow its presence in the enterprise cloud segment. Kingsoft Cloud also suffers from concentration risks, as it derives a significant proportion of its revenue from its largest shareholders and its top customers. Also, Kingsoft Cloud's valuations are not very attractive at 8.3 times trailing twelve months' Enterprise Value-to-Revenue and 4.9 times consensus forward next twelve months' Enterprise Value-to-Revenue.

Company Description

Started in 2012 as a subsidiary of Chinese software and internet service company Kingsoft Group, Kingsoft Cloud Holdings Limited is the largest independent cloud service provider in China. Kingsoft Cloud was subsequently spun off and listed as a separate independent entity on the Nasdaq on May 8, 2020. Kingsoft Group remains Kingsoft Cloud's largest shareholder with a 43.5% stake, while Hong Kong-listed Chinese smartphone manufacturer Xiaomi Corporation (OTCPK:XIACY) [1810:HK] is the company's second largest shareholder with a 13.8% equity interest.

The Need For Independent Service Providers In The Growing Chinese Cloud Market

Kingsoft Cloud is one of the leading companies in a growing Chinese cloud market.

The internet cloud service market in China is expected to grow by a +28.3% CAGR from RMB53.8 billion in 2019 to RMB217.5 billion in 2024, according to research by Frost & Sullivan. It is also noteworthy that the proportion of cloud service as a percentage of total IT spending was only 6.0% in China in 2019, as compared to a ratio of 15.8% for the US last year. This suggests that cloud service in China still has room for further growth to catch up with other developed markets in terms of market penetration.

The coronavirus pandemic has also helped to accelerate the growth of the Chinese cloud service market. At the company's 3Q 2020 earnings call on November 18, 2020, Kingsoft Cloud noted that "our revenues still grew very healthy even on a sequential basis" after June 2020 with COVID-19 relatively well-contained in China, because "the pandemic has changed many habits of people as more and more people got used to online service".

Kingsoft Cloud is the country's third largest internet cloud service provider in China based on its revenue derived from IaaS (Internet-as-a-Service) and PaaS (Platform-as-a-Service) public cloud service, and it had a market share of 5.4% in 2019. Furthermore, Kingsoft Cloud is seen as a pioneer in China's video cloud sub-sector, as the company was the first in the country to provide video cloud solutions to customers. The current clients of its video cloud service include notable names such as ByteDance (BDNCE), Bilibili (BILI) and iQIYI (IQ), among others.

Apart from capitalizing on the growth of the cloud market in China, Kingsoft Cloud is well-positioned to grab market share from its larger rivals as a result of its status as an independent player that is not affiliated with any of the internet giants in China. The company highlighted at its recent 3Q 2020 results briefing that the "multi-cloud strategy" is "a technology capability requirement", and "more customers would like to select us to be their second vendor" as Kingsoft Cloud is "a leading neutral cloud service provider."

Kingsoft Cloud is the largest independent cloud service provider in China, and it stands to benefit from the trend of an increasing number of companies adopting a multi-cloud strategy. A multi-cloud strategy is deemed as necessary for many Chinese companies, as the reliance on a single cloud service provider exposes them to the potential risks of downtime and data loss. More importantly, some of these Chinese companies are competing directly with the internet giants such as Tencent (OTCPK:TCEHY) (OTCPK:TCTZF) [700:HK] and Alibaba (BABA), and they prefer to work with independent cloud service providers such as Kingsoft Cloud.

Picking The Right Spots

Strategy is very much about choosing where to compete, and Kingsoft Cloud is picking the right spots. The company emphasized at its 3Q 2020 earnings call on November 18, 2020 that it remains "very focused on the key verticals" and "the premium customer strategy."

Kingsoft Cloud defines premium customers as clients with annual or annualized revenues exceeding RMB700,000, and this group of customers contributed 97.4% of the company's top line in FY 2019. The number of premium customers for Kingsoft Cloud more than doubled from 113 in FY 2017 to 243 in FY 2019, while the mean revenue per premium customers also grew from RMB10.3 million to RMB15.9 million over the same period. More importantly, Kingsoft Cloud is not only winning new premium customers but also retaining existing ones. The net dollar retention rate of Kingsoft Cloud's public cloud service premium customers was 155% in FY 2019.

Separately, Kingsoft Cloud focuses its attention and allocates its resources to growing verticals such as video, gaming and financial service.

Within the internet cloud market, the video sub-sector is forecasted by Frost & Sullivan to be the fastest-growing (as compared to the other sub-sectors), boasting a CAGR of +37.9% for the 2019-2024 period. The gaming sub-sector is expected to be the second fastest-growing sub-sector within the Chinese internet cloud market with a 2019-2024 CAGR of +36.8%. In the cloud market for traditional enterprises and public service organizations in China, Frost & Sullivan sees financial service as the second fastest-growing sub-sector (after the manufacturing sub-sector) with a CAGR of +28.1% for the 2019-2024 period. In other words, Kingsoft Cloud has positioned itself in the fastest-growing sub-sectors of China's cloud market.

A new vertical which Kingsoft Cloud has been aggressively expanding into is the healthcare sector, and one example is a new health care big data project in the Hubei province with a budget of RMB56.8 million. The company disclosed at its recent 3Q 2020 earnings call that it is making "great progress in these (healthcare) projects, and we believe we will be a leading player in China in the health care sector."

More Work Needs To Be Done To Grow Enterprise Cloud Market Segment

Kingsoft Cloud generated 87.4% of its FY 2019 revenue from its core public cloud service business, and the company has almost three times the number of public cloud service premium customers (175) as compared to the number of cloud service premium customers (67) as of December 31, 2019. This suggests that Kingsoft Cloud is still too reliant on its core public cloud service business, and the company needs to work harder to grow its presence in the enterprise cloud service market.

At its 3Q 2020 earnings call on November 18, 2020, Kingsoft Cloud acknowledged that the enterprise cloud market "is much larger than the public cloud service market" and disclosed that the company has a target of growing the revenue contribution from enterprise cloud to one-third of its total revenue by 2023-2024. Notably, Kingsoft Cloud's enterprise cloud service revenue grew +66.2% QoQ and +257.3% YoY to RMB409.1 million in 3Q 2020, and accounted for 23.7% of its total revenue in the most recent quarter (as compared to 11.4% in 3Q 2019).

The 3Q 2020 results suggest that Kingsoft Cloud is making good progress with respect to its plans to increase revenue contribution from enterprise cloud, but it is necessary to note that the company benefited from a surge in project deliveries in 3Q 2020, as many enterprise cloud projects were earlier delayed due to the COVID-19 outbreak in 1H 2020. More importantly, while Kingsoft Cloud already has a firm foothold in the Chinese internet cloud market, the company faces stiffer competition in the domestic enterprise cloud market with established IT service providers already dominating this crowded space.

Concentration Risks In The Spotlight

Kingsoft Cloud suffers from concentration risks, as the company derives a significant proportion of its revenue from its largest shareholders and its top customers. The company generated 2.8% and 14.4% of its sales from Kingsoft Group and Xiaomi in FY 2019, respectively. Its top three clients, including Xiaomi, in aggregate accounted for approximately 57% of its FY 2019 revenue.

Kingsoft Cloud's largest customer contributed 31% of the company's FY 2019 revenue, and this top client is speculated to be ByteDance, which is best known for its short video app TikTok. ByteDance has been highlighted as a threat to national security by the Trump administration, and the company was in talks earlier to divest its US operations.

It is clear that investors and sell-side analysts are concerned about the revenue concentration risks associated with ByteDance. At the company's recent 3Q 2020 results briefing, one of the attendees highlighted that "ByteDance started their own cloud business" and asked if this will "affect our revenue growth from ByteDance." Kingsoft Cloud responded to the question by saying that "to our knowledge, the cloud service provided by ByteDance is now the same from us" and "we still keep a very close and healthy relationship with our customers."

Nevertheless, if ByteDance reduces the amount of business it does with Kingsoft Cloud going forward, it could have a significant negative impact on the company's future revenue growth.

Valuation And Risk Factors

Kingsoft Cloud trades at 8.3 times trailing twelve months' Enterprise Value-to-Revenue and 4.9 times consensus forward next twelve months' Enterprise Value-to-Revenue based on its share price of $36.76 as of November 25, 2020. In contrast, peers UCloud Technology Co., Ltd. [688158:CH] and Wangsu Science & Technology Co., Ltd. [300017:CH] are valued by the market at consensus forward next twelve months' Enterprise Value-to-Revenue multiples of 9.9 times and 2.2 times, respectively.

The key risk factors for Kingsoft Cloud are a failure to grow revenue contribution from the enterprise cloud market in line with market expectations, and a significant decrease in revenue from its largest customers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.