Kingsoft Corp Ltd

HKEX:3888

Earnings Call Transcript 2018-Q4

[Operator]

Ladies and gentlemen, good day, and welcome to Fourth Quarter 2018 Kingsoft Corporation Earnings Conference Call. [Operator Instructions] I must advise that this conference is being recorded today, Tuesday, 26th of March, 2019.

I'd like to hand the conference over to your first speaker for today, Ms. Francie Lu. Thank you. Go ahead.

[Francie Lu, executive]

Thank you. Ladies and gentlemen, good evening and good morning. I would like to welcome everyone to our 2018 fourth quarter and annual earnings call. I'm Francie Lu, the IR Director of Kingsoft.

I would like to start by reminding you that some information provided during the earnings call may include forward-looking statements, which may not be relied upon in the future for various reasons. These forward-looking statements are based on our own information and information from other sources, which we believe to be reliable. Please refer to the other publicly disclosed documents for detailed discussion on risk factors, which may affect our business and operations.

Having said that, please allow me to introduce our management team who join us today: Mr. Zou Tao, our Executive Director and CEO; and Mr. Francis Ng, our Executive Director and CFO.

Now I'm turning the call to Mr. Zou.

[Tao Zou, executive]

[Foreign Language]

[Francie Lu, executive]

I will do the translation for Mr. Zou. We delivered a steady fourth quarter in 2018 and our revenue continued to grow. I was encouraged by the outstanding performance of our cloud services and office software and services during the quarter and the year. One of the highlights was Kingsoft Cloud's progressing in video cloud sector with strong revenue growth. WPS Office products continued to attract more and more users, and an ecosystem surrounding the products was gradually established. We launched a new season for our flagship JX Online III PC game, and our existing mobile game, JX Online I, maintained its performance during the quarter even though China's game market experienced a number of uncertainties at the time. The development in these businesses was in line with our strategic planning.

Our top line in the fourth quarter continued to grow, increasing 27% year-on-year and 14% quarter-on-quarter to RMB 1,759 million. The revenue growth reflected our strong and stable execution capability under the changing environment. We were particularly delighted to see the cloud services and office software and service and other businesses maintaining their robust growth during the quarter, with revenue reaching a 20% and 46% quarter-on-quarter growth, respectively.

Now I'm turning the call to our CFO, Francis.

[Yuk Keung Ng, executive]

Okay. Thank you, Francie. Hi, everyone. Before I start, I would like to explain the operating results, Cheetah Mobile, which has been presented as a discontinued operation for the 9 months ended September 30, 2017. From October 1, 2017, we started to account our interest in Cheetah Mobile as an associate. That means that we are no longer fully consolidate Cheetah Mobile's top line and expenses, will equity pick up our share of product in the associate.

With the changing market and regulation environment in China, the performance of our online games business was under pressure in 2018, just like other major gaming companies in -- last year. Nevertheless, our flagship PC game, JX Online III, launched a new season in this quarter and was much welcomed by our gamers. The update of game not only provided our gamer with a new game experience but also strengthened our confidence in the long-term development of the game. In 2018, we continued to host JX Online III Master Competition to further development -- to further develop the e-sports business. The peak concurrent viewer of the competition reached 11.23 million across all the streaming platform in 2018, which helped to bring the new value of our classic IP.

Our existing mobile game, JX Online I, performed well during the quarter and maintained its popularity among gamers. We released new mobile game, including JX World II and the Legend of Sword and Fairy 4 in 2018, which also recorded decent performances. We are going to focus on our cooperation with Tencent in the coming year on the release of our key mobile games, JX Online III and JX Online II. Going forward, in response to the changing market and rapidly evolving game industry, we will continue to focus on improving user experience and provide high-quality content.

In the fourth quarter, Kingsoft Cloud maintained its leading position in video sector, with breakthrough in enterprise cloud markets, such as government, finance, health care and media, leading to a rapid growth of the business. Under the changing network environment and player terminal, the revenue of video cloud business continued its fast growth, with achievement in the application of AI-based products, such as Image Enhancement and Smart High Definition for video cloud services. Regarding the financial cloud, Kingsoft Cloud became an important cooperative partner with China Construction Bank during the bank's strategic Fintech transformation. In the face of an increasingly competitive market, Kingsoft Cloud is confident to continue to develop the verticals by leveraging its established cloud ecosystem, talented team and strong reach (sic) [ research ] and development capabilities. Kingsoft Cloud will work with the upstream and downstream partners, continue to promote the all-cloud services and strive to meet the customer needs for optimizing cost and better experience.

For the fourth quarter 2018, WPS Office continued its healthy growth by adding a series of smart and efficient products and features to attract a larger user base. As of November 2018, the monthly active user of Android WPS Office has exceeded 100 million in Mainland China. The monthly active user of WPS Docs, our online collaborative office application, exceeded 69 million within 4 months after its release. And at the same time, the user of its WeChat Mini Program version exceeded 80 million at the end of 2018. My WPS, the WeChat Mini Program serving WPS members, ranked among the top 10 million (sic) [ top 10 mini ] program on the Aladdin Index and was the only utility application on the list. With its rapid growth in overseas market, WPS Office recently won the 2018 Top App for Overseas Growth presented by App Annie. After teaming up with Alibaba's DingTalk in December 2018, WPS provided a customized Web Office for DingTalk Smart Docs, aiming to create a smart office ecosystem through its open platform.

To better meet the needs of government and enterprise clients, WPS 2019 rolled out new features in security and collaboration. At the global AI Challenger 2018, our AI LAB team won the first and the second place in the competition of machine translation, which is an AI technology in language -- natural language processing that will be applied to our smart writing products. Such technology is expected to quickly enhance the user experience in creative writing and office work.

As for the financial results, I'm starting the Q4 using RMB as a currency. Revenue increased 27% year-over-year and 14% quarter-over-quarter to CNY 1,759 million. The revenue split was 37% for our online games, 41% for our cloud services and 22% for our office software and others. You'll notice that the cloud service contribution ranked #1 since the last quarter 2018.

Revenue from online games business decreased 12% year-over-year and 3% quarter-over-quarter to CNY 659 million. The year-over-year decreases largely reflected natural declining life cycle of existing games, partially offset by the revenue contribution from introducing a series of new mobile games.

Average -- ADPCU for group's online game decreased 23% year-over-year and 8% quarter-over-quarter to 0.7 million. APA, average paying account, for the group's online game decreased 24% year-over-year and 11% quarter-over-quarter to 3 million. The decreases were largely due to the natural declining of life cycle of existing games, and yet we expected the online -- JX Online III and JX Online II mobile will be launching later this year.

Revenue from the cloud services increased 81% year-over-year and 20% quarter-over-quarter to CNY 727 million. The strong increases were mainly due to the increased usage from mobile video, Internet sectors and revenue growth on enterprise cloud services, demonstrating that Kingsoft Cloud further strengthened the leading position in specific sectors and enlarged enterprise cloud business by providing comprehensive cloud services with advanced technology.

Revenue from office software and services and others increased 64% year-over-year and 46% quarter-over-quarter to CNY 373 million. The year-over-year increase was mainly due to, firstly, the VAS -- revenue growth on the value-added service of WPS Office personal edition and the sales of enterprise edition, driven by providing more intelligent function and richer content; and secondly, the healthy revenue growth of WPS online marketing services driven by increased user traffic by continuous optimization of operational strategy. The quarter-over-quarter increase primarily reflected the favorable seasonality of sales of WPS Office enterprise edition and the revenue of online marketing service of its personal edition.

Cost of revenue increased 64% year-over-year and 19% quarter-over-quarter to CNY 1,004 million. The increases were primarily due to the increase in bandwidth and IDC costs associating with fast-growing customer usage and increased investments in cloud business as well.

Gross profit decreased 2% year-over-year and increased 9% quarter-over-quarter to CNY 755 million. The GP margin decreased by 13 percentage point year-over-year and 2 percentage point quarter-over-quarter to 43%. The decreases of gross profit margins are mainly due to an increased revenue contribution from cloud services, which has relatively lower gross profit margin and higher growth potential.

Our research and development cost net increase is 28% year-over-year and kept flat with last quarter to CNY 515 million. The year-over-year increase was mainly due to the enhanced R&D investments, reflecting that we engage in developing new technology and further improving the function of our product and optimizing user experience.

Selling and distribution expenses increased 23% year-over-year and decreased 6% quarter-over-quarter to CNY 215 million. The year-over-year increase primarily reflected the increased investment of WPS and cloud business in exploring enterprise and government markets. And the quarter-over-quarter decrease were mainly due to the decreased promotion activity of online games.

Administrative expenses increased 85% year-over-year and 27% quarter-over-quarter to CNY 146 million. And the year-over-year increases were largely due to the increased staff-related costs and professional fees. The quarter-over-quarter increase were mainly attributable to an increased professional services fee.

Share-based compensation costs increased 1% year-over-year and 1% quarter-over-quarter to CNY 51 million. Operating loss before share-based compensation costs was CNY 105 million compared to profit of CNY 189 million in corresponding period last year and a loss of CNY 134 million in the third quarter 2018.

Net other losses were CNY 8 million compared to net other losses of CNY 20 million in the corresponding period last year and the net losses of CNY 83 million in third quarter 2018. The net losses in the third quarter 2018 was primarily due to the recognition of foreign exchange loss.

We recorded share of profit of associates of CNY 261 million for the fourth quarter 2018 compared to the share of profit of CNY 60 million in the fourth quarter 2017 and a share of profits of CNY 28 million for the third quarter 2018. The profits of the fourth quarter 2018 was mainly due to the Cheetah Mobile disposal share in a certain investing company in the fourth quarter.

Income tax expenses for the fourth quarter 2018 was CNY 11 million compared to income tax benefit of CNY 5 million and income tax expenses of CNY 29 million for the fourth quarter 2017 and the third quarter of 2018, respectively. The year-over-year changes were primarily attributable to the specific deferred tax assets recognized in the fourth quarter 2017. As a result of the reasons discussed above, the profit attributable to owners of parents was CNY 229 million compared to a profit of CNY 2,475 million in the corresponding period last year and a loss of CNY 59 million in the third quarter 2018. Profit to owners of parents, excluding ESOP, was CNY 262 million compared to profit of CNY 2,508 million in the corresponding period last year and a loss of CNY 22 million in the third quarter 2018.

Let's turn to the full year 2018. Revenue increased 14% year-over-year to CNY 5,906 million. Online game make up 43%, decreased 18% year-over-year to CNY 2,552 million. Cloud services make up 38%, increased -- and increases 66% year-over-year to CNY 2,218 million. And office software and services and others make up 19% and increase 56% year-over-year to CNY 1,137 million. Gross profit margin decreased 12-percentage point year-over-year to 46%. Profit to the owner of parents was CNY 389 million and CNY 3,202 million for the year ended 2018 and 2017, respectively.

On our balance sheet, we have cash and bank deposit of CNY 9.9 billion at the end of 2018. Net cash generated from operating activity was CNY 770 million. Capital expenditure was CNY 1,406 million and CNY 722 million for the year ended 31 December 2018 and December 31, 2017, respectively.

In the face of the changing marketing condition, as mentioned earlier by Mr. Zou, we achieved a year of steady revenue growth with the group's hard work in 2018. Our profitability was affected, but then yet our fundamental remained intact. Looking ahead, we see a clear momentum of growth, driven by the further development of all our business. We expect to bring our new flagship mobile games to our user within this year and continue strong growth and development for -- of our cloud services and office software and services business. With all these initiative, I'm confident that our performance will be improved in 2019.

This conclude my presentation. Now I hand over the call to question and answer.

[Francie Lu, executive]

Operator, we're ready for the Q&A session.

[Operator]

[Operator Instructions] Our first question comes from the line of Liping Zhao of CICC.

[Liping Zhao, analyst]

[Foreign Language] I'll do the translation by myself. So I have 3 questions for the management. The first one is related to our game pipeline because the market is waiting for the most flagship game, JX III mobile. And also, there is cooperated game with Bilibili. So can management share what's the time line for that 2 games? And the second question is related to the outlook of -- or the segment growth in 2019. And the third question is related to WPS margin. We've noticed that that WPS top line has a very strong growth in fourth quarter. But if we calculate the op margin in the second half, there is a little bit decrease. So what's the main reason behind it?

[Tao Zou, executive]

[Foreign Language]

[Yuk Keung Ng, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So with the first question on the games pipeline for JX Online III and [indiscernible]. For JX Online III, as you all know, a few days ago, the Tencent new game release conference, creators already promised to launch the JX Online III mobile game the latest by the second quarter of 2019. So based on our recent testing results, we believe that the game could be launched in early June of 2019. And for [indiscernible], we have not got the license for this game yet. So we are planning to launch the game in April or May in Japan first. And regarding for the license, we believe that we could get a license later in the year. And for the second question on the financial guidance, Francis just explained that in 2018, our revenue for the game business had a 18% year-on-year decline. So this had a big impact on our profit because the game is still our most profitable business. Although WPS has been performing very well in 2018, the scale for WPS is still quite small comparing to the other businesses. The cloud also grows very fast in 2018, but it's still in its investment stage. In 2019, as Mr. Zou already said, we have passed our most difficult times. So we believe that with the new launch of JX Online III and JX Online II in 2019, our revenue and also profit will improve in the coming year. We still take a more conservative budget for the game business, considering some of the other mobile games have not got their license yet. So with this in mind, we're guiding a close to 30% growth rate for game in 2019. As games business still very profitable, as you all know, a lot of our R&D investment has already expensed in the past. So once the game start to launch, it will have a big improvement on our profit.

[Yuk Keung Ng, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So for WPS, it start to grow very fast in both mobile and PC and -- as well as the memberships. So we believe that we can maintain a high growth rate around 20% growth in top line in 2019. And in terms of operating profit margin, it will maintain a healthy margin of over 20% similar to what we had in 2018. And for the cloud business, with the strong growth momentum, we believe that our top line growth will be 60% and over and the op margin will have a significant improvement comparing to what we had in 2018. So overall, this is the guidance for the 3 businesses for 2019.

[Yuk Keung Ng, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So with -- regarding on the WPS op margin performance in the second quarter, the decline was a deliberate action. WPS, as you all know, is a driver in Kingsoft. So we decided to invest in new areas such as AI and also the overseas development. So we increased our investment in the new areas and the number of staff also increased in the second quarter of 2018. And we also started a new development center in [ Yuhan ] as well. So the margin decreased a little bit in 2018 second -- in the second half, but we believe that you will all support our Board of Directors and management team's decision because WPS, we're not only focusing on the short-term profit, but more importantly, we're focusing on its long-term development.

[Operator]

Our next question comes from the line of Thomas Chong of Crédit Suisse.

[Yiu Hung Chong, analyst]

I have 2 questions. My first question is about our strong cloud revenue in Q4. I just want to get a sense about how we should think about our 2019 outlook given that we have 60% year-on-year or even more higher growth for this year. Just want to understand about the dynamics behind, in particular, the trend among different industry categories. For example, how we should think about the driver? Is it video cloud, game cloud? And what's our competitive edge over our peers? And my second question is back to the online games. Understand that we're having 30% year-on-year growth, but can management give us some color about the growth trend for the PC games in 2019? [Foreign Language]

[Tao Zou, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So for the strong growth for the cloud business in the past, one of the area is video cloud. We maintain a leading position in the market. Our revenue maintain a very strong growth in 2018. And the second area is the government enterprise, which we call the non-internet businesses. The growth is also very, very high in this category. One of the example is the contract that we get from the China Construction Bank. We're 1 of the 2 partners for this contract with CCB. So for the reasons for the cloud -- the advantage for our cloud business, we have 3 advantages. The first one is the timing. We believe that the cloud in China is still at its early development stage. So as you all know that some -- our competitors, some of the other cloud companies are -- their revenue is also growing very fast. So we believe that we are not at a point for serious competition for the market share with each other yet. So we are still growing very fast as we enter into the business at the early stage, and we have developed a good technology, good resources and good R&D capability through the past 5 to 6 years. And the second advantage is actually the nature of the 2B business. The business, by nature, is not a winner-take-all market. So it's not only a game of scale for 2B businesses. We could compete with our competitors based on their past experience even though we are not as strong as some of our competitors in terms of our scale or the financial resources. The last advantage is actually our technology capability. The China Construction Bank has one milestone to prove that we were at least as good as our competitors in terms of technology. So we believe that the timing of the market, which is at the early stage, and also the 2B business as a nature and also our capability in terms of technology are the 3 main reasons for the fast and strong growth for our cloud businesses.

[Tao Zou, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So I'll translate for Mr. Zou. So for PC and mobile games, basically, JX Online III is our last major PC game and all the other new games will be on the mobile side. So going forward, the mobile revenue contribution will be larger than the PC game revenue contribution in the future. And for the PC game, as you all know, from the Internet mobile transformation in China, the new PC gamers have declined in the past and that's also one of the reasons why our JX Online III PC game revenue declined in 2018. But this is one of the reasons I already explained in the past. Another reason for the JX Online III PC revenue decline was because we launched a revamped version for the game, but the revamped version was mainly engine update to the game. We didn't launch any new content until the very end of last year. And the trend is more industry-wise trend. So this will also apply to Kingsoft.

[Operator]

We have our next question from the line of Hillman Chan of Citigroup.

[Hillman Chan, analyst]

[Foreign Language] So my first question is about the pickup in the gross margin for the Kingsoft Cloud businesses. Could management share more color on the rationale behind in terms of perhaps the pricing and also the cost for that? And also, my second question will be -- if management can share more on the performance of the beta testing for JX mobile III and II. And also, what is the launch date for mobile JX II? And the last question is about WPS growth [ to 100% ] on the growth strategy for the personal and the enterprise versions. And how we should think about the features like in this year as part and also the upcoming growth in advertising?

[Yuk Keung Ng, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So for the cloud margin improvement, in 2019, our revenue will -- we believe, will continue to grow at over 60%. So our op margin will have a significant improvement. The reason behind that -- we have 2 major reasons. The first one is the scale of economy. With the top line of 60% and up growth, we'll definitely leverage our scale -- economy of scale because some of the R&D and fixed costs will now increase proportionally with the revenue increase. The second reason is that with the scale increase, our efficiency will also increase in both public and private cloud. So due to the most recent on the economy of scale and also the efficiency improvement, we believe that the margin will improve in 2019.

[Tao Zou, executive]

[Foreign Language]

[Francie Lu, executive]

Okay. So for the mobile game testing data, I cannot disclose the detailed results from the testing, but for JX Online III mobile game, we have already completed the PR1 testing. So we're going to start the PR2 testing in March or April. And based on the result from the PR1 testing for JX Online III mobile, I can say that it's very similar to what we have for JX Online I in 2016. And as I said earlier that we're aiming to launch the JX Online III mobile game in -- by end of May or early June this year, and this is a mutual agreement between Kingsoft and Tencent. And for JX Online II mobile game, we have not done the PR1 testing yet. We have done several rounds of small-scale testing in the past. For the launching time, we're going to have -- we're going to launch the JX Online II mobile game after JX Online III mobile game for at least 2 to 3 months later. For the WPS question, for the WPS enterprise version, we have obviously gradually completed the transition from the onetime licensing business model to the subscription model. And also, we think that now it's a good time and it's also a good opportunity for WPS enterprise product to grow in China, especially after the U.S.-China trade war, and the government is promoting domestic product. And in this area, basically, WPS does not have any competitor in China. And for the personal edition, we are developing -- we're still continuing to develop the cloud strategy for the personal version and also the AI strategy. We launched WPS 2019 last year. Basically, we have already applied a lot of the AI functions. And we are going to continue with this strategy going forward to improve its efficiency for the WPS personal version. And also in this year, 2019, we are going to officially start our overseas development for WPS. Basically, in the past, we have not done any major investment in the overseas market. But our MAU from the overseas market already exceeded 70 million to 80 million. So in this year, we are going to officially start the overseas strategy, and we have already set up our R&D team in the second half of 2018. So we believe that we could develop in the overseas market, leveraging on our past experience from the domestic market.

[Operator]

Thank you. Ladies and gentlemen, that is the end of our question-and-answer session. Now I'd like to hand the conference back to our presenters. Please go ahead.

[Francie Lu, executive]

This will conclude our presentation today. And thank you, everyone, for your attendance. Thank you.

[Yuk Keung Ng, executive]

Thank you. [Foreign Language]

[Operator]

Thank you. Ladies and gentlemen, that does conclude the conference for today, and thank you for participating. You may now all disconnect. Thank you.