VNET Group, Inc.

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Hello, ladies and gentlemen. Thank you for standing by for the second quarter 2022 earnings conference call for VNet Group Inc. At this time, all participants are in listen-only mode. After the speaker's presentation, after the management's prepared remarks, there will be a question and answer session. Participants from our management include Mr. Samuel Shen, Chief Executive Officer and Executive Chairman of Retail IDC, Mr. Tim Chen, Chief Financial Officer, and Ms. Xingyuan Liu, Investor Relations Director of the company. Please note that today's conference call is being recorded. I'll now turn the call over to the first speaker today, Ms. Xingyuan Liu. Please go ahead.

Thank you, operator. Hello, everyone, and welcome to our second quarter 2022 earnings conference call. Our earnings release was distributed earlier today, and you can find a copy on our IR website as well as our newswire services. Please note that the discussion today will contain forward-looking statements made under the SIFT-HBR provisions of the US Private Securities Litigation Report Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from our current expectations. For detailed discussions of these risks and uncertainties, please refer to our latest annual report and other documents filed with the SEC. VNAT does not undertake any obligations to update any forward-looking statements except as required under applicable laws. Please also know that VNAT's earnings press release and this conference call include the disclosure of unaudited GAAP financial matters as well as unaudited non-GAAP financial matters. VNAT's earnings press release contains a reconciliation of the unaudited non-GAAP matters to the unaudited GAAP matters. As a reminder, this conference is being recorded. In addition, a webcast of this conference call will also be available on our IR website at ir.vnet.com. I will now turn the call over to our CEO, Samuel.

All right. Thank you, Xin Yuan. Good morning and good evening, everyone. Thank you for joining our second quarter 2022 earnings conference call. During the second quarter, our focus remained on driving healthy results and delivering high quality solutions and services to our customers. Our solid growth momentum across our business segments amid macro challenges clearly reflects the effectiveness of our growth strategy and our strong execution capabilities. On the operations front, total cabinets under management increased to approximately 80,800 by the end of the second quarter, compared with approximately 62,900 one year ago. At the same time, cabinets utilized by customers increased sequentially by approximately 1,500 to 44,500 by the end of the second quarter, compared with approximately 36,600 one year ago. Accordingly, the overall utilization rate maintained a sequential ramp-up, reaching 55.1% by the end of the second quarter. Our retail MRR per cabinet reached RMB 9,186, showing a healthy increase from the same period last year. On the financial front, we delivered a robust financial performance, with a year-over-year growth of 15.2% and 14.5% in revenue and adjusted EBITDA year-over-year, respectively. With the rapid growth of China's digital economy, we, as the leading IDT service providers, are in a good position to benefit from this growth momentum and local government supportive measures. This May, the National Committee of the Chinese People's Political Consultative Conference held a consultative session and called for stronger efforts to boost development of the digital economy across a broad swath of industries. Technological empowerment was highlighted as a vital driver for higher quality economic growth. We believe this will carry immense potential to significantly amplify demand for IDC services. Within this environment, We are confident in our strength and our ability to capture exciting new growth opportunities. Next, let's take a closer look at the business updates, starting with the recovery momentum from the impact of COVID resurgences. Encouragingly, in June, with the gradual easing of COVID-19-related lockdowns and mobility restrictions in Shanghai, Beijing, and Hebei Province, We immediately resumed construction on new projects in these areas and have seen moving rates recovering steadily. Next, a review of our progress in key business segments during the quarter. Our wholesale business made solid progress in the second quarter. We once again extended our contract with an existing customer, a leading social platform in China, for building its network infrastructure in the northern region of China. This new order will generate a total capacity of approximately 14 megawatts and further demonstrates our value proposition for this business segment. In addition, we recently signed a new contract of approximately 15 megawatts with the leading cloud service providers in China to build its network infrastructure in the Yangtze River Delta region. In the data center for this customer, aside from conventional air cooling, We will also offer liquid cooling solutions, a more sustainable approach that will help reduce PUE and carbon emissions. Moving on to our retail business, thanks to our diversified customer base, we are pleased to see our retail business growing steadily amid macro challenges. In the second quarter, we leverage our technologies and expertise to cater to various vertical needs, with a suite of various services. Existing customer expansion and new customer acquisition both achieve impressive results, driven by a rising digital demand from a wide variety of industries, such as local service, automobile, financial services, hardware manufacturing, and online gaming. Looking ahead, we plan to harness our advanced engineering capabilities to reach our service portfolios creating more value for our customers and generating more diverse revenue streams. On the blue cloud business front, we continue exploring opportunities that will allow us to diversify our industry-specific cloud solutions. During the second quarter, we extended our manufacturing execution system, aka MES, to a leading automotive city manufacturer in China. Through the delivery of MES, We help the customer manage manufacturing flexibility, improve productivity, and maximize efficiency by deploying digitalization, automation, and new technologies that will provide a real-time workflow visibility, flexibility, and insight into the entire manufacturing operations process, from order release to ready-to-forward shipment. This system has been successfully implemented across all of our customers' production lines, and we're very pleased with the progress we have made in this area. In the meantime, we are actively accumulating more industry-specific expertise and look forward to tap into greater opportunities in the cloud business industry in the future. Despite macro headwinds, the unprecedented COVID-19 resurgence, and lockdowns in the first half of the year, Our sustained growth highlighted our excellent business resilience and our ability to capture the rising demand for high-quality IDC services. However, in the near term, the uncertain economic outlook and threat of COVID-19 outbreaks may bring some short-term challenges to us. While the long-term demand trend is secure, taking into account the short-term challenges of the current slowdown environment and the impact from COVID-related disruptions. We are adjusting our outlook for the full year of 2022 and revising our four-year delivery plan to the range of 9,400 to 12,400 cabinets from previously provided 14,400 to 17,400 cabinets. Going forward, we remain focused on our dual core growth strategy leveraging our scalable service offerings to drive growth and building our customer base across verticals. As an industry frontrunner and a fundamental link in China's digitalization change, we will seize the opportunities from the nation's rapidly expanding and evolving digital economy, creating sustainable value for our stakeholders in the long term. Thank you, everyone. With that, I will now turn the call over to our CFO, Tim Chen, to discuss our financial performance for the quarter and our business outlook. Hi, Tim.

Thank you very much, Samuel. Good morning and good evening, everyone. Before we start the detailed discussion of our financials, please note that we will present non-GATT measures today, and our non-GATT results exclude certain non-cash expenses which are not part of our core operations. The details of these expenses may be found in the reconciliation tables included in our earnings press release. Please also note that unless otherwise stated, all the financials we present today are for the second quarter of 2022 and in women v. terms. For the second quarter, again, we delivered a robust financial performance driven by rising demand from both our wholesale and retail businesses. Our solid financial position gives us a firm foundation to drive a long-term and sustainable growth as we continue to leverage our scalable service offerings and build our customer base across a wider variety of industries. Next, let me walk you through our second quarter financial results. Unless otherwise specified, the growth rates I will be reviewing are all on a year-over-year basis. In the second quarter, our net revenue increased by 15.2% to $1.72 billion from the same period last year. mainly due to increased customer demand for our highly scalable carrier and cloud-neutral IDC solutions from both wholesale and retail IDC customers, as well as a continued growth of our cloud business. Gross profit was $357.8 million in the second quarter of 2022, roughly flat compared with the same period of 2021. Gross margin was 20.7% in the second quarter of 2022 compared to 24% in the same period of 2021. Adjusted cash gross profit, which excludes depreciation, amortization, and share-based composition expenses, was $713.7 million in the second quarter of 2022, an increase of 11.5% from the same period of 2021. Adjusted cash gross margin in the second quarter of 2022 was 41.4% compared to 42.8% in the same period of 2021. Adjusted operating compensation for post-combination employment in an acquisition and impairment of loan receivables to a potential investee were $250.7 million in the second quarter of 2022 compared to $235.6 million in the same period of 2021. As a percentage of net revenues, adjusted operating expenses in the second quarter of 2022 were 14.5% compared to 15.7% in the same period of 2021. Adjusted EBITDA. in the second quarter of 2022 was $486.9 million, representing an increase of 14.5% from the same period of 2021. Adjusted EBITDA in the second quarter of 2022 excluded share-based compensation expenses of $47.5 million. Adjusted EBITDA margin in the second quarter of 2022 was 28.2%, compared to 28.4% in the same period of 2021. Our net loss attributable to ordinary shareholders in the second quarter of 2022 was $377.2 million compared to a net profit of $455.9 million in the same period of 2021. Basic and diluted loss were both 0.43 per ordinary share and both 2.58 per ADS. Each ADS represents six Class A ordinary shares. Turning to our balance sheet, as of June 30, 2022, the aggregate amount of the company's cash, cash equivalent and restricted cash was $3.62 billion. Meanwhile, net cash generated from operating activities in the second quarter of 2022 was $942.7 million compared to $314.8 million in the same period of 2021. Our CapEx in the second quarter of 2022 was $540.6 million. And now, on to our financial outlook. As Samuel mentioned, We faced the impact from COVID-related disruptions in the second quarter of 2022 on data center construction and customer move-in schedules and ongoing macroeconomic uncertainties as well. As a result, we adjusted our outlook for 2022. Based on our current estimates, we expect our net revenues to be in the range of $7,250 million to $7,550 million, and adjusted EBITDA to be in the range of $1,800 million to $1,950 million. We always believe opportunities go alongside challenges. The COVID impacts are short-term in nature, and digitalization is rapidly advancing in the wider society. Looking ahead, we will remain committed to advancing our dual core growth strategy, broadening the spectrum of our services, increasing customer diversification, and capitalizing on the enormous opportunities presented by a thriving digital economy in China. This concludes our prepared remarks for today. Operator, we are now ready to take questions.

Thank you. We will now begin the question and answer session. To ask a question, please press star 11 on your telephone.

First question comes from the line of Ethan Zhang from Dongmura.

Please proceed. Thank you.

Thank you, management, for letting me ask the first question. So I have two questions. The first one is, given the current situation of the electricity supplies in China, especially the heat wave in Sichuan and surrounding areas, how do you see the trend of the utility cost in the second half of this year and the impact on our EBITDA margin? And second question is regarding the CapEx trends. So I remember we guided around 5 billion RMB CapEx for the full year 2022. But during the first half, since that, we only completed a limited portion of our CapEx targets. wonder if we maintain the previous guidance on our CAPEX spending for this year, and how would be our focus or target for CAPEX spending in the second half of this year? Thank you.

Thank you very much, Ethan. Let me take this first two questions. First, in terms of electricity and impact of some of the areas, Sichuan as an example, we do not expect to be a major increase in the electricity tariffs. However, in the areas that are impacted by electricity shortages, not dissimilar to last year and early parts of this year where some of the data centers would need to switch over to diesel. or we would actually acquire diesel in preparation for potential shortfalls in terms of electricity supply. I think that will show up in the figures for the second half, especially for anything in the affected areas. As to the CAPEX and whether there are any changes to the CAPEX guidance, we still expect to spend roughly in a range of 4 billion RMB and that despite some of the capacity being pushed into 2023, as you know, these constructions do have a longer lead time, and so there will still be money being spent with regards to the power infrastructure, the buildings, and so forth. It will just be slowed down a little bit, but we still expect that it will be for the full year around $4 billion. I hope that answers your questions.

Thank you.

Thank you for the questions. Our next question comes from Edison Lee of Jefferies. Please proceed with your question.

Hi, morning, Samuel and Tim. Thank you very much for the presentation. I want to see what kind of power cost increases that you are assuming in your new guidance for the second half. And also, I want to know for the two new wholesale projects, What is the timing in terms of surface launch and EBITDA contribution? Thanks.

Hi, Edison.

Let me talk about the first one first. In terms of the second half, we've assumed small increases in terms of coming from the power side. As you know, some of the power increases already took place in the first half. We do expect a little bit of further increases, but not in really the Tier 1 areas, but I would say the outer areas of the regions. We can go into some more of the details later on, but not a very large increase. I think the full year we had given to the market previously was about a 1% margin impact. I'd say that this moves the needle a little bit in the second half, but nothing that would be very material. Let me pass to Samuel to talk a little bit about the two wholesale wins.

Sure. Thank you, Tim, and also thank you, Addison, for the questions. Regarding the wholesale wins that we announced today, the social platform, it is actually existing customers but with a new contract. And basically, a contract is signed in the second quarter. And then for another one, which is public cloud service providers, and then we're expecting to sign the contract in Q3. And we're very pleased because, you know, spend quite a bit of time working with the customers and finally secure a design win. So that's pretty encouraging for us.

Sorry, Sam, can you talk about the timing of these contracts coming into service and

Oh, yeah. As I said, the social platform wins. That will be second quarter, this quarter. And then for public health service providers, the contract will be signed in Q3, and then we're expecting this to be serviced in the ramp-up starting from Q4 this year. Okay.

So, Edison, both of these, I would say – small or inexorable contribution in 2022, but the ramp-ups should be within 2023.

Is the ramp-up period also two years for these two projects?

They should actually be quite quick. Again, contractually, as you know, our customers will sign a commitment, but what we've seen, at least from the customers that we've just talked about, they can actually ramp up extremely quickly. I would say At the moment, probably assuming that most of the ramp-up should be within 2023 for these projects.

Okay, thank you, Tim.

Yeah, most welcome. Thank you for the questions. As a reminder, to ask questions, please press star 11 on your telephone. Our next question comes from the line of Alex Wang from Daiwa Capital Markets. Please proceed with your question.

For my first question, regarding our pipeline, I understood that we cut our capacity addition plan in the near term. But I understand that we previously got roughly 17,000 for 23-24 capacity addition. So I want to have more color on this. Do we have any change on that previous guidance? And the second thing is, about the utilization ramp-up. Happy to see a ramp-up acceleration in existing projects starting from June. So could we add more color on the current utilization rate for existing wholesale projects in service? And given current macro and COVID situation, I want to have more sense about what's the typical career for this kind of capacity rates normalized utilization rates. Thanks.

Thank you, Alex. So let me take the first question in terms of the pipeline. You're correct. I think previously we had a range from $14,400 to $17,400 in terms of the cabinet deliveries in 2022. We did revise down to a range of $9,400 to $12,400. You'll see the details that we've included in the IRPPT that will be uploaded to our website. So that is the range of guidance down from the 17.4 that you discussed earlier on. You'll see that the projects that we've taken out, again, some of these we expect to take place in 2023. There's some related to construction slowdowns and then others related to customer demand being pushed back. And so rather than have everything ramped up in terms of delivering the cabinets and then waiting for the customer, we decided to also then match our pace of delivery with the customer requirements as well. Of the second question, maybe I'll pass it to Samuel and he can address that for you.

Yes. In terms of the ramp up for our wholesale customers, what happened is most of the customers basically from the contract were committed to have two years to ramp up to hit the 90% or even higher utilization rate. But in reality, from our experiences and by talking to the customers, you know, given their business growth, normally, you know, will be within a year. They basically hit the 90% or even higher. And so for the two MOU that we talked about today, including the social platform and public cloud service providers. We have a high expectation that can ramp up to 90% or even higher within a year period of time, given the current forecast. Then separately, from a retail point of view, we're also seeing kind of momentum from the customer digital transformation trend as well. So I would say given, even though with the macro a little bit uncertain, but the business is pretty solid in the quarters ahead of time.

Thank you.

Any other questions? Our next question comes from the line of Sarah Wang from UBS. Please proceed.

Hi, Samuel and team. Thanks for the opportunity to ask a question. So I have two questions. First, it's still on the delivery target. And I asked what's the split between wholesale and retail of the delivery target of cabinets. And another question is, so what's the increased magnitude? What's the magnitude of power tariff increase in second quarter? I noticed that our EBITDA margin actually stayed relatively stable versus last year. So just wondering if there's any other areas. we can actually save costs to offset the poverty tariff increase. Thank you.

Hi, sir. Can you repeat the first part of the question, please, again?

Hi. The first question is, what's the split between wholesale and retail, others of our delivery target?

Okay. Thank you. Let me handle that first question. I'd say that Right now, the split between the wholesale and retail, we're still looking at a similar split of around 60-40. So we've talked about, again, in the past, 60-20, 20-60 being the wholesale, and then scale retail and retail. So we still expect that to be the same in that range, more than half being wholesale-related, maybe up to two-thirds being wholesale-related. In terms of the power increases, again, the vast majority of the increase that we saw were in the Tier 1 cities. Again, the early part of the year, we saw them go up by anywhere from 10 to 20% in the Tier 1 cities. And so we factored in the impact to the full year margins. In quarter one, we did have some tax rebates and other income, and that's kind of some of the reasons behind why the margins in the first quarter weren't impacted as much. And then in the second quarter, there were some costs incurred there, but again, we have been quite focused on making sure we help to implement cost controls. So we'll continue to do that in the third and fourth quarter, but there are going to be limits to how much we can do to offset increases in our operating costs in general. I hope that helps, Sarah.

Got it, thank you. Thank you for the questions.

The next question comes from the line of Albert Hung of JP Morgan. Please proceed with your question.

Hi, Benjamin Ting. Thank you for taking my question. My first question is, if I look at the 2022 new guidance, the EBITDA margin implies that second half adjusted EBITDA could be like 22%, which is a multi-year low. Can I know what are the one-off and structural margin drag in second half and how to drive the margin recovery in the next year? And the second question is the cut in the revenue is mainly driven by wholesale or a growth-based IDC demand weakness. And from your point of view, how long do you expect the downside to that? Historically, hardware spending will be the leading indicator for ITC. And right now, the hardware spending looks still quite weak in second half. Does that imply first half next year will also see things slow down in ITC? Thank you.

Okay, thank you Albert. Let me take the first part of the questions and then maybe Tim can help to chime in with additional contacts. I think as Tim pointed out, the first quarter of the year, because we did have the tax subsidy and annual reimbursement reimbursement from the depository bank. And then so by removing the one-time thing, then the second quarter margin is pretty much on par. However, with the revised guidance, as you can see our second half EBITDA margin is going to be roughly about a 22% ratio. I would say in a nutshell, aside from the fact that some of the costs and expense got delayed to the second half due to the COVID outbreak and lockdown in the first half. We're also expecting some of the subpar revenue in the pipeline, basically for new retail customer acquisition, and then as well as some of the increased engineering cost, mainly focusing on the invest ahead of a revenue type. And then so that's basically impact our EBITDA margin in the second half. A lot of the analysts, they're asking about a power tariff or even our data center maintenance and upgrade. I think both electrical and mechanical parts, although not really material, put data center, but if we add up, it is still, you know, amount in the P&L. So that's basically impact the EBITDA ratio in the second half. Are we expecting that will continue going on? We strongly doubt, because a lot of costs are basically impacting the second half. It's more seasonality. And so we're expecting to have the, you know, improvement in 2023. And then, Tim, do you want to take on the second question?

in terms of the you know you're asking about you know how long this will last for I think Samuel started to address that and kind of will this drag into 2023 into the leading indicators I would say that you know in in our shifting of some of the capacity deliveries to 2023 alongside or matching with the customer demands is that you know we already see you know some of the things that they had initially wanted by end of year being pushed into the sort of first half of 2023. So there is that visibility that customers still intend to require these data centers, but it has been shifted backwards. In terms of which area we've kind of seen, let's say the slower ramp-ups, I would say, you know, just given the sheer scale of the ramp-up pace of a wholesale customer versus a retail customer, I would say that it is more on the wholesale side. They are a sort of larger contributor in terms of billable cabinets ramp up. But it's not to say that we've not seen a sort of similar slower pace during the times that there were lockdowns in place. We certainly hope that we see less and less of these types of lockdowns in the second half. And so then customers can actually resume a more normal pace ramp up. during the rest of this year and into next year.

Thank you.

Questions? Our next question comes from from Credit Suisse. Please proceed with your question.

Hi. Thank you, management, for taking my question. I have two questions. The first one is regarding wholesale demand. So for the move-ins you have seen for the existing customers we have had or existing orders, how different is that, say, in terms of months required for ramp-up orders? it's different to our previous expectations, say previous guidance versus our new guidance. That's number one question. The second question is the MSR. I see there is a small decline in New South MSR for two quarters running quarter on quarter. I was wondering, is there any trends we should pick up here or should we still you know, expect, you know, them to be broadly in line or previously we mentioned slightly upwards in the longer term. Thank you. Two questions.

Thank you, Clyde. I would say from a wholesale customer's point of view, you know, basically I think Tim and I, we talked about, you know, specifically two type of wholesale customers we're talking to almost on a weekly basis. the public health service providers and social platforms and especially for video type of customers who require a huge storage store of the data. I would say we're not seeing any difference from their moving rates. Aside from the COVID-19 impact or lockdowns impact and so on and so forth, Their business continues to grow. When we talk to them, they proactively plan their demand forecast and do the site selection. When we participate and win the bid, it is not just a one-time deal. It is more like lifetime partnership and so on and so forth. Again, from our partnership, we're seeing a similar trend from a moving rate perspective. So that's the reason when Tim and I, we talked about, aside from what contractual say, two years commit to rent box 90%, we actually seen the actual results way more faster than that. So again, with the two MOU that we talked about today, hopefully we're seeing exactly the same trend as we talked about. King, do you want to address the monthly recurring revenue for the retail one?

Yeah, sure. In terms of the monthly recurring revenue, I think the main thing is in a quarter-to-quarter, you will see some fluctuation, and that's because the figure there is a total retail-related revenue divided by cabinets. We do expect that these levels will remain around $9,000. And, Clive, you're absolutely correct in your second part of your statement, which is whether or not we expect this longer term to trend upwards. I think the answer is definitely yes. And that's going to be driven by some of the investments that Samuel mentioned earlier on. The investments on the retail services side, that will then allow us to provide, again, a larger suite of services to the customers and expand then the contribution of the value-added services to the overall MRR. So again, longer term expected to trend up, but I think quarter to quarter to quarter, roughly fluctuating around the 9,000 level.

Hope that helps. Thank you very much, Sam. Thank you.

Thank you for the questions. Our next question comes from the line of Mingran Li of CICC. Please proceed with your question.

Hi, management. Thank you for taking my questions. I have two questions. The first one is based on the current wholesale and retail demand, could you share more about the delivery pipeline and capex plan in recent years, like in 2023? And my second question is regarding the utility costs. Recently, in some regions in China, there's a power supply shortage. Is there any material impact for us? And could you share more detail about the future trend, you think, of the utility cost and the impact on our margin? Thanks.

Yeah, let me take those two questions. In terms of, I guess, CapEx and delivery plans for 2023, I would say that, you know, based on the fact that some of the capacity we had planned for 22 being shifted into 23, I would say year on year, we would expect that the capacity in terms of megawatts will be larger in 23 as compared to 22, clearly, as things ramp up again and also as some of the construction delays ease, hopefully, as we see a COVID, less COVID impact year in 2023. And so CapEx also, we talked about earlier on that we still expect CapEx spend to be around 4 billion renminbi this year. Next year it likely will be higher than that as we then continue to build out the capacity, especially with the additional MOU wins. Those will then clearly form part of what we see in terms of the spend for the latter part of this year. but also then into next year in terms of expected future tender winds as well. The second question in terms of power, again, the cost that we're seeing is largely similar to the last time around where there were power shortages around China, and these were related to mostly short-term purchases of diesel fuel and making sure that our data centers continue operating when there was uncertainty in terms of continued power supply from the grid. So these are the costs that we expect to see. Again, on a single data center basis, these are not material. If they persist or if they start to spread throughout China, then it will become a larger figure. But at the moment, I think largely covered in what we've already provided to the market in terms of what our views are for the second half and balance of the year. Hope that helps.

Thank you.

Thank you very much for the answers. Ladies and gentlemen, that concludes our conference for today. Thank you for joining.