GDS Holdings Limited (GDS) Earnings Call Transcript & Summary

Hello, ladies and gentlemen. Thank you for standing by for the GDS Holdings Limited Second Quarter 2022 Earnings Conference Call. [Operator Instructions] Today's conference call is being recorded. I will now turn the call over to your host, Ms. Laura Chen, Head of Investor Relations for the company. Please go ahead, Laura.

Thank you. Hello, everyone. Welcome to the Second Quarter 2022 Earnings Conference Call of GDS Holdings Limited. The company's results were issued their Newswire services earlier today and are posted online. A summary presentation, which we will refer to during this conference call, can be viewed and downloaded from our IR website at investorsgds-services.com. Leading today's call is Mr. William Huang, GDS Founder, Chairman and CEO, who will provide an overview of our business strategy and performance. Mr. Dan Newman, GDS CFO, will then review the financial and operating results. Ms. Jamie Khoo, our COO, is also available to answer questions. Before we continue, please note that today's discussion will contain forward-looking statements made under the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements involve inherent risks and uncertainties. As such, the company's results may be materially different from the views expressed today. Further information regarding these and other risks and uncertainties is included in the company's prospectus as filed with the U.S. SEC. The company does not assume any obligation to update any forward-looking statements, except as required under applicable law. Please also note that GDS earnings press release and this conference call includes discussions of unaudited GAAP financial information as well as unaudited non-GAAP financial measures. GDS press release contains a reconciliation of the unaudited non-GAAP measures to the unaudited most directly comparable GAAP measures. I will now turn the call over to GDS Founder, Chairman and CEO, William. Please go ahead, William.

Thank you. Hello, everyone. This is William. Thank you for joining us on today's call. The world is undergoing a lot of uncertainties and it's very unpredictable right now. For the companies in China, it's an extremely challenging year, especially the tech sector. Our customers and impacted -- are impacted by the economic slowdown the COVID lockdown and the supply chain shortage. This is reflected in their weaker than normal business performance and the results. However, GDS business is resilient and defensive. Despite the challenges, we are still delivering solid results growing revenue by 24% and adjusted EBITDA by 18% in the second quarter. At the same time, we continue to make significant progress in the execution of our growth strategy by further developing our customer franchise as demand diversified across the cloud, Internet and enterprise verticals, stepping up our international expansion and establishing a new data center front as the channel to access private capital. We have strengthened our position in absolute and relative terms for future recovery and value creation. Even in a softer demand environment, there are still significant new business opportunities. As a result of our customer targeting and the market presence, we are well placed to compete. In the second quarter, we won 3 new hyperscale orders. The first came from a global cloud customer who we are already serving in Mainland China. But this latest order was for our Hong Kong 1 data center. As a result of this deal, we now have the largest global cloud and the largest China cloud as our anchor customers in Hong Kong 1, which is quite an achievement. The second was from a China cloud customer for capacity at a location near Beijing. We already have significant presence, this is a typical land and expand order. The third was from a major Chinese bank for capacity in Shanghai, continuing the trend, which we highlighted for the last few quarters. Financial institutions and large enterprises once again accounted for around 40% of new booking in 2Q '22. During the first half of this year, our new bookings was 31,000 square meters. For the full year, we are confident of achieving 70,000 square meters of net additional area committed. We may be able to do more, but it depends on new timing. This is a transitional year. Going forward, we still target 80,000 square meters and then up to 90,000 square meters of annual new bookings. However, within this number, we expect a change in the mix with, perhaps 15% to 20% coming from our regional business. GDS business is focused on Tier 1 markets, which was affected by lockdowns. Nonetheless, we still achieved over 13,000 square meters of net additional area utilized in the second quarter. Based on feedback from our customers, we expect moving to continue at a similar level for the next few quarters. However, in a medium-term, we believe that moving will return to historic levels. We have a large backlog, totaling 240,000 square meters which underpins our multiyear growth. Our backlog is solid. Our data centers are concentrated in Tier 1 market where future supply is limited. Customers have secured this resource because it is very strategic for them. We will continue to deliver the backlog. It is just a matter of time. To adjust to the current slower environment, we have scaled down our capacity delivery schedule. In the first half of 2022, we brought 16,500 square meters of capacity into service. In the second half, we plan to bring another 31,000 square meters into service. As compared with our original plan for FY '22, we have pushed back nearly 39,000 square meters of completions into next year and beyond. Our home market customers are fully increased emphasis on international expansion, particularly in Southeast Asia. We are also putting a lot of time and effort into scaling up our -- and accelerating our regionalization strategy. In Hong Kong, we have accomplished the difficult task of establishing a 5-year pipeline of purpose-built data center capacity [indiscernible] in a prime location. Our first data center, Hong Kong 1, will come into service in the next few months. It is almost sold out with Chinese and global customers. We are now working on anchor customers' orders for Hong Kong 2. In Southeast Asia, we have secured hyperscale capacity at campuses in Johor, Malaysia and Batam, Indonesia. All of our campuses are now under construction. The scale -- the sales pipeline for this capacity is even stronger than what we expected. The customer profile is varied across verticals and it included both Chinese and global names. There are a few deals which we are confident of winning this year, which will demonstrate strong proof of concept. With demand from Chinese and global customers, Southeast Asia is one of the fastest-growing data center market in the world. We believe that our regional business, including Hong Kong will become a second growth engine for GDS alongside the Mainland China. As part of today's earnings release, we announced the formation of RMB 6.7 billion equivalent to USD 1 billion, Mainland China data center fund. It is important for us to have access to capital from a variety of sources, public and private, onshore and offshore. This data center fund will significantly enhance our financing strategy and benefit all of our shareholders. To finish up, we have been through difficult times and cycles in the past. The challenges that we are experiencing now are for short term, while data center industry is for long term. During this time of uncertainty, we continue to build up our position by expanding our customer base and enhancing our market presence, both in and outside of China. We believe we will be well prepared both in terms of business operations and the financial capabilities when the recovery happens. We remain very confident about our future. I will now pass on to Dan for financial and operating reviews as well as to explain in more detail about the fund.

Thank you, William. Starting on Slide 14, where we strip out the contribution from equipment sales and the effect of FX changes. In Q2 '22, our service revenue grew by 2.6% and underlying adjusted EBITDA grew by 0.2% quarter-on-quarter. Our underlying adjusted EBITDA margin was 46% compared to 47.1% in the previous quarter. Turning to Slide 15. Service revenue growth is driven mainly by delivery of the committed backlog and closing of acquisitions. Net additional area utilized during 2Q '22, was 13,659 square meters. Around 8,300 square meters was in Tier 1 market affected by lockdowns and the remaining 5,300 square meters was from B-O-T projects in unaffected remote areas. In the second half of 2022, we expect a similar level of move-in as we saw during the first half. Monthly service revenue per square meter was RMB 2,265, down by 1.4% compared to the previous quarter. The decrease is mainly due to dilution from move-in at B-O-T projects. This dilution effect will continue in the second half as we deliver most of the remaining B-O-T backlog. However, for FY '22 as a whole, we still expect MSR to decline by around 4% to 5% year-on-year, in line with our original expectations. Turning to Slide 16. Our underlying adjusted gross profit margin was 50.9% for 2Q '22 compared to 52.4% in the previous quarter. The extreme hot weather this summer has resulted in a higher seasonal PUE than we normally see in the second and third quarter. Furthermore, power tariffs are now up the maximum permitted 20% across our Tier 1 markets. In 2Q '22, utility cost was 30% of service revenue compared with 28.3% in 1Q '22 and 26.9% in 2Q '21. There's no sign yet that tariffs will come down in the near term. Therefore, we expect the combined effect of higher power consumption and higher power tariffs to continue being a drag on our margins in the second half of the year. Turning to Slide 17. We think about our CapEx in 3 parts: Mainland China organic, acquisitions and regional expansion. For Mainland China organic, we spent RMB 2.7 billion in the first half of 2022 out of our full year budget of RMB 6 billion. As William mentioned, we've scaled back our project delivery. However, while CapEx is generally linked to capacity expansion, there is a significant portion that has to be front-ended for installation of power infrastructure and new campuses. Accordingly, it will take time for our Mainland China organic CapEx to come down. We expect Mainland China organic CapEx to be several billion lower next year. For acquisitions, in the first half of 2022, we paid just over RMB 3 billion of consideration. We will pay another RMB 1 billion by the end of the year. As of now, there's no material acquisition consideration that will be payable next year. For regional expansion, which includes Hong Kong and Macau as well as Southeast Asia, we spent just over RMB 1 billion in the first half out of our original full year budget of RMB 2 billion. Regional CapEx is likely to step up by several billion next year given the expected new business wins. For the whole of 2022, we will most likely still hit our original CapEx guidance of RMB 12 billion before taking account of any potential capital recycling through the data center fund. Turning to how we fund this CapEx. We think it makes sense to take a different approach for our regional business and our Mainland China business given the differences in the capital markets, investor base and valuations. There's a lot of money chasing digital infrastructure in the region and GDS Regional is a very attractive investment opportunity. We believe that we have already created significant value from our initiatives in Hong Kong and Southeast Asia. Accordingly, we have set up an international holding company under GDS Holdings to hold all of our projects outside of Mainland China. We will use this international holdco as the equity capital raising vehicle for our regional business. As a first step, we intend offering a small minority stake to private equity investors who we believe can add value. We have started work on the process and aim to get this done in the next couple of quarters. For our business in Mainland China, excluding acquisitions, our objective is to become self-financing within a few years. With buildup in operating cash flow as more data centers reach stabilization and substantial front-end CapEx already incurred. The gap to free cash flow breakeven is narrowing down. Turning to Slide 18. In order to enhance our access to capital, which is a competitive advantage in uncertain times. We've been considering structures, which enable us to bring in outside equity investors at the project level in Mainland China. We find that there is strong interest, particularly among real estate investors in this kind of participation. Further to this strategy, we recently entered into a framework agreement with an investor, which is a sovereign wealth fund for the formation of our first offshore Mainland China data center fund. As envisaged by the framework agreement, the fund will have RMB 6.7 billion equivalent to USD 1 billion of committed capital with 70% coming from the investor and 30% from GDS. The investment objective of the fund is to acquire data centers in Mainland China, either from our own portfolio or from third parties through M&A transactions. GDS will manage these data centers under long-term contracts. We are looking to seed the fund with a few projects in which we have invested significant capital for which we are still several years away from stabilization. This will allow us to recycle capital and accelerate monetization while maintaining our recurring income model with management fees. Our target is to complete the formation of the fund and inject at least 1 project by the end of this year. Meanwhile, we are also in discussions with some domestic financial institutions about an onshore version of this fund structure, although these discussions are currently at an earlier stage. Looking at our financing position on Slide 19. At the end of 2Q '22, we had RMB 9.2 billion or USD 1.4 billion of cash on our balance sheet. And our net debt to LQA adjusted EBITDA ratio was 7.2x on a consolidated basis. However, as shown on Slide 20, we should really look at our leverage in 2 different [ aspects ]. Our in-service portfolio, which is 96% committed and 68% utilized has a net debt to LQA adjusted gross profit ratio of 4.2x. As these data centers reach full utilization, the leverage ratio will come down closer to 3x. We have another portfolio, which includes area under construction and area held for future development. For this part of the portfolio, we believe that it makes more sense to look at the ratio of net debt to fixed assets, which is a reasonable 53%. Once we have completed the regional equity capital raise and some capital recycling through the fund, we expect our consolidated leverage to come down. Turning to Slide 21. As at the end of 2Q, we had total capacity in service and under construction of 667,000 square meters. Against this, we had total area committed by customers of 588,000 square meters. Assuming that we delivered all the backlog and sell out remaining inventory. Our area utilized or revenue-generating capacity would increase by around 90%. The total cost to complete all existing projects is around RMB 9.8 billion or USD 1.5 billion. It is a relatively small amount of CapEx to generate a large amount of growth because we have already made most of the investment. On top of our existing projects, we have secured another 457,000 square meters of pipeline held for future development, it's land and buildings with project approvals and energy quota, predominantly in Tier 1 markets, which we believe is a very valuable asset. Turning to Slide 22. After evaluating the impact of COVID lockdowns and slower economic growth, we are revising our original guidance for 2022 revenue and adjusted EBITDA. We now expect revenue of RMB 9.25 billion to RMB 9.4 billion and adjusted EBITDA of RMB 4.2 billion to RMB 4.28 billion. Our CapEx guidance of around RMB 12 billion remains unchanged, but could be lower if we inject any data centers into the fund by year-end. We'd now like to open the call to questions. Operator?

[Operator Instructions] Our first question comes from Michael Elias with Cowen.

Great, 2 if I may. So first, I just wanted to touch a little bit on the China data center fund and get a better sense of what the mandate is. Is this for -- is this really just a capital recycling vehicle of your stabilized assets or pre-leased assets? Or is this really a vehicle for you to go and do more outside M&A? That's my first question. And then second question is, in the U.S., we've seen over the years is kind of a decline in returns for build-to-suit type deals. Now I'm just wondering, as we think about your B-O-T projects, how would you characterize the willingness to pursue incremental B-O-T projects? And any color you can give around the return expectations there?

Yes. Thank you, Michael. The mandate of the data center fund is actually broad. It includes acquiring data center projects from GDS at all stages of development and also acquiring data centers from third parties through M&A transactions, which where the fund would be the direct buyers rather than buying from GDS. Having said that, from our perspective, for the first phase, we're focused on injecting a small number of projects from our own portfolio in order to hit a certain level of capital recycling. We're looking at something like USD 300 million to USD 500 million in terms of injection equity value in existing state, either by the end of this year or if not by the end of this year, by the end of the first quarter. Thereafter, I think we're more open-minded. We consider further injections from our own portfolio and also to consider what opportunities there are in the market. Certainly, it's very welcome to have this fund to give us a reserve of capital for third-party M&A, which, of course, we did not have before. Second question, William, about our appetite for kind of B-O-T type projects in remote areas [ like we say ] given the level of returns.

I think we [ didn't ] -- historically, we did a lot of these built-to-suit, which we think the return is quite good, right? But in the last 2 years, I think that we rejected a couple of deals. I mean, because the returns getting lower. So I think the -- we are -- we still will discipline to do the business, which we think is suitable. We have the ability to access those kind of deals in any time, but it depends on our option, right? So I think this is our position.

Our next question comes from Tina Hou with Goldman Sachs.

I have also 2 questions, if it's okay. The first one is regarding your overseas business in the ASEAN markets, especially with Malaysia and Indonesia, would you characterize it more similar to Tier 1 markets in China or more like B-O-T projects type of things? And also, I believe previously, our strategy in ASEAN is more to go out with our domestic customers. But now we see that Hong Kong data center has also secured a global #1 cloud customer. So wondering in the ASEAN market, are we open more to international customers as well? And if yes, how do we compete with other global data center platforms in those markets? This is the first question. Second question is also regarding the China data center fund. So you mentioned that you're looking at injecting some like ramping up projects. So wondering how do you choose from all of these different locations in Tier 1, edge of town, downtown and also like B-O-T projects?

Okay. I'll answer the first question about the regionalization. I think the number one, how we look at it in regionalization? We still maintain our strategy in the Tier 1 market, right? So Southeast Asia is big, right? But we understand the Singapore market is the most attractive market in the Southeast Asia, even in the world. If I remember, I mean, Singapore data center market is represent almost 50% of the total Southeast Asia. But the situation is in the last 2 years, Singapore government stopped to allocate the power, right? So that means if you look at the Singapore market, the demand is very strong from the global multinational even from China. So I think this is a very attractive market for us. So if you look at the next 3 years, in Singapore gets a very, very limited supply, almost 0 in the next 3 years. But the demand is still there. So our strategy is build up data center close to Singapore. So I think we still see this as a Tier 1 market and a very clear certain demand in the next 3 or 5 years. So that's our strategy. So we think the -- our data center strategy still works in this region. And Hong Kong, obviously, is another top market in Asia, right? So I think the -- we are -- in the last 5 years, we built out -- in a couple of years, we build -- it's very difficult to build the land bank and in a very, very good location in Hong Kong. We're successful to achieve that. So -- and we see this demand continuous [indiscernible] in Hong Kong. It's from the -- it's just like what happened in Singapore. It's not only from China, it's also from the global. So we are well positioned to catch up this trend still. So these 2 markets, we are very confident and I think location is good. [ Talk about ] how to compare with a multinational company in this region. I think GDS has become a -- we have -- after 20 years, we build up our very, very world-class capability to do the data center business. Number one, I think we are more familiar with the customer, we are more committed with the region. So in terms of the -- to build our market [ projects ], I think we are always -- we are still maintaining the first mover in this region. So this is number one. We always take first move advantage, which I think this is our strength. On the other hand, we have -- because we built a large scale in the last couple of years. So we do have -- we can view more cheaper, more faster, and we deploy our operating capability more faster, more cheaper than anyone else. So that's our strength. So I think we are -- we think we have all kind of the capability to compete with any competitor in those regions. We are confident.

Okay. Tina asked how do we select projects for the fund. So as I responded to Michael earlier, the mandated fund is very broad. But for the seed projects, we selected and proposed. It still has to go through a process with the investor. We selected and proposed projects in a category which we call precore. These are all projects which are under construction, maybe a small part is in service, partly precommitted. And as you say, 3 years away from being complete and fully stabilized, at least based on our current projections. So from a financial perspective, these are projects where we've already invested considerable sums of money. And we believe created value because the value creation comes through forming these projects and getting the customer commitments and sort. But where we are going to be years away from having revenue, EBITDA or certainly fully stabilized EBITDA. And it feels like maybe the public equity market doesn't value these situations. They probably don't value our Southeast Asian business either. So from our perspective, it was kind of getting -- hopefully the biggest [ bankrupt buck ], taking these projects and recycling the most capital with the least EBITDA in the next few years. And maybe that will also help to highlight the value whilst still having a kind of recurring income model going forward. After these seed projects, as I said before, we're open-minded. We may do other kinds of projects. That was our thinking for the first phase.

I think this [indiscernible] in a position to very flexible to access the different capital. And the [indiscernible] can more flexible do more valuable business and acquisition as well.

Our next question comes from Jonathan Atkin with RBC Capital Markets.

This is Bora on for John. First, on M&A. Can you comment on what you've been seeing in terms of multiples if you've been seeing any movement up or down? And how target-rich is the M&A environment in edge of town versus, say, municipal sites? And then secondly, on your progress in Indonesia and Malaysia, when could we -- when could that start to become a bit of a needle mover generating revenues? And are there any other markets in the region that you would consider? Or is that it for now?

First of all, target-rich. I think that's a good way of putting it. I think there's a highly fragmented market. We're much bigger than any other player, but there's a long tail. And there's a lot of companies with small portfolios. There's a lot of companies who are kind of like single project companies. And so in theory, at least, there's a lot of potential targets. But when it comes to what is the driver for doing the M&A? And what is the strategic rationale? Yes, we -- in the past, we were very focused on building up our resource pipeline. We also valued situations which enhance the customer franchise. And in the past also would give us scale. Now we don't see that any pick acquisitions, it's obvious to us whether they make -- whether there'll be a very strong strategic rationale but therefore, there has to be a strong financial rationale. I can't say really where market multiples are. We have our own view about what makes sense. It has to be highly accretive to us. So it's not so much about what is the market multiple. It's what makes financial sense to us. And that's why we take a disciplined approach and wait to see those opportunities, which do satisfy our financial natural criteria. For Indonesia and Malaysia, I don't think you have to wait for revenue to move the needle in terms of valuation, Bora. I think the -- Yes, I think probably apparent to many investors that we've already created value with what we've done, maybe when we do the regional equity capital raising and put a value on the business, that will illuminate a number for investors. Also, when we have some -- when we're able to announce some significant business wins, which is not really -- not very long now before we're able to do that. So I think, yes, to business wins and regional capital raising, I think -- I would hope that, that moves the needle in the next few months or couple of quarters at the most.

And on the targets, was that more on the edge of town or for municipal sites or both?

Our business topic?

Yes.

Bora, I think, yes. I think we have the ambition to do more business globally, right? So because we absolutely maintain the strongest position in China already, right? So now we are seeking to build a business outside of China as well in the same time. So I think our step is the number 1 is Hong Kong, which we did, and we're well positioned. Number 2 is Southeast Asia, which we think the -- it's good timing to step in. But we -- in the meanwhile, we also look at other Asian market. So we -- I think we will look at the more market, right? If we think timing is ready.

[ Before ] in China M&A targets.

In China, M&A targets, I think the fact is that in China, M&A target is getting more, I think, but the question is we still wait, we have a lot of patience because we try to create value for our shareholders. So now I think they're still in the transition the seller, a lot of the data center owner. This started to lower their expectation, which we think is not -- still not meet our expectation. So I think we still wait for them, right.