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Why Kingsoft Cloud’s Stock Is Currently Too Expensive

Kingsoft Cloud Holdings (NASDAQ:KC) has delivered a strong start to its IPO. The Chinese company, a subsidiary of Chinese tech giant Kingsoft Corp, debuted its IPO Friday at a share price of $17 and saw the stock close at $23.84 at the end of trading, a rise of over 40%. The company currently has a valuation of $4.7 billion, making it the largest Chinese IPO of this year.

Much of the discussion around Kingsoft Cloud such as this article from CNBC has focused on a completely separate company, Chinese Starbucks (NASDAQ:SBUX) rival Luckin Coffee (NASDAQ:LK). Luckin Coffee revealed in April that $314 million in reported sales had been fabricated, sending shares plummeting before trading was permanently halted. The company is also reportedly facing a securities fraud investigation from the SEC. The implication by CNBC and others has been that Kingsoft Cloud may be fudging the books just like Luckin, as Chinese financial numbers are often viewed to be unreliable.

These fears are likely unfounded given that Kingsoft Corp is audited as it trades on the Hong Kong Stock Exchange, and Kingsoft is part of a rapidly growing Chinese tech industry that has not even been slowed down much by the coronavirus. But its profitability numbers are ugly even by tech IPO standards, and investors may be better off looking at more established Chinese tech players.

The Financial Numbers

Kingsoft Cloud is a cloud company that claims in its SEC report that it is the “third largest internet cloud service provider in China with a market share of 5.4% in terms of revenue.” The cloud market in China, while currently small, has significant potential for growth. Kingsoft claims that the Chinese cloud market will have a CAGR of 28.3% up to 2024, and is in line with other claims that China will be the world’s largest cloud market by 2023.

The potential is clearly shown by Kingsoft’s financial numbers. Kingsoft reports a 2019 revenue of 3.9 billion yuan ($568 million), a 78% increase compared to 2018. Kingsoft also reported similar growth numbers from 2017 to 2018, though the rate of revenue growth declined as should be expected.

But while the revenue growth is great, Kingsoft’s other financial numbers are not. Tech IPOs normally report good gross profit numbers but do not record a net profit. But in Kingsoft’s case, the company recorded a gross profit of $1.1 million in 2019, preceded by larger gross losses in 2017 and 2018.

Most tech companies record gross profits and argue that they can eventually become net profitable by dialing back on other expenses, typically sales and marketing. But Kingsoft cannot make that argument. And as should be expected from such an unprofitable company, Kingsoft is burning through cash as it reported a negative free cash flow of $206.6 million in 2019. Kingsoft had $290 million in cash as of December 31, 2019, but this is not a company which will be profitable anytime soon.

China and the Cloud

Kingsoft proponents could point that a $4.7 billion valuation does not appear that unreasonable at first glance. Kingsoft has $358 million in total liabilities and $290 million in cash, so a $4.7 billion enterprise value is a close enough approximation. This gives Kingsoft an EV/revenue ratio of 8.27. By comparison, Alibaba (NYSE:NYSE:BABA) has an EV/revenue ratio of 7.2. Compared to other IPOs which trade at valuations far in excess of their competitors, Kingsoft appears outright reasonable.

The problem is that we are comparing Kingsoft not to other IPOs, but to other Chinese tech and cloud companies. And the case for Kingsoft over Alibaba or even a company trading overseas like Tencent is not strong. Alibaba may not be growing as rapidly as Kingsoft, but it has a consistent history of profitability and is more diversified. Alibaba has a comparable EV/revenue ratio to Facebook (NASDAQ:NASDAQ:FB) and almost certainly has higher growth potential.

The Chinese tech market is not all rosy, especially given the prospect of less cooperation and higher tensions between China and the United States. And of course, investors may be worried about the potential of fraud. But these are all reasons to stick with the more established company which will be better able to weather these risks as opposed to a company whose main selling point is how it can continue to grow rapidly.

Kingsoft’s profitability numbers are headed in the right direction, and if it can show a consistent ability to make a gross profit and eventually make a net profit, then perhaps it could become a worthwhile investment. But its financial numbers present a too high-risk level currently. The takeaway from this IPO should be that the Chinese cloud market is a really interesting market and that Chinese tech companies are worthwhile investment targets. But that is a reason to pursue more established players like Tencent and Alibaba.

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