GDS Holdings Ltd annual report, Q4 FY2016

GDS Holdings Limited — Form 20-F Summary

Reporting period: Fiscal year ended December 31, 2016. The filing is an annual report, not a standalone quarterly filing; therefore, fourth-quarter-specific results are not separately presented. Financial statements are prepared under U.S. GAAP and reported primarily in RMB, with selected U.S. dollar translations at RMB6.9430 per US$1.00.

Business context

GDS develops and operates carrier- and cloud-neutral data centers in China, providing colocation, managed hosting, managed cloud, consulting and related equipment services. At December 31, 2016, the company operated approximately 60,982 square meters in service, with 25,055 square meters under construction and approximately 19,038 square meters held for future development. It served approximately 400 customers, including approximately 230 financial institutions.

Cloud service providers represented nearly 45% of total area committed. Internet and financial-services customers represented 64.3% and 20.3%, respectively, of total area committed. The company completed its initial public offering in November 2016, issuing 20,070,735 ADSs representing 160,565,880 Class A ordinary shares and raising approximately US$186.7 million before expenses and underwriting discounts.

Key financial metrics

RMB in thousands, except percentages and per-share data	2015	2016	Change
Net revenue	703,636	1,055,960	+50.1%
Gross profit	188,639	265,674	+40.3%
Gross margin	26.8%	25.2%	-1.6 percentage points
Loss from operations	(1,217)	(42,374)	Loss widened
Operating margin	(0.2%)	(4.0%)	-3.8 percentage points
Net loss	(98,584)	(276,412)	Loss widened
Net loss attributable to ordinary shareholders	(216,637)	(403,402)	Loss widened
Net loss per ordinary share	(0.99)	(1.35)	Loss widened
Adjusted EBITDA	164,701	270,545	+64.3%
Adjusted EBITDA margin	23.4%	25.6%	+2.2 percentage points

Colocation revenue increased to RMB770.1 million, managed-services revenue to RMB224.6 million, consulting revenue decreased to RMB8.3 million, and IT equipment sales increased to RMB52.9 million. Operating expenses rose 62.3% to RMB308.0 million, primarily due to higher share-based compensation, personnel costs, directors’ fees and professional fees. Share-based compensation increased to RMB64.2 million from RMB4.1 million.

Cash flow, liquidity and capital structure

Cash at December 31, 2016 was RMB1,811.3 million, compared with RMB924.5 million at December 31, 2015. Restricted cash was RMB27.7 million.
Operating cash flow was negative RMB150.2 million, compared with negative RMB80.3 million in 2015.
Investing cash flow was negative RMB1,147.1 million, including RMB987.8 million of property and equipment purchases and RMB159.4 million related to acquisitions and acquisition-related payments.
Financing cash flow was RMB2,128.6 million, supported by borrowings, convertible bonds and IPO proceeds.
Total loans and borrowings were RMB2,138.2 million, including RMB628.5 million current and RMB1,509.7 million long-term borrowings. Convertible bonds payable were RMB1,040.6 million.
Total consolidated indebtedness, including borrowings, capital lease and other financing obligations and convertible bonds, was RMB4,290.3 million, or approximately US$617.9 million.
Capital lease and other financing obligations totaled RMB1,111.6 million at present value. Operating lease commitments totaled RMB838.2 million, and capital commitments totaled RMB511.0 million.
The company reported total available working-capital and project-financing facilities of RMB3,181.3 million, of which RMB968.9 million was unused at year-end. Management stated that available cash and expected operating cash flows were sufficient for at least the following 12 months, but noted that additional financing could be required.

Material changes versus 2015

Revenue grew 50.1%, driven by a 65.8% increase in service revenue and higher utilized data center area.
Area in service increased from 37,869 square meters to 60,982 square meters; area utilized increased from 22,365 square meters to 37,082 square meters.
Total area committed increased 70.0% to 61,043 square meters. The commitment rate improved to 89.0%, while utilization increased to 60.8% from 59.1%.
Gross margin declined as utility costs, depreciation and amortization, network costs, maintenance and personnel expenses grew faster than revenue.
Interest expense more than doubled to RMB265.2 million, primarily due to convertible bonds issued in December 2015 and January 2016 and increased borrowings.
General and administrative expense increased 76.6%, including substantially higher share-based compensation and professional fees.
Net loss increased materially to RMB276.4 million, and accumulated deficit increased to RMB858.7 million.
The 2016 VIE restructuring shifted substantially more revenue-generating activity into consolidated variable-interest entities. VIE revenue increased to RMB846.2 million, or approximately 80.1% of consolidated revenue, from RMB30.6 million in 2015.
Guangzhou Weiteng was acquired in May 2016 for RMB129.5 million and contributed RMB36.9 million of revenue and RMB2.9 million of net loss from acquisition through year-end.
Preferred shares were converted into ordinary shares upon the IPO, and RMB343.3 million of preference dividends were settled through cash and ordinary shares.

Outlook, management commentary and unusual items

Management expects continued growth in China’s high-performance data center and cloud-services markets and intends to expand capacity, cloud partnerships and managed cloud offerings. The filing cites industry projections from 451 Research of a 16.6% compound annual growth rate for China’s high-performance data center market from 2015 to 2018, although the company has not independently verified the underlying data.

Expansion remains capital-intensive. The company expected to invest approximately RMB293.2 million to fully ramp existing in-service facilities and approximately RMB1,105.8 million to complete and ramp facilities under construction. The filing does not provide formal revenue or earnings guidance.

Management expects costs to increase as new facilities, personnel, utilities and public-company compliance requirements expand.
The company expects managed cloud expansion to require significant upfront investment and potentially reduce margins.
As of year-end, 13.6% of total area committed was scheduled for customer contract renewal during 2017.
A customer provided notice in November 2016 to terminate a colocation agreement effective January 2017; the company received a termination fee of US$6.742 million in March 2017.
In March 2017, the company agreed to acquire a Shenzhen data center project for an aggregate purchase price of RMB313.0 million, including contingent consideration.
In April 2017, the company drew US$45.0 million under new Shenzhen loan facilities, bearing an effective interest rate of 5.41% and maturing in October 2018.
Goodwill was RMB1,341.1 million at year-end, with no impairment recorded in 2016. Its recoverability depends on assumptions regarding future occupancy, pricing, costs and cash flows.

Principal risks and contingencies

High leverage, variable-rate debt, secured financing, cross-default provisions and financial covenants could constrain liquidity or trigger accelerated repayment. The company previously violated a borrowing-range covenant and obtained a waiver.
Negative operating cash flow and substantial capital expenditures create continuing dependence on debt, equity and other financing sources.
Revenue and committed capacity are concentrated among a limited number of customers; two customers represented 18.6% and 14.6% of 2016 revenue and 24.5% and 20.1% of total area committed.
Service interruptions, power shortages, network failures, cybersecurity incidents, equipment failure or natural disasters could result in penalties, customer losses and litigation.
Many leased data center properties have not been registered or filed as required, and certain premises may have title, construction, usage or fire-safety deficiencies that could require relocation or suspension of operations.
The company relies on PRC VIE contractual arrangements because of foreign-investment restrictions on value-added telecommunications and Internet data center services. Regulatory changes or unfavorable enforcement could lead to fines, license restrictions, restructuring, loss of control or deconsolidation of VIEs.
The company disclosed potential historical non-compliance involving IDC licensing, geographic license scope and certain customer contracts. Penalties could be several times the related service revenue, although no specific penalty amount was recorded in the filing.
Substantially all revenue-generating operations are in China, exposing the company to PRC regulatory, tax, foreign-exchange, political and legal-system risks. Approximately RMB1,975.2 million of assets were restricted from distribution offshore, and PRC subsidiaries had no retained earnings available for dividends.
The US$150.0 million convertible bonds due 2019 carry 10% total annual interest, are secured by equity interests, and could result in issuance of at least 93,977,837 Class A ordinary shares if converted, creating substantial dilution.
The company does not expect to pay dividends in the foreseeable future.
The filing states that the company’s PRC-based auditor was not subject to PCAOB inspection at the time, creating additional audit and investor-protection risks.

Most important facts for investors to verify

Reconcile reported cash of RMB1,811.3 million with near-term debt, lease, capital and contractual obligations, including RMB1,543.2 million due within one year.
Assess whether utilization can rise from 60.8% toward the 89.0% commitment rate without materially increasing power, depreciation, lease and maintenance costs.
Review customer concentration, 2017 renewals, the early termination and the quality of non-binding commitments included in total area committed.
Examine the sustainability of positive adjusted EBITDA in light of negative operating cash flow, high interest expense and substantial non-GAAP adjustments.
Evaluate VIE, IDC-license and other PRC regulatory exposures, including the effect of the 2017 MIIT Circular and the extent of any historical non-compliance.
Quantify potential dilution from convertible bonds, options and restricted shares; 28.6 million options were outstanding and 12.9 million restricted shares were unvested at year-end.
Review debt covenants, security pledges, change-of-control provisions and maturity concentrations, particularly 2017 obligations and the 2019 convertible bonds.
Assess goodwill of RMB1,341.1 million and other long-lived assets for impairment sensitivity to occupancy, pricing, construction delays and financing costs.