GDS’ 1Q22 earnings generally came in line with expectations, and the overall business showed resilience. In the short to medium term, the Company's annual performance remains under certain pressure due to macro headwinds and other factors, but from a structural point of view, demand from internet companies due to longer online time during the pandemic as well as the trend of going overseas have in part offset those headwinds. GDS kept its full-year guidance unchanged, which also reflects its resilience. As macro headwinds dwindle, we expect that the most difficult stage of the industry is about to come to an end, and the recovery of the macro economy will lead to the gradual stabilization of the Company's earnings. Currently, GDS is trading at less than 15x 2022E EV/EBITDA. In the longer run, we think GDS still has decent upside as smaller competitors are forced out of the market and industry fundamentals reverse course. We are optimistic about GDS’ medium-to-long-term value and reiterate our “BUY” call on its H-shares and ADRs.
Earnings overview: Financial indicators were largely in line with expectations and the full-year guidance was kept unchanged.
In 1Q22, GDS' revenue was Rmb2.24bn （+31.5% YoY, +2.6% QoQ）， including data center revenue of Rmb2.24bn （+31.6% YoY, +2.6% QoQ） and equipment revenue of Rmb59,000, maintaining a stable growth trend mainly thanks to the utilization of new production capacity. The adjusted non-GAAP gross profit margin was 52.4% （-2.0ppts YoY）， which was mainly affected by the rise in power tariffs. The adjusted EBITDA was Rmb1.05bn （+28.5% YoY）， corresponding to an EBITDA margin of 46.9% （-1.0ppt YoY, -0.1ppts QoQ）。
Despite the macro headwinds, GDS maintained its prior full-year guidance unchanged, anticipating annual revenue of Rmb9.32bn-9.68bn （corresponding to a growth rate of 19.2%-23.8% YoY） and adjusted EBITDA of Rmb4.285bn-4.45bn （corresponding a growth rate of 15.7%-20.2% YoY）。
The guidance shows strong resilience in the face of uncertainties in 2Q22.
Data center: Orders grew steadily, and utilization rate was under pressure in the short term.
In the first quarter, GDS added 18,188 sqm of new orders （corresponding to about 42MW of IT load based on our estimates）， all of which were organic orders, down 9.5% QoQ, mainly reflecting weaker demand for internet and cloud computing. Currently, data centers in operation are 492,000 sqm, projects under construction are 168,000 sqm, and overall data center projects in the pipeline are 660,000 sqm, still in steady expansion. From the perspective of operational efficiency, the utilization rate in 1Q22 was 67.4% （-2.2ppts YoY, +1.9ppts QoQ）， and the extended listing cycle of major customers will continue in the short term. The monthly service revenue （MSR） was Rmb2,296 （vs. Rmb2,339 in 1Q21 and Rmb2,351 in 4Q21）， mainly reflecting relatively weak market demand. In terms of resource reserves, pipelines in first-tier cities maintain a high proportion of 90%, and resources are still distributed in major cities with significant geographical advantages.
Customer mix: Cloud computing and internet companies remain the key customers, but the structure has diverged.
The number of corporate customers in 1Q22 was 773 （+9.0% YoY）。 By category, cloud computing manufacturers accounted for 67.8%, large internet companies accounted for 20.1%, and financial institutions and large enterprises accounted for 12.1%. While cloud computing and internet companies remain the top two customer categories, we notice a significant increase in demand from financial institutions compared to that in 2021. By customer, the top five largest customers contributed 68.9% of the contracted area and 61.5% of the revenue （vs. 70.1% and 62.1% in 4Q21, respectively）。
Affected by macro factors, the growth in the demand from major customers and the progress of cabinet launches slowed, and the delivery cycle was further extended, which affected order fulfillment in the quarter, resulting in a decrease in the proportion of revenue from major customers. However, demand from internet companies due to longer user online time and strategies to go overseas has partly offset the above-mentioned headwinds. In terms of overseas business, GDS has an operating area of 1,303 sqm （+41.2% QoQ） and resource reserves of 28,000 sqm, which is the same as the previous quarter. In the future, the Company will gradually strengthen cooperation with overseas leading customers, and maintain steady advances in the current complex market environment.
Outlook: The most difficult time is coming to an end.
The data center sector as a whole came under pressure in 1Q22 due to the slowdown in demand from downstream cloud computing and internet customers, the rise in electricity tariffs due to macro factors, the regulation of China concepts stocks and the tightening of policies. The earnings decline of some cloud computing companies in 1Q22 has also caused market concerns.
From the perspective of operating costs, we expect that the short-term upward trend of power tariffs will be alleviated given the current energy price trend, and the marginal pressure will be reduced. On the demand side, although the short-term revenue of cloud computing companies is under pressure, orders are still being fulfilled. As the pandemic subsides, project delivery will proceed, and the demand for IDCs will continue to be unlocked. Therefore, we believe that the overall industry-wide profitability will stabilize and recover in the second half of the year with the improvement of the pandemic situation. At the same time, GDS continues to build capacity, albeit at a slower pace. In terms of resources in first-tier cities, the energy consumption policy has accelerated the clearance and exit of small- and medium-sized manufacturers, which means high-quality resources will be scarcer, and market share will be further concentrated to leading companies. We believe that the most difficult period for the industry is coming to an end, and GDS will be better-poised to compete and embrace an inflection point in 2H22 given the favorable competitive landscape and its continuous capacity expansion and healthy earnings and guidance.
Potential risks: Valuation downside due to fluctuations in long-term interest rates; reduced IT spending as the pandemic continues to evolve; IDC policy changes in first-tier cities; increased competition; losses due to continued investment and expansion.
Investment advice: Considering the full-year earnings guidance of GDS and the current macro headwinds, we trim our 2022E/23E/24E revenue forecasts to Rmb9.32bn /11.21bn/13.14bn （from prior forecasts of Rmb9.44bn/11.47bn/13.91bn）， and adjusted EBITDA to Rmb4.32bn/5.30bn/6.30bn （from prior forecasts of Rmb4.37bn/5.41bn/6.58bn）。 Based on its earnings guidance, GDS expects 2022E EBITDA growth of 20%. While the sector as a whole is trading at a lower valuation of 15x EV/EBITDA, we believe GDS deserves a valuation that matches its EBITDA growth, which reflects its true fundamentals. Therefore, we assign 20x 2022E EV/EBITDA to derive a target price of HK$50/US$48 for its H-shares/ADRs, and reiterate the “BUY” rating.