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21Vianet Group, Inc. (NASDAQ:VNET)

Q3 2012 Earnings Conference Call

November 16, 2012, 08:00 a.m. ET

Executives

Josh Chen - Founder, Chairman and CEO

Jun Zhang - COO

Shang Hsiao - President and CFO

Analysts

Sandeep Gupta - Barclays Capital

Chad Bartley - Pacific Crest

James Breen - William Blair

Gary Yu - Morgan Stanley

C.K. Tang - JPMorgan

Eric Chu - Canaccord Genuity

Operator

Good morning ladies and gentlemen. Thank you everyone and welcome to 21Vianet Group’s Third Quarter 2012 Earnings Conference Call. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference call.

Before we begin I will read the forward-looking statements. This call may contain forward-looking statements made pursuant to the Safe Harbor provisions for the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management’s current expectation and observations that involve known and unknown risks, uncertainties and other factors not under the company’s control which may cause actual results, performance, or achievements of the company to be materially different from the results, performance or expectations implied by these forward-looking statements. All forward-looking statements are expressly qualified in their entirety by the cautionary statements with factors and details of the company’s filings with the SEC. 21Vianet undertakes no duty to revise or update any forward-looking statements for select events or circumstances after the date of this conference call.

With us today are Josh Chen, 21Vianet Co-founder, Chairman and CEO; Jun Zhang, our Chief Operating Officer; and Mr. Shang Hsiao, President and CFO of 21Vianet. Following managements prepared remarks we will conduct the Q&A.

At this time I’d now like to turn the conference call over to Josh Chen, 21Vianet Co-founder, Chairman and CEO.

Josh Chen

Thank you, operator. Good morning and good evening everyone and welcome to 21Vianet third quarter 2012 earnings conference call. During the third quarter we continue to deliver financial and operational results lead by the further expansion and diversification of our Internet and cloud infrastructure capabilities. As we remain focused on expanding our data center footprint, but steady addition of our self-built data centers help us further elevate capacity constraint of our network while also improving our ability to deliver to drive meaningful margin improvement. However, we believe we are well positioned to capitalize on new emerging opportunities with our consistent and well defined, satisfying and enhancing our service by acquisition and a strategic partnership.

Our recent acquisition of Fastweb will calculate how CDN platform our cloud enabling technology solution decreasing us to more (inaudible) of our cloud computing service. Our recent policy with Microsoft represents another great step for work in December. As you know Microsoft has selected 21Vianet as its operational entity and has licensed its technology with knowhow and the right to 21Vianet to operate Office 365 and Windows Azure service in China. Shang will discuss this further detail later

We have (inaudible) because our platform China will have now have asset to Microsoft premier call service. With dedicated support and sales customer service and technology from both companies, we commentary end to launch our initial service in mid of 2013. Our partnership with Microsoft along with the acquisition of Fastweb offered us promising new revenue stream and activities to expand our customer base.

Recently Forrester Research found that over 87% of Chinese companies have planned to move their main business functions to a cloud in the near-term. They predict that the public and the private cloud market in China will grow in a compounded annual growth rate of 36% from 2011 to 2013 to over US$5.4 billion. More strategically these opportunities will help us get a significant amount of cloud interiors with a seasoned owners and will be critical in the thriving new face of industry and a phase developer. These initiatives combined with increasing internet data usage in China will bring significantly bring business for future growth for the coming years. So we design our vision of becoming a leading internet industry software operator in China.

With that, I will now turn the call over to our COO, Jung Zhang for operational update.

Jun Zhang

Thank you, Josh. Good morning and good evening everyone. As Josh alluded to at the beginning, we’re continued to dramatically expand our data center facility during the quarter while streamlining our new business operations. And with September, we increased our overall cabinet capacity to over 11,600 cabinets with several cabinets with self-built cabinets from further expanding to 53% of the overall products. This remained well on track to this holiday mix of 55% build and a 35% partnered cabinet. Even though visit will elaborate fluctuate each model to accommodate customer’s demand. As we continue to integrate Fastweb and build-out of our cloud platform. We will need significantly to increase an upgrade our platform capacity further driving our foundation. 21Vianet continues to perform and execute well as evidence by our financial result over the quarter with MRR for cabinet remaining stable.

As we are in place and basically the dramatic increase in network demand from software and the Microsoft cloud services beginning in the mid of next year and expand with our continued organic growth. We will need to significantly increase and upgrade our platform capacity and further improve its overall efficiency over the next two quarters. This upgrade and expansion in platform capacity will be necessary to support the future growth and dramatic increase we will see in our support team and transmission services, as cloud computing services roll out and begin to gain attraction. Related to that, we remain committed to aggressively expanding our transmission footprint through expansion of our network.

With regards to our acquisition of Fastweb although it’s relatively it’s more expecting on the absolute dollar amount, we’re very excited with potential growth opportunities it provides us. With less than 20% of the last year our two company customer base with an excess of several blue-chip enterprise customers in China, and now our combined entity service over 1900 customers. We believe that the integrating with Fastweb will have percentage wise growth and generate a further margin expansion as we build out our cloud computing platform.

At this time, I’d like to turn the call over to Mr. Shang Hsiao, our President and the CFO who will discuss our financial performance as well as financial forecast for our recent initiatives in greater detail.

Shang Hsiao

Thank you, Jun and good evening everyone. Before I start going through our financial details, I would like to state that we represent non-GAAP measure on today’s conference call. Our non-GAAP result excludes certain non-cash expenses, which are not a part of our core operation. The detail of these expenses may be found in the reconciliation table included in our earlier release. Also note that all the financial numbers we are presenting today are in RMB amounts unless otherwise noted. After the financial I will provide additional details on our recently alliance Microsoft partnership.

Now moving on to the detail financial results, our net revenue for the third quarter of 2012 increased by 51% to RMB396.1 million. Our monthly recurring revenue or MRR define as the revenue recognized on a fixed and recurrent basis each month grew to over RMB139.2 million in September 2012 from RMB124 million in June 2012.

The MRR per cabinet remained stable at RMB10,027 in this quarter compared to RMB10,053 last quarter reflecting the continuing strong demand, especially in Tier 1 cities. Going forward, we continue to expect the MRR per cabinet to remain above RMB10,000 per cabinet but this may fluctuate, based on demand of interconnectivity service. Our utilization rate were 67.7% in the third quarter of 2012 compared to 81.2% last quarter, reflecting the increased capacity associated with the placing of new phase at the end of the third quarter.

Net revenue from hosting and related service increased by 33% to RMB218.9 million in the third quarter of 2012, primarily due to an increase in total cabinet under management in self-built and partly data center attributable to growing customer demand.

Net revenue from management network service increased 83% to RMB177.2 million in the third quarter of 2012. This increase was primarily driven by the network capacity demand for data transmission service were increasing management network service revenue was primarily driven by an increase in network capacity growth for data transmission service.

For the third quarter of 2012, adjusted gross profit increased by 51% to RMB118.7 million. Adjusted gross profit margin was 30% compared with 30.1% in the third quarter of 2011. Adjusted operating expenses increased to RMB68.8 million as a percentage of net revenue adjusted operation expense was 17.4%. More specifically, adjusted sales and marketing expenses increased to RMB25 million from RMB19.5 million in the comparable period in 2011, primarily due to the expansion of our sales and service support team.

Adjusted general and administrative expenses increased to approximately RMB26.8 million from RMB13.1 million in the prior year period, primarily due to expansion of related headcount and office rental and other expansion related expenses. Adjusted research and development expenses increased to RMB17 million from RMB8.8 million R&D which reflect our effort to further strengthen our research.

The main difference between adjusted operating expenses and our higher GAAP total operating expenses amount is primarily due to the change in the fair value of contingent purchase consideration payable of RMB12 million and share-based compensation expenses of RMB21.5 million. The change in the fair value of the contingent purchase consideration payable is resulting from an increase in the present value of estimated cash and share consideration as of September 30 of 2012, associated with the company acquisition of the Management Network Entities Gehua and Fastweb.

From a profitability perspective, adjusted EBITDA for the third quarter of 2012 increased by 41% to RMB76 million. Adjusted EBITDA margin for the quarter was 19.2% compared to second quarter of 19.3% and also 20.5% in the prior year. More specifically the total increase R&D spending our new Gehua initiative adjusted EBITDA margin on operating basis we have remain steady.

Our adjusted net profit for the quarter was RMB52.2 million compared with RMB61.6 million in the prior year period. The decrease in adjusted net profit was primarily due to the RMB1.2 million foreign exchange loss in this quarter compared with our RMB24.2 million in the prior year period in 2011.

Adjusted net profit margin was 13.2% compared with 23.6% in the prior year period. Adjusted diluted earnings per share for the quarter was RMB0.18, which represents the equivalent of RMB0.90 or US$0.14 per ADS.

The diluted share count based on upon our weighted average number of the company's ordinary shares, as of September 30, 2012, our cash and cash equivalents and short-term investment was RMB700 million compared to RMB1.3 billion as of December 31st, 2011.

Accounts receivable turnover days or days sales outstanding was 61 days compared to 58 days in the second quarter.

Regarding CapEx in the third quarter of 2012 we spent approximately RMB192.2 million. For 2012 we plan to spend RMB537.2 million. CapEx are all in the structure as previously estimated the CapEx spending also including additional data center we plan to build in 2012.

Looking at our financial outlook, currently the company expect quarter four net revenue to be in the range of RMB430 million to RMB420 million. Adjusted EBITDA is expected to be in the range of RMB77 million to RMB83 million. This forecast reflects the company’s current and preliminary review which is subject to change. Moving onto our expanding partnership with Microsoft as Josh mentioned earlier, Microsoft has licensed to us to this technology the knowhow and like to operate in all the other 350 prior Windows service in China. Under this agreement RMB21 billion that we're hiring 200 to 300 software engineer who will be responsible for the design and technical support of the overall platform, customer support as well as the reorganization. In addition we will host and managing the Microsoft survey in our data center and will be paid by Microsoft for hosting and managing this service.

Microsoft has the finishing rate include CapEx for the server capacity part of the sales and marketing for this service at the warehouse the training of our software engineer, 21Vianet will also be in charge of all contract and billing as well as invoicing for the customer in China. For the top line perspective we'll share the revenue with the Microsoft channel week, we anticipate there for 2013 we will be able to generate additional 5% of revenue for 21Vianet. We don’t have a current margin expectation for next season for 2013. We anticipate also year too, after this launch, this service should be able to generate more than 50% gross margin. As we continue the ramping up our overall capacity and build our cloud service with Microsoft later in next year. We certainly believe this new initiative will further solidify our foundation and future growth potential going forward.

This concludes our prepared remarks for today. Operator, we’re now ready to take some questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And the first question comes from the line of James Ratcliffe from Barclays. Please go ahead.

Sandeep Gupta - Barclays Capital

This is Sandeep Gupta for James. Shang, could you provide us with status update on your relationship with China Unicom and Telecom? It seems like you’re able to add a significant number of leased cabinets in the quarter compared to the first half of the year and also if you could share thoughts on how should we think about the mix in the near-term as we go through this Microsoft project? That’s it that was my question?

Josh Chen

(Inaudible) as particularly as the company in the city where we don’t feel our data center normally we will try to lease those companies from China Telecom and Unicom and sell to our customer. So in the third quarter, actually we do have our several customer they did have a demand of the company also of the Tier 1 city. So we are helping them so right now still a lot easier to get our company function China Telecom and China Unicom in the Tier 2, Tier 3 city. So that’s our, we probably had some get the company from Tier 2 and Tier 3 set the company from Tier 2 and Tier city and sell to our customer. And your second question is regarding to the mix between the self-built and partner company. At the end of the third quarter China with the mix was somewhere around 63% versus 37%. Since we continue to build our self-built company by the end of this year we expect the mix will become 70% self-built and 30% partner. So that will be the mix towards the end of this year. Thank you, Sandeep.

Operator

And your next question comes from the line of Chad Bartley from Pacific Crest. Please go ahead.

Chad Bartley - Pacific Crest

Based on the investments in network capacity as well as the engineers that you talked about, can you give us some more commentary on your gross margin and your EBITDA margin, how that should progress next year, and into early 2013 versus late 2013. And then one more time can you go over what you expect in terms of the revenue contribution from the Microsoft deal? Thank you.

Josh Chen

For the EBITDA margin, I have to say because our partnership with Microsoft 21 billion actually we have acquired to only invest in the people and I mentioned on the release we will hire additional 200 to 300 people and actually all of them are Copenhagen and Geneva. So for the EBITDA margin that will impact on our EBITDA margin little bit but we do expect EBITDA margin for this year let’s say for the following quarter should be somewhere around like 19% to 19.5% which is a very consistent to what we had in the third quarter. And in terms of the Microsoft partnership revenue may be I talk about little bit more. Actually under the partnership agreement with Microsoft we are on a revenue sharing basis. So, but for the revenue sharing basis the 21 billion we will only recognize the net which is a portion of what we would receive. We will recognize that.

Okay, I’ll just give an example. If a customer ordered of $100 revenue, for the cloud service, and maybe $60, $70 will go to the Microsoft, but we will collect the money but for 21Vianet we will only recognize $30 and $40 of that $100 as our revenue and rest of that we will pay to the Microsoft as a royalty payment. The royalty prepayment is not a fixed payment we need to pay to the Microsoft. The royalty payment actually will be based on the revenue sharing. So no revenue, no royalty payment. So I also mentioned, by the end of 2013, 5% incremental revenue will be generated by this partnership. When I say 5%, somehow that implies the total revenue, our portion will be about US$17 million to US$19 million. That’s our expectation right now. Okay Chad?

Chad Bartley - Pacific Crest

Okay, Shang. And then just a follow-up on the margin, I mean with the guidance we can get comfortable with 34 gross margin EBITDA margin more or less, but in terms of 2013, should we expect pressure early on and then expansion later in the year or how will margins progress next year?

Shang Hsiao

I think about our gross margin for the year of the 2013. Right now at this moment, we expect towards the end of the 2013, the company should have somewhere around 23% of the EBITDA margin. But in the first quarter, in the beginning of 2013, we expect our gross margin should be somewhere between 19.5% to 20.5%., but gradually quarter-by-quarter we will increase the gross margin. So that’s for the EBITDA margin. In term of the gross margins, the gross margin for the third quarter was around 30% and we expect our gross margin will be quite stable for the next quarter, maybe for the first quarter of the next year. Then, thereafter, the gross margin we’re starting to pick up not only for the Microsoft power issue but also for the company we acquired Fastweb. Right now there gross margin actually is up somewhere around like a 35%. We hope in the future we can continue to increase their gross margin through the cost integration. So that’s why we expect our gross margin will continue to be increased. By the end of the 2013 we hope our gross margin will be increased somewhere around 33%.

Operator

(Operator Instructions) Your next question comes from the line of James Breen of William Blair. Please go ahead.

James Breen - William Blair

Shang, can you talk about as you building out and optimizing the network over the next, three to four months, what’s the capital structure of the company looks like, we noticed that you added some debt in the most recent quarter and, how ultimately do you think about in terms of financing? Thanks.

Shang Hsiao

Our COO already mentioned about it, because right now the traffic is running on our network actually was very, very high also we anticipate, the future traffic from the cloud computing service from this partnership Microsoft as well as the CDM service from the Fastweb.

James Breen - William Blair

So your hires were okay?

Shang Hsiao

So for the next three to four months, for the next three to four months, we were, starting to expanding as well as upgrade our network, region-by-region, through this upgrade and expansion and our network capacity would be able to support the company for the next couple of years. But when we doing this network expansion we probably will spend somewhere around RMB100 million for the next two to three months now RMB100 million actually already been budgeted for our next year CapEx, next year CapEx right now we are forecast should be somewhere around RMB600 million. Now only in the expansion of the network as well as building our own data center so do I answer your question?

Operator

(Operator Instructions) Your next question comes from the line of Gary Yu from Morgan Stanley. Please go ahead.

Gary Yu - Morgan Stanley

I have three questions if I can. First is that can you share with us how many revenue have you included in the third quarter net revenue numbers and what you expect in the fourth quarter on revenue from Fastweb? The second question I have is when I look at your fourth quarter guidance do you have a breakdown of hosting MNS revenue expectation going into next quarter because the guidance is kind of soft compared to what we've been expecting, so I just wanted to see you where the slowdown in revenue came from? And the last question I have is if I look at your CapEx number and your current cash position do you see any need for further financing either, from the debt market or the equity market in the near future? Thank you.

Josh Chen

For the fourth quarter right now we forecast the acquisition on company we had Fastweb till now we expect there may have somewhere between the RMB12 million to RMB15 million, that’s the revenue they may generate, in the fourth quarter RMB12 million to RMB15 million. And for the fourth quarter revenue, right now I think the breakdown I would say for the hosting business represent somewhere around like 57% and 33% go to the management network service, for U.S. mainly continue to say about the guidance, because when we’re starting to upgrade and expand our network region by region, because this expansion is very, very important for us. So when we say make assumption if we expand the network in Shanghai area and that area network will become a little bit instable during that period of upgrade and expansion. So somehow that was sort of a little bit was new order generation. Because normally our customers were putting their server on the company and we cannot charge them and here we can have the interconnectivity since the network will be instable during the period of time. So the time of the interconnectivity will be a little bit delayed. So we solved that, that’s why we provide more conservative revenue guidance in the Q4.

But for the upgrade and expansion of our backbone, normally will take three to four months and region by region. So once we pass through that then everything will be back to normal. That’s why we provide more conservative revenue guidance for the Q4. And CapEx for the next year, like I earlier mentioned will be somewhere around 600 million next year. And our cash position right now we still have more than RMB700 million that’s on our bank account, that money should be sufficient for us to carry over one to it or two years and whether or not we do have the need of the fund depend on whether or not how fast does just how they view our data center would be constructed, but we have not discussing the possible financial position right now. We're evaluating the situation but so far we still don’t have a plan for that coming under a discussion basis. But once we decided to do something we'll provide information to the market immediately. Thank you, Gary.

Operator

(Operator Instructions) And your next question comes from the line of C.K. Tang from JPMorgan. Please go ahead.

C.K. Tang - JPMorgan

Just a follow-up question regarding the network expansion as you mentioned earlier, could you provide some guidance on the duration on how long these networks upgrade take? Thanks.

Josh Chen

And the network expansion based on our previous experience because the company did that four years ago that took us three to four months and we upgrade and expansion region by region North, South and East and West. And so for the whole process, we expect will take somewhere around three to four months actually we already starting to do that, three to four months. But when I say that will affect the customer revenue generation for us, but that’s only for a particular region where we're doing the expansion, so three to four months. Okay, C.K.

Operator

(Operator Instructions) And your next question comes from the line of Eric Chu from Canaccord. Please go ahead.

Eric Chu - Canaccord Genuity

A couple of quick questions, one is utilization rate, I mean it looks like the quarter though the utilization rate is a little bit lower than (inaudible) back, should we start to see some kind of gradual acceleration from this point on and also the MRR per cabinet, I think from a power consumption perspective, should we start to see some of the new cabinets to have an incremental contribution to that benefit to that metric and finally I just forgot to make some general comments regarding the Internet traffic and also the general demand environment in China? Thanks.

Josh Chen

Secular rate, utilization rate was a 67.7% in the Q3 and originally we expect that utilization rate would be close to 70%. Somehow that’s a little bit under our expectation but I think but the sales order so far we have seen is pretty much over there but towards the end of September, is that time actually I have to say our network have a certain limitation on the increase of the traffic. So some other process sold down a little bit towards the end of the September. But going forward, I think that utilization rate will starting to pick up a little bit. But they will pick up in the region where we complete the expansion and as well as upgrade of our network. But we do expect the utilization rate will gradually pick up.

And another one is the for the MRR per cabinet, if you compare the Q2 and Q3 our MRR per cabinet, monthly recurring revenue per cabinet actually they remained quite stable. The think you mentioned about power increase that may contribute to our MRR per cabinet. We do see some signs over there that were helping our MRR but based on our 3Q, those are backup and not being in our MRR per cabinet. So maybe in the next two quarter once the power rate increase a little bit, that may contribute a sum in our MRR. And the third question is regarding to the Internet traffic, general internal traffic in China.

We do believe that internet traffic in China continue to grow. And that could be evidenced from customer and actually in Q3, we had one new customer become our top five customer. Before our top five customer they are very, very consistent and another company called YY, we believe they're doing very good job, for the past couple of months, and their traffic increased significantly. And also I also want to mention for the past two quarter, Q1 and Q2 our biggest customer at that time was Youku, 360Buy a private company. They now represent our biggest customer. And their traffic search for the past couple of months. And so at least from our point when we look at our customer internet traffic, those traffic continue to increase over the past couple of months. So, in the future, at least we remain confident the Internet shopping in China will grow based on our customer performance. Okay Eric?

Operator

(Operator Instructions) There are no further questions in queue. I will turn the call back to the management for closing remarks.

Josh Chen

Okay. Thank you everyone to join our call. Thank you. Have a good day. Bye, bye.

Operator

Thank you, ladies and gentlemen. That does conclude our conference for today. Thank you for your participation. You may all disconnect.

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