Rising AI And Localization Costs Will Pressure Margins Yet Support Long-Term Recovery Potential

Catalysts

About Kingsoft

Kingsoft is a China based software and gaming company that develops AI enabled office productivity suites and operates a portfolio of online games.

What are the underlying business or industry changes driving this perspective?

• Although AI powered WPS individual subscriptions are growing at double digit rates and lifting user value, elevated R&D spending near 35% of revenue and rising server and bandwidth costs may prevent this user growth from translating into a sustained recovery in net margins.
• Although WPS 365 enterprise collaboration revenue is expanding rapidly among private and local state owned enterprises, the need to scale delivery capabilities and integrate deeply with complex OA systems could slow contract roll out schedules and defer enterprise revenue recognition.
• While localization projects for government and information innovation customers are growing above 50% and supported by policy tailwinds through 2027, any adjustment to procurement policies or local competition could cap pricing power and limit long term operating margin expansion from this higher margin software base.
• Despite accelerating international adoption of WPS on mobile and PC, intensified competition with entrenched global incumbents could raise overseas marketing and channel costs, delaying the point at which international revenue contribution materially offsets recent group level revenue declines.
• While the gaming portfolio is being refreshed with new IPs and overseas launches, continued drops in legacy high margin titles combined with heavier promotional and advertising expenses risk prolonging pressure on group earnings even if newer games gradually rebuild the revenue mix.

Assumptions

This narrative explores a more pessimistic perspective on Kingsoft compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Kingsoft's revenue will grow by 11.2% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 15.1% today to 14.6% in 3 years time.
• The bearish analysts expect earnings to reach CN¥2.0 billion (and earnings per share of CN¥1.45) by about December 2028, up from CN¥1.5 billion today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as CN¥3.7 billion.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 34.0x on those 2028 earnings, up from 24.4x today. This future PE is greater than the current PE for the HK Entertainment industry at 14.3x.
• The bearish analysts expect the number of shares outstanding to grow by 6.87% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 9.11%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The structural decline in legacy high margin online titles, combined with a 47% year-on-year drop in online games and other revenue and heavier promotional spending to support new launches, could mean the games segment remains a drag on group performance, limiting consolidated revenue growth and compressing net margins over the long term.
• While AI enabled office products, localization projects and WPS 365 are growing rapidly, the company is structurally lifting research and development intensity toward the mid 30s as a percentage of revenue. If this is maintained as AI competition escalates, it could structurally cap operating leverage and slow earnings growth.
• The strategy of competing directly with Microsoft Office in overseas 2B and 2C markets, even with mobile and AI advantages, may require sustained increases in server, bandwidth, channel and marketing costs to gain share. This could dilute the profitability of the international business and weigh on group net margins.
• Policy driven localization and information innovation projects, which currently underpin 51% year-on-year growth in WPS software revenue and offer higher quality demand, could decelerate if procurement priorities, budget cycles or domestic competition shift after 2027. This would create a structural headwind for long term revenue growth and margin expansion.
• The company is simultaneously scaling AI infrastructure, building out large campuses like the Wuhan industrial base and increasing share based compensation and personnel costs. Alongside a 70% year-on-year decline in operating profit before share based compensation, this raises the risk that rising fixed cost commitments outpace revenue growth and lead to structurally weaker earnings.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Kingsoft is HK$33.04, which represents up to two standard deviations below the consensus price target of HK$40.87. This valuation is based on what can be assumed as the expectations of Kingsoft's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of HK$51.32, and the most bearish reporting a price target of just HK$33.04.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be CN¥13.6 billion, earnings will come to CN¥2.0 billion, and it would be trading on a PE ratio of 34.0x, assuming you use a discount rate of 9.1%.
  
• Given the current share price of HK$29.0, the analyst price target of HK$33.04 is 12.2% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.