How much upside is left for NXT?
When we started the Montgomery Small Companies Fund 12 months ago, data centre operator NEXTDC (ASX:NXT) was one of the first businesses we bought. On our analysis, the shares were cheap. One year on and the share price has almost doubled. NXT continues to be a great business but, at current prices, is it still a good investment?
Recap: what’s happened – “problems” resolved
At $6.50 back in October 2019 the market was fixated on two things; NXT’s earnings growth had hit an ‘air pocket’ driven by delivery problems with S2 (its huge Sydney data centre development) and the company’s ability to fund the growth pipeline. On our assessment it was those issues that were causing the shares to trade at just half of the $13 long term valuation we had for NXT back then.
Problem 1 – Tick: Earnings “air pocket” gone and certainty clarified. NXT management delivered S2, and that development is now sold out. Investors now view the company’s next data centre development in Sydney, S3, as an asset that can’t come quickly enough rather than wondering if it would get built at all. The earnings “air pocket” is now long forgotten, as it should be. Next year’s earnings is a pretty useless yardstick with which to assess value in a growth business developing and operating 30+ year assets.
Problem 2 – Tick: Capital raised and growth funding assured. NXT’s growth is capital intensive, however the company has a proven track record of developing multiple datacentres (9 and counting) having to date organically deployed $1.5 billion, building from scratch arguably the highest quality connectivity-neutral datacentres in Australia. Management have built these (mostly) on time and on budget and have demonstrated consistent returns on capital in the range of 15-20 per cent EBITDA/Capital, unlevered.
These returns are great, and these are 30+ year assets. Put your hand up if you want some of that!
Gary Rollo is the Portfolio Manager of the Montgomery Small Companies Fund. Gary joined Montgomery in August 2019 after spending three years at MHOR Asset Management in Sydney as a Founder and Portfolio Manager. Prior to this, Gary was a Portfolio Manager at Renaissance Asset Manager in Sydney for six years. Before moving to Australia, Gary spent five years in London running Morgan Stanley’s Technology Sector Equity Research Team, as well as two years covering technology companies for JP Morgan.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Scott
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Thank you Gary.
Scott
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Very good analysis of the NXT business model. As a long time holder partly because of an interview Roger gave about NXT many years ago, I do wonder where it will be in 5, 10 years time? At what point, do management stop investing in new dc’s, fill the already built and start paying down debt leading to dividends down the track? Not concerned with it at all, just curious. Craig and team have done amazing things to this point. Also, had a takeover been considered in your analysis. Thank you
Gary Rollo
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Scott. Thanks for your question. If there is a stock where it pays to take a long term view then its NXT. Its assets have 30 year plus life cycle. Its income potential is realised when these assets become fully utilised and that takes some time post the capital being deployed. But to your question. Where will NXT be in 5 to 10 years time. In my mind they have options. Stop developing and let the cash flow or carry the cashflow off to the next DC development opportunity. (Perhaps the clue is in the name NextDC…). If conditions in 5 years have the same demand clarity and drivers of today then its going to be tough for board and management to decide to stop. Why would they, every dollar they put down earns 15-20% return pre-tax unlevered. Now thats at odds with the model shape I have built that formed the basis for the analysis for the blog, but thats simply because I needed to draw a line in the sand to show the value in what they have in their project base today. In the long run, long life cash generating assets are coveted by those that have the luxury of long term capital availability – large pension funds, sovereign wealth fund type money. The visibility and certainty of returns for the assets in NXT’s portfolio fit those investors, if NXT stops developing they become a very attractive asset for those types of investors. Thats also likely in NXT’s long term future. Hope that helps. G
Anthony
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Thanks for the interesting article about a company with significant growth potential. But there’s two things that concern me. The first is the very low amount of revenue (205M in FY2020) for a company with a market capitalization of $5 billion. Not only is the revenue quite small, but they are still making significant losses ($45M). It makes me wonder whether their business model is actually profitable in the long term. My second concern relates to the very large capital expenditure required and the lifespan of the infrastructure. The property and buildings will have a long lifespan, but will the IT hardware (and cooling systems) become redundant or need replacing in 10 yrs time? How long does computer memory and computer hardware last? Surely not 30 years? So I am worried that there might be some large capital depreciations required in the future, and that this might make it very difficult for this company to make a profit when their revenue is so low. I’d be interested to hear your comments.
Gary Rollo
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Anthony. Thanks for your questions. Lets take them one by one. First the small amount of revenue relative the high amount of market cap. There are a number of factors in there, but the biggest is simply that the assets that NXT has developed and the capital deployed in them hasn’t yet come on line. At June 30 F20 NXT had $1.7bn of equity, and PPE (hard assets – the datacentres). These assets are at various stages of their lifecycle, using NXT’s Sydney assets to provide example S1 (16MW capacity) is full, S2 (30MW) is sold out & S3 (80MW) is under construction. Collectively NXT have committed $775mn to these assets, mostly S1 and S2, with another $1.2-4bn to commit (our estimate). Today only 25MW or so of that 126MW of capacity is billing and earning a return, but these assets we expect have the capability when full to make $350mn or so of EBITDA when fully built out and utilsed. Investors have seen the rate of return from a full S1, they understand the asset life and the demand drivers are strong enough to fill up that Sydney capacity (& perhaps more beyond that). So you get low revenue today, and the market cap comes from investors discounting the returns from the assets built or under construction and coming online. We have laid out how we get to our share price which supports this type of market cap.
The second question future capex required to maintain the assets. The first part around computer asset life. NXT doesn’t invest in those. NXT’s customers build out their IT assets in NXT’s DCs, NXT provides the infrastructure to allow them to do so and ensure that those assets can be always on and secure. Will there be capex associated with that infrastructure. Yes. Buts its small in the scheme of the asset values and the cashflows recieved from the operations of the assets. We have built 5% maint capex into our model and NXT think they won’t require anywhere near that based on their experiences with their first generation assets. It is however too early to know. Hope all that helps. G