Why I think NextDC is undervalued
What’s going on with the share price of data center provider NextDC (ASX: NXT)? Over the past year, it has massively underperformed other firms in both the tech and AREIT sectors. But with interest rates staying low, and the demand for data center services booming, is its market valuation set to rise?
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.
cassidy
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Hi Gary,
Fast forward almost 12 months from when you wrote this article, NextDC is pretty much bang on the $13 price you predicted (currently $12.13 as I write this comment). This share price prediction was a long-term and conservative take on the numbers. My question is with NextDC hovering at the $12-13 mark already, how much more room for share price growth is there left? I have been researching cloud computing businesses extensively and am looking to invest in what is an industry with huge growth left.
Cheers Cassidy
Gary Rollo
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Cassidy – thanks for your question – we posted a more recent blog on just this very subject. Hopefully this helps answer your question. https://rogermontgomery.com/how-much-upside-is-left-for-nxt/
Kim
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Gary,
I’m puzzled by your 30 year life for the assets. Sure the building and possibly the racking inside may have a 30 year life but the computer hardware will typically be replaced every 3 years (warranty period) or more regularly. As a beneficiary of the 3 years cycle through purchases on Grays On Line auctions I can tell you that the resale value of the hardware is a small fraction of its original price, effectively 100% amortisation on computers every 3 years. The cooling system and power distribution may change at the same time or may be good for a couple of computer changes, depending mainly on technology changes with the computing hardware – computers become more power and thermally efficient as they evolve.
What’s the basis for a 30 year asset life?
Gary Rollo
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Hi Kim. Thank for your question. NXT provides the building and the infrastructure that creates the optimal environment for the IT equipment/Computers to operate. It doesn’t provide the computer hardware, these are deployed by the customers and you are right typically have a short asset life, the three years you suggest sounds about right. NXT’s infrastructure has minimal capex required to maintain it to the capability required over that 30+ years. Hope that helps. Gary
Andrew
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Hi Gary,
Thank you for your article. In addition to the NextDC share price underperforming the tech and AREIT sectors I have seen it reported as one of the top 10 most-shorted stocks on the ASX. Is this correct? I was wondering if you could provide some insight into what could be the short thesis for the business?
Cheers,
Andrew.
Roger Montgomery
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Let’s get back to you on that.
Gary Rollo
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Hi Andrew, thanks for your comment. Yes NXT has a significant short base, 13% of shares have been sold short according to shortman.com.au. I consider the short thesis to be a combination of two factors, first around the capital intensity of NXT’s growth & second around the earning “airpocket” that I introduced in the post. The post lays out our view around these issues – that NXT’s earnings capacity is about to increase considerably with the availability of the new S2 DC, i.e. the earnings airpocket looks like its about to come to an end. Also that whilst NXT’s growth is capital intensive, it has demonstrated that it makes good returns on that capital, that these assets are long duration, and our view is that those returns deserve funding. We think that the completion of construction of S2 is a significant catalyst for investors, including the shorts, to re-visit the stock. Hope that helps.
Stan Tan
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What are your thoughts on investing in a utility company like AGL instead of NXT?
Both are similar to a REIT or infrastructure type stock but NXT is trading like a growth stock which IMO it isn’t because of the capex required to grow sales and profits.
NXT’s return on capital is around the 15% mark which is similar or maybe just a bit higher than AGL.
Thoughts?
Roger Montgomery
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perhaps its the growth runway that differentiates them Stan.
Gary Rollo
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Hi Stan. Thanks for your comment. I haven’t thought to compare NXT to a utility, at least not at this stage of NXT’s life. NXT presents today as a growth story, but with the longer term cashflow profile of a REIT with long duration assets, with sticky customers with high friction costs of change. That will have some commonality with Utilities, but also present other different factors too. Gary
Dave Edgelow
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Hi Roger, Gary, a quick question if I may.
It’s interesting that customers pay for ‘power capacity’ in MW but NextDC would pay for the actual electricity (for many MW). Assuming this is the major operating cost and there are long-term contracts for hyper-scalers, how susceptible is NextDC to increases in electricity prices?
Price increases would also apply to competitors, so the question is about the risk of long-term service contracts, probably on a firm price basis, while input costs go up. For example, would a 50% increase in electricity cut GP by 10% and how was that considered in your investment thesis?
Dave
Gary Rollo
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Dave
Thanks for your question.
Power – yes its a key above the line cost, that is a Cost of Goods Sold (COGS) that gets incurred before Gross Profit (GP). Generally the Hyper-scaler part of the client base pay their own power bill, its simply a pass-thru for NXT. A rise in the unit cost of power would have no impact on NXT’s GP. Today we estimate Hyper-scalers are roughly 70% (maybe more) of NXT’s customer base. The other part of the customer base are what NXT calls retail, and here there is power cost exposure, where NXT provides an all-in cost to the customer including power. However, there is annual cost review (at a minimum) and if power prices rise to fast too quickly many of the contracts are subject to an out of cycle price adjustment to reflect the change. Note that if power prices rise, this is likely a factor that impacts all market providers (at the same time – and all are likely to lift prices to reflect the rising power cost). Plus the friction cost for an existing client to leave one DC provider for another (time, risks & $’s) is also a considerable factor. Clients tend to be quite sticky. In short, power costs are a factor, but not one we consider to be a long term value creator/inhibitor.
Hope that helps. Gary
Dave Edgelow
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Hi Gary, thanks for the quick and detailed reply, particularly at 9:30pm! Dave
brian lovelock
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Hi Garry
I would like to ask you a couple of questions please.
Does NXT have competitors within Aus ie are other data centres being built.
NXT are building bigger centres. Does the cost per MW fall for bigger centres.
Does NXT have expertise in building data centres ie do they have a competitive advantage in building centres or it a standard procedure.
Regards Brian
Roger Montgomery
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Thanks for the question Brian, I’d like Gary and Dom to respond to that one so stay tuned.
Gary Rollo
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Hi Brian – Thanks for your comment. Taking each of the questions in turn;
Competitors? – Yes. Major international groups – Equinix, Digital Realty & others and local players Macquarie Telecom, CDC & Others. Each have the same philosophy of building fitted-out capacity for the expected 12 month or so demand picture.
Does cost per MW fall in bigger centres? Yes the evidence suggests so. Each of NXT’s 1 series DC’s (with the benefit of hindisght) are now smaller than management would build in the same market today, as as the sites get bigger we can see that the new centres (series 2) capital intensity per unit of capacity made available is lower than its predecessor. Scale lowers unit capital costs, although other factors like land costs rising in suitable locations and currency (fit-out assets are USD denominated) will also play a part.
Competitive advantage in building (design) data centres? NXT will tell you yes – it has invested to achieve Cat IV certification. NXT’s strategy is to play at the premium end, catering for the mission critical end of the market. Our view of NXT is not assuming new DC’s built beyond S3, and therefore not dependent on NXT having a competitive advantage in new-builds. Its dependedent on NXT having great assets in the right place at the right time, with the sector drivers we see in place we think NXT’s asset suite, including S3 build, are likely to become fully utilised over time and deliver strong cashflows at maturity.
Hope that helps. Gary
Dr Patrick
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The article is at odds with the May 2019 article on WAAAX by Roger Montgomery which mentions risks of companies with excessively high EV to EBITDA including the mentioned Nextdc in the same article
Difficult to see how the financial metrics suddenly change in 5 months .
When cheap money ends we will see if this company is over valued.
Roger Montgomery
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Hi Dr Patrick, there are a couple of considerations here. The first is that The Montgomery Fund and the Montgomery Small Companies Fund have different mandates. The Montgomery Small Companies Fund mandate requires it to be fully invested at all times. As an investor you do the allocating of an appropriate amount to cash yourself. For example, if you decide that for every $100 of your investment portfolio, you want 10% in small companies, 15% in cash and the remaining 75% in other investments. You simply allocate those amounts yourself. Let’s now assume that over the course of the ensuing year, the Small Companies investment doubles (while everything else remains unchanged), your allocation to small companies might have risen to 18% of the entire portfolio. If your strategy is to re-balance your portfolio annually and back to the original weights, you would simply reduce your allocation to small companies and redistribute to the remaining assets so that the original weights are achieved. If you don’t want to manage the cash yourself, you may consider a fund like The Montgomery Fund. With the Montgomery Small Companies Fund the idea is that you, as an investor, will allocate an appropriate amount to The Fund, knowing that it will virtually always be fully invested.
The second consideration is that there are hundreds, if not thousands of way to invest successfully and The Montgomery Fund and The Montgomery Small Companies Fund are managed by different teams – as is also The Montgomery Global Fund. While the differences in investment philosophy might be slight, the way that investment philosophy is expressed can be different because different teams are making the decisions for their own funds. That provides you with a variety investment options and a diversification opportunity.
Finally, considering a company like NextDC; As you point out current metrics might make it difficult for a value investor that generally adheres to the requirement of a demonstrated track record, to include it in their portfolio. But what if as a life-long small company investor you have successfully invested with a company’s management in their previous venture and you can see that management are again traveling down a similar road to profit? In that case, and provided your mandate permits you to invest in early-stage or emerging companies, you can back management and invest in the venture.
It’s certainly a different approach. As you know, at Montgomery, we invest in quality first and we reckon Gary Rollo and Dominic Rose certainly meet our quality filter!
Dr Patrick
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With a p/e of 122 nextdc is hardly cheap anx has a negative eps for most of its time as a listed company hardly fits the value model that Montgomery purports to hold dear.
Roger Montgomery
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Hey Dr Patrick, The Montgomery Fund and the Montgomery Small Companies Fund have different mandates. The Montgomery Small Companies Fund is to be fully invested and the idea is that you, as an investor, will allocate an appropriate amount to The Fund, knowing that it is invested in smaller companies and that it will virtually always be fully invested. Keep in mind there are hundreds, if not thousands of way to invest successfully and The Montgomery Fund and The Montgomery Small Companies Fund are managed by different teams. Therefore the approaches are bound to be different. Take NextDC; the metrics make it difficult to justify with a traditional value investing mandate. But what if as a life-long small company investor you have successfully invested with a company’s management previously and you can see that management are travelling down the same road they executed last time? In that case, and provided your mandate permits it, you can back management even though the numbers might make an immediate value case less obvious.