The data centre revolution: NEXTDC

Craig Scroggie is the CEO of NEXTDC who I spoke to in March. We don’t normally talk to people so soon afterwards but the thing is that when we spoke to them the share price was around about $6.50. It went up to $8 but after the results came out the share price fell back to $6.50 and it’s roughly where it is now.

The results were good — they beat expectations, beat guidance, beat what the market thought; it was a record result. I thought it was worth talking to Craig about what happened. The thing about NEXTDC is it’s a classic growth stock, it’s possibly the quintessential growth stock in the market. It has been growing rapidly, the share price has been going up, the revenues have been growing rapidly and it’s market cap is around $2.1 billion even at this current share price and the net profit was $6.6 million and so that is a trailing PE of 318 times. It’s on a forward PE of over 200, so a massive PE. A value investor wouldn’t go anywhere near this stock but it is building. 

The thing is, and it’s a bit like Amazon really, the profit needs to be ignored because it’s just building this infrastructure really quickly and all the money is just going back into building this business and this set of data centres as quickly as possible. Companies by their thousands, virtually every company, is shifting its computing into external data centres like those owned by NEXTDC. This is a very fast growing business and well worth looking at. I’ve got Craig to tell us what’s going on, why the share price fell and also just explain a bit again perhaps how the business works and what growth they can expect and when he’s going to bring home the bacon. 

Here is Craig Scroggie, the CEO of NEXTDC.

Craig, the main reason for talking to you again is obviously partly to catch up with what’s going on but the share price fell quite a lot after the results and I’m just trying to figure out or investigate why that happened.  It seemed to be that the market was expecting you to make new announcements of new contracts, big new contracts with your results but you didn’t do that.  I’m just wondering whether you acknowledge to some extent that you raised expectations of new contracts which were then not fulfilled.

Yeah, I think if you look at our FY18 results we beat market consensus.  We had record revenue and record EBITDA so company year on year growth continues to be 30% plus and on a compound basis from a start up, from zero first year, nothing in development, $1.2 million in revenue.  Fast forward, in excess of 150 in this year, $200 million plus in revenue, the company is still growing rapidly.  What happens in the data centre business ultimately is there are two streams, the first stream ultimately is the enterprise business and enterprise is all of those big companies that are moving out of their own offices, out of their computer room if it’s in a building, and they move out of that into a colocation data centre for a couple of reasons.  One, they don’t want to own generators, they don’t to run UPS systems, they need to connect to a multiplicity of service providers.  The second one is a lot of their computing today and will increasingly over time will be provided through public and private cloud.  The big second driver ultimately is the hyper scale public and private cloud.

For us what that means in our business is ultimately those big hyperscale customers, they make commitments to us for 5, 10 or 15 years.  Now, sometimes they come very quickly and sometimes they take a lot of time.  What you saw in our results and what the market saw was we had a record year so we’ve never sold as much obviously as we sold in FY18, it was a record sales year but we did a very big number in the first half and we had a small number in the second half.  We don’t control obviously the timing of those orders, we are a premium provider so we don’t view pricing discounts and other things to drive customers to place orders because these are if you’re making a 5, 10 or a 15 year commitment for your computing to be hosted with us it’s not something that you do quickly, it’s not a decision that you take lightly and it’s difficult for us ultimately to control the timing of those so I think the market reaction was probably yes we had a record year, we had record results.  We’ve given again another very big growth number for FY19 but we didn’t have in the second half of the year extremely large contracts like we signed in the first half and the market probably looked at that and said we just expected you to continue to do extraordinary things.

What we said to the market was we are still in negotiation for some very large scale commitments that we will obviously announce when they are complete but we didn’t do them in the second half.  So I acknowledge that as a growth stock the market expects us to continue to post extraordinary sales numbers and based on what we’re building, Alan, I think is the best description, the commitments to the size and scale of what we’re committed to fitting out or building out, we expect that public and private cloud computing will continue to grow at a very rapid pace.

Yeah, I think there was an expectation after your half-yearly report in February.  I don’t know whether that was justified or not but there was certainly an expectation that you were going to announce some big contracts.  Do you think you learnt anything out of that?

Sorry, in the first half we did announce some very big contracts so that was essentially the first half of FY18, we probably sold more in the half.

Yeah, you sold some contracts.  The market can do what it likes really I suppose, there’s an expectation built up that you’re just going to keep doing it.  I just wonder whether there’s a tension really, in terms of your market position there’s a tension between short term traders who are looking for kind of instant growth and so on, instant gratification and the long term investors who are there for sort of the 5 to 10 or 15 years.

There’s no question.  If you look at our larger shareholders, Alan, the big Australian superannuation funds, the larger and very long-term shareholders that have been on our registry and continue to join the company, and we announced that in the last raising a few months back obviously Uni Super, which is one of the large long-term superannuation funds in Australia, they had invested $150 million in us.  These guys don’t trade their stock, they are not short term, they look at long term fundamentals are the core drivers of the business, it’s an infrastructure business.  For us to build a building, and this is why the day to day machinations of the share price, share prices go up and down but what doesn’t change is the underlying long-term fundamentals of our business because we are a digital infrastructure business and I tend to think about data centres just like the roads, rail and port of yesterday.  Where we are going tomorrow as a society is that we are extremely reliant on all of these digital technologies and those digital technologies, whether it’s ones we use at home like a Facebook for social media or Netflix for movie streaming right through to digital productivity tools in the workplace like Microsoft, or Amazon, or Google, those things are not changing.

The underlying growth fundamental for long term digital infrastructure is very strong and we build the platform that allows those organisations to reach their end users both commercial and consumer.

I think it’s important to understand that you’re an infrastructure business rather than a real estate business because I think it possibly begets confusion because a real estate business rents space, you are selling something other than that, you’re selling traffic.  Perhaps you could explain to just remind us how the business actually works internally because you measure your data centres in megawatts not in space even though you buy space and you develop a building, you measure the size of the thing according to megawatts.

Of course, yeah.  The best way to think about the business at a very basic level is that the very first thing we do is we’re a hotel for computers.  There is a physical aspect to what we do, obviously we provide the home for all of that computing infrastructure to be located but that’s really the beginning.  The reason that we think about the business in the context of power is that ultimately over time you’ve seen in the last 50 years since Gordon Moore wrote the whitepaper that talked about the price performance doubling of integrated circuits which is referred to as Moore’s law.  That’s been true for 50 years and what we’ve seen is as the number of transistors on a circuit obviously continues to grow materially over time they get smaller and smaller space.  In computing we have seen that have a huge influence and that means that over time the data centre, the physical component, why a legacy data centre has changed materially certainly in the last decade is that you need more power and more cooling, efficiency, security, network connectivity, all of these things outside of just the physical component of providing space means that the business is a lot more complicated than just being a real estate business.

We provide 100% uptime guarantee for our customers and that’s for power, security and connectivity so it’s not just the housing and the security of the infrastructure but then the network connectivity to allow a multiplicity of people to connect to a service provider.  If you’re an enterprise, say if you’re a client of ours like Australia Post, today Australia Post will have hundreds of connections to other service providers that are business to business consumers of their services so you don’t only have the consumer services that are serving on their web infrastructure every day but you’ve got them consuming productivity tools from Microsoft, you’ve got them using Amazon, you’ve got them using multiple services and we provide the digital connectivity infrastructure that allows those enterprise customers to connect to all the clouds, the Microsofts, Amazons, Googles, IBMs, and hundreds of others.  The question you ask is a good one because a lot of people look at the business just like it’s a large real estate business.  At a very basic level that is true but that’s actually where the hard work starts.

How do you charge your customers?  You charge them per watt?

Customers pay ultimately on the number of kilowatts they consume for power, they pay for the space they consume, the density, they pay for the cooling and they pay for their connectivity.  There are a number of elements to the customers’ services that are very different to – if you have a look in our results pack, Alan, because this is actually a really good metric, we share this and we’ve shared it every half over the last five years.  If you compare us to a real estate business, if you look at our dollar per square metre yield in the data centre business we’re almost $10,000 a square metre.  If you did on a rental basis, if you just looked at it like a real estate business you won’t see too many real estate businesses that are generating $10,000 a square metre in income.

Not many at all I would say.

Because of all those other services we provide.

Yes.  The other characteristic of your business is that you’ve got a lot of depreciation so therefore you’re a high cash flow business but the issue of course as you’re growing is that you haven’t got a lot of free cash flow, in fact you’ve got bugger all free cash flow.

No, because growth requires cash as you know, yeah.  This is the other thing too about building a business like this, is that because it’s an infrastructure business it does require material capital investment upfront, that these second generation of buildings that we’re building at the moment and are opened, they open on day one – for example our second Melbourne facility opened a year ago, it will be under construction still for probably another two years until it’s fully fitted out.  Our second Sydney facility will open in this half and it will continue to be under construction for a couple of years while we start the third generation of facilities.  They are long multi-year projects and the capital required to build that infrastructure is material, we’re now looking at a capital envelope this year of just under half a billion in FY19 and with the Melbourne, Sydney and Perth, those three new developments over the next three to five years, it will be 2 billion plus in capital investment.

The characteristic of an infrastructure business is that they throw off cash and generally pay a decent yield.  Obviously, you’re going flat out at the moment, when do you think you will…

Yeah, they also grow slowly.

That’s right.  When can shareholders of your business expect you to bring home the bacon and become that kind of infrastructure business, is it ever in your future?

I guess it’s probably the question I get asked most regularly, Alan, and I’ll give you an answer.  I don’t have a perfect answer for this question because it’s an interesting one, and I pose it to you – I guess my answer I would pose to you as a question and that is if you look at our financials if you are able to generate mid high-teens early 20% return on capital for investment and you’re able to continue to grow at 30% to 40% every year and you continue to have great opportunities to build a long term sustainable infrastructure business.  Should you stop investing and essentially return that cash to shareholders in dividends or should you continue to take advantage of those opportunities, continue to grow at a rapid rate and continue to generate very high returns on invested capital.  We’re a growth business in the infrastructure space in a digital market that in my view today has no end in sight.  We have a vision to build a company that’s worth more than $30 billion, today we’re a company that’s worth $2 or $3 billion.  So in the next five to 10 years, yeah.

It seems to me it depends on what the payoff is.

That’s exactly the right answer, yes.

If the payoff is an exit then fine, keep building, but as long as there is a payoff, as long as you do get taken over by Amazon or something.

We’re not building the company, Alan, in the context of wanting to be bought by someone.  How did today’s ASX top 10 or top 50 most successful companies – they didn’t get built in five years.  People always underestimate what can be done in a decade, overestimate what can be done in a year.  We think about this is what we’re going to achieve in the next decade.  Infrastructure businesses take time, just to build a single building can take us two or three years until it’s fully populated and the scale of what we’re building now can take three to five years.  My answer for you is we plan to continue to grow the company as long as we can make great returns for shareholders and those returns in the context of return on capital they don’t necessarily mean that we would stop investing in the growth opportunities. 

We’re genuinely a growth stock and I think the answer for me is if we can continue to produce the style and type of returns that we are producing in the market and have produced over the last seven years we should continue to grow but if we couldn’t we would probably stop and look at that and say is now the time to change our strategy and be a dividend paying stock.  At the moment growth and returns, there’s few companies that are growing at the rate we’re growing at and there’s few that can demonstrate the return on capital that we are currently demonstrating.

That was Craig Scroggie, the CEO of NEXTDC.