Two companies ticking the boxes

Short term performance is not something we tend to focus on here at InvestSMART, so it came as a pleasant surprise to us when we saw the InvestSMART Ethical Share Fund (ASX:INES) was the highest performing actively managed Australian equity ETF* for the month of October returning 1.8%.

The portfolio uses an ethical screen which rules out companies associated with mining, gambling, alcohol, tobacco etc. This allows the team to focus on hand picking companies that can grow and become tomorrows leaders rather than focusing on yesterday’s heroes.

Here are Portfolio Manager, Nathan Bell’s thoughts on two companies in the Fund.

ResMed Inc.

ResMed, a developer of medical devices to treat respiratory disorders, saw its share price jump 10% following a strong result for the three months to September. Revenue growth accelerated with sales increasing 17% to US$681m after removing the effects of currency fluctuations.

Better yet, operating profit rose 19% thanks to the gross margin's expansion from 58.3% to 59.5%. Last year's acquisition of MatrixCare - which operates on a higher margin - was one contributor, but we're glad to see management's ongoing program to cut costs in manufacturing and procurement still working its magic. 

The core business of selling continuous positive airway pressure (CPAP) devices and masks performed strongly, with revenue up 13% in the Americas and up 8% in Europe and Asia. We're happy to see Asian and European sales back in the black, as recent results have been poor due to government rebate changes in Japan and France last year.

The company's high-growth software-as-a-service (SaaS) business - led by Brightree and MatrixCare - increased revenue by an impressive 83%, though the division still only accounts for 15% or so of total sales. 

Growth in research spending outpaced revenue growth, but this is a business where extra research spending today is better thought of as an investment in future sales. Net profit still managed to increase 14% to US$135m.

NEXTDC Limited

We started building a position in data centre company NextDC. NextDC spends lots of money upfront to construct large data centres for which it won't earn any revenue for some time. 

Even when revenues do start to appear, the profits generated depend on utilisation rates. A data centre at 20% capacity won't be making a profit and it's only when utilisation rates get towards 80-90% that margins start to rise and strong returns can be earned.

That means there are reported lags - costs are counted early and profits take time to trickle in. 

The highest margins, which ultimately contribute to strong returns on capital, only start to be realised a few years after a data centre is open. There are three significant costs that get counted in the meantime.

Power must be paid for and is the largest direct cost. That mostly gets passed through straight to customers and is usually paid in proportion to utilisation. 

Accounting depreciation for construction of the centres, however, starts being recognised straight away, before utilisation has ramped up. That means new facilities attract plenty of cost without contributing much revenue. In other words, as NextDC spends mightily on new projects, profits tend to be understated.

Lastly, corporate costs appear unusually high. At over $17m, this equates to about 18% of interim revenue. That isn't necessarily a sign of management largesse; it includes sales, marketing, customer support and development costs of new sites. We also note high interest costs while the company builds furiously.

With that understanding in mind, the accounts make more sense. Depreciation, amortisation and interest costs come to about $50m in the interim accounts and go some way to explaining low reported profits. 

Revenue and margins ought to climb as the company's sells capacity at new centres. This isn't as scary as it looks. Yet the discomfort and scepticism that accompanies NextDC might just be the opportunity. 

Building stickiness

It's easy to focus on the standard financial metrics but other numbers are just as important.

NextDC aims to attract large cloud platforms inside its centres. These platforms - the likes of Google, Amazon, Microsoft, Netflix - use third-party data centres to allow customers direct server connections. 

These interconnections, also known as cross-connects, are a crucial service. They provide a meeting place where businesses can create physical connections with one another on neutral ground and, for NextDC, they generate stable, high-margin fee revenue. 

The number of interconnections grew 34% over the period to almost 10,000. Over the past four years the number of interconnections has grown 42% a year compared to customer growth of 27%. Each customer now has, on average, nine cross-connects, up from five in 2014.

Interconnections are starting to resemble an eco-system in their own right and customers will find it hard to untangle themselves from that web. 

NextDC currently earns less than 10% of its data centre revenue from cross-connects. By contrast, Equinix, the industry giant, earns over 17% and that number is growing strongly. There is still a long runway for NextDC to establish and grow its web of interconnections. 

Interestingly, the revenue per cross-connect is rising. In 2015, the company generated $985 per connection; it now generates $1,278. 

With the number of connections rising strongly and revenue per connection growing, there is scope for margins to expand and for cross-connects to contribute more to profit while keeping customers put.

High risk

NextDC resembles an infrastructure business more than a technology one. It spends big sums upfront and earns steady, high-margin cash flows over time. The big difference, however, is that the data centre industry attracts far more competition.

High margins and soaring demand have ensured capital is flooding to the industry. We've been concerned about additional capacity being built by competitors and how it might impact pricing and utilisation.

So far, the impact appears limited. Revenue per megawatt (MW) actually rose slightly to $4.5m and has been rising three years running. It's worth asking how, with so much capacity entering the industry, pricing remains firm.

One answer may be that it's just too early for prices to start falling and that, eventually, they will. That remains a key risk. Another explanation, however, is that data centres that are already at capacity are showing surprising growth.

NextDC's mature data centres boast utilisation over 90% but still include contracted price increases of 2-3% a year as well as growth in interconnections. The company also suggests that customers increase their power density over time, meaning that they occupy the same space but utilise more powerful equipment. 

Equinix reports that its mature centres still generate 7% revenue growth annually. It's likely that NextDC will perform similarly.

In our view, NextDC is building an infrastructure business that locks in customers and could provide decades of long-term stable cash flows at a high margin. NextDC's mature assets and immediate growth options are probably worth $5-8 a share while longer-dated growth options could see the business worth up to $15 a share. 

See here for more information including how to invest in the InvestSMART Ethical Share Fund.

To invest in the InvestSMART Ethical Share Fund simply look up the code INES in your share trading account.


*Bell Potter report, click here to read

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