NextDC and the contrarian's dilemma

Have you ever tried patting your back with one hand and slapping your head with the other? We have.

Our original review of NextDC recognised that this was a terrific business even though its financial results suggested otherwise. At the time, NextDC earned low returns, low margins and wasn't profitable. Cash was flying out the door and, for puritans who only buy businesses with high returns and low multiples, this was yet another hot stock to avoid.

We argued, however, that building data centres naturally entailed high upfront costs and that, as utilisation grew, so would margins.

We also noted that NextDC specifically employed a strategy of welcoming large hyper connectors to their facilities which encouraged smaller firms to join the eco-system. This ‘Westfield' model earned high margin connection fees and resulted in low churn rates.

After noting all these positives, however, we didn't upgrade. Cue the slap.

Contrarian dilemma

Contrarians often face this conundrum: a newish idea that is isn't recognisably cheap, propelled by an enthusiastic narrative, is not our natural hunting ground. Adding to that, this is a technically complex industry and we're often reluctant to upgrade a stock the first time we encounter it.

Excuses aside, NextDC has soared since our initial coverage, rising 75%, and the business is performing splendidly. New facilities have been financed and built without incident while higher utilisation has indeed led to higher margins.

Having raced passed our original sell price, what should we do now?

The first thing is to forget about the price. The business has grown since we last looked at it, so a certain amount of hope value has become reality and we need to include that in an updated valuation for the existing business. From there we can consider opportunities for further expansion and see if a margin of safety exists.

Bigger and better

The most significant change has been capacity which, following the completion of new data centres, has risen from 43 megawatts (MW) to 87MW, an important fact because capacity is sold on a power output basis rather than by server or shelf space.

That capacity is not yet fully utilised so we must make some assumptions about revenue to gauge how profitable this might be. If we assume $4m per MW, NextDC should generate about $350m in revenue from a fully utilised asset base. That won't be the case this year or next but, in short time, we expect utilisation to fill up. The movement of data from owner hosted servers to the connected cloud is nowhere near maturity and growth has been rapid.

As data centre supply grows, however, it is reasonable to expect margins to fall as well. Hence we lower our margin assumptions from 70% to 60%, which suggests earnings before interest, depreciation and amortisation (EBITDA) of about $210m.

On a multiple of about 12 times, those earnings would be worth an enterprise value of about $2.5bn. Deducting net debt of $100m would then leave an equity value of about $2.4bn or $7 a share – not too far from today's share price. We can cross-check that number by looking at the balance sheet. NextDC reports net tangible assets of about $2.60 a share and we expect that asset base to generate return on equity of about 25%. With that kind of return in mind, paying three times NTA seems a reasonable price. Those hunting for an obvious mispricing will be disappointed: there doesn't appear to be one here.

Ambition grows

That counts the completed asset base available today but the business has also already committed funds to significant expansion. NextDC is building three new data centres that will seek to double the capacity of its existing footprint. We aren't counting that development which leaves a window for the optimistic.

If you believe NextDC can build those new centres and fill them with customers, and that the industry will continue on its current trajectory, it's possible NextDC is still cheap. For us, though, that entails entirely too much hope and doesn't count the risk. We also note that as management's success swells, so does its ambition.

The new construction phase is enormous and, in a fast-moving industry with large, powerful competitors and customers, we treat big upfront expenses with caution.  

Advantage NXT

Interconnections (that is, physical fibre connections between server) have grown faster than revenue or customers and we expect this trend to continue. The network now boasts about 7,500 cross connects, each contributing sticky high margin revenue and each acting like a cabled anchor to keep tenets in place. Just three years ago, there were only 2,000 cross connects. The Westfield model is working.

NextDC will also connect its metro data centres with fibre to provide yet more connection possibilities and with that yet more stickiness. This is a crucial competitive advantage and highlights a key attraction of the business. Once inside the web, it is hard to escape without incurring significant cost and inconvenience. And once captured, there are further opportunities to sell customers additional services and add high margin revenue.

This remains a business we would love to own. Yet management's ambition should be countered with investor caution; we ought to look down before we look up. We are raising our buy price to $6 and our Sell price to $10 but this remains a stock on our radar. HOLD.