NextDC Sell-Off Unwarranted

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Data centre operator NextDC has been sold off sharply but brokers believe the company's position has been greatly misunderstood.

-Investors nervous about new wholesale supply coming to market
-Yet, content companies remain dependent on operators to aggregate services
-Has the share price fall made NextDC an acquisition target?
 

By Eva Brocklehurst

Data centre operator NextDC ((NXT)) has been sold off sharply in recent months and the stock is now at a compelling entry point, brokers believe. They assert that the company's position has been greatly misunderstood.

Morgans attributes a large portion of the slump in the share price to rising market interest rates, which lowers valuation. A second part to the problem lies with confusion over market dynamics. While the former is justified, the latter confusion is misplaced and creates a buying opportunity.

The broker points out that the company does not compete with the likes of Microsoft Azure, Amazon Web Services, Google Compute Engine or Alibaba Cloud. Rather, many of these names are customers and their success will continue contributing to NextDC's evolution. Microsoft, for example, generates around 90% of its total revenue from distributors, which add value by bundling services on top of the Microsoft offering.

The broker suspects investors are nervous about new wholesale supply coming to the market, yet international operators have always used a combination of co-location and wholesale, or owned, facilities. Despite content companies having their own facilities overseas, and in some cases in Australia, they remain dependent on operators to aggregate their services and put them close to the channel or end user.

At current levels Morgans believes investors are paying for the success in the build up of the company's base data centres and paying nothing for the new facilities.The broker looks back at 2014 and notes this was a good time to buy the stock, as investors panicked on hearing about pricing pressure from B grade facilities and it was later proved that the company's value proposition was unique.

The main risk to the share price relates to the rate of sales and whether this levels off, slows or accelerates, in the broker's opinion. Faster customer demand would lead to an appreciation of the share price because of a higher fill rate. Conversely, slower demand may disappoint relative to market expectations.

The business is very capital intensive, so the ability to access funding on an ongoing basis and utilise debt effectively is the main operational risk. The broker believes the company has the balance sheet capacity to handle substantially more debt and self-fund expansion through operating cash flow from the base buildings. Morgans upgrades to Add.

Deutsche Bank also observes NextDC has underperformed recently and this is driven by a sharp increase in risk-free interest rates which reflect the stock's perceived quasi-utility characteristics. Competition concerns, a lack of catalysts and significant recent equity issuance have exacerbated the outlook.

The broker expects competitive concerns are largely overdone and the sensitivity to increased rates is reduced after the recent de-rating of the stock. Deutsche Bank finds the valuation compelling, with NextDC trading at a 28% discount to its peers, on an ungeared asset basis.

This broker also contends new entrants to the market target customers with different data storage requirements such as backup data and they also possess higher risk profiles. Hence, the risk factor for the company is expected to be repriced more favourably over time.

The company has raised a significant amount of equity capital in the past year, which has increased exposure and allocation for existing equity holders. Deutsche Bank observes this produces fewer incremental, motivated purchasers of the stock to provide share price support. Coinciding with risk-free rates and competitive concerns, this contributes to the recent weak performance.

Deutsche Bank notes a significant amount of new capacity in absolute terms and the company does not generally announce anchor tenants, so the potential for positive catalysts for the new data centres remain somewhat limited over the next 12 months.

Citi follows a similar theme. The broker does not believe the proposed entry of AirTrunk into the Australian data centre market will have a material impact on NextDC. Demand is expected to absorb the potential expansion, and new supply is expected to be added incrementally and rationally.

The broker explains the current situation for NextDC as a converging of models. When the company listed it was providing secure facilities where retail customers could locate hardware/software infrastructure. Over time strong growth in cloud providers has meant the focus shifted towards a more balanced exposure between retail and wholesale customers. Around 60% of the company's FY14 revenue came from white space customers and Citi expects the wholesale/retail split to be around 50% currently.

One question the broker does ask is whether, given the recent share price fall, the stock is an acquisition target. Citi outlines two potential reasons to acquire NextDC and notes the global data centre industry has been consolidating. The first reason is global players that may be looking to expand their Australian footprint and the second is wholesale players looking to expand a retail offering.

There are six Buy ratings on FNArena's database. The consensus target of $4.49 suggests 48.3% upside to the last share price. Targets range from $4.01 (Morgans) to $4.90 (Macquarie).
 

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