NextDC And The AI Boom

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NextDC reported a beat on earnings, and its outlook is little more than gobsmacking, driven by AI demand. Can the company pull it off?

-NextDC notes overwhelming AI-based data centre demand
-Expansion plans considerable
-Cost, time, and return on investment in the spotlight
-Not the only player in town

By Greg Peel

NextDC ((NXT)) builds and operates data centres in Australia, but is also in the process of expanding to New Zealand and South East Asia.

In Australia, the company currently operates three centres In Sydney, with two more in planning (known as S1, S2, S3, etc.), three in Melbourne (M1, etc), with fourth in planning, two in Brisbane, two in Perth and plans for Port Hedland, Adelaide, Darwin, and the Sunshine Coast.

In technical terms, a data centre is a big building housing rows and rows of bloody big computers that suck loads of power and generate loads of heat, thus needing to be cooled with more power. The centres store and crunch data – loads of it.

There are different kings of data centres.

Enterprise centres serve the IT infrastructure requirements of corporations and are tailored to that corporation’s needs.

Colocation centres are used by multiple corporations to house computing hardware, servers, and supporting infrastructure, such as power, cooling, and networking equipment, in an off-site location.

Edge centres, are smaller, decentralised facilities that provide compute and storage in a location closer to where data are being generated and used. They are situated near their intended users, allowing for real-time data processing and analysis.

The biggie, however, is hyperscale centres. Hyperscale centres, also known as cloud data centres, are massive, centralised, and custom-built facilities which support primarily cloud service providers and large internet companies with enormous compute, storage, and networking requirements.

Hyperscale centres provide the capacity for AI. That’s why there’s a lot of excitement surrounding them, and why the rush is to build more.

The problem for data centre developers is first you have to buy the land, then the centres take a long time to build and cost an awful lot of money. Once built, capacity is typically leased on long term contracts, particularly for hyperscale, maybe ten to fifteen years, thus it takes a while for return on investment to convert into earnings.

Is it all just hype?

That’s what many thought when Microsoft launched ChatGPT and it seemed science fiction had caught up with reality, driving an AI frenzy on Wall Street, and leading to sceptical comparisons with the dotcom bubble/burst of 1999-2000.

But leading AI chipmaker Nvidia has silenced the critics, posting quarter upon quarter of significant earnings “beats” and blow-away guidance for the next quarter, all driven by demand for its AI chips. That story parlays into a need for data centres.

Perhaps the greatest takeaway for analysts following NextDC’s first half result release, which featured beats on revenue and earnings, was management’s upbeat commentary at the post-result conference call. Barrenjoey was compelled to describe it as “potentially one of the most upbeat calls we’ve attended this reporting season”.

NextDC’s cloud-driven assets have grown at an order of magnitude of some 2.5x each generation, note analysts.

Generative AI demand, however, goes a step further still, with NextDC suggesting GenAI demand will be 3-5x the cloud market. This could see the company fielding orders in the hundreds of megawatts, ie really big, which they could aim to satisfy with colocation or pure hyperscale data centres, or “AI Factories” — AI-dedicated assets, customised to AI’s needs.

As an example, management noted demand is such that one customer alone could account for all of S4’s planned 300MW capacity, if management was happy to take that concentration risk.

But to recap on what was noted above, Wilsons points out any material contract win would be multi-year, with any scalable earnings contribution many years off.

And there’s the matter of return on that investment. It would make sense that as the data centre market reaches scale, like any new technology, equivalent revenues per contract would diminish over time as prices come down.

Barrenjoey had assumed exactly that in its valuation of NextDC, but management has suggested second and third generation data centre returns could potentially match or even exceed first generation. The company is expecting, for example, M2-M3 returns could meet or exceed M1, with Barrenjoey noting the land for M1 was acquired at premium, perhaps future builds will be more efficient given scale, and the pricing environment remains favourable.

If you build it they will come. Management noted because demand still significantly exceeds supply, it had seen significant improvement in unit pricing for both enterprise and hyperscale customers. Management also noted NextDC has never had a pipeline of size and scale it has now.

Funding?

It all costs money – lots of it – and time. Can NextDC find the funding to satisfy demand and still make a solid return on investment?

Management reiterated FY24 guidance at its result, implying fixed cost growth increasing to -$14m in the second half from -$6m in the first, Goldman Sachs notes.

As at the end of December, the company had liquidity of $2.09bn, including an undrawn debt facility of $1.5bn and $589m in cash. But that won’t cover the cost of planned expansion.

Due to higher density, a smaller AAA-rated customer base and earlier positive cash flow profile, NextDC may be able to borrow against these contracts and lower its cost of capital, Macquarie suggests. This broker would expect the terminal return on capital invested and revenue per megawatt for this capacity to be lower than the current asset base, but with a higher internal rate of return. This would increase cash flow.

There is also the possibility of joint ventures, Macquarie suggests, but structure and return profile is unclear. This would nevertheless reduce the risk of a capital raise in a scenario in which a large amount of capacity is brought forward.

At its result release, NextDC reported over 50MW of build capacity under development with a further 50MW-plus of additional developments in plan, including accelerated expansions for S3 and M2. Additional capacity is also planned at M2, M3, S3, P2, B2 and SC1 (Sunshine Coast) in line with record pipeline and strong growth in enterprise, cloud and AI demand.

So no mucking around.

Surely it’s a winner?

Wilsons, Barrenjoey and Goldman Sachs each have a Buy or equivalent rating for NextDC. Among brokers monitored daily by FNArena, Macquarie, Citi, UBS and Morgans also have Buy-equivalents.

Post-result, Wilsons lifted its price target by 32% to $20.07, Goldmans by 13% to $18.80, and Barrenjoey went to $18.00 from $13.80. The consensus target among the other aforementioned brokers is $18.77, up from $15.23 prior. We note the share price has appreciated some 10% (last $16.75) since the result release.

Ord Minnet, nevertheless, lifted its target to $14.00 from $12.00, which looks a bit out of place. Ord Minnett also stands out with a Lighten rating. This broker has a five-step system, so Lighten sits between Hold and Sell.

Ord Minnett white-labels some of its research from Morningstar, including NextDC, and Morningstar is very big on “moats” – basically barriers to entry – and suggests NextDC doesn’t have one.

Morningstar thinks the company lacks sufficient network effect, cost advantage, or switching costs to warrant an economic moat. The Australian data centre industry is rapidly growing, the research house notes, and there are many players investing heavily to capture demand, including the world’s leading colocation provider Equinix.

The issue with such a robust, long term demand outlook is that earnings and cash flow in the short term will be negatively affected, Morningstar notes, because spending on new capacity takes time to plan, build, fit out and fill with customers.

DataCentre magazine has rated the top ten data centre companies operating in Australia, with NextDC currently second behind Equinix.

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