Rudi’s View: Opportunity In Data Centres

Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | May 08 2024

Opportunity In Data Centres

By Rudi Filapek-Vandyck

The concept confounds many an investor, and market commentators too; from the moment the market understands there's a whole lotta growth up for grabs on the horizon, share prices move to above market-average multiples which, at face value, makes the stocks in question look 'expensive'.

But are they really? Is the opportunity already gone?

In many cases the answer is: no, the opportunity is still there. If the promised growth comes through, and management executes on the opportunities available, there's often plenty of room left for upside surprises, which, when looking back withhindsight, only makes that share price from the past, 'bloated' though it may have looked in-the-moment, actually a cheap 'bargain'.

One such prime example from the recent past has been delivered by healthcare imaging services provider, Pro Medicus ((PME)) whose share price has been trading on forward-looking multiples above 100x. But as the emerging global leader in its field added new contract after new contract, it forcedanalysts to regularly upgrade already bullish forecasts, with forward-valuations and price targets rising further on the back of it.

In simple terms: Pro Medicus shares looked 'expensive' back in 2020, when the price crossed the $30 mark. Last week they surged above $110. And while most analysts have valuations that are well-below that price level, Macquarie believes they are being too conservative. AI and new services and customers are still on the horizon. Macquarie has set a price target of $120. For now.

Goldman Sachs sits on $134.

In investment terms, Pro Medicus shares gained 52.8% in 2020, followed by 82.8% in 2021, then retreated -13.4% in 2022, only to advance a further 77.2% in 2023 and, thus far in 2024, another 15%. That's one helluva return for a stock that along the way attracted comments ranging from 'absolutely crazy', to 'bubble', to 'egregiously overvalued'.

For good measure: nothing from the past four years indicates this company will not encounter a growth hiccup at some stage, or worse, and its shares might well come back down to earth if that happens. But shouldn't investors equally be aware that such concerns, and calls of 'the next example of irrational exuberance', have been expressed way too liberally, and way, way too early?

For all we know, this company is nowhere near to about to run out of growth. Certainly, management at the helm thinks so. Thus far any weakness in the share price has been but an opportunity to get on board.

Never ask a barber whether you need a haircut. Never ask a value investor whether to invest into the next emerging growth opportunity.

Data Centres Are In Strong Demand

A similar dilemma has opened up with the emergence of generative artificial intelligence ('GenAI'), mostly in the US, and in the slipstream of the next tech (r)evolution, the surging demand for data centres.

Already, fund managers have been taking profits on their Goodman Group ((GMG)) shares that have appreciated by 45.7% in 2023, and by a further 33.6% in the first three months of 2024. Shares in NextDC ((NXT)) have gained 52.7% and 29.6% respectively and have been described as 'overvalued'.

But what if both companies are still only at the early stage of a strong demand growth period that has many more years to run? Might those elevated valuations in the here and now mirror Pro Medicus shares from years past?

A fresh research update by analysts at Morgan Stanley is certainly challenging all who are questioning the ongoing opportunity on offer.

With the local market for data centres to more than double by 2030 (150% projected growth), it's rather difficult not to expect a whole lot more upside for companies leveraged to that demand, assuming, of course, management teams execute and the global landscape does not come irrepairably unstuck, like through war or much higher bond yields.

Three things make this research exercise unique:

-it incorporates the latest updates and insights from US companies, today's heartland of GenAI and data centres

-the research is a deep, multi-disciplinary collaboration between analysts across technology, media and telcos (TMT), REITs, Utilities & Sustainability, and Mining/Resources sectors

-the research is uniquely focused on the Australian market

Let's start with the basic outcomes. Morgan Stanley's 12-month price target for data centres operator NextDC has been raised by 13% to $20 (Monday's share price $17), while the target for Goodman Group has lifted to $35.30 ($33.94 on Monday). The target for Macquarie Technology ((MAQ)) is $100 ($84 on Monday).

Supporting these upgrades is US feedback that growth in AI and GenAI, and the associated rapid rise in demand for computing power, is accelerating. This, in return, boosts demand for data centre capacity. Conclusion: a golden period has opened up for companies such as the three mentioned. Those worried about capacity catching up will have to wait many more years, all else remaining equal.

Not many investors would be aware, but Australia already is a global Top Five data centres hub, with capacity similar to London, but lagging the US, Europe, the Data Centre Alley of North Virginia, and Beijing/Shanghai.

Morgan Stanley's current projections imply additional investments made in new data centres will total between $21bn-$28bn over the next eight years, providing companies with an incremental revenue opportunity of $5.6bn-$8.4bn per annum. These numbers, states the report, could well prove conservative.

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