Rudi's View | Apr 12 2017
In this week's Weekly Insights:
-NextDC: The Coming Of Age Of A Cloud Infra Story
-No Weekly Insights Next Week
-Conviction Calls: Morningstar, CLSA, Morgans, Moelis
-New Website: VIP Promotion For Subscribers
-2016 - L'Année Extraordinaire
-All-Weather Model Portfolio
-Rudi On TV
-Rudi On Tour
NextDC: The Coming Of Age Of A Cloud Infra Story
By Rudi Filapek-Vandyck, Editor FNArena
The late Winston Churchill was once quoted as saying: "You can always count on the Americans to do the right thing, after they have tried everything else". I have come to the conclusion that one might as well replace "Americans" with "the share market" and stick with the rest of that quote.
As a case in point, in December last year I spoke at the special Christmas event of the Chatswood chapter of the Australian Investors' Association (AIA). The theme was whether I had one regret I wanted to share with the audience, or one important lesson, and I chose NextDC ((NXT)).
When it comes to companies operating in a favourable environment, we would all be hard pressed to list many companies that have even more favourable operational dynamics than has NextDC, in my view.
As consumers we are all using ever more data in our daily mobile and online habits and the same applies to businesses, both big and small. More data and services are migrating from hard drives to the cloud, just ask Atlassian, Xero ((XRO)), WiseTech Global ((WTC)), and many others.
This migration is in its early stages, still, with steady, double-digit annual growth in general uptake pretty much assured for the next decade or so. Meanwhile, large international players such as Amazon, Microsoft, Google, Oracle and IBM are providing the infrastructure that facilitates such migration. While all are experiencing robust growth in cloud infrastructure, entering the game requires large investments and long lead times, not to mention the technical scrutiny. Nobody wants to see clients data go missing or becoming publicly available.
Early stages of migration, the world around. Big players trying to catch up with demand. High margins for early movers. This situation calls for more entrepreneurs being lured into this emerging growth sector, assuming they can secure the funds to invest.
This is where NextDC fits in. The company operates data centres in Sydney, Melbourne, Brisbane, Canberra and Perth and has secured the funds to expand with one new centre in each of the first three cities.
Note the expansion was initiated one year earlier than planned because demand is so high, the existing centres are filling up faster than anticipated.
Still, none of the above guarantees that NextDC will end up being a local success story. Management can make mistakes. Delays can happen. Industry dynamics can change. Competition can change pricing in the industry. But thus far none of these risks has actually materialised.
Instead, I would argue operational risks have diminished as management has been able to showcase its expertise and abilities and success is being seen with the first data centres in Sydney, Melbourne and Brisbane, less so with the under-utilised centres in Perth and Canberra.
Last year I allowed NextDC to become the largest holding in the FNArena/Vested Equities All-Weather Model Portfolio. This was partially on the back of a robust share price performance. Between March 2015 and September 2016 the share price rose by no less than 176%. Then the Big Switch announced itself and the share price landed in free fall.
This is where Churchill's opening quote, amended for the share market, finds its justification. Knowing you are owning a marvelous, longer term investment that, sadly, short term has fallen out of favour is one big gut-wrenching experience, as I can report from first hand experience. Or as I said to the Chatswood audience: character building.
Nevertheless, lessons have been learned. NextDC, now in free fall, sort of automatically became my Conviction Call for the year ahead. I truly hope many in the audience that night have grabbed the opportunity that a non-interested share market was offering at the time. Because guess what happened? NextDC shares have rallied back to where they were in October, and that's not that far off from their peak in September.
Still, FNArena's consensus target ($4.43) sits more than 14% above today's share price. UBS even has a price target of $4.80, suggesting further upside could still be in excess of 22%.
Part of the growing attraction of NextDC, and one of the attractions when I first started buying shares for the Model Portfolio back in 2015, is that large parts of the investment community are as yet not familiar with this company. There's a general idea, sort of, without much attention to depth or detail. But interest certainly is growing, with positive impact on the share price.
On my observation, the more analysts cast their expert eye over the company and its potential, the more positive news flow is being generated to add to NextDC's investment appeal. The latest to initiate coverage is Canaccord Genuity. On March 31st the stockbroker issued an initiation with Buy and a $4.85 price target; even higher than UBS.
From the Canaccord Genuity research report: "NXT's ecosystem is well-rated by independent global data centre database, Cloudscene, ranking second only to Equinix in Australia. Individually Cloudscene also rates NXT's assets highly, with each of M1, S1, B1 and P1 appearing in the top 10 (out of 214 facilities in the directory)."
In other words, the analysts subscribe to the thesis that NextDC represents "quality". Equally important, on the analysts' calculations, a share price of under $4 (where it is now) only reflects the value of the existing data centres: "we believe investors are therefore currently paying very little for an option on the development portfolio, all of which are significantly larger than their existing city counterparts and could be worth significantly more in the future".
Of course, I hear some of you saying, this company is not profitable as yet and there are no dividend payments on the horizon. True. These achievements will be there one day, I am sure, and last year these factors were used as justification to sell down the shares from $4.41 to $2.80, but one cannot overlook the fact this future owner of critical infrastructure is still in the build-up phase.
Underlying, this is how growth looks like on Canaccord Genuity's projections: 405% in FY17, 51% in FY18 and 119% in FY19.
Ten days before Canaccord Genuity's initiation, analysts at RBC Capital released their update on demand for cloud services and cloud servicing infrastructure in Australia. Their conclusion: the local market is facing a shortfall, due to fast growing demand, and NextDC seems but poised to grab a big chunk of the demand coming to market.
RBC Capital has a price target for the stock of $5.50 (the highest I have seen to date) and the rating is Top Pick, which was re-iterated with the release of the report.
From the report: "We see NXT as being well positioned to capture significant upside from the substantial demand for data centre space coming to market in the next few years. We see recent concerns around over-capacity in Sydney and Melbourne as unjustified, especially in a geographical context, and expect NXT to surprise the market with positive news over the next 12 months as its 2's open".
Underpinning RBC Capital's positive view is that cloud computing services as an industry is projected to grow at 12-14% per annum over the medium term, while NextDC in a relative sense remains undervalued vis-a-vis international peers, despite a substantial revenue growth profile over the next five years, while the three new centres combined should add $1.50 per share in value for the company.
It is always difficult to make too confident predictions in the face of adversity and share market silliness, but I had anticipated that a strong interim report in February would awaken the market's animal spirits and bring some mojo back for the NextDC share price. This is exactly what has occurred.
Consider that in February, prior to the result release, NextDC shares were seen hovering just above $3. They touched upon $4 by the end of March and have retreated somewhat since.
Having drawn valuable lessons from 2016, NextDC is no longer the largest holding in the Model Portfolio, but it remains a key holding and I continue to view its prospects in a positive light. Not everything that falls in price turns out a wonderful and attractive investment opportunity. Investors have once again been reminded of this fact by The Reject Shop's ((TRS)) profit warning on Friday.
I suggest, however, that if the share market for whatever reason again decides to abandon this future success story (it is but a small cap story, after all), you won't let the opportunity slip past.
In the meantime, it remains imperative that management continues to meet market expectations (as it has to date), in particular when building and setting up the additional centres which are scheduled for completion by mid-year (Brisbane and Melbourne) and later this calendar year (Sydney).
No Weekly Insights Next Week
Your Editor will take a break next week hence Weekly Insights will not be published in the week April 17-21. The next edition will be written and sent out on Monday 24th April to paying subscribers and published on Wednesday 26th April for non-paying members and other readers.
Conviction Calls: Morningstar, CLSA, Morgans, Moelis
Mining analysts at Morningstar, what most of us still remember as "Huntley's", are not siding with the market bulls on bulk commodities. Last week, Mathew Hodge and David Wang issued a report titled "False Dawn: The bulk commodity mining rally will prove short-lived".
The title essentially says it all. Market euphoria won't last. Chinese demand is credit-led, and thus temporary. Smaller, high cost producers are using the boost in prices to re-enter markets. Share prices look bloated. This is going to end in tears.
Central to Morningstar's thesis is the assessment that Chinese steel demand should already be in a down-trend. In 2016 Chinese authorities went against the grain by stimulating credit growth and this has created a contra-trend anomaly. Investors should not assume last year's market dynamics to last much longer.
Morningstar thinks -20% downside for the larger diversifieds Rio Tinto ((RIO)) and BHP Billiton ((BHP)) is not out of the question, while smaller single-commodity leveraged companies such as Fortescue Metals ((FMG)) and Whitehaven Coal ((WHC)) might well see their share prices deflate by some -50%, again.
Underlying such assessments is the prediction bulk commodity prices remain poised to trend back towards US$35/tonne for iron ore and US$80/tonne for metallurgical coal. Currently, these prices are closer to US$75/t and US$175/t respectively.