Back in October, we made the case that NEXTDC’s (ASX:NXT) material share price underperformance would be temporary and that there were catalysts ahead that would bring that to an end. Today, we update our thesis post NXT’s 1H20 results and outlook. So, what did we learn and how do our learnings apply to our NXT’s thesis drivers?
Learning 1 – The earnings “air pocket” is resolved – S2 delivered = earnings growth
NXT’s earnings growth outlook was impacted by the late delivery of S2, its 30megawatt (MW) data centre development in Sydney. NXT effectively had no inventory of sufficient size to sell to the booming Hyperscale market in Sydney since 2017 when S1’s wholesale capacity sold out. The delivery of S2, 14MW built today and building to 22MW by the end of the year changes the game here. Today, 16MW is contracted and this will convert to earnings steadily over FY20 & FY21 as those contracts deploy and billing ramps up. We calculate S2’s EBITDA capacity at $75 million (or so) which is material given NXT’s current EBITDA run rate of $100 million. NXT’s earnings growth outlook is back to positive.
Learning 2: Clarity emerging on funding options that could see NXT’s growth horizon extended
Our October article argued that NXT’s growth pipeline deserved funding given the strength of industry fundamentals, the quality and duration of the asset base and management’s track record of developing high returning assets. NXT’s results provided a funding outlook that included the following clarifying points relating to NXT’s funding needs and options:
Retail inventory funded for all markets
NXT needs a level of market ready inventory of MW capacity to do business in the retail market. A review of NXT’s available inventory position, coupled with the view that S2 is funded to get to 22MW built by the end of the year, means NXT now has a funded retail inventory availability position in all markets. Given retail sell through is around 2-3MW per annum, NXT’s expected funding needs for this business is, we estimate around $30-40 million of capex requirements a year, varying as the retail sell though rate rises or falls. This level of ongoing funding support for NXT’s retail business is well within the existing means of NXT’s capital structure.
Can NXT access Soveriegn Wealth type pools of capital?
The wholesale business and its large lumpy deals bring capital “indigestion.” Contracts here can require more than $100 million at a time, more if a new data centre site is required to service the capacity expansion. To date, NXT has funded these deals through raising debt directly on to its balance sheet. In the last six months we and the market have observed a steady stream of transactions involving global data centre operators and a new pool of investors that bring long term patient capital with low funding costs – the global Soveriegn wealth fund. NXT’s management’s view is that this type of investor is interested in the long tenor of wholesale (Hyperscale type) contracts due to their c.10 year duration, rather than retail with its shorter contract duration (3 years). In our view, this bodes well for NXT, as funding/investment partnerships here would address a significant market concern and could materially lift NXT’s growth options beyond that which is available to it today within it’s existing capital structure.
Absorbing these two clarifying points provides support for our view that NXT can fund its existing asset development pipeline, or choose to do so on terms acceptable to NXT. In addition the market may need to consider the potential for growth beyond NXT’s S3 asset development when assessing NXT’s valuation framework – an update on that later.
Learning 3: Confidence in Melbourne?
The hyperscalers (Microsoft and Amazon) have delivered a boom in the Sydney data centre market, we estimate they have deployed in excess of 100MW of capacity in this market over the last seven years. Melbourne however has not seen anything like this scale of investment, yet. NXT management’s investment case for M2 was made with the view that Melbourne would at some point become home to a second hyperscale availability zone in Australia. The facility opened in 1H18 and NXT has to date invested $150 million and we estimate is making around an unacceptable 3 per cent rate of return. Management spoke with increased confidence regarding M2’s prospects, which is consistent with industry feedback of emerging demand in Melbourne. We think that M2 could be a good asset as our maths suggest it offers NXT its lowest unit cost of capex per MW in its portfolio, and the site is more easily extendable than NXT’s other investment options. Contracts here have the potential to be financially significant, as well a positive shot for sentiment. Of course, it all depends on the timing of lumpy deals amongst other things.
Valuation – Digital infrastructure using 7 per cent cost of equity = $13
Our valuation view of NXT reflects its long-term asset nature and is cashflow based on what we believe is a conservative set of assumptions. We use a long-term cost of equity of 7 per cent, we take the view that, in the long run, NXT will be regarded much like a REIT, a sector where we see dividend yields today of 4.5-6 per cent. Our valuation includes only the assets we see in NXT’s existing portfolio that it has committed capital to – i.e. nothing beyond S3. A funding model utilising capital available from Sovereign wealth pools of capital would likely bring other value creation opportunities into this asset pool and could also lower NXT’s cost of debt which would likely be accretive to our equity valuation framework.
As we noted in in prior piece, we don’t expect to re-rate to that $13 valuation tomorrow but see NXT’s shares at $7.70 as good long-term value as management execute a proven strategy in a strong growth market to close that value gap over time.