Investors have a habit of being seduced by megatrends and ignoring company valuations. They focus on the trend and forget the market has already priced in its potential.
Some megatrend stocks overshoot as hype builds and inevitably plunge as reality takes over. Investors, burned by the trend, give up on the stock just as company valuations start to appeal.
Consider cloud computing, one of the technology sector’s great megatrends as companies use remote servers to store, manage and process data. As consumers and organisations download more digital-rich content, such as video, data-storage services are tipped to boom.
Spending on public cloud infrastructure is forecast to reach US$173 billion in 2026, from US$38 billion in 2015, according to statistics portal Statista.
Morgan Stanley predicts Microsoft Corp will earn 30% of its revenue from cloud products by 2018. Research group IDC predicts cloud IT infrastructure spending will be 46% of total expenditure on enterprise IT infrastructure by 2019.
I could go on with other forecasts of a cloud-service boom (Forbes online in March 2016 had an excellent summary of cloud industry reports). But suffice to say that companies have to spend a lot more on managing data offsite in the coming digital era.
That’s good news for leading software-as-a-service (SAAS) companies and providers of cloud hardware, such as data-storage infrastructure. But the market is well aware of this trend and Australian investors arguably got too excited about it in the past two years.
Accounting software provider Xero is another example. It has outstanding prospects as more companies worldwide use its cloud-based platform to manage their financial accounts. And a valuation to match: $1.97 billion for a company that lost $44 million in the first half of FY16.
At its share-price peak of almost $42 in early 2014, Xero was worth around $5 billion and one investment bank dubbed it the “Apple of accounting” – a sure-fire sign of megatrend exuberance if ever there was one. Xero hit a 52-week low last year of $11.90 and now trades at $14.45.
Data centre provider NEXTDC has also had share-price volatility since it listed in 2010, but seems to be breaking out of previous price resistance. It has good prospects as more companies store information in NEXTDC state-of-the-art data centres.
These examples show why it often pays to stand aside with megatrend stocks until the initial hype fades, focus on valuations, and buy them when they are cheaper. Yes, valuing stocks that do not have earnings, in Xero’s case, is hard work but other metrics, such as revenue multiples, can provide a valuation guide.
It also pays to look offshore for cloud-computing stocks. Our market has limited exposure to this trend and several emerging cloud-based tech stocks are too small and speculative. Some came to ASX in the past two years as backdoor listings through the shells of failed mining companies.
The iShares US Technology ETF, while not purely focused on cloud computing, provides exposure to a range of US tech giants, such as Microsoft Corp and Cisco Systems, which benefit from it. It trades on the New York Stock Exchange under the ticker code IYW.
I mostly prefer cloud-based infrastructure providers to SAAS companies, with one exception (Xero), at least in Australia. It’s a bit like buying the companies that provide the picks and shovels in mining booms rather than speculating on the explorers.
A limited group of ASX-listed stocks fit the bill, but most are small- or micro-cap stocks that suit experienced long-term investors, and are not for the faint-hearted. Here are some preferred ways to play the cloud-computing trend.
1. Xero
The New Zealand-based provider of cloud-based accounting software was a classic “unicorn” company. It established a multi-billion-dollar valuation, has a product with clear competitive advantages, stronger partner networks, and global ambition.
Almost 600,000 businesses use its software worldwide and a few I know rave about it. About 425,000 of those are in Australia and New Zealand, and the rest are mostly spread between the United Kingdom and the United States – two huge markets for Xero to crack.
The group’s total revenue grew 71% in the first half of fiscal 2016 to $92.8 million and its average revenue per user was $30.70. A retention rate of 84% means Xero is keeping most of its customers each year and rapidly adding new ones.
Like all great SAAS companies, Xero has high profit margins (36% and rising as it eventually reduces its sales and marketing spend), recurring revenue, and can scale globally.
The market is willing to pay almost $2 billion for Xero because it believes rapid revenue growth will eventually turn into rapid earnings growth and justify the valuation.
Accounting software is a great business when it works. Ask any small business owners who get used to an accounting package about how likely they are to leave it. Good accounting software is about as “sticky” as products get and can create strong lifetime income per customer.
The big question with Xero is valuation. On Macquarie’s numbers, Xero trades on a revenue multiple (enterprise value to sales) of about 6 times. That’s the fourth-highest in a basket of 20 global SAAS stocks in Macquarie’s analysis, but Xero is delivering faster revenue growth than most. It arguably should trade on a slightly higher revenue multiple, based on SAAS comparisons with leading software firms overseas.
Several prominent offshore SAAS stocks traded on a revenue multiple above 30 at their peak, and Xero has underperformed its global peer group this year.
Xero is not cheap, even after losing two thirds of its peak share price. But it looks a lot more interesting for long-term investors who want exposure to cloud-based providers, and for those who believe it can reverse its period of underperformance later this year.
Chart 1: Xero
Source: Yahoo!7 Finance
2. NextDC
The operator of data-storage centres has emerged as the go-to local stock for investors seeking cloud-computing exposure.
The Queensland company has cemented a valuable first-mover advantage with facilities in Sydney, Melbourne, Brisbane, Canberra and Perth.
NextDC listed on ASX in late 2010 through a $40 million float at $1 a share, and trades at $3.06 after rallying this year. The market cheered its FY16 half-year results, with revenue up 51% to $42.1 million and underlying earnings up 279% to $11.4 million.
NextDC expects full-year revenue to grow by 40-48% on FY15 and underlying earnings to rise 213-250% on FY15.
Rapid growth in earnings and improving capacity utilisation at its facilities is a relief for investors who backed the potential, but needed to see it translate quickly into profit.
NextDC has been among my favoured small-cap stocks in the past five years. I still don’t believe the market fully appreciates the barriers to entry in data storage.
These high-tech facilities are not easy to replicate because they require inner-city locations that have plenty of access to energy and water, for cooling. NextDC has a valuable headstart on new industry entrants.
It looks superbly positioned to capitalise on growth in internet traffic and data storage in the next five years. But gains will be slower after its rally this year.
Six of 10 broking firms that cover NextDC have a buy recommendation, three have a hold and one has a sell. A consensus price target of $3.10 suggests it is fully valued.
That’s probably right, but investors who are comfortable with small-cap stocks should wait and watch for better value. NextDC has attractive long-term prospects.
Chart 2: NextDC
Source: Yahoo!7 Finance
3. Asia Pacific Data Centre Group (AJD)
I have mentioned Asia Pacific Data Centre Group several times in columns for the Switzer Super Report, most recently in September. AJD has delivered a 20% total return (including distributions) over 12 months and rallied this year.
AJD is part of a new breed of specialist Australian Real Estate Investment Trusts (AREITs) that are producing good returns and its looks a lower-risk way to play the cloud-computing trend.
AJD owns data centres in Melbourne, Sydney and Perth. NEXTDC is the operator and it takes the risk of finding tenants for the buildings, and triple-net leases mean it pays for capital and maintenance – a big benefit to AJD.
At $1.41, AJD trades at a premium to its $1.25 Net Tangible Asset (NTA) backing. It has mostly traded at a discount since listing on ASX because of its tenant risk (it has one tenant in NextDC) and because its market was less familiar with specialist AREITs and cloud computing.
But NextDC’s strong performance is mitigating risks for AJD and driving its unit price higher. Like NextDC, AJD is due for a share-price pullback or consolidation.
AJD will not produce the same types of return NextDC is capable of, but does not come with the same risk profile.
An expected yield of almost 7% is another attraction and it has good long-term potential as the value of data-centre properties rises.
Chart 3: Asia Pacific Data Centre Group
Source: Yahoo!7 Finance
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column provides general information rather than specific advice or recommendations and takes no account of an investor’s individual needs. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at May 10, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
