Why we love small-cap data company NEXTDC

How long have you held stock NEXTDC (NXT)?

We’ve held NEXTDC for eight months, with the bulk of our current position bought between late November 2012 and January 2013.

What do you like about it?

There are three key things we like about NEXTDC. Firstly, it’s a key beneficiary of a confluence of technology trends – cloud computing, big data, social media, and mobile computing – which are all leading to an avalanche of data and computing requirements. At the same time, higher power requirements for new servers are pushing equipment out of in-house server rooms and into large-scale data centres, such as those run by NEXTDC.

Secondly, NEXTDC is in a unique position as the only national data centre operator that’s independent of telecommunications and IT consulting firms. This independence means that NEXTDC data centres represent neutral ground for the companies driving the above trends. A company like Optus wouldn’t put their servers in a Telstra data centre, but they would (and do) put their equipment into NEXTDC data centres. This leads to a diverse client mix within NEXTDC centres, that gives rise to the ability of clients to connect directly to each other within the data centre. These “cross-connects” benefit clients by saving transmission costs and increasing speeds, and transform NEXTDC data centres from mere providers of power and cooling to places where clients can do business. NEXTDC is successfully building these client ecosystems within the IT and Cloud space, which leads to a strong competitive position and high returns over time.

The third reason we like NEXTDC is due to where it is in its life cycle. The catalyst for originally buying our position in November 2012 was confirming the value proposition of the NEXTDC offering through conversations with potential clients. Strong client signups since then have reaffirmed this value proposition, yet the company still has significant growth ahead as it fills the five data centres it originally planned at IPO and potentially opens more beyond this.

How is it better than its competitors?

NEXTDC is in a unique position as the only national independent data centre provider. Most data centres in Australia are operated by IT and telecommunications companies, which don’t give rise to the ecosystems that can develop within a NEXTDC centre. Equinix and Global Switch operate independent data centres in Sydney, but don’t provide a national presence like NEXTDC does.

What do you like about its management?

Before becoming CEO in June 2012, Craig Scroggie ran Symantec’s Asia Pacific Business and was a board member of NEXTDC. We first spoke to Craig about the NEXTDC business six months prior to his appointment as CEO, and it was clear then that he had a solid understanding of the data centre business. Since becoming CEO, he has transformed the sales organisation within NEXTDC, which has led to significant traction in signing up customers for their data centres.

What is your target price on the company?

NEXTDC is a capital-intensive business, like an infrastructure company. The return on the stock will be determined by the return on capital they earn on their data centres, and how many they can open over time to meet demand. The company has five data centres that are currently open or in the process of being built – we think the value of these five centres equates to $3.50 per share, and if you count the value of additional data centres beyond these, the stock is worth $5-6 per share.

At what point would you sell it?

We like to buy stocks where we think they are misunderstood by the market, which is what creates the value opportunity. If we’re right on our thesis, the market view should adjust over time, leading to the stock price reaching our target price, which would be the time to sell. With NEXTDC I anticipate this is a process that will take several years, as the company fills its existing data centres, rolls out additional data centres, and proves its return potential.

How much has it added to your overall portfolio over the last 12 months?

From November 2012 to January 2013 we paid an average of $1.87 per share. The stock has risen 44% to $2.70 in the eight months we have held it. In that time, NEXTDC has added 1.5% to the overall fund performance, with the fund currently holding a 5% position in the stock.

Is it a liquid stock?

NEXTDC is reasonably liquid with a market cap of $450 million and around $1.5 million worth of shares traded each day.

Where do you see the value?

The market underappreciates the return on capital this business can generate, with the most common misconception being that NEXTDC provides a commodity service (space and power) where competition will erode returns over time. What this misses is the customer value that is created from developing a strong ecosystem within the data centre. It’s these ecosystems that are difficult for competitors to replicate, and will allow NEXTDC to earn sustainable high returns on capital over time, due to the additional value-add they are providing customers.

The best examples of similar companies are international data centre operators like Equinix and Telecity, who generate returns in excess of 30% on their mature data centres. As NEXTDC continues to gain traction and its utilisation levels rise, we think the market will better appreciate the return potential of this business, and the stock will continue to outperform.

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.

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