After releasing fourth-quarter results last month, Megaport (ASX: MP1) issued full fiscal 2023 financials and 2024 guidance on Aug. 22 and yet again excited investors. While guidance unsurprisingly implies that revenue growth will decelerate from the 40% level of the past two years, the swing to profits the firm now expects is even larger than Morningstar analyst Matthew Dolgin previously projected.

Dolgin raised his fair value estimate to $17 from $13 and expects Megaport to continue translating its rapid sales growth to higher levels of profitability.

Megaport is a software-defined network service provider that allows enterprise customers to connect between data centers. At the end of fiscal-year 2023, Megaport was connected to 400 data centers throughout North America, Europe, Asia, and Australia.

Most of the firm’s customer connections are to cloud service providers, like Amazon Web Services or Microsoft Azure, but Megaport also enables customers to connect between their own equipment in different locations and to internet exchanges.

With a software-defined, rather than traditional, network, customers have flexibility to adjust connection needs almost instantaneously through a self-serve online portal without long-term commitments.

Megaport’s business strategy

Demand for software-defined networks, or SDNs, like Megaport offers should grow tremendously in coming years, as enterprises increasingly use cloud services, often with multiple cloud providers.

Companies typically need to connect their private equipment to cloud partners, and data often needs to be transferred between cloud providers. Software-defined networks allow enterprises to quickly provision capacity through an online portal and flexibly adjust capacity to meet their current needs.

Megaport’s growth has been driven both by adding new customers at high rate while also seeing customers use its services more. The firm has averaged about 25% annual customer growth the past five years while still seeing services per customer and revenue per service grow, despite the higher base. Dolgin expects the trend to continue as customers continue to increase their reliance on multiple cloud providers and become more aware of Megaport’s alternative to traditional connectivity options.

Morningstar raises fair value estimate

Dolgin increased his fair value estimate for Megaport to $17 from $13, which implies a price/sales ratio of 13, based on his fiscal 2024 forecast. He continues to project the firm will become free cash flow positive in 2024 and now also expects positive net income in 2024, a year earlier than previously projected. We expect a steep rise in margins due to operating leverage. Companies with operating leverage can translate revenue growth into earnings growth as they have relatively low variable costs for the additional sales they make.  

Dolgin projects revenue to grow by more than 25% in fiscal 2024 but to then gradually decline to a low teens rate by the end of the decade. He thinks the deceleration in sales growth, which has been in the 35%-40% annual range since fiscal 2021, is inevitable as the sales base becomes much larger.

However, Dolgin projects services per customer to grow from 10.7 in 2023 to 12.5 by 2025. Historically, the longer customers are with Megaport, the more services they add. Customers that joined in 2014 and 2015 used an average of over 25 services each by the end of fiscal 2023. As the business matures and tenure of the customer base rises, Dolgin expects a material boost as price per service rises modestly—about 3% annually over the next decade.

Incremental customers are highly profitable for Megaport. With many costs in data centers fixed, gross margin went from negative in 2017 to 68% by 2023.

Dolgin projects gross margin to continue rising until it reaches 80% within the next five years, and expects earnings before interest, taxes, depreciation and amortisation (“EBITDA”) and net income to follow a similar path. After generating positive EBITDA for the first time in 2023, we project margins to continue expanding, reaching about 55% by the end of the decade.

After shares rose over 16% to $12.15 on August 22nd they still remain 29% undervalued given the increase in our fair value estimate to $17.