NextDC NXT held its Annual General Meeting with bullish updates highlighting a very strong demand for global data centers, driven by the move to cloud and artificial intelligence.

Why it matters: NextDC is accelerating its data center rollouts to meet this demand, with capital expenditure increasing from AUD 690 million in fiscal 2023 to AUD 1 billion in fiscal 2024 and an expected AUD 1.4 billion in fiscal 2025 to expand in Australia and Asia Pacific. While positive for long-term growth, given the four to six-year timeframe between initial investment and maturity, this capex further delays cash flow breakeven. The company raised AUD 679 million in new equity in October to fund the gap. Based on the disclosure of NextDC's more mature Victorian data center business, we believe that mature data centers with over 90% utilization generate economic profit. Our terminal forecasts assume the vast majority of Next DC's data centers will reach this maturity.

The bottom line: We increase capex forecasts in line with guidance and include the capital raises but retain our $14 fair value estimate and no-moat rating. The share price is down over the past six months but is still in 2-star territory. The share price fall has reduced Next DC's price/book ratio to around 2.8 times. NextDC does not revalue its data centers each year like a property REIT, and we estimate its early data centers in major city CBD areas have substantially increased in value.

Long view: The data center sector is attracting enormous from a large number of investors. It is very difficult to gauge exactly how much capacity is going into a particular market, let alone see how this tallies with future demand, leading to high uncertainty ratings.

The shares are currently trading at a 14% premium to our fair value of $14.

Business strategy and outlook

NextDC has a big opportunity in front of it, with ample room to increase its data center footprint within Australia and the Asia-Pacific region, and reap the financial benefits that its larger scale should provide. The firm is already a primary provider of cloud on ramps to the biggest global cloud providers, and we expect the firm’s importance for cloud connectivity in Australia to grow.

NextDC benefits from industry trends, including increasing use of cloud computing, the Internet of Things and artificial intelligence, that are driving exponential growth in data creation.

While the firm remains focused on deepening its presence in important Australian markets, which we think is smart, it has also announced plans to build its first data centers in Kuala Lumpur and Auckland with Singapore and Bangkok also under evaluation. The Australian market is less penetrated by global companies than other parts of the world are, and Next DC has an opportunity to be a leader in the country. The firm currently has four data centers in Sydney and three in Melbourne to go along with two in Perth, two in Brisbane, and one each in Adelaide, Canberra, Darwin and Newman . NextDC also already owns land and has plans in place to expand its capacity materially in some of these markets, especially with fifth and sixth data centers in Sydney and a fourth in Melbourne.

As NextDC gains size, we expect it will see some of the intracontinental benefits that firms like Digital Realty and Equinix have globally. Namely, the firm will enable its customers to use NextDC to connect their points of presence throughout the continent and to connect to their cloud providers. We expect interconnection services to become increasingly important for NextDC as more businesses transition to hybrid cloud storage models. At the end of fiscal 2024, interconnection revenue contributed around 9.2% of NextDC’s net recurring revenue and we expect this will trend higher over time as the firm’s network ecosystem matures. The company has foreshadowed that it will be announcing plans for artificial intelligence factories in an effort to meet the huge wall of data center demand that is building from AI.

Moat rating

In our view, NextDC does not have an economic moat as we see significant risks to it earning above cost of capital, mainly due to the large planned capacity expansion in the Australian data center market. While we see network effects in certain of NextDC’s key metro data centers and switching costs, across the industry the outlook for returns is less certain. NextDC has invested over AUD 2.8 billion between fiscal 2015 and fiscal 2023 to expand its portfolio of data centers from five facilities to 11 data centers and one edge data center and more than tripled total power capacity. This substantial investment program has depressed ROICs, which averaged 4.0% for the eight years ended fiscal 2023, under half of our estimated weighted average cost of capital. We expect NextDC to reap the benefits of this investment in the future as capacity utilization improves underpinning margin and ROIC expansion. However, we do not expect ROICs to consistently exceed our WACC estimate over the next decade, which supports our qualitative no moat assessment for NextDC.

The key determinant of whether a data center provider can establish a long-term competitive advantage is cloud service provider and customer density, or the number of network providers (such as Telstra or Optus), key customers (such as large financial institutions and content providers), and cloud service providers (such as AWS, Google Cloud, and Microsoft Azure) that are connecting to a facility. Network providers are vital as they allow data stored within the data center to be transmitted to the outside world. A network dense ecosystem is highly valuable as it attracts cloud providers such as AWS and Google to establish cloud on ramps, which then attract enterprises requiring connection between their private cloud and public cloud providers. A network dense data center is appealing to a prospective enterprise as it will allow them to directly connect with multiple cloud providers and other enterprises resulting in reduced latency and improved security. This dynamic creates a powerful network effect which is difficult and costly for new entrants to replicate. We see NextDC as having the second-highest network density in the Australian market behind narrow-moat Equinix, the largest provider of collocated data centers in the world. We view Equinix as competitively advantaged due to its denser ecosystem with connection to over 155 network providers compared with NextDC who offers connection to over 70 providers. We see several of NextDC’s established central business district data centers as benefiting from this network effect but as capacity expands into outer metro areas where there is more land and greater competition we would expect this advantage to weaken.

Network effect is the main moat source for data centers, however, switching costs are apparent for existing customers. In our view, all data center providers benefit from switching costs as established tenants are unlikely to switch providers due to the operational risk and monetary costs associated with moving critical data storage equipment. According to Info-Tech Research Group, the cost to move one rack’s worth of equipment is USD 10,000 which is approximately 9% of NextDC’s average annual revenue per customer. This monetary cost along with the risk of downtime makes a potential switch to another provider expensive and potentially harmful to the tenant’s business operations. An example of this is the Australian Department of Defence which stores data in a data center owned by Global Switch. The Department of Defence made plans to migrate from the Switch facility into its own data center in 2017 due to security concerns. Chinese company, Shagang, had made its first investment in Global Switch. The original plan, estimated to cost AUD 200 million was to leave by the time the contract expired in 2020. However, the department extended its tenure in the facility in an AUD 53.5 million deal in October 2020 after the migration plans were delayed due to the scale of the undertaking, with the new contract running until September 2025. While NextDC does not disclose its customer churn rate, we understand that it is extremely low. Despite our view that customer switching costs do exist, we think this moat source is less important over our forecast period as we expect existing customers to be a small portion of total customers over our forecast period.

NextDC has insufficient scale to establish a cost advantage. By comparison, global competitor Digital Realty which operates around 200 data centers has a cost advantage as it can procure cooling equipment and electricity in bulk at favorable pricing. For example, approximately 35% of Digital Realty’s cash operating expenses are utility costs and the company secured electricity pricing in Chicago at 20% below market rates to 2022 by negotiating power needs for the region rather than individual centers. This cost advantage has resulted in operating margins averaging 23% over the 10 years to 2020, compared with 20% for Equinix and approximately 17% for CoreSite. We think it is unlikely that NextDC will achieve the necessary scale to negotiate discounted electricity prices over our 10-year forecast period.

NextDC has provided some financial disclosure for two of its more established data centers. M1 was launched in fiscal 2013 and reached over 90% billing utilization by 2018. We estimate that its ROIC has averaged around 14.6% over the four years from fiscal 2019 to fiscal 2023. S1 was launched in fiscal 2014 and reached over 90% billing utilization by 2018. We estimate that its ROIC has averaged around 12.2% over the four years from fiscal 2019 to fiscal 2023. These are well above our estimate of NextDC’s overall WACC of 8.3%, although the financials they are based off don’t include a contribution to corporate overhead. However, given the capacity increases over the past three years and planned for the next few years, both for NextDC and the industry, it is harder to assume that all of the new capacity will generate similar returns. Total power planned from NextDC has risen over 20-fold from 42MW in fiscal 2015 to 1,010 MW by fiscal 2024 with power built increasing five-fold from 24.4 MW in fiscal 2015 to 165 MW by fiscal 2024. Competitors have also announced aggressive expansion plans in Australia.

NextDC bulls say

  • NextDC is well placed to benefit from industry megatrends including the growing adoption of cloud computing, the Internet of Things and artificial intelligence leading, to exponential growth in data creation.
  • The shift to cloud-based services increases the need for enterprises to connect to numerous cloud providers and the connection is fastest, safest and most efficient in a co-located data center.
  • With the Australian market less penetrated by the biggest global data center providers, NextDC has an opportunity to be one of the biggest providers on the continent.

NextDC bears say

  • Rapid technological advancements could reduce the space required by tenants to store data and leave NextDC with excess capacity and margin deterioration.
  • NextDC is heavily reliant on cloud providers, which could choose to attract customers to their own facilities, undermining NextDC’s’s business model.
  • Increasing adoption of virtual connectivity solutions may reduce demand for physical space and physical connection within NextDC’s data centers.

3 ASX players with exposure to data centres 

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

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Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

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