17 June 2020

    Cloud(y) with a Chance of Big Deals

    Delano Gallagher (CFA)

    Senior Investment Analyst

    Delano Gallagher (CFA)

    Senior Investment Analyst

    The wait between meals may have been long but the double main course was well worth the wait….and each came with a serving of dessert!

    Next DC (Next) has tended to polarise investors since it first listed on the ASX 10 years ago. But the market was never more divided than between June’18 and December’19. The bone of contention? Next’s freshly minted second Melbourne data centre (M2) and if there was demand for a data centre of its size in Melbourne.

    Next offers remote storage, processing, and distribution of very large amounts of data to, among others, global heavyweight cloud computing service providers Amazon Web Services, Microsoft Azure and Google Cloud.

    Leading into its June’18 result, Next had successfully filled its phase 1 data centres in Sydney, Melbourne and Brisbane (S1, M1 and B1). It was well on the way to constructing a second data centre in each of these three regions (S2, M2 and B2). Also, Next had raised equity as recently as May’18 to fund the acquisition of commercial properties for a third data centre in both Sydney and Melbourne, and a second data centre in Perth. The message to investors was clear. Next was “experience(ing) very strong demand for its premium data centre services”. But missing at the June’18 result was an announcement of a big customer win to start filling the phase 2 data centres, let alone the justification of a third data centre in both Sydney and Melbourne.

    Data centres require big licks of money upfront in order to be built. This is escalating as the size of new data centres dwarfs that of older generations. But once filled, data centres earn attractive stable recurring earnings. To date Next has invested $580m in building its phase 1 data centres. The construction under way for the second phase data centres S2, M2 and B2, will likely cost upward of $1.1b, and the third data centres in Sydney and Melbourne will likely cost twice as much as this. Over the years Next has regularly raised money to fund this construction through both the equity and the debt markets.

    It takes time (up to 2 years) for data centre providers to negotiate large contracts with the likes of Amazon and Google. It also takes time to find the land, obtain the consent, and build the data centres (also a multi-year process). So, data centre providers like Next must balance the timing of their decision making such that they’re in a position to sign contracts and sell data centre capacity to their customers when required. Back in 2018, Next had yet to publicly announce large contracts for M2. Some investors were worried Next was investing large sums of money to acquire land and build an empty data centre without hope of filling the facility. They believed the lack of deals to date was a sign of trouble. But like us, other investors in the company believed it was only a matter of time before the deals would flow.

    What gave us this confidence?

    Firstly, Next had always built data centre capacity to order. Management had not built capacity speculatively in the past. Evaluating their track record and assessing the people (core to our investment process) was central to this view.

    Secondly, finalising deals with the likes of Amazon, Microsoft and Google takes time because of the very strict criteria they use in selecting a data centre. A data centre’s location is everything. It can’t be on a flood plain or under a flight path, and it needs access to a large supply of electricity. The data must also often be duplicated across multiple sites and on different electricity (and water) grids to reduce the risk of single site or energy supply failure. Suffice to say there are a limited number of sites in Sydney and Melbourne that meet all these criteria. And M2 and S2 both tick these boxes. The strategic nature of these sites, along with confidence in management and their track record led us to believe that Next would be a beneficiary of the increased data usage and the required storage capacity in Australia.

    It took a while, but in March 2020 Next announced its first big deal with a global customer at M2. The long wait was over. A second large deal, also in M2 was announced in May 2020. These two deals took M2 from being pretty much vacant to almost at full capacity in a matter of months. To top it off, both deals contained options for the underlying customers to take additional capacity in the future which will take M2 to over 110% capacity if exercised. This means that Next must either expand M2 or bring forward the construction of M3.

    From famine to feast. Our patient, long term approach to investing in companies has begun paying off with Next. And we suspect there will be more courses on the menu in the coming few years.