The "Plumbing" that's Outperforming the Tech Index

Here at North Ridge Partners we are taking a short break from writing about the unrelenting growth in data and cloud computing, AI, SaaS, e-commerce, and social media. Instead, today we are turning our attention to something a little less esoteric: the plumbing and wiring that makes lightning-fast, Internet-enabled growth possible. It’s the data centre industry.

To Kick-Off

Data centres (DCs) are the physical instance of the Cloud. They provide the critical infrastructure (physical computing rack space, the power to keep it running, cooling, and security), all within typically non-descript industrial buildings. From an investment perspective, DCs combine a somewhat unusual mix of real estate and tech investment value drivers - indeed, listed DC entities can be structured as either ‘limited’ or ‘c’ corporations or as real estate investment trusts (REITs) that are obligated to pay out their profits in regular distributions.

Investment Performance

Listed DCs have outperformed both tech and broader market indices over the last five years:

·       DCs delivered a capital return of 157% from the start of 2015 to Q3 2020.

·       Over the same period, the NASDAQ recorded a 139% capital return, with a significant portion of that coming in recent months as the FAANG stocks roared back from their initial COVID-19 dip.

·       The broader market (using the S&P500 as a proxy) lagged both, with 66% capital return.

·       In addition to this capital outperformance, DCs have also paid out an annual net yield of 2.7% taking total annual shareholder returns to 20.6% over the period.

It’s worth noting that we have excluded Australia’s leading listed DC operator, NextDC from our averages, given it is treated as an outlier, with a 534% capital return over the period!

What’s driving these outcomes?

DCs have benefited from a solid tailwind in recent years, which isn’t likely to ease up any time soon. If anything, COVID-19 is driving a faster shift to e-commerce and work-from-home, so the demands for data appear to only be heading one way.

 Here are a few of the drivers of the tailwind that we think is going remain in place for years to come:

·       The accelerating demand for data and network densification (5G, AI, etc) appear largely immune to macro risks such as COVID/recession.

·       In an industry where scale is key, ‘hyperscale’ DCs have emerged as the new standard, providing not just larger physical size but also architecture that allows for huge scalability. This has seen both DC operators as well as their hyperscale tenants (think Amazon, Apple, Microsoft, and Google) to rapidly build out new facilities (now totalling more than 500 worldwide).

·       Market consolidation has been a feature in North America and Europe as DC operators focus on competitive differentiation from the hyperscale operators. In particular, a shift from lower value, price competitive wholesale business into interconnection, and co-location services (which rely on "network effects") can prove defensive and deliver higher barriers to entry.

·       Low interest rates have drawn investors chasing both yield and also trend-driven capital growth.

·       There are still significant opportunities in emerging markets, with large populations of Internet adopters still at the beginning of their online consumption journey (e.g. Indonesia, India, Africa).

Geographical Trends

From 2010 - 2019 DCs generated attractive growth rates in nearly all geographies:

·       Asia Pacific grew at a CAGR of 13.8% and is expected to remain the highest growth region through 2030, maintaining its momentum at similar rates of growth.

·       The EMEA region grew at a CAGR of 13.6%.

·       The Americas region grew at a CAGR of 6.1%.

Valuation Metrics

The large data centre operators currently trade on average at around 12-13x revenues and ~23x EBITDA.

Given the REIT status of many of these DC operators, more real estate-specific cash-based valuation multiples are also regularly used. Adjusted Funds from Operations (“AFFO”) is a widely used metric, measuring a company’s recurring and normalised cash generated from operations by adjusting for the recurring capital expenditures to maintain properties and associated revenue streams, and by normalising rental revenue recognition.

The large data centre players are trading on average AFFO multiples of ~24x, with the best performers on 30x plus. AFFO multiples previously generally sat at ~20x or below, so valuations have shifted notably higher in recent times with the positive tailwinds for the industry.

Conclusion

Data Centres may not create as much buzz as the latest EV or SaaS offerings, but they have delivered outstanding returns over the past five years and put simply – secular trends will continue to underpin growth. With scale and network effect critical, we forsee ongoing consolidation in the industry and in particular, opportunities for listed players to emerge in the developing markets.

Peter Hynd - Partner - North Ridge Partners

Sydney, November 2020