In an environment where the market has fallen almost 30%; where many share prices have halved and some are 70 or 80% lower, it may seem odd to upgrade Macquarie Telecom.
The share price has fallen a comparatively modest 28% from its peaks and, trading on a price-to-earnings ratio of 30 times, it doesn't look particularly cheap.
As we explained in our initial review of this business, however, (see Macquarie Telecom looks to the cloud) this is a much better business than it originally appears; and it will get better still.
Key Points
Cloud business still growing
Balance sheet is safe
Superbly managed
Still best known as a corporate telco providing voice, data and mobile services to government and corporate customers, about 60% of profit now comes from the wildly understated 'Hosting' business.
We explained that business in detail in our last review. In summary, it hosts private and hybrid cloud services inside its own data centres. This attracts high margins - more than twice those of traditional telco services - and is currently undergoing enormous expansion.
For tomorrow
Macquarie is completing construction that will triple data centre capacity. It isn't alone in recognising that cloud services are booming - data centre building activity is widespread - but it's centres include a high services component and are particularly strong in the govenment sector.
Instead of a mere property service, it provides hosting and managed services to enable customers to use hybrid and private clouds. In English, this means customers can create their own private networks and switch between using those and the public clouds of AWS, Azure or Google Cloud.
Macquarie is expanding its existing Sydney data centre in two tranches, lifting capacity from 14.5 megawatts (MW) to 47MW.
Unlike peers, it will sell the underlying property to protect the balance sheet and hence carry only a small amount of debt. Historically, the business, still run by the brothers who founded it, has eschewed debt altogether, so we expect debt repayment to be swift.
Many customers will struggle with the virus-inspired shock and some may reduce service demand, but Macquarie counts 40% of all government departments as customers and has the highest customer satisfaction scores in the industry.
Impacts from the coronavirus ought to be limited, certainly not enough to worry the balance sheet which carries just $76m of debt - about 1.5 times last years operating profit.
Once complete, Macquarie's additional data centre capacity will contribute to strong profits and free cash flow as construction and interest costs subside.
We estimate that new capacity will add almost $150m in new revenue, with 30% of that revenue to convert to earnings before interest, tax, depreciation and amortisation (EBITDA), growing Hosting EBITDA from $32m to $77m. Adding $20m for the telco business suggests EBITDA of close to $100m as capacity is filled.
Today's market capitalisation of $440m and an enterprise value of $515m (adding net debt) suggest we are paying a modest price for high-quality growth. If we assume depreciation and amortisation costs come to $35m, and deduct a tax and interest expenses, we expect Maquarie should be able to generate net profit of about $40m after completing its expansion. A prospective PER of 11 times for a well-managed business with an owner-operator at the helm - the founders own over 50% of the business - is a good deal in any market.
As with all upgrades in this environment, we recommend you start small and buy in tranches. This is a relatively illiquid stock so be patient with purchases. A few cents either side of the official Buy price aren't worth quibbling over. We're upgrading to BUY.
Disclosure: The author owns shares in Macquarie Telecom.
Note: The Intelligent Investor Ethical Fund owns shares in Macquarie Telecom.
