In its third-quarter sales update, no-moat Megaport (ASX: MP1) reported its fourth consecutive quarter of positive cash flow and eighth quarter of positive adjusted earnings before interest, taxes, depreciation and amortisation (“EBITDA”).

It also said it expects capital expenditures for the full year to be around a third below last year, despite the business being around 30% larger. Management upgraded its full-year EBITDA guidance to $57 million at the midpoint, from $54 million, while leaving its revenue and capex guidance unchanged. We maintain our $15 fair value estimate. The shares are currently fairly valued.

Adjusted EBITDA, which excludes stock-based compensation and nonrecurring costs, dipped to $14 million from $15 million in the previous two quarters, However, this was to be expected. Megaport incurs most of its customer acquisition costs upfront, especially when acquiring customers through its direct channel, and captures the customer value over a lifetime of around a decade.

This means that as the business invests for growth, profitability may initially dip, especially when a company is as fast-growing as Megaport. Given that Megaport was investing heavily in marketing during the quarter—as part of new CEO Michael Reid’s efforts to rebuild Megaport’s go-to-market strategy—profitability dipped because marketing sits at the beginning of the sales cycle and therefore doesn’t produce commensurate revenue until much later.

However, as discussed in our Jan. 16 note, we believe Megaport’s returns on sales and marketing spending, as measured by its ratio of customer lifetime value to customer acquisition costs, are highly attractive.

Business strategy and outlook

We expect Megaport will grow rapidly in the coming years in terms of revenue and profitability.

As an early mover in the space for software-defined networks, or SDNs, Megaport has mostly focused on customer acquisition and product development during the first decade of its existence. We believe this was the correct strategy.

When enterprises move to the cloud, as many started doing in Megaport’s first decade, they need to connect their private equipment to cloud service providers, or CSPs, between data centers, and between CSPs. Megaport offered a novel service which made establishing these connections faster, cheaper and more flexible.

We expect tremendous growth within Megaport’s existing customer base. Enterprises that start using SDN services show rapid growth in the number of services they use, which evidences strong product-market fit. Megaport’s first customer cohorts have grown their annual recurring revenue 10-fold in under a decade and recent cohorts continue to display exceptionally strong net revenue retention, despite average initial ARR increasing over fivefold since Megaport’s establishment.

We also believe growth within existing customers will entail only limited incremental costs from Megaport’s side in terms of sales and marketing or product development. Combined with higher levels of equipment utilization, we expect to continue to see continued strong operating leverage driving margin expansion.

However, we expect net new customer growth to slow. Megaport has enjoyed an early-mover advantage during most of its first decade of existence, but other providers have since come to offer similar offerings. As a result, we see gross additions declining and customer acquisition costs increasing. Nevertheless, we estimate Megaport will continue to have highly attractive ratios in terms of lifetime value to customer acquisition costs.

Moat rating

Learn how to find companies with sustainable competitive advantages or moats.

We believe Megaport is an early mover and leader in an attractive, nascent industry. However, we believe its connectivity services cannot be protected from commoditization and subsequent price-based competition. As such, we do not believe Megaport has an economic moat.

We believe network effects and switching costs would be the most likely moat sources, but we don’t see convincing evidence to believe these form a moat for Megaport.

As an early mover in the space, Megaport has come to offer fast, secure and flexible connectivity services to over 800 data centers in over 150 cities throughout the world and to most of the major cloud service providers, such as Amazon Web Services, Microsoft Azure, and the Google Cloud Platform.

Most enterprises operate their businesses from multiple data centers and from multiple cloud service providers, which, in the absence of a connectivity service provider like Megaport, means they would need to establish physical connections to each location and to each provider.

Software-defined network service providers like Megaport, create networks of established physical connections within and between data centers and allow enterprises to access each location and provider within the network through a single connection. As such, as Megaport increases the number of data centers and CSPs on its platform, Megaport can offer its services to more prospective customers and can service a larger share of their connectivity needs.

However, we do not believe the number of data centers and CSPs on its platform provides Megaport with sufficient defensibility to create a network effect. Principally, we view such connectivity services as replicable and commoditizable.

In the case of connectivity services to data centers, we see the least defensibility. We believe SDNs like Megaport enjoy advantages due to their data center agnostic platforms, as compared with data center operators, who offer similar connectivity services within their own networks of data centers. However, when comparing Megaport’s network with its direct SDN competitors, PacketFabric and Console Connect, we see Megaport’s initial first-mover advantage being eroded as these companies offer comparable network coverage and density. We see Megaport’s closure of several data centers in recent years as further evidence that data center coverage and density do not provide a defensible network effect.

Similarly, we don’t see network effects arising from providing connectivity services to a larger number of CSPs. Megaport offers connectivity services to most of the major CSPs, including Amazon, Microsoft, Google, Cloudflare, Oracle, IBM, Salesforce, SAP, Rackspace, Nutanix, and Alibaba. However, offering connectivity services to these CSPs is nonexclusive and is therefore also replicable by competitors, thereby preventing network effects. We see Megaport, PacketFabric, and Console Connect offering mostly undifferentiated connectivity services to most of the same major CSPs with minor variation in terms of niche CSPs.

This is not to say we don’t see barriers to entry or expect large numbers of SDNs to arise. For them to be competitive, we believe aspiring new entrants need to build out a presence in over 100 data centers and offer connectivity services to the largest handful of CSPs, which would take tens of millions of dollars and several years. Subsequently, these companies will need to spend several additional years trying to attract customers to increase utilization on their infrastructure and to get operating leverage on their research and development investment. This is no easy feat, in our view.

Megaport only reached EBITDA breakeven at around 40% port utilization and at significant scale. Moreover, we believe new entrants will struggle to convert prospective customers without charging significantly less than Megaport and other more established SDNs. New entrants would therefore need to achieve much higher levels of utilization to break even. Our expectation for commoditization is therefore based on existing SDNs like PacketFabric and Console Connect increasingly competing with each other for business.

We also don’t see sufficient evidence that Megaport’s first-mover advantage has translated into switching costs with existing customers. Megaport’s first-year gross customer retention rate is currently around 80%, which is relatively weak. However, Megaport employs a flexible, trial-based go-to-market strategy, which explains relatively high first-year churn. We therefore view gross retention in later years as more representative of product stickiness.

We view customer churn from year two onward of mid- to high single digits as being slightly below what we would expect for a company possessing an economic moat, especially given we expect Megaport’s customers to skew toward larger and more stable enterprises with relatively low business failure rates.

Megaport’s surviving customers do display impressive growth in the number of services and revenue contracted, which we believe represents attractive economics for Megaport as this revenue growth comes at little incremental cost to Megaport in terms of sales and marketing spending.

We estimate net revenue retention, which incorporates customer churn, upsells and downgrades, but excludes new customers acquired, has been industry-leading at over 120%. Additionally, first year per customer revenue has also been growing impressively and was up around fivefold between 2014 and 2022, meaning net revenue retention is coming off a higher base. However, we believe this reflects strong product market fit in a nascent industry, rather than a maintainable competitive moat. We see this further evidenced in gross retention and net revenue retention, which have been trending down over the past decade.