Why the short sellers may be wrong about Megaport

News this week that network solutions provider Megaport (MP1) has secured a new CEO, after the shock resignation of Vincent English earlier this month, marks the latest development in a difficult 12 months for the company.

Despite the appointment, shares in the company—which helps customers connect and integrate various network and data center services— are continuing to wallow around four-year lows. The lack of movement and a substantial short position against MP1 shares suggests a heavy dose of market skepticism towards the former tech darling.

But the company—which is also considered the most undervalued ASX stock in Morningstar’s coverage universe—may be on the brink of a major turnaround, according to one Morningstar analyst.

Former tech darling falls from grace

New CEO Michael Reid takes the reins following a major tumble in Megaport shares, which are now 80% down on their all-time high in December 2021.

The fall in the stock’s price has also coincided with a major rise in short positions against MP1 shares. At just under 10% of shares shorted, Megaport is the fourth most shorted stock on the ASX, marginally behind other recent ASX pariahs: Flight Centre (FLT), Core Lithium (CXO) and Zip Co (ZIP).

Short sellers profit when a stock falls. They do this by borrowing stocks that they believe are overvalued, selling them, and buying them back later at a lower price.

Megaport’s place among the most shorted stocks on the ASX is all the more surprising considering the company was once considered a favourite for tech-tilted Australian investors.

The stock’s popularity started to gather momentum in 2019, when shares began rising rapidly. At the time, the company was still yet to turn a profit but investors were attracted to the business’s strong quarter-on-quarter revenue growth and a growing roster of high-profile clients like Adobe, Tesla and Zoom.

Shares peaked at an all-time high in December 2021, at the time tallying up a 450% rise since the start of 2019.

Things began to change in 2022, however, driven in part by shifting investor appetites, according to Morningstar analyst Matthew Dolgin.

“If you look at a basket of high-growth, cash-burning companies like Megaport, they were really in favour pre-2022 but last year that reverses and companies that were not profitable were really out of favour […] of those, Megaport was hit harder than most,” he said.

Dolgin says Morningstar’s long-term views on the company have remained unchanged. As a result, it has taken just over a year for Megaport shares to fall from overvalued territory to become the most undervalued stock in Morningstar’s ASX coverage universe.

The downturn has been further compounded this year by company-specific problems surrounding slowing growth and management turmoil.

Megaport’s previously strong revenue and customer growth failed to meet market expectations in its most recent half-year report, triggering another 20% decline in the company’s share price and pulling Morningstar’s fair value estimate down from $15 to $13—still well within 5-star undervalued territory given the stock’s decline last year.

Further still, a surprise resignation by long-time CEO Vincent English earlier this month added more volatility to the stock.

Dolgin says he was surprised by English’s departure but reiterated that Morningstar’s most recent fair value estimate of $13 per share remains in place.

“We're uneasy about the abruptness of this development, but we don't have any information that changes our outlook for the stock.”

Strong fundamentals drive Megaport towards profits

Following English’s departure, Megaport shares tumbled again and now sit around $4.20, a four-year low not seen since February 2019. However, despite the turmoil, Dolgin says the company’s underlying growth fundamentals remain strong.

“We think the selloff is based on the nitpicking of specific metrics—like the slowdown in port growth and customer growth, and slower uptake of some new products—rather than looking at the big picture of a company that continues to grow revenue at a fast clip while making huge strides toward profitability each quarter,” he says.

“We’re less concerned with specific product uptake than with the customers continuing to spend more at Megaport, especially as Megaport now services many blue-chip companies.”

Morningstar forecasts see Megaport tipping into profitability for the first time, within the next two years.

“Given the high level of profitability incremental customers and connections generated, we believe this adds up to Megaport averaging more than 25% top line growth over the next five years while continuing to narrow its losses, leading to net income breakeven by 2025.“

That said, Morningstar has maintained a ‘High’ uncertainty rating on the company—largely due to the recent market volatility.

If Megaport fails to meet those forecasts and break even, and continues to burn cash, it may eventually be forced to raise new capital, which could be driving the large short position against the company.

But with a new CEO in tow and potential profitability on the horizon, it remains to be seen what’s next for Megaport.