Is there further upside in Megaport shares?
The shares of the ASX technology company surged after a sales update.
Mentioned: Megaport Ltd (MP1)
We maintain our $15 per share fair value estimate for no-moat Megaport (ASX: MP1) following its fiscal 2024 second-quarter sales update. Megaport’s shares jumped around 30% on the update.
Although the update was strong, we also see the stock price jump as continuing a trend of volatility coinciding with Megaport’s quarterly updates and possibly enjoying a lift with the broader technology sector rally during the day.
At current prices, we continue to view Megaport’s shares as materially undervalued and not reflective of its long-term revenue and margin potential. Shares are currently trading at a 16% discount to our fair value.
Revenue growth was strong during the quarter, providing an early signal that new CEO Michael Reid’s efforts to professionalize Megaport’s go-to-market strategy may be bearing fruit.
Revenue grew 5% quarter on quarter, unchanged from the previous quarter. However, Megaport benefited from a weakening Australian dollar in the previous quarter, while in the current quarter, it faced currency headwinds as the Australian dollar strengthened, thus signaling a reacceleration in the underlying business.
Adjusted earnngs before interest, taxes, depreciation, and amortisation (“EBITDA”), which excludes stock-based compensation and nonrecurring costs, continued its upward trend, albeit marginally. Adjusted EBITDA was $15.1 million during the quarter, up from $15.0 million in the prior quarter, resulting in the adjusted EBITDA margin declining to 31% from 32% as the denominator increased.
New hires for Megaport’s rapidly growing sales team, as part of Reid’s new go-to-market strategy for the company, were the driver for the margin contraction. Given that their hiring was toward the end of the quarter, this effect will likely persist through the remainder of the fiscal year.
We also don’t expect these hires to contribute meaningfully to revenue growth for the remainder of the fiscal year, as salespeople will typically take six to 12 months to learn about a product, its customers, and its competitors.
We expect Megaport will grow rapidly in coming years, both 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, or ARR, tenfold in under a decade and recent cohorts continue to display exceptionally strong net revenue retention, despite average initial ARR increasing over five-fold 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 ave highly attractive ratios in terms of lifetime value to customer acquisition costs, or LTV/CAC.
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, or CSPs, 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, or SDNs, 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.