piranka
Investment thesis
While many investors are quick to dismiss China and thus, GDS Holdings (NASDAQ:GDS), as a potential investment, I aim to highlight the attractive risk reward profile of this Chinese data centre player. GDS is regarded as a leading data centre player in China serving the best-in-class internet and cloud players as well as traditional industry players. As a result of the Chinese government’s tough clampdown on Chinese technology companies like Alibaba (BABA) and Tencent (OTCPK:TCEHY), there has been a huge drawdown in GDS shares as these cloud and internet players form a large portion of GDS business. That said, GDS looks set to invest and expand into offshore markets like Southeast Asia, Hong Kong and Macau, while setting up a China data centre fund to recycle capital to self-fund its mainland Chinese business. My 1-year target price is $29, implying 102% upside from current levels. As such, I do think that the risk reward perspective for GDS is very attractive and skewed to the positive and recommend this leading Chinese data centre player to long-term investors.
Regional expansion takes flight
While GDS is scaling back on growth in onshore markets, there has been solid progress in its offshore market expansion. These offshore markets include Southeast Asia, Hong Kong and Macau, where GDS has made considerable progress on construction of new capacity as well as gathered strong demand from customers. In total, GDS plans to double the capital expenditures spent in these offshore markets to RMB4 billion in 2023 , which has been funded by private equity investors using an international holding company structure.
I think that the regional expansion in offshore markets will be pivotal to GDS’s second growth engine as it looks towards the longer term to find new markets to enter and expand into. Specifically, in the offshore markets of Southeast Asia, Hong Kong and Macau, there has been 344MW of capacity that has been secured. Most of the capacity that has been secured comes from the Southeast Asia market. In terms of sales, GDS expects that they will be able to secure orders from global customers as well as Chinese customers in 2022, with strong demand across different verticals like financial services, internet sectors. For most of the Southeast Asia data centre projects, I estimate that the development costs will be similar to tier-1 cities in China and should generate 12% unlevered IRR.
In the Southeast Asia region, competition comes from players like Chindata (CD), Keppel (OTCPK:KPELF), and Digital Realty (DLR). I think that GDS has an early mover advantage in the region as it has large scale resources located close to Singapore, which actually hosts almost 50% of all Southeast Asia data centre demand. This is because there is scarce incremental capacity supply in the future due to local government regulations. Second, GDS has an advantage in already having an established relationship with the top cloud and internet Chinese companies. These top internet and cloud companies have pivoted their focus to the Southeast Asia region and thus Singapore as a result of tougher operating conditions in China, resulting in these customers taking up almost 50% of incremental demand for data centres in Singapore. Lastly, GDS has a strong execution and deployment capability while doing so at a lower cost compared to peers. The projects in Hong Kong and Macau are smaller at 80 MW and 14 MW respectively. Management intends to sell minority takes in these data centres in the region that will then raise almost $200 million to $300 million to fund the continued regional expansion plans over the next 2 years.
Capital recycling using China data centre fund
As GDS looks to recycle capital from its mainland China projects that are nearing full stabilisation, the company is targeting to be able to self-finance its mainland Chinese business by setting up a China data centre fund.
I think that this works as GDS is looking to scale down on its mainland China capacity delivery as well as reduce spending of capital expenditures in the onshore market. By setting up a China data centre fund, this will enable GDS to recycle the capital from its more stabilised assets in mainland China to fund new growth initiatives. The fund will be targeting mainly projects that are only about 3 years away from full stabilisation.
With a greater number of data centres in GDS’s portfolio becoming stabilised, this new capital recycling strategy will help finance the mainland China business and bridge the gap to positive free cash flows in the future. As stated in the disclosures, the fund will aim to acquire data centre projects in the mainland China region either from GDS portfolio or from third parties, through an M&A strategy, and GDS will be in charge of the development, operations and sales of each data centre project, and continue to earn recurring service fees from these services provided.
In addition, according to management, GDS is also discussing with financial institutions to create an onshore version of the data centre fund. In the short term, I am of the review that the fund will recycle capital from GDS projects that are close to full ramp up, aiding in accelerating the pace at which GDS can monetise its assets and at the same time, shift GDS to more of an asset light model by earning management fees.
2Q22 results impacted by weakening economy
GDS 2Q22 service revenue and adjusted EBITDA grew at 24% year on year and 23.6% year on year respectively, both just slightly softer than market expectations. At the same time, the 2022 full year revenue and EBITDA guidance was lowered by approximately 2% and 3%, respectively, as management factored in the covid 19 lockdown impact in China as well as impact of slowing economic growth in the country.
As a result, the poorer macro backdrop did result in near-term weakness in bookings growth as well as customer move-in. For 2Q22, new additional area committed was down 71% year on year to 13,000 square metre, and this figure was achieved due to 3 large hyper scale orders from a global cloud customer that already has an existing relationship with GDS, a Chinese cloud customer, as well as a major Chinese bank.
For the whole of 2022, management expects to achieve 70,000 square metres of new bookings, mainly due to softening demand and the Chinese economy slowing. With its backlog of more than 240,000 square metres, the management will become more selective on new projects with a target new bookings of about 80,000 to 90,000 square metres each year, almost 20% coming from offshore markets.
As a result of restrictions from the covid 19 lockdowns, there were some capacity that had to be postponed for delivery. As a result, the capital expenditure budget will be expected to be around RMB6 billion and RMB4 billion in 2022 and 2023 respectively for mainland China, while the regional capital expenditures will increase to RMB4 billion by 2023.
Also, utility costs contributed to a weakening of margins as it rose by 3 percentage points year on year to 30% of service revenues in 2Q22. This was a result of a hotter than average summer in China as well as higher power tariffs in the mainland market. I think that we will likely see utility costs continue to drag down margins in the near-term, for at least 2H22 as I expect that power tariffs will continue to remain elevated.
Valuations
My target price for GDS is based on an equal weight of both the EV/EBITDA multiple method as well as the DCF method. I assume 2024F EV/EBITDA multiple to be at 15x, while assuming a discount rate of 16% to take into account the high customer concentration risk.
As such, my 1-year target price is $29, implying 102% upside from current levels. I think that we are seeing an excellent opportunity to invest in GDS as valuations of the company is cheap as much of the negative sentiment and news has been priced into the company. As a result, I continue to like the stock as the company has material upside with the risk reward skewing very positively.
Risks
Customer concentration
As GDS has a few large internet and cloud customers that makes up a large portion of its revenues, there is the risk that a slowdown in either of these customers or these industries will lead to a material slowdown in revenues for the company. As a result, the company is looking to diversify this concentration risk by looking to expand to more verticals as well as new geographies.
Macroeconomic environment
As a result of the tight covid 19 restrictions, the Chinese economy is slowing and this has a negative impact on the growth of GDS. If the Chinese government does not remove covid restrictions, it may lead to further deterioration in the Chinese economy that may bring further downside to GDS.
Conclusion
I like that GDS is looking for a secondary growth engine as it looks to regional expansion opportunities. The early progress in the Southeast Asia, Macau and Hong Kong regions are encouraging and further investments and capital expenditures should be put into these new emerging markets for GDS. In addition, the setting up of a capital recycling China data centre fund is a good step forward to accelerate monetisation of the maturing GDS portfolio while ensuring that GDS is able to finance its mainland China business going forward. The recent 2Q22 results do reflect some weakness in the Chinese economy as well as from the weakness resulting from imposed covid 19 restrictions.
However, I continue to think that the Chinese data centre player looks very attractive as a long-term investment. Investors with a longer term mindset are able to invest in GDS at very attractive valuations. My 1-year target price is $29, implying 102% upside from current levels. I like the stock as there is a clear material positive skew to the risk reward profile of the company and when the sentiment around the stock improves, the patient investor will benefit from the improving growth and profitability of the company.
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