Will Cloud Operators show investors the money?01.07.2014

Will cloud operators such as Macquarie Telecom and Xero keep delivering investors big returns? We look at the sector more closely.

ASX listed Small Cap Macquarie Telecom

The downgrade this month from Macquarie Telecom has seen its shares decline 23 per cent and highlights that although the internet cloud has much potential, there is also a lot of risk.

Macquarie Telecom (MAQ) is nearing the end of a massive capital spending program where it has boosted its data centre offering from one to three centres at a cost of about $100 million, and its downgrade signified that, for various reasons, the cash just isn’t rolling in fast enough.

Next DC and ASG

This problem has afflicted other companies. Like Macquarie Telecom, Next DC and ASG have spent hundreds of millions rolling out their versions of strategies aimed at harnessing the power of shared infrastructure, yet their share prices have not been performing. Data centre owner Next DC’s shares have declined 43 per cent from August last year, while ASG’s shares have halved over the past two years.

Is there money to be made in the cloud?

The question for investors is whether there is money to be made. Put another way, are these merely short-term hiccups, or are these companies too far ahead of their time, from an investors’ perspective.

The ''cloud'' is lucrative because it means small and medium-size businesses don't have to spend thousands on servers and software. It's all owned and managed directly by companies who manage the software remotely from data centres, which means the customer doesn’t have to spend much money upfront on software, nor on the upgrades.

Xero the biggest player

Arguably the most successful cloud operator on the ASX is Xero, which sells its services to small and medium-sized accountants. At $24.28 its shares are below their March high of close to $43, but the company’s market cap is still over $3 billion, and it is yet to make any meaningful sales, let alone earnings.

But if Xero doesn’t start seeing some big money made in the US soon, its stock will continue to decline.  This problem is already afflicting others in the sector.

Perpetual increasing it's stake

Earlier this month Perpetual announced that it had increased its stake in Macquarie Telecom from 12.4 per cent to 13.4 per cent. We spoke to the portfolio manager Nathan Parkin whose fund purchased the stock. Understandably he wasn’t happy about the downgrade, but says that the problem isn’t with the business model, but with its management’s lack of accountability to investors.

One of his bug bears is the $10 million and counting that Macquarie Telecoms has been spending on Ninefold which as we understand it, employs computer programmers which are to be used by corporates to develop apps and the like.

“I still believe in the company as a longer term investment, but it’s been lazy with its expenses. To my mind they haven’t got the licence to spend that money when not hitting their numbers.”

More to be made from Macquarie Telecom

Parkin still thinks that there is big money to be made in Macquarie Telecoms, which is forecast to spin out masses of cash from its investment in cloud infrastructure: “This company is trading on a free cash flow multiple of 10 times. The PE of the market of the markets is 15 times.”
The company might be cheap, but as Parkin also said, “The stock isn’t going anywhere unless it can increase its profits.”

About the Author

Richard Hemming

Investment analyst and Editor of Under the Radar Report

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