The local tech darling growing faster than Amazon, Microsoft, and Google

Given the pressure many high P/E names have faced of late, it may surprise you to learn that a small-cap growth darling stunned the market today with its 29th consecutive quarter of revenue growth and its first-ever quarter of positive EBITDA. 

Yep, after what has been objectively a terrible year for Megaport (ASX: MP1), shareholders can now breathe a much-needed sigh of relief and relish in the news that its share price shot up by more than 13% during trading today, before settling at 10.4% higher. 

It's probably no surprise then that Wilson Asset Management's Sam Koch said the result was a record-breaker. 

"The data that we've received over the last two result announcements have highlighted the company's improving profitability - which is what shareholders are after," Koch said. 

"I think if you look at the top three cloud computing service providers - Amazon, Microsoft, and Google... they're highlighting that the industry is growing at a rate of over 30%... We expect Megaport to really be able to grow ahead of that number." 

However, while he's bullish on the outlook for Megaport, he notes there could be real risks on the horizon. 

In this wire, Koch breaks down some of the key highlights from Megaport's latest result, reveals whether he would be buying the stock, why he thinks today's price movements were an overreaction, and shares the risks he believes should be on Megaport's investors' radars for FY23. 

Megaport key results FY22

• Revenues up 40% to $109.7 million in FY22, and for the June quarter up 35% to $30.6 million
• Normalised EBITDA of -$10.2 million for FY21, improved by 23%. However, Megaport posted its first positive EBITDA quarter in June, reporting normalised EBITDA of $1.0 million
• Net loss after tax improved by 12% to $48.5 million, compared to -$55 million loss in FY21
• Cash on the balance sheet of $82.5 million
  
• Capital expenditure (CAPEX) up 127% to $50.2 million
• Earnings per share of -$0.31, up 11% compared to FY21's -$0.35 per share

Note: This interview took place on 9th August 2022. This stock isn't held in any of Wilson Asset Management's portfolios. Ally Selby has a position in this stock. Sam Koch also has a personal position in this stock. 

What were the key takeaways from this result? What surprised you the most?

The FY22 result was largely pre-released in July. However, the information we received today was incrementally positive. 

The 4Q22 result was a record in many respects - it was the first quarter that Megaport achieved a positive EBITDA result for the overall group and it was the 29th consecutive quarter of revenue growth. That's what surprised the market the most. 

In the current macro environment, profitability is a key focus for investors. The outlook for Megaport’s earnings growth from here is dependent on the timing of revenue growth and investments in the platform. However, the result clearly removes the risk of Megaport needing to raise external equity to underwrite its growth plans.

The data that we have received over the last two result announcements have highlighted the company’s improving profitability – which is what shareholders are after. This is thanks to accelerating revenue growth, improving customer economics, as well as increasing operating leverage as Megaport focuses on cost control.

If you think about this first point, accelerating revenue growth, the company definitely underperformed expectations earlier in the year, when their go-to-market strategy (the indirect and direct sales channel) wasn't firing on all cylinders. In the last quarter, they've managed to turn performance around and demonstrate accelerating revenue growth as a result. 

Moving to customer economics - I think that this result highlights that customer cohorts are improving over time. You can see increased revenue from the average customer over the last nine years, and you can also see decreasing churn per customer as well. So those things will drive better economics to the business longer term. 

What was the market’s reaction to this result? Was this an overreaction, an under reaction or appropriate?

I think this is an overreaction to an incrementally positive result that we've seen today. What's driving that overreaction is market sentiment and market positioning towards the stock. 

If you look at short interest, which is a measure of bets against the company, short interest in Megaport going into this FY22 result was at an all-time high, with Megaport the 10th most shorted company on the ASX. 

Now, what we are seeing today is a reflection of some of those investors that were shorting the company potentially unwinding those bets. So today's reaction is an overreaction in my view, and it's more about market positioning than anything fundamental.

Would you buy, hold or sell Megaport on the back of these results?

Rating: HOLD

We don't hold Megaport in any of WAM's portfolios right now. If we did, I would be holding it off the back of this result, mainly because it's being driven by that market positioning that I mentioned, rather than anything fundamental.

What’s your outlook on Megaport and the tech sector over FY23?

Specific to Megaport, we're positive about its outlook. I think if you look at the top three cloud computing service providers - Amazon, Microsoft, and Google, as a proxy for the adoption of cloud computing services globally, they're highlighting that the industry is growing at a rate of over 30% over their last seven quarterlies. 

We expect Megaport to really be able to grow ahead of that number, and grow ahead of the industry, because they have the ability to optimise their go-to-market strategy, following their underperformance in that area. 

And they also have the ability to increase penetration of their own niche offering to customers well ahead of industry growth rates. So overall, we are positive on the outlook.

So why are we not buying? Well, for us, it's price dependent. The stock has rallied aggressively over the last month and a half - partly as a result of bearish positioning within the market. And so at this stage, we're looking for a better entry price or further evidence that they will be able to sustain the revenue growth that they demonstrated within Q422 before getting more excited about the company.

I think what's driven the tech sector over the last six to eight weeks has been market positioning going into the end of FY22. At the end of the June quarter, some stocks were trading below their cash on their balance sheets, so positioning within the market was quite bearish. 

And with extreme positioning, you can often see extreme rallies, which are driven by short squeezes or investors deploying the excess cash they’ve built up within their funds. Pockets of extreme volatility are to be expected in the current uncertain macroeconomic environment.

What's our outlook on the tech sector as a whole? I think from here, we'll need to really see fundamentals continue to improve on a company-by-company basis, and see certain stocks and sectors outperform. We've had the bounce driven by market positioning, so it's all about fundamentals from here. 

Are there any risks to this company and its sector that investors should be aware of given the current market environment?

I think the key risk for Megaport is competitive intensity, and whether or not that increases. Part of Megaport's appeal is that they have this exclusive agreement with data centre providers which enables them to offer their software-defined network to some of the data centres' clients. 

Now, data centre operators in some jurisdictions are removing that exclusivity, which is obviously inviting competitors into the space and increasing the potential for competitive intensity. So it's something that we are keeping a watching eye on. 

The market should really be focusing on Megaport's revenue growth, and customer cohort data, including churn and services, relative to its peers to really think about whether or not they can succeed going into the future. 

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

Rating: 2 

In regards to the small-cap industrial market, I would place it at a two. What's really driven that view is the fact that you're seeing valuations within that space come back quite a lot on fears of slowing consumer confidence, rising inflation, rising interest rates and an ensuing recession. 

That's a risk, but at the same time, it can be quite short-sighted. In a sense, it gives us the opportunity to think a little bit longer term. If you're backing companies with excellent management teams, with great balance sheets, that can capitalise on this uncertainty with capital management, internal CAPEX or M&A, then you should be able to expect accelerated growth on the other side.

Catch all of our August 2022 Reporting Season coverage

The Livewire Team is working with our contributors to provide coverage of a selection of stocks this reporting season. You can access all of our reporting season content by clicking here.