Megaport Limited: Maximising gross profit growth for self funding status

About the author:

Author name:

By Nick Harris

Job title:

Senior Analyst

Date posted:

01 February 2023, 7:30 AM

Sectors Covered:

Telecommunications, Technology

• Megaport Limited's (ASX:MP1) Q2 / 1H FY23 was mixed. Revenue and OPEX were inline while gross profit and EBITDA beat. The stock was sold off, in our view, on decelerating KPI’s which suggest slowing sales momentum. Gross profit acceleration was missed.
• Reacting to the macro environment management re-focussed MP1 on becoming FCF positive (not just sales growth). They delivered impressive leverage with a US$1.4m QoQ increase in revenue becoming a US$1.5m QoQ increase in gross profit and a US$0.8m QoQ increase in EBITDA. Sales were +24% (Q2 vs Q1 annualised) while Gross profit was up 41% and EBITDA +457%.
• 1H23 FCF was ~US$30m (pa) and new initiatives will see burn halve in FY24 (before organic growth). New initiatives materially lower cash burn and we forecast MP1 to become FCF positive in FY25 within its current funding envelop.

Event: 2Q23 and unaudited 1H23 numbers

Headline EBITDA was above our and consensus expectations (US$ adjusted) with revenue broadly inline. Cash burn was higher than we expected due to higher cash expenses. Cash burn reduced but not as much as we had expected.

FY24 guidance suggests cash burn will half YoY and our maths suggests drop by 2/3rds as revenue grows from a combination of price rises and steady sales momentum.

The share price dipped significantly due to anaemic QoQ growth in KPI’s. These are traditionally a lead indicator and growth in Ports, MCR & MVE’s sold were all materially lower than expected.

MCRs & MVEs declined QoQ which was attributed to customer proof of concepts completing and not yet being migrated from proof of concepts (tests) to hopefully live paying deals. MP1’s new CRO should help.

Analysis

After a slow Q1, slower port sales persisted in Q2. This is partially due to port consolidation that commenced in Q1. Existing MP1 customers spin down their ports number by now taking, for example, a 1x100gbps port instead of 3x10gbps.

This port consolidation also slows new ports sold in the quarter. If a net new customer wanted a 30gbps connection to the cloud previously they would have bought 3x10gbps ports to MP1 and MP1 would have bought 3x10gbps ports to the Cloud on-ramp (booked by MP1 as 6 new ports sold).

However now the new customer buys 1x100gbps port to MP1 and MP1 buys 1x100gbps port to the cloud on-ramp (booked by MP1 as 2 new ports sold).

The same customer is now buying 66% less ports. This extreme example illustrates why ports are not necessarily the best measure of future success. This negative impacts revenue and unit sales.

This does positively impact gross profits and unit economics as cost of goods sold declines substantially. MP1’s gross profit margin lifted ~250bps in Q1 and 250bps in Q2. From Q1 to Q2 MP1 added US$1.4m of revenue and added US$1.6m of gross profit (US$0.2m more than revenue). Higher profit growth has been missed.

From Q1 to Q2 FY23 revenue grew by 24%, gross profit grew by 41% and EBITDA grew by 114%. This is extremely impressive operating leverage. This trend should continue over the next twelve months as MP1 optimises and automates.

Forecast, valuation and investment view

Our FY23 forecasts are largely unchanged while our FY24 EBITDA and FCF life increase 3.7% and 82% respectively on lower operating costs. The lower sales focus sees us reduce revenue and FCF growth in the outer years which lowers our Price Target from (login to view).

The key risk and unknown for investors is whether, or not, the currently declining sales momentum persists. We think this is short term and see value in MP1 for those with a higher risk profile. Add recommendation retained.

Price catalysts

• Becoming Free Cash Flow (FCF) positive and accelerating sales in the medium term.

Risks

• We prioritise MP1 becoming free cash flow positive as this should mean additional capital is not required. This isn’t guaranteed and not everyone agrees. 
• Q1 and Q2 disappointed and slow revenue in Q3 FY23 is again possible.
• MP1’s share price is particularly affected by changes in bond yields and inflation. An increase in interest rates decreases valuations.

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