GDS Holdings: Valuation De-Rating Is Justified (NASDAQ:GDS)

Elevator Pitch

I assign a Hold investment rating to GDS Holdings Limited’s (NASDAQ:GDS) [9698:HK] shares. In the company’s media releases, GDS refers to itself as a “developer and operator of high-performance data centers in China.”

I have an unfavorable view of the Chinese data center market’s supply-demand dynamics, and GDS’s upcoming Q4 results announcement in March is unlikely to throw up positive surprises. On the flip side, I am positive on GDS’s efforts in expanding outside China, and negatives for the stock are priced in to a large extent. Therefore, my view of GDS’s shares is mixed, which explains why I rate GDS as a Hold.

Valuation Multiple De-rating Justified By Worries Of Industry Oversupply

The market currently values GDS at a consensus forward next twelve months’ EV/EBITDA multiple of 15.3 times as per S&P Capital IQ data. In the past one month, GDS’s share price jumped by +34% in the past one month on investors’ optimism regarding China’s reopening. But the stock’s current forward EV/EBITDA ratio is still only roughly one-third of its all-time high EV/EBITDA multiple of 44.8 times recorded in February 2021.

There are various indicators which suggests that the Chinese data center market suffers from a mismatch between demand and supply.

In December 2021, Reuters reported that the Chinese authorities cautioned “local governments” to “avoid the blind and disorderly development of data centers.” A May 23, 2022 article published by Cushman & Wakefield (CWK) cited research by China’s “Ministry of Industry and Information Technology” which points to an oversupply of data centers in “China’s central, western and northeast regions.” Furthermore, CWK’s internal research suggests that data center cabinets in China could potentially double from around 7 million in 2025 to 15 million by 2035.

Investors’ concerns about the negative impact of industry oversupply on GDS’s medium-to-long financial performance are reflected in the sell-side analysts’ consensus financial estimates for the company. According to S&P Capital IQ’s consensus data, the market sees GDS’s top line CAGR decreasing from +52.6% for the FY 2017-2020 period (excluding FY 2021-2022 due to COVID-19) to +16.7% for the FY 2023-2026 time frame.

Expansion In Foreign Markets

As of September 30, 2022, GDS had 97 data centers in Mainland China, three in Southeast Asia, and two in Hong Kong, as per the company’s Q3 2022 earnings presentation. Data centers in Mainland China and those outside GDS’s home market contributed 94% and 6% of the company’s total data center capacity, respectively at the end of the third quarter of 2022.

In a nutshell, GDS is still very much reliant on the domestic data center market now, but that the company’s geographical mix should change significantly in the future with increased exposure to foreign markets.

At the company’s most recent third quarter earnings call in late-November 2022, GDS revealed that it has the intention to raise “sufficient private equity to fully capitalize GDS International’s current business plan.”

A number of financial metrics taken from the company’s Q3 presentation slides suggest that GDS is very focused on growing its presence in foreign markets in the future. The international markets’ share of GDS’s data centers under construction (in terms of square meters) grew from 9% as of end-Q2 2022 to 22% at the end of September 2022. Also, GDS estimated that the company’s capital expenditure for international markets to have doubled from RMB1 billion in fiscal 2021 to RMB2 billion for FY 2022. More significantly, GDS is guiding that its capital expenditure allocated to foreign markets will double again this year to RMB4 billion, as per management’s comments at its most recent quarterly earnings briefing.

But it will take a few more years for GDS’s international business operations to have any meaningful contribution to the company’s operating earnings. GDS acknowledged at the company’s Q3 2022 results briefing that GDS International should only achieve EBITDA-breakeven in FY 2024.

Q4 2022 Financial Results Preview

I have a dim view of GDS’s near-term prospects, and I don’t expect any positive surprises relating to the company’s financial performance in the upcoming quarter.

Based on financial projections taken from S&P Capital IQ, analysts forecast that GDS’s revenue growth will moderate from +14.9% for the third quarter of 2022 to +9.0% in Q4 2022 in YoY terms. Over the same period, GDS’ YoY EBITDA expansion is projected to slow from +10.9% to +2.1%.

In my opinion, the market’s bearish expectations of GDS’s Q4 2022 top line and operating income are realistic. Elevated utility costs, and negative operating leverage driven by a slowdown in revenue growth should continue to be a drag on GDS’s financial results in the short term.

As such, it is unlikely that GDS will report above-expectations Q4 2022 revenue and operating earnings in March 2023, which eliminates a potential re-rating catalyst for the stock in the near term.

Closing Thoughts

GDS’s shares are rated as a Hold. The stock’s EV/EBITDA multiple has already compressed substantially since early-2021, and the company is working hard to diversify away from its home market. But GDS’s international business isn’t likely to generate positive EBITDA for the company in 2023 and 2024, so it is too early to re-rate the company’s shares now based on its foreign market expansion plans.