The Capital Call

Dusting off the 2022 crystal ball

Now that Christmas is out of the way and 2022 is heaving into view, the inevitable temptation is to dust off that crystal ball and start to wonder out loud about what might happen in the coming year which is exactly the time at which I usually tend to run a mile, largely because my ability to predict the future is utterly lamentable. But what we can, with some caution, anticipate are the big debates that will continue to echo through into the new year.

I suppose one must start with the question of what will happen to rates – inflation and interest rates. Talk to any market observer and I’m sure they’ll have a view on inflation rates which are currently surging across the Anglo-Saxon world. I was in Team Transitory but it’s clear we were wrong, and the US and the UK have a much bigger problem with inflation than we first thought. But I wouldn’t get too carried away with the seductive argument that we’re about to return to some 1970s inflationary nightmare.

A large part of the surge in retail prices is based on energy prices and at least as regards this surge there’s an arithmetic iron law about to emerge. As UK-based strategist Joachim Klement at investment bank Liberum observes “to keep energy inflation at current levels we would have to see Brent crude oil prices rise to all-time highs in September 2022. Even if crude oil prices remain above $100/bbl. for the coming year, energy price inflation would half from 9.3 percent today to less than five percent while headline inflation would drop to 2.1 percent.”

As for wage pressure pushing up inflation expectations, I’d also be a tad cautious. We are in an entirely new world of collective wage bargaining compared to the 1970s, when governments anxiously watched national wage negotiations as they fuelled a surge in wages as a result of collective bargaining deals. Most of these deals in the private sector have long gone and the unions are a pale shadow of their former selves.

As The Economist’s Duncan Weldon has pointed out, borrowing on a note by US Federal Reserve researcher Jeremy Rudd, “outside of a few unionized industries (which now account for only about six percent of employment), a formal wage bargain—in the sense of a structured negotiation over pay rates for the coming year—doesn’t really exist anymore in the United States. In a world where most employment is “at will,” changes in the cost of living will enter nominal wages as part of an employer’s attempt to retain workers: if employers pay their workers a wage that falls too far behind the cost of living, they will start to see more quits, which will in turn force them to raise the wages they pay to existing workers (and those they offer to new hires). But there is no real scope for direct negotiation”. My guess is that these structural developments will significantly blunt any wage inflation spiral and thus help moderate inflation expectations as we head towards 2023.

What’s rather more predictable is that interest rates in the US and the UK will rise. If I had to wave a finger in the (cold) air, I’d suggest we’ll see US interest rates at 1.5 percent by the end of 2022/mid 2023 with the UK probably at between one to 1.5 percent. More to the point I think the chances of interest rates in either country moving above two to 2.5 percent are next to zero, that is unless we do feel the full force of the much-hyped inflationary wage spiral.

My logic is based on simple macro-economic observations: governments cannot afford to pay too much on their debt and central bank finances would be on thin ice if rates rose too fast; globalisation is far from over and is still, along with technology, exerting a downward pressure over the long term on prices; and last but by no means least, there’s still a glut of excess savings globally which needs to find a home in ‘safe’ currencies such as the dollar.

Of course, many will disagree with this analysis, but I think if you accept that we are still in a low rates environment – by central bank design – then I also think you need to accept that the central economics underpinning the current bull equity market trend are still in place. Put simply, low interest rates inflate the equity risk premium, and make equities an attractive asset class. Markets may wobble and blow up every once in a while, but I currently see no real alternative to equities as a home for risk capital. That will underpin market valuations. The old ‘average’ price to earnings ratio of between 15 to 20 is now 20 to 25, while growth stocks can be regarded as fair value if their PEs are between 25 and 40. That, I think, underpins the surge in interest in digital infrastructure stocks.

Moving beyond the gyrations of financial markets, I’d pick out three structural developments worth watching in the digital infra space: measures of carbon intensity; the battle over the last mile; and cybersecurity for critical digital infrastructure.

The US government may be struggling to get all its carbon reduction plans through the Senate but Europe is racing ahead aggressively. The new German government will be at the forefront of an intensive push to measure carbon emissions and attach those numbers to an increasing array of corporate ESG benchmarks which will turn be regulated by state mandate. The centre piece will be a series of carbon emissions per share/carbon emissions per business unit measures on their way through the statute book.

The logic behind these changes is laudable – voluntary disclosures of carbon emissions are patchy and ESG measures vary wildly by data provider. Legislation mandating benchmarks will standardise these measures. But the underlying agenda is much more radical. Rather than measure direct emissions, the real intent is to see through the business product cycle to measure the true sustainability of a product or service over its life span. This move will catch the digital infrastructure space and especially the data centre providers – they’ll be forced to measure and publish the true impact of their services on the environment with carbon taxes as one likely long term imposition based on these impact measures. This will, in turn, fuel ever more demand for data centres to invest in energy efficiency and renewable power sources.

The good news for these data centres – as well as tower co providers and alt nets – is that demand for their services will keep exponentially increasing because of all the new technologies coming along the track. I’m inclined to skate over the grand technological claims offered up by enthusiasts for 5G and the metaverse. I don’t doubt that big changes are coming for both, but I sense that 2022 is yet another of steady development with no big headline developments – unless of course Apple finally reveals those augmented reality glasses.

No, I think the more interesting story is last mile fibre and broadband solutions. The move to work from home isn’t going away and that places a spotlight on those last mile technologies – arguably at the expense of building ever fatter, faster inner-city connections. In this regard I think that the current suspense around the fate of UK based BT Group is fascinating, with big, acquisitive European shareholders prowling the share register.

BT is I think a test case for how a boring, stodgy old fashioned fixed telco can turn itself into a digital infrastructure asset by investing huge amounts of money – at the expense of its shareholders – into last mile fibre solutions. After much derision, BT is really making progress at connecting up the suburbs and exurbs – my own home, which is a good few miles from the nearest suburban exchange, has just been linked to fibre to the home (at speeds much faster than my son at university in a big city, much to his horror). In parallel, BT looks like it’s still trying to jettison previous projects such as its Sports TV channel, thus giving greater clarity to its move back into infrastructure. On this score I think Charter Communications is the telco leviathan to watch in 2022.

The US government’s digital access policies will increasingly echo those of the UK – increasing public investment in the last mile. Next up, I’d expect the new centre left German government to lean in heavily into the digital divide and last mile policies – broadband connections in Germany are surprisingly dreadful. Stepping back from the detail, I think we can see a big capital push to invest even more money into the last mile across the developed world, aided by governments, but funded largely by private capital. Private equity won’t be far behind, and we should expect the pace of PE deals in alt net land to increase.

My last prediction is arguably the most obvious – that ever more scrutiny will be placed on essential digital infrastructure and its national security implications. The driver for this may be one of the existing rogue states. A zero Covid policy in several states has resulted in some regimes becoming more desperate to a) make news and b) make money by carefully selected cyber-attacks. My money would be on a carefully staged attack on a key piece of digital infrastructure in the West, designed to register BELOW the level of military threat but big enough to cause a fuss and make money for the hackers. For me that spells taking down a key piece of digital infrastructure for a short period of time. The bottom line though is that providers of key infrastructure will need to spend ever more money to protect these increasingly strategic assets.

This time it might really be different

A few years back the economists Carmen Reinhart and Kenneth Rogoff published a wonderful economics tome called This Time is Different, about eight centuries of financial folly. Their engaging idea is that everyone always says that their financial crisis or major new trend is really different this time, but it never is. Their message is that history is forever doomed to endlessly repeat itself. These words sprung to my mind when recently writing an article for a UK financial publication on the rise – or should we say, the return of – the metaverse.

Facebook’s name change produced a collective shudder amongst investment cynics like myself who’ve also moonlighted as tech nerds. I’m old enough to remember all the failed attempts at augmented reality (AR), virtual reality (VR) and everything in between. Obviously, this time it really is different because Facebook says it is and it is pumping countless tens of billions into research to prove the point.

But the smart money knows that in many ways the meta verse is already here, it’s just that the current day experts realise that if they shout too loudly they’ll be accused of hubris. Take the endless number of virtual gaming worlds already sucking up teenagers’ attention. Or the growing B2B AR and VR implementations used by businesses built around frameworks such as Microsoft’s HoloLens. Or the fast-emerging Digital twins metaverse at the enterprise level which takes the Internet of Things (IoT) and then jams it into top gear by allowing engineers to remotely test system stresses and capabilities.

Another clue that maybe it really is different this time is that investors are taking note. Giant US investment bank Morgan Stanley has just released a spate of reports. ‘The Next Big Theme – Metaverse’ by Edward Stanley is one summing up the tone nicely – which highlight in detail why it might be different this time. That report certainly finds an echo with investment managers. I recently interviewed one of the UK’s leading technology fund managers, Ben Rogoff at Polar Capital, and he couldn’t stop him talking about the metaverse. I’ve even waxed lyrically – and cynically – on the investment case HERE.

My own central case is that it’s not really a case of this time it’s different, it’s just that existing technologies and infrastructure are finally catching up with marketeers’ exaggerated demands. Virtual worlds sounded fun initially but try getting excited about all this interaction via ADSL telephone modems. Or clunky AR glasses. Again, it sounded cool when Google brought out ‘those’ glasses but frankly the technology – and content and means of delivering the content – wasn’t quite there. In sum we’d seen the future already, but the present wasn’t a patch on the promise.

Now that promise is being delivered and the infrastructure implications are seismic, I think. But before we think through those implications let’s first get the definitional boring stuff out of the way. According to Morgan Stanley, the metaverse in a nutshell is: ‘A virtual world for immersive experiences that is persistently available and where users can explore vast numbers of experiences concurrently. Within these experiences, people across the world can meet, play, watch, trade and learn across millions of experiences.’ Or as Bart Schouw of Software AG nicely sums it up in a recent Information Age article: the metaverse mainly “refers to a convergence of physical, augmented, and virtual reality in a shared online space – or the universe of data.”

As I said there’s plenty of products already out there that are making use of these overlapping technologies. For instance, many Snowball customers today run edge-based processing with drones and then map it into 3D point clouds as they collect the drone information.

Kick the tyres and you begin to realise that in fact metaverse isn’t really a ‘product’ or ‘single technology’ as such but its own infrastructure. You can already see this new infrastructure at work via outfits such as Subspace which is helping gaming businesses reach bigger audiences by building a “parallel internet that puts high-traffic applications on their own network, ensuring the fastest and most stable path for instant experiences”. In this alternative narrative, the metaverse isn’t an application but “the next iteration of the internet that supports real-time experiences.” Or perhaps more succinctly Network as a Service model with outfits such as Subspace offering up a huge global private network for near real time applications.

OK but back in the world of hard infrastructure reality, we have to accept some real challenges, not least the obvious “interface challenges”, a wonderfully euphemistic way of saying that no one over the age of 30 is going to wear a stupid VR headset.

But there are other less obvious challenges. One school of thought reckons that for the metaverse to be really game-changing, it needs to be connected to countless tens of billions of devices via the IoT. As Bart Schouw puts it “The only way to do that will be by mass ingestion of the data coming from the Internet of Things. Only with this data will you be able to create a rich and meaningful environment. The next need after “seeing” will be “interacting,” meaning that the data not only needs to be represented in a meaningful way but also must be responsive.”

Which bring us nicely to the $64 trillion question: Latency or responsiveness needs to be absolutely minimised in order to simulate real world response times. And here we get to the infrastructure challenge. If this slightly dry subject interests you, I recommend reading a fascinating discussion between Bill Vass, VP of Engineering at Amazon Web Services, Patrick Cozzi of Cesium and Marc Petit of Epic Games. They discuss the Cloud Infrastructure for the Metaverse HERE.

To make the metaverse sing and dance, operators somehow need to find a way to overcome the big challenge: that the bridge of the network is going to cause problems. If I’m sitting at home constantly tapping away for a response and the latency starts cruising above 100 ms, then I’m off making a cup of coffee. Figuring out the solution requires a triad of solutions. Main core functions sitting in the cloud, helped along by edge services and networks all connecting to smarter devices in your pocket. As Voss says, if customers have “a really powerful thing, like an iPhone, they can run a lot there, or a car, they can run a lot there. If it’s less powerful, and they have good network, they’ll offload more and more to those tiers.”

For this lay observer, that suggests the following. The first is that to make the metaverse really work someone who is trusted to make smart handheld devices needs to run with the metaverse ball. Cue Apple. If anyone can make a device with the processing power of an old supercomputer sit on your nose, the boys and girls at Cupertino can.

BUT, and yes this is a big infrastructure BUT, that device needs to link into both services and a base layer of infrastructure that makes said Apple device work with next to no latency. And in this, I see an impending battle. We’ve already seen the likes of Google and Facebook migrate down the value chain into owning bits of digital infrastructure such as data centres and sub sea cables. But if they want to dominate the metaverse – and not leave it to Apple – they have to offer a seamless service with next to no latency into the last mile. They cannot be reliant on some backwoods telecom operator to send that final bit of data over ancient wires and cables. Or to put it bluntly I cannot see how Facebook and presumably Google can make the metaverse work unless they own the last mile into the customer, i.e the whole digital infrastructure chain.

But as they head downstream into your homes, they might run into mobile operators heading the other way, upstream. Back to Bill Vass from Amazon – “So everything you get on the cloud, you get in this (5G) hub much closer to the customer from a latency perspective. Solves the speed of light problem to a certain extent”. Already we’re seeing products emerge such as Wavelength which push the cloud to the 5G hubs, with very low latency that is ideal for metaverse applications.

Which brings me very nicely back to that Morgan Stanley report I mentioned at the beginning. If Facebook and Google start playing in the telco space, why can’t the telcos play in the cloud/content/metaverse space? This might upend the traditional model which is based around the idea of ‘Build it and they will come’.

Perhaps the better model is to build both simultaneously, i.e products and infrastructure. And telcos already know this model works. According to the Morgan Stanley Metaverse report “Vodafone saw reasonably significant volume spikes at the time of the Pokémon Go phenomenon in 2016. Vodafone noted that AR/VR is ‘sticky’ (seven out of 10 people that use Pokémon Go return to use the application the following day), while also stating that AR/VR triggers considerable other mobile usage (Facebook, YouTube, tweets, etc.) as well as fixed usage.”

So, here’s my slightly ambitious reading of one distinct possibility. Whilst most digital infrastructure investors wax lyrically about say Autonomous Cars or Smart Factories as the killer apps for 5G, what about thinking of AR/VR as “the medium-term killer 5G app” (Source: Vodafone CTO, Technology Day, Q32021)? In other words, the launch of stand-alone 5G networks in 2023 could drive a wave of AR/VR innovation and the mobile telcos could be in the lead pushing new products and services as part of an expanded metaverse. If you already provide infrastructure via a network, why not take Facebook at their word and play them at their own game? This way the telcos can square the circle of mobile volumes continuing to rise by ca +30-40% YoY whilst being constantly undercut by per unit deflation (price per Gb). For the telcos, the metaverse could be the solution to their revenue growth rate challenge. The challenge then becomes how to move faster than Facebook or, should we say, Meta!

The importance of narratives

An investment columnist’s job always involves the juggling of narratives. The economist Robert Shiller, rightly in my view, thinks that investors are far less focussed on hard numbers than they say they are and much more impressed by financial narratives. Take for instance a boring measure such as price to earnings ratios based on forward earnings ratio. In the good/bad old days, if that number was much above 20, investors would frown and mutter ‘expensive’ under their breath. But once the narrative of technological disruption becomes attached to the PE ratio and the investors can combine the narrative of tech change and corporate adaptation (currently called digitisation), then suddenly 20 looks laughably cheap.

And so, narratives are important. Which brings me to this column. I was toying with the idea of investigating the wave of M&A activity within the digital infrastructure sector and the wall of private equity money heading into the sector. But another narrative screams out at me: market mayhem or, less elegantly, the possibility of an imminent equities sell off.

As I write this, the US markets in particular seem to be shaking off the growing number of alarm bells. As a literate audience you’ll be able to tick off the obvious ones such as (in no order of importance): China; inflation; Covid not quite going away; faltering recovery as stimulus dies down. I could also mention valuations, slowing earnings growth projections for mid-2020 and a few other bond market flashing sirens, but for me the most obvious factors are the least discussed, notably faltering momentum and declining global liquidity flows.

For this observer, the logic of market gains over the last decade isn’t terrifically complicated. Central banks have flushed money into the financial system, bought out bond holders and encouraged investors to take the view that there is no alternative except to invest in equities. This liquidity driven push into equities takes on a form of momentum over time, pushing yet more money towards sectors, sometimes unconnected to fundamentals.

Quite a few hedge fund-oriented research outfits keep a close eye on these flows and many are now saying that their liquidity measures are flashing red. For instance, one London based outfit called Cross Border Capital only this week observed that “both US private sector liquidity and US cross-border capital inflows have already turned lower from exceptionally high levels, whereas US Fed liquidity remains unusually elevated”. If the US Federal Reserve was to start to aggressively taper, they think we’re guaranteed a big stock market correction.

It’s also the case that as liquidity tightens, equity market momentum falters. In that scenario the marginal buyer of equities – the ones who felt they had no choice other than to invest in equities – head for the hills, sell equities en-masse and start to re-appraise their bond portfolios. We are now at one of those possible turning points.

Most measures of relative strength within US equities are beginning to point downwards. That said, one shouldn’t get too carried away with crystal ball gazing. Market volatility levels are still low – the classic measure, the VIX, is languishing below 15, significantly below the 25+ point mid-September, though it’s also worth noting that that level is still quite elevated compared to FX volatility (CVIX Index) and rates volatility (MOVE Index). As for earnings, Corporate USA Inc still looks in good shape as we head into another earnings season. According to BlackRock “companies representing more than half of the S&P 500 Index market value have reported third-quarter earnings. Over 80% of them have beaten expectations on profit and more than three quarters have exceeded revenue estimates”.

Obviously, we need to take all this debate around signals with a large household cup of salt but when you combine it with the macro and geopolitical warning signs I’ve already listed, then maybe it’s time to sit up and take notice. Which prompts my next question – what happens to the publicly listed digital infrastructure space if we do head into a downturn?

As luck would have it, I’ve been crunching numbers across a number of sectors in recent weeks looking at what happened in past stock market sell offs. The big table below contains the fruits of those efforts.

I’ve looked at six S&P 500 sell offs over the last 15 years or so since QE properly started. Declines in the US benchmark index have varied between just under 10% through to 48% in 2008/9. I’ve also pulled out the biggest stock market listed digital infrastructure businesses – which happen to be the leading holdings within the Digital Infrastructure Investor Index (DIGITAL) – and analysed how they performed during those periods of maximum distress.

I’ve also included peer group data for general tech stocks – I’ve used Microsoft as a surrogate – and traditional infrastructure funds, in this case two long established UK listed investment funds, HICL and INPP which have both been around on the London market for two decades. These two funds invest in ‘classic’ infrastructure such as public private partnerships and they are the very definition of what it means to be an alternative fund.

First the good news. By and large the leading digital infrastructure businesses – mostly US listed of course – have fallen by less than the market index (the S&P 500). Unfortunately, that relative out- performance isn’t actually that impressive. Take the February/March 2020 sell off – the S&P 500 fell 33% but my average for 11 large cap digital infra businesses declined 23%. By comparison Microsoft was down 23% while even my two ‘classic’ infrastructure names were down around 20%. Or take the 2008/2009 sell off. The S&P 500 was down 48% but digital infra stocks were down 44%.

Now the bad news. I’ve also included measures of share price volatility which clearly show that the daily dispersion of returns is much, much greater for my digital infrastructure businesses. It’s also on average in excess of Microsoft and the ‘classic’ infrastructure plays.

Stepping back from the wall of numbers I’d make the following observation. Many big institutional investors choose to invest in the digital infrastructure for two reasons. The first, much voiced by the sector, is a thematic one based around growth. I would argue that an equally important reason is that investors like the bond-like dependability of the sector: steady cashflows unaffected by the business cycle should provide some diversification benefits in the event of a sell off. In effect this pigeonholes digital infra stocks as a form of low volatility, quality stock. But the numbers above don’t really support this notion of digital infra stocks as being even remotely alternative. In reality, digital infrastructure stocks display very few of the qualities I’d expect from a genuine alternative – in fact they sell off nearly as aggressively as growth stocks in a high volatility regime. If the current market moves from its current levels of market volatility to a proper sell off – a big if I grant you – then my worry is that digital infrastructure stocks will provide no safe haven.

Analysis of DIGITAL – looking at the hard numbers

October 4, 2021

It’s official: investing in digital infra stocks really has beaten the big benchmark, the S&P 500, over the last five years or more! I, like many, had always made the assumption that investing in the right tower co, for instance, was a smart strategy, but would the ‘average’ investor have done so well if they’d invested in a diverse basket of digital infra stocks, i.e. would a basket of tech infrastructure stocks have outperformed, say, the S&P 500?

Until recently it was very difficult to answer this question because there was no real world basket to compare with, but a few weeks ago Digital Infrastructure Investor launched their Digital Infrastructure Investor Global Index, ticker DIGITAL. This index went live June 28th and contains 32 mostly well known constituents. I’m sure you’ll hear much more about this new equity index over the next few months, but for now I’m simply curious about what the numbers tell us. What do the hard numbers tell us about investing in tower cos, data centres and fibre operators?

The big, important number is that of returns over the medium term. Usefully, the index has been put through the trusty old time machine that is called a quantitative backtest and the numbers that have come back look impressive. Since 12th April 2015 $5000 invested in the S&P 500, for instance, would have returned $10,400 to date, whereas this index returned over $12,000.

Obviously back tests come with all sorts of expected caveats, so for me the more interesting story requires a bit more digging around in the numbers playground. In particular, what are the key technical and fundamental numbers supporting this curated assembly of digital infrastructure equity players?

To help answer this I’ve taken the top eleven constituents in the index which trade on either the US or European exchanges and then run that smaller sub set of stocks through the various sources of stock data including Bloomberg, Yahoo Finance and Sharepad in the UK.

Note that these eleven stocks do comprise well over 65 percent of the aggregate value of the index, so although they don’t give us the complete story about the index, they are nevertheless bound to dominate any narratives that do emerge. On the issue of geography, many of the longer tail of 21 stocks in the wider index are not listed in either the US or Europe, and thus underlying financial data is patchier.

So, digging around inside this shorter list of 11 (out of 32) names reveals some interesting insights, not least the fact that these stocks have collectively beaten the S&P since the middle of the last decade. In terms of longer time scales, more than a few of the businesses haven’t been around more than five to 10 years, but for the six that can boast a 15-year share price track record, the total shareholder return including dividends has been a stonking 783 percent versus 229 percent for the S&P 500.

That said, I think the most interesting insight is a technical one. The average beta across these large cap tech stocks over the last five years is a relatively lowly 0.4 (to the S&P 500), while the average correlation over the same time is also a relatively lowly 0.486. These two numbers would suggest that the big digital infrastructure names aren’t really your classic momentum players and thus they might offer some diversification benefits for an equity investor. Yet there is a price to pay – the average volatility of these top 11 stocks is double that of the benchmark S&P 500 index. So, these infra stocks potentially offer some diversification benefits but at the price of greater price volatility.

What about valuation metrics? The consensus view has long been that these stocks are collectively more than a tad overpriced. The numbers tend to back this up. The average price to earnings ratio – if there is one – is well over 100 times earnings and the average price to net asset value is a slightly eye watering 19.5 times. But before we mark this down as a win for the valuation critics, it’s also important to consider some other hugely important numbers.

The first is that the dividend yield, where dividends are paid, is a generous 2.57 percent versus 1.28 percent for the S&P 500 benchmark, and that doesn’t include any share buybacks. In addition, it is clear that these businesses are veritable cash machines, producing lots of free cashflow based off surging turnover growth. Using analysts’ estimates for the coming year, this cross section of 11 stocks is expected to grow turnover by around 20 percent in the coming year.

That in turn translates through into an average forecast earnings per share growth of 81 percent across the 11 stocks in the coming financial year. So, whilst it’s true that buying into these digital infrastructure stocks does mean paying a very substantial premium against the benchmark, you’re also on the receiving end of very strong both top and bottom-line growth which is feeding through into cash pay-outs to shareholders.

Now, many investors might still think that these valuations are aggressive (and they are in my view) and they may also point to high gearing across the sector – running in the hundreds of per cent for these 11 stocks on average. But I would suggest that for many investors the obvious growth characteristics of this space plus its collective diversification benefits might be exactly what they need to ignore these valuation concerns. And certainly, most analysts don’t seem to be too put off by the rich valuation metrics – the average broker rating across the sector is 2.2, with one representing very bullish and five very bearish. It’s also worth noting that the average short ratio is five, which doesn’t seem terrifically bearish.

Stepping back from this tsunami of numbers, a couple of points do stand out for me. The first is that these valuations do demand that the digital infrastructure giants deliver on their growth promise. A quarter or two of disappointing numbers or even a year or two of underwhelming growth could spell trouble because of those rich valuations. My sense is that given the secular demand profile of this sector, that shouldn’t be too great a risk, but given the obvious scramble to build new operating assets, there’s always an ever present risk of a supply glut which could hit margins.

The other obvious point is that high gearing is fine if growth in the bottom line – profits and free cashflow – is surging. But that situation could turn nasty if interest rates and bond yields start to rise and cashflow growth slows down. That could be a dangerous double whammy that could in turn smash those dividend payouts. On that point I’d note that the average dividend cover for these 11 stocks is a lowly 0.5, which suggests that dividends could be vulnerable if free cashflow starts to wilt.

The Opportunities and Challenges of the Sub-Sea Cable Market for Digital Infrastructure Investors

September 7, 2021

My guess is that when you ask most mainstream institutional investors what they think digital infrastructure looks like, in actual physical form, they’ll probably trip off a list of visualizations including mobile phone towers, data centers, and finally, everyone’s favorite, hard hat workmen laying urban cable – in recent years they might even mutter about satellite dishes and low orbit constellations. But I’d wager that very few would get excited about sub-sea cables which is peculiar because one of the most successful IPOs of recent years in this space is that of D9 Digital Infrastructure is in large part, currently, a sub-sea play via its takeover of Aqua Comms. This successful and profitable business owns a bunch of assets including trans-Atlantic cables including America Europe Connect-1 (AEC-1), America Europe Connect-2 (AEC-2), and CeltixConnect-1 (CC-1). It’s also just announced an investment in a new cable into the middle east out of Europe.

If I were charitable, I suppose one could forgive the markets ignorance of sub-sea by way of taxonomy. Perhaps investors pigeonhole sub-sea cable as part of a wider fiber play which consists of a number of segments including long-haul (terrestrial and subsea) linking countries and cities together, as well as metro rings (the backbone network within a city) plus customers favorite, FTTP, (running from the metro ring to houses and businesses). And while we’re on that taxonomy point. one might also assume that terrestrial fiber might be a more attractive option because…well…it’s on land! That makes the process of laying cables and getting permissions and worrying about technology upgrades that much easier. So, if as an investor you’ve bought into the idea of all those exponential growth curves in data usage, better to focus on terrestrial and not be too bothered with all that tricky stuff involving water.

I say tricky because sub-sea sounds more than a tad challenging, and I’m not just talking about the obvious challenges of laying a cable in the deeps as well as repowering said fiber every 20 to 30 kilometers. Terrestrial cables typically have complicated rights of way issues to navigate. And if all that isn’t bad enough, experts such as Thor Johnson at D9 warn that backlogs and waiting times for the construction of new sub-sea projects is getting longer all the time. Whereas waiting for the cable supply and then installation would typically take two to three years, Johnsen reckons its now closer to three to four years and growing all the time.

Lurking in the background though is a more practicable challenge: the corporate structure of the sub-sea industry. Traditionally, the funding model for sub-sea has involved big consortia of telco businesses and carriers. The end result is a legacy network where many of the old cables, especially in the all-important Atlantic circuit, are nearing retirement or in need of extensive modernization to allow greater capacity.

That said, despite all these obvious challenges, sub-sea as one segment of the fiber market seems to be growing fast, as are most other digital infrastructure platforms (to be fair). Many of the most important sub-sea cables (at least in terms of capacity) have been built within the last five years. And some routes already look busy.

Take for example the all-important trans-Atlantic routes. At the last count, there were 18 cables going across from the US or Canada to Northern Europe (and especially the UK). D9 owns two of the more well-known cables AEC 1 and AEC 2 but many of the other owners have familiar names such as Vodafone, Tata and Google. Which of course reminds us of an essential fact – that sub-sea markets tend be highly concentrated in terms of ownership, much more so than long haul terrestrial fiber.

The majority of digital data carried via sub-sea today tends to be from a handful of giant companies such as Google, Amazon, Microsoft and Facebook. Rather than relying on the traditional model (telecom consortia) for access to subsea cables, these organizations are deploying their own sub-sea cables. They are doing so to cut costs and expand control and, as a result, the scale and pace of this deployment is significant. According to one industry insider, at the moment more than two-third of digital data moving across the Atlantic is on private networks owned by Google, Microsoft, Amazon or Facebook.

This all leads to one important point: that the sub-sea business is increasingly a scale game played by large operators who can a) afford the capital overlays and then b) continuously upgrade to allow for ever more data traffic.

Both of these trends can be glimpsed through the example of Google. According to, Google currently has either a stake or privately owns 14 undersea cables,  mostly in consortiums run by the likes of Aqua. Many of the most important span the Atlantic but the data giant has also expanded into other routes such as the Middle East-Africa-Asia route which until recently did not have a Google (or Facebook/Microsoft) cable on it, so one was announced. Soon thereafter, Google announced a project to traverse the Mediterranean and then wrap around Africa.

The technological upgrade path is also clear. Google’s first undersea cable, the Unity system, as part of a consortium across the Pacific, was ready for service back in 2010 and had eight cable pairs with system capacity of just 8 Tbps. The most recent cable, Equiano, which is 15,000 kilometers in length and connects Portugal to South Africa, has 12 pairs but a gigantic capacity of 240 Tbps.

Given this race to scale (and the need to modernize) and link up vast global networks, it’s arguably something of a surprise that there are still niche players such as Aqua in the business, competing against rivals such as Telxius (part of Telefonica) and GTT.

D9, for instance, through its Aqua business, has investments in a number of transatlantic lines: AEC 1 is their first cable with six fibers with four sold to a variety of corporations while another pair is leased, leaving one available pair. D9 also runs AEC 2 across the Atlantic plus AEC 3 which is imminent, coming on shore in Cornwall, UK.

The revenue stack for these independent operators is varied. Some pairs are leased on long term 15-to-20-year deals with the OTT Big Data plays; most of the FAANGs (Facebook, Amazon, Apple, Netflix, Google) seem to be Aqua customers. But mixed in with these (probably lower margin) revenue streams, there’ll also be shorter duration deals in the one-to-five year range for data hungry customers, especially those in the second tier. For example data hungry players such as Akamai and Disney.

This increasingly complex ecology of infrastructure players – traditional carriers battling it out with Big Data vendors and independents playing all sides – becomes even more interesting in certain geographies. One insider tells me that the most interesting competition at the moment is either in shorter haul interconnector cables (for example, UK to the Nordics) or into specific regional markets, with India topping most lists.

And there’s one final observation on this competitive ecology that worth noting: “Amazon and AWS don’t seem to be as active as we’d expect in this market currently. They seem happy to buy capacity rather than lay their own cables,” one industry consultant tells me. Given Amazon’s vaulting global ambitions, I can’t imagine that state of affairs will continue for much longer.

That mention of Amazon though should act as a warning to bigger institutional investors interested in this space. Some investors I talked to admit they like the space but as a result of this competitive landscape tread cautiously around it. Says one: “We’d argue that a sub-sea fiber on a heavily competed route with few customers, poor contract terms and looming competition would naturally be less interesting than a long-haul fiber route with strong customers on good contracts, solid growth potential (new laterals and new customers) and limited opportunity for a competitor to find rights of way.”

Specialists like Aqua/D9 will of course disagree and point to the extraordinary growth in demand across the planet, with new routes opening all the time. They also remind us that even the old routes will need upgrading soon, but one is left wondering whether the sheer scale of capex needed for the next phase of sub-sea modernization might be a challenge too far even for deep-pocketed institutional investors.

Welcome to Space 3.0 Digital Infrastructure

August 2, 2021

As a life long sci-fi fan, I have to admit that the news that Branson and Bezos have in the last few weeks properly kickstarted the space tourism model left me a tad cold. I freely admit that I am terrified of heights and fast moving things so I’m probably not the target market but my skepticism was more nuanced than that. Sure, space tourism is exciting but I think it is a side show to a much bigger story, namely the brand new space-based digital infrastructure model that is taking shape above us.

To understand the real revolution underway lets first rewind. Space 1.0 was largely state run, funded by militaries and bureaucrats and comprised huge, bulky satellites. Space 2.0 took off in the last decade and spawned a fleet of listed satellite owners of communications platforms in search of specialist niche markets. As David Williams, co-founder of Avanti Communications Group plc, the United Kingdom’s first start-up satellite operator and now boss of satellite focused quantum cryptography form Arqit freely admits, this model had its flaws which became increasingly obvious to stock market investors by the middle part of the last decade. These Space 2.0 stalwarts were, he admits, “cost plus” platforms, forced to focus on broad products such as maritime comms to generate enough cashflow to pay the bills. We all know how unsuccessful that model was compared to functionally specific satellite-based platforms such as Sky in Europe and Dish in the US. These operators made their money out of using the satellites for a much bigger content first product. For Sky, a satellite firm, space-based costs were probably just a couple of per cent of total costs.

Space 3.0 is radically different again. The cost of sending a kilo via a launch outfit such as SpaceX is now one hundredth of the cost in the 1980s and there are now over 150 other rocket launch companies competing for business launching thousands of low earth orbit satellites for every purpose imaginable.

Media and investment commentators such as yours truly tend to focus on one itsy bitsy aspect – rural broadband in the developed world. Here in the UK, Space X has just launched its open beta for the Starlink product and from many subscribers I have talked to, the feedback is positive so far. Latency is massively reduced; speeds are as promised and at the moment there’s no big challenges around data usage (though I’ll bet that will change very very soon). Another operator OneWeb, rescued in part by Her Majesty’s UK government, also looks to be making solid progress and has just announced what I think could be a very fruitful partnership with incumbent telco BT to operate village level satellite hubs that can redistribute the signal to nearby rural houses.

But even this focus on rural broadband – obviously, a crowd pleaser for rural politicians seeking infrastructure spends – is I think missing the bigger picture. The real story is that the multitude of these low earth orbit constellations are pioneering a new product set – satellite data products. Rural broadband is one part of a broader mix of products that ranges from autonomous cars to land mapping.

One way of gauging this new digital infrastructure market is through the lens of recently stock market listed UK space fund Seraphim, which raised £180m to invest in this space using a venture capital approach. They also helpfully run a Space VC investment index. Cynics will snort that this an early stage side show with its obviously high valuations but I’d suggest that the headline numbers for Q1 2021 below tell you something is happening out there.

  • $8.7bn invested in last 12 months
  • $2.7bn invested in Q1 ($2.6bn in Q4 20)
  • 68 deals closed in Q1 (highest since Q1 18)
  • $850m biggest deal closed in Q1 (SpaceX)
  • $46m average deal size in Q1 21 (vs. $50m Q4 20)
  • 11 space-related SPAC mergers announced
  • $7.2bn funding committed to these SPAC mergers.

A better way of understanding the Space 3.0 model is to focus on investment stories, or more specifically some of the businesses in that Seraphim portfolio. Perhaps the most traditional example is a firm called AST Group which has just reversed into a SPAC with the ticker ASTS. The best way of describing this business model is that they provide cell towers in space.  

A more radical product comes in the shape of Iceye which provides 25cm resolution day or night of every metre of the earth every hour. That presumably requires a huge amount of data that needs to be processed back on earth in huge data centres? Or perhaps not.

Circling the earth are another constellation of satellites from a firm called D Orbit which is currently trialling something called Nebula, an on-demand, on-orbit cloud computing and data storage service. According to a recent press release this new product “features an intelligent automation SpaceCloud iX5-100 radiation tolerant computing module by specialist Unibap, will demonstrate a range of innovative applications for advanced geospatial Earth Observation (EO) and Space Surveillance and Tracking (SST) applications using sophisticated, Artificial Intelligence/Machine Learning (AI/ML) algorithms for extremely low-latency decision support”.

In layman’s terms, this a data centre in space. Sci-fi nerd heaven. All we need now are space elevators!

Stepping back from the company-by-company details, a new model emerges for space-based infrastructure: it’s just a tool by which new products can be slotted into a digital framework. So just as investors have pumped money into everything from cloud-based firms, or Google and its search technology through to enterprise as software business models, we have low earth, lower cost space based constellations as adjuncts to new products. With all the same bonkers valuations.

That said, despite those pie in the sky (!) valuations, I’d maintain there are some very earth bound investment implications for infrastructure investors.

The first, as evidenced by Seraphim’s successful fund raise and their wider index data, is that space is moving out of the shadows of early stage VC and becoming a mainstream sub asset class. Even fairly ‘traditional’ infrastructure investors such as Cordiant admit that they’ve been looking in detail at these Space 3.0 propositions. And that’s all because these are fast turning from ideas into market ready products.

I’d also counsel caution for the space based rural connectivity argument. In countries such as the UK our incumbent telcos have certainly been slow off the market, but I think fibre will end up becoming the default solution for between 90 and 95 percent of the homes in the developed world, eventually. It might take five years to get there but I find the up front expense of solutions such as Starlink and the high monthly running costs unattractive.  I also think they’ll run into capacity issues as that final one to five percent of difficult to reach homes swarm on to the space based networks.

In the developing world, by contrast, I think space base broadband solutions are viable and exciting but I’d wager that upstart space telcos will face intense competition from the Big Tech giants. I can absolutely imagine services from Facebook or Netflix delivered directly by satellite – cutting out the telco – for a monthly fee by Bigtech.

But all of these markets are a side show to what I think is the real big deal. Autonomous cars. I’d be a rich man for every telco and digital infrastructure payer who says the future of 5G is autonomous transport. I believe them until I think what happens when my self-driving car skips out of a 5G network zone. Do I trust the major mobile telcos to have 100 percent connected within a decade to 5G? Of course not and until that happens and I can be guaranteed seamless connectivity all the time, in all national geographies, I’ll avoid autonomous cars. The solution? Look to the heavens for seamless global connectivity with a small receiver built into the car. Is this imminent, not yet but IT IS the future.

Switching on Advisors to the Digital Infra Opportunity

July 6

In my humble opinion, one of the biggest challenges facing digital infrastructure businesses as well as funds is to find a way to get to talk to advised clients and their advisors. Institutions by and large understand the space as do many sophisticated private investors, especially the very active ones. But advisors tend to lump these digital assets into an alternative box alongside more traditional infrastructure assets and then treat with some suspicion, the suspicion of the ‘new’.

Yet there are signs that is changing and the example of a recently launched UK fund of funds might offer some useful clues as to what advisors might want from the digital infra sector. Gravis is a successful UK based infrastructure house that has also built up a fund of funds business that sells heavily to advisors. Its idea is simple. All these alternative investment ideas structured as funds (or opcos) are difficult to research for most advisors, so you need someone to build an overlay that finds the right funds (and single businesses) and then assembles them together in an income-oriented fund of funds. Over time its existing infrastructure and listed property equities fund have accumulated pretty big sums of money – as have rival offerings from peers – and now its launched what it thinks over time will be its biggest fund ever: a digital infrastructure equities fund of funds which invests in towers, data centres, fibreoptic networks, logistics warehouses. Or as the manager describes them physical structures, which are all tangible, and all have a bit of concrete poured in them, as well as contractual leases, producing high cashflow predictability.

In this universe, they’ve identified around 120 listed, global digital infrastructure companies although it’s interesting to note that within their definition the number of funds and businesses has doubled in terms of numbers over a decade and has increased more than six-fold in terms of aggregate market cap. More specifically Gravis analysis reveals that this universe has increased in market cap terms from £73.5bn in 2010 to £461.3bn in 2020. As for returns, between 2011 and 2020, returns have averaged c.18.9% per annum with volatility of 15.43%. From this growing universe, the Gravis team led by Matthew Norris has identified 29 businesses and funds for the portfolio which is now live and growing steadily in size.

Graphic : The growth of the digital infrastructure universe

Source: Gravis Capital Management, Ltd, 2021

As you’d expect the big sales pitch is one we’re all familiar with – as Norris observes “we’re living in the fourth industrial revolution” but the first key message from this fund is that it includes a very heavy helping of tech-enabled logistics park operators alongside the more expected tower cos and fibre operators.

According to Norris “If you go back in time, especially in the UK, data centres are actually born on logistic parks.  One of the biggest owners, possibly the biggest owner of data centres in Europe is probably property business Segro, and that data centre is on the Slough trading estate. The Slough trading estate gave birth to Segro 100 years ago and then as good fortune would have it, they found themselves close to London as well as a big fibreoptics cable from the Atlantic plus it helps that there’s access to power.” Segro has its own power station.

It is easy to see why logistics park operators will appeal to professional clients. You have classic property-based assets, with long leases and lashings of technology. As a result, the Gravis fund is exposed 45% to logistics businesses with the remainder in classic digital infra: 25% in data centres, 25% in tower cos and 5% in another bucket that includes fibreoptic networks and battery storage.

The next big lesson is that Gravis, like many advisers I’ve talked to, likes tower cos and are overweight exposure to this sector compared to their universe weights. Norris echoes those who’ve called these businesses “the best business ever”.  He likes the fact that the steel towers being put up last 25/50 years, and that according to one of the tower co operator’s maintenance capex on each is just 900 dollars per tower per year – “it’s a great asset, long-life asset”. And there’s also the increasingly obvious densification drive coming out of 5G especially in the US “where you have carrier neutral towers and the mobile network operators go to the tower codes and put their dishes on.  We are likely to see co-tenancy on towers, so competing operators on the same tower- that’s great news for the owner of the tower.

The next useful insight is that the digital infra space needs to be more vocal about its intrinsic valuation strengths as an equity asset class and not run scared of those who argue the sector is overpriced and a bond proxy. On the multiples question, Norris points to businesses that have contractual cashflows, are earning steady money, paying dividends, and increasing those dividends on average between 2 and 3%. Unlike say classic property REITs , which produce higher yields, the digital infrastructure space has very obvious drivers of huge growth “over many, many sequential years, so what you might have to sacrifice in yield you should make up for in terms of dividend growth. “

As for the cacophony of voices that say these assets are bond proxies and will falter as interest rates pick up, Gravis reminds us that these are not in fact anything remotely like fixed-income assets. “We’re talking about growth income here,” observes Norris “and there are two types of growth that you get from owning a data centre and a tower co. One is your contractual rental growth.  And then the second growth element is actually releasing up more space, growing the rental income, by hanging another dish on the same tower.  So, my response would be I hear what you say but this is not fixed income, this is growth income, plus market growth.”

I also sometimes detect another variation on the bond proxy argument which is that although there are obvious growth opportunities, most digital assets do not have explicit inflation protection, unlike say classic public-private partnership infrastructure assets. It’s a fair observation but I’ve always felt it is a misguided one. Sure, there may not always be explicit CPI agreements in place but as Norris reminds us “as long as the income can grow in line or faster than inflation then it’s going to be inflation proofed. With tower cos and data centres their top line should be rising faster than inflation just because of the growth characteristics and their cost base should be rising at or below inflation, you should see some level of operating leverage coming through.  So, I think those two sub-sections will perform very well.”

My own hunch is that these characteristics of the asset class are, in reality, fairly well understood but there’s another risk that is I think less so. Security.

I’ve visited more than my fair share of data centres and towers over the years and the first question I always ask is a security-related one. Cybersecurity tops many lists but in reality, that’s actually more of a risk for the tenant rather than the physical infrastructure owner. But physical security is very much a concern for everyone, especially the real asset owner. And here Norris at Gravis spies an opportunity, rather than a risk.

“I think that creates a barrier to entry, I think that’s why you and I wouldn’t be very successful at setting that kind of business up because you have to have a track record of building very secure, reliable centres. The ones that I’ve visited, especially the ones that have government servers in them, they literally do have those bollards around the centre to prevent terrorist attacks and when you enter the data centre you go in through one of those man trap scales that weigh you on the way in and weighs you on the way out.  So, absolutely, security is an issue but also it creates a competitive advantage.  If you are an established player in the market, you have the reputation. “

This brings us to the last key insight – ESG. I see it topping more and more financial professionals lists of concerns, and not always for the right reasons. ESG has become akin to a gateway drug that encourages all sorts of slightly inchoate concerns, mostly but not always based around energy efficiency.  According to Norris “we have done a lot of research on this and, it’s much more efficient to have servers in a data centre, in a bespoke environment. Here at Gravis, we still have a server in the corner of our kitchen.  That’s bonkers.  That’s not the right environment to have it, so we waste energy cooling that server in the corner of a kitchen.  If all businesses like ours put their servers into dedicated data centres, less power would be used…..  I think there’s more work to be done proving the point that the place for your server is a data centre because you’ll use less energy”.

This I think is a key message. Rather than focus all the attention on digital infrastructure operators own ESG policies – important though they are – also try and remind investors of their own obligations, their own inefficiencies that make the problem much worse!