GDS Holdings: Shares Could Stay Cheap Without Catalysts

Elevator Pitch

My Hold investment rating for GDS Holdings Limited (NASDAQ:GDS) [9698:HK] stock stays unchanged. On one hand, GDS' 2H 2023 EBITDA margin outlook is unfavorable, and this suggests that there is an absence of earnings-related catalysts for the near term. On the other hand, the stock's valuations aren't expensive as evidenced by recent insider buying. This explains my Neutral view and Hold rating for GDS.

GDS Maintained Its Full Year EBITDA Guidance Despite Q2 Beat

My prior July 25, 2023 write-up touched on GDS' high net leverage ratio and the privatization deals for its listed data center peers. In the two months or so following the publication of my earlier article, GDS' share price dropped by -11.8% (source: Seeking Alpha price data), which was worse than the S&P's -6.1% decline in the same time frame.

In my opinion, the market might have been disappointed by the fact that GDS chose to leave the company's existing full-year fiscal 2023 EBITDA guidance, even though its actual Q2 2023 EBITDA was better what the sell-side analysts expected.

The normalized EBITDA for GDS expanded by +16% YoY from RMB1,062 million in the second quarter of FY 2022 to RMB1,235 million for the most recent quarter. The company's actual Q2 2023 EBITDA came in +10% higher than the market's consensus forecast of RMB1,125 million as per S&P Capital IQ's consensus data.

I am of the view that there are valid reasons for GDS' cautiousness regarding expectations for the company's full-year EBITDA.

One key factor is that GDS benefited from "a one-time service revenue of RMB70.7 million (US$9.7 million), arising from an early termination" as disclosed in its Q2 2023 results press release. In specific terms, GDS' EBITDA margin for the second quarter of 2023 would have been -240 basis points lower, assuming that the company didn't have this non-recurring revenue item in the recent quarter. This implies that GDS' EBITDA margin is expected to normalize in the third and fourth quarters of this fiscal year excluding this one-off item.

Another key factor is that GDS' overseas expansion plans outside of Mainland China will still be a drag on the company's operating profitability in the current year. At its Q2 2023 earnings briefing in late August, GDS mentioned that "for the International segment, we will be EBITDA positive next year." This suggests that the company's foreign business operations will stay loss-making at the EBITDA level in fiscal 2023.

It is also worthy of note that the company's EBITDA margin for the near term will be negatively impacted by utility expenses. GDS cautioned at its second quarter results call that its Q3 2023 operating profitability is likely to be affected by "higher power tariffs and higher power usage in the peak summer months." The company also admitted at its most recent quarterly earnings briefing that "we don't have any knowledge about" the timing of a potential decrease in power tariffs and utility costs. This implies that elevated utility costs are likely to be a drag on GDS' EBITDA margin in the second half of this year.

In a nutshell, GDS' 2H 2023 EBITDA margin is expected to be weaker due to a number of factors mentioned above. As per the mid-point of the company's financial guidance, GDS' EBITDA margin is projected to contract from 48.5% in 1H 2023 to 44.6% for 2H 2023.

Insider Buying And Valuations

GDS' CEO and founder, William Huang, has acquired a significant amount of the company's shares in the past few months.

In late May, William Huang highlighted at the Q1 2023 results briefing that he has the intention to "purchase approximately 1 million ADSs (American Depositary Shares), and possibly more, over the next 12 months" to "emphasize my commitment to our company."

William Huang subsequently disclosed at the second quarter earnings call on August 22 this year that he has "already bought the 50%" of the insider purchases he guided for earlier, and stressed that he "will continue to execute" on the remaining half of the shares acquisition.

In my late-July article, I had noted that "GDS' deleveraging efforts" will make it difficult for the company to have sufficient capital to execute on "share buybacks." The company's net debt-to-EBITDA ratio was still pretty high at 7.7 times as of June 30, 2023, and this means that it is unlikely that GDS can use share repurchases as a way of signaling to the market that its shares' valuations are undemanding. As such, it is important that the company's CEO has engaged in meaningful insider purchases for the last couple of months.

GDS' key valuation metrics are now about half of their historical averages. The market currently values GDS at consensus forward next twelve months' Enterprise Value-to-Revenue and EV/EBITDA multiples of 5.3 times and 11.5 times, respectively as per S&P Capital IQ data. In comparison, the stock's five-year mean consensus forward Enterprise Value-to-Revenue and EV/EBITDA ratios were much higher at 10.2 times and 22.5 times, respectively.

Concluding Thoughts

GDS' stock justifies a Hold rating. Although its valuations are inexpensive and the company's CEO has been buying shares recently, expectations of weaker EBITDA profitability in 2H 2023 implies a lack of re-rating catalysts. As such, I continue to rate GDS as a Hold.

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