Data centre firm GDS's figures don’t stack up: short seller

Temasek-backed GDS is taking advantage of blind euphoria over data centres' growth prospects, Blue Orca says. GDS hits back. Whether the claims are true or not investors should take a more critical look at serial capital-raisers using lofty valuations to make acquisitions.

Activist investment fund Blue Orca Capital says Nasdaq-listed developer and operator of data centres, GDS Holdings, is another Chinese company whose financial accounts do not add up. 

If the Texas-based short-seller's allegations prove to be true it will be painful for GDS's equity investors and creditors, which include Singaporean state fund Temasek.

It could also mean egg on the face for early investors in GDS including the International Finance Corp and Japan’s Softbank.

GDS’s stock hit a high of $45.72 on July 14, up over 400% since its IPO in November 2016 at $10. Blue Orca values GDS’s shares at just $4.32 and even that might be too high it says.

“Given management’s shattered credibility, its crushing debts, and evidence that the company is inflating the value and performance of its data centres, we think GDS’s equity could easily be worth $0.00,” said the short-seller, which is led by Soren Aandahl. GDS's shares tumbled 37.2% on Tuesday after Blue Orca's 53-page report hit traders' screens.

GDS founder William Wei Huang said on messaging service WeChat that Blue Orca's claims were unfounded, disruptive and false. Major shareholder, Temasek unit ST Telemedia Global Data Centres, said it remained confident in its investment in GDS.

Their statements sent GDS stock back up 14.52% in US trading on Wednesday to $25.

Away from passionate back-and-forth between management and the short-seller, data centre analysts are already offering other possible explanations for the anomalies, picking holes in the short-seller’s arguments and thinking through the longer-term implications for the sector.

What is clear is that investors globally have been star-struck by the widespread adoption of cloud computing, the internet of things, smart cities, and big data analytics. All are generating a dazzling explosion of data.

Asia’s fast-growing middle class will propel the region into a leader of this trend. By 2021 there will be twice as much mobile data in the region than in North America and Western Europe combined, according to US IT hardware firm Cisco Systems.

Businesses across the region are rapidly outsourcing their data storage into the cloud to amplify their computing power. The cloud, rather prosaically, is made up of nondescript-looking storehouses called data centres that keep computer servers sitting on racks, safe and cool. 

In China, Alibaba and Tencent are frequently cited as demand drivers, but others such as JD.com, Microsoft, Ctrip, Huawei, and financial institutions continue to request or are ramping up their requirements for third-party capacity. Microsoft demand appears driven in significant measure by Office 365, sector analysts said.

Data centres' share prices have soared in recent years and certainly deserve close inspection. Take California-headquartered Equinix: its share price peaked in 2000 at $504, just before the dot.com bubble burst sending its shares down to $2.95 in 2003. The US firm’s stock is now trading at $439, on a P/E multiple of 108.5 times.

Like many of its peers, GDS has clearly used its high valuation of around 47 times 2018 Ebitda to raise capital to buy as many data centres as possible at around 10 times Ebitda. 

This works well in bull markets, but as sentiment turns against technology stocks globally, it could all come to a grinding halt.

“One outcome is that capital raisings will possibly become more difficult in the near term on perceived governance concerns,” said Credit Suisse analyst Colin McCallum. 

CHINA HUSTLE

While the demand for data centres is undoubtedly growing globally, Blue Orca took a sceptical look at the finances of GDS to understand whether it was using debt and equity investors’ money to capture this growth opportunity wisely and creating value for its shareholders.

In its alarming report, the short-seller likens GDS to scandal-hit Chinese companies that listed in the US between 2008 and 2016 that are described in the recent Netflix film The China Hustle. Aandahl helped expose a few of these companies, such as Universal Travel, L&L Energy and China Medical. Other short-sellers such as Carson Block’s Muddy Waters have also sought to make money shorting fraudulent Chinese firms listed in the US.

In a survey published last month by the Asian Corporate Governance Association, 68% of foreign investors described engaging with Chinese A-share firms as very difficult, while 80% of investors said engagement did not lead to constructive outcomes. This means research from activists such as Blue Orca can be very valuable – and equally difficult to refute.

Given investors’ skittishness as they try to navigate unfamiliar Chinese companies’ accounting practices and the opaque markets in which they operate, a company’s reputation can be damaged just by a negative report being issued.

Specifically, Blue Orca said GDS was borrowing crippling amounts of debt to buy data centres from undisclosed related parties which are not nearly as valuable as the company claims.

Blue Orca said databases in China indicated that in three of GDS’s four major post-IPO transactions, GDS not only acquired data centres from undisclosed related parties, but overstated the purchase price of such acquisitions in its US Securities and Exchange Commission filings.

One example given by Blue Orca was GDS's June 2017 purchase of Shenzhen Yaode Data Services for Rmb312 million. However, publicly available SAIC (State Administration for Industry and Commerce) filings show that two GDS employees also served as the acquisition target’s director and supervisor prior to the acquisition. Furthermore, publicly available SAIC filings in China state that the true purchase price of the transaction was only Rmb500,000, not Rmb312 million as GDS stated in its SEC filings.

A short seller Trinity Research Group wacked GDS rival 21 Vianet in 2014, also accusing it of failing to disclose related parties in acquisitions.

GDS refuted the claim saying the SEC filings are correct and the SAIC filings only reflect a portion of the consideration. Analysts also noted that the SEC and SAIC may have used different methodologies in their filings. “The price cited in GDS' filings to the SEC appears more in line with market prices,” RBC Capital Markets analysts said.

GDS said none of the employees, directors or shareholders of the acquired data centres identified in the report were at any time an employee, director or related party of GDS.

Blue Orca, which takes its name from the formal term for killer whales, says it has also discovered evidence of unrelated data centre operators selling a substantial amount of empty cabinet space in a building which is supposedly exclusively operated and 94% utilised by GDS.

“One operator, GZIDC, told us over a recorded phone call that it leased out 1.5 floors of the G6 building and operated at ~60% utilisation. GZIDC followed up our inquiry by sending a quote offering to rent us a significant amount of space in the very same data centre GDS claims to exclusively operate at 94% utilisation,” Blue Orca said in its report.  

Blue Orca said GDS has overstated utilisation of its data centres by 20% and that its growth is largely illusory.

To be sure, Blue Orca did not say whether it had checked its findings with GDS. There may be a simple explanation such as that GDS has sub-let the space in its data centre to other companies who just have not managed to fill it yet.

GDS countered that its customers are sub-letting space.

Tencent and one other large Internet customer are the primary direct tenants, and roughly 20% of the data centre may be leased to a smaller entity that subleases space, analysts said.

“GDS is following standard industry practice with respect to capacity utilisation in recognising space as fully utilised even if the subtenant has not entirely subleased its space,” the RBC Capital Markets analysts said in a note to investors dated August 1.

Since its IPO, GDS has been a serial capital raiser, issuing equity and debt despite ample cash on its balance sheet.

"GDS claims to need such money to grow. Yet GDS discloses that it keeps over 65% of its cash balance offshore, where it would be essentially useless if the purpose of raising such cash was to buy and build data centres in China," Blue Orca said. 

Of course, the US currency may be needed to service US dollar-denominated debt and for other legitimate business uses.

GDS noted that it can only remit funds onshore when it has approval fro PRC State Administration of Foreign Exchange.

On the positive side, GDS's prolific capital raising in recent years has provided it with a buffer against market shocks in the near term.

Last month, unrated GDS issued seven-year term $300 million convertible bonds, redeemable from the fifth year onwards.

Left lead on the deal was JP Morgan. Bookrunners were Citigroup, RBC Capital Markets while they were joined by Credit Agricole, DBS Bank and Haitong International in a "No Books" role. 

Last year, RBC Capital Markets acted as financial advisor and sole placement agent to GDS in connection with the $100 million private placement of equity, while Simpson Thacher & Bartlett served as legal counsel.

But GDS is cash flow negative, and is therefore contingent on benign stock market conditions to raise more capital to sustain its growth rate via acquisitions from 2020 and 2021. 

Neither GDS nor Blue Orca responded to requests for additional comment.

GDS's financial results announcement is scheduled for August 14.

This article was updated to included GDS's latest rebuttal of Blue Orca's allegations

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