Description

Summary –

Since being written up on VIC by Ruby831 nearly a year ago, Q9 Networks has experienced accelerating operating momentum and has hit or exceeded analysts’ and Ruby’s estimates.  However, the stock is down slightly since then, due to what we believe are misplaced concerns relating to some, but not all, of the broadly defined US comp base, as well as fears about slowing growth.  In fact, the company is performing strongly, the outlook is very positive, and the company’s basic business model (unlike some of the comps) is very sound.  The company is growing EBITDA at a rate of more than 50% annually, and trades at 10x current year EBITDA and 8x our estimated run rate for Q4 2008 (the quarter ending 10/31/08).  Q9 is in a unique position in Canada and is building a powerful strategic asset.

 

As this is an update to an excellent write-up done by Ruby831 on 2/9/07, I will focus on bringing the information up to date and on summarizing the arguments for buying Q9 stock.  Q9 has had an excellent year, meeting or beating all targets, including analyst estimates.

The company reported their 4^th quarter results (10/31 year end) in the past three weeks.  For the year, the company achieved the following:

Grew capacity 51% (4,530 to 6,830 cabinets)

Grew cabinets utilized 13% (4,147 to 4,695)

Grew contracted quarterly revenue 20% ($10.8mm to $12.9mm)

Grew annualized EBITDA 52% ($11.6mm to $17.7mm)

Grew EBITDA margin from 23% to 28%.

During the past year, the company opened and began filling new capacity in Toronto and Calgary, and in the earnings conference call announced that they would be building a third data center in Calgary, to open around June 2009, based on the on-going growth they see in that market.

However, the stock is slightly down since Ruby’s write-up, most recently trading at $13.  What has happened?

Mainly, we believe that Q9 has been impacted by the sell-off in two of the US comps, and by concerns about a slowing organic growth.  Over the past several months, US comps Savvis (SVVS) and Navisite (NAVI) have missed their numbers, due to higher churn and slowing organic growth, and have significantly raised their guidance for maintenance and overall capex, thus lowering calculated free cash flow and causing concerns about their business models.  On the other hand, the US industry leader Equinix (EQIX), which we believe has a business model and financial characteristics much closer to Q9, is on track and is up 35% in the past year.

As Ruby covered in his write-up, Q9 is in the colocation/data center business, and is the leading independent provider in Canada. The company essentially got into business with the 2002 purchase of a data center in Brampton, Ontario, outside of Toronto, from Exodus Communications, which was then in bankruptcy.  The company has grown organically since, adding data centers in Toronto and Calgary, and as they filled, adding another Toronto data center (completed Q1 2007), another in Calgary (completed Q2 2007) and a second phase in Brampton (opening this quarter, Q1 ’08).

Over the past year, with its new capacity rolling in and with the build-up of the sales organization, as discussed by Ruby, contracted quarterly revenue has been growing by more than $700,000 per quarter.  It is likely that the growth will accelerate because, in any quarter, 50% of growth has been coming from existing customers, and as the customer base grows, there is a larger base of customers with whom the company can grow organically.

For the current quarter, the company announced that it is losing the final piece of business from a customer that was acquired by a US company and whose data center needs are being brought in-house to its now US parent.  This is the only meaningful customer the company has lost in the past few years.  The first phase of this occurred in Q1 ’07, and the second phase - 135 cabinets or roughly $3 million in annual revenues - will occur in Q1 ’08.  As a result, revenues and EBITDA will be roughly flat this quarter, as the customer loss offsets organic growth.

 

	2006 Q3	2006 Q4	2007 Q1	2007Q2	2007 Q3	2007 Q4
Total Revenue	11,976	12,453	12,812	13,422	14,643	15,609
Gross Profit	3,712	4,443	4,406	3,945	4,413	4,995
EBITDAS	3,175	3,477	3,292	3,011	4,094	4,787
Stock Based Comp	559	568	576	571	344	371
EBITDA	2,616	2,909	2,716	2,440	3,750	4,416
EBITDAS - est. maintenance capex	2,480	2,755	2,549	2,233	3,245	3,882
Total Cabinets Utilized EOP	4,059	4,147	4,154	4,362	4,598	4,695
Net Additional Cabinets Sold	129	88	7	208	236	97
Quarterly Revenue under contract BOP	9,995	10,342	10,813	11,222	12,121	13,003
Quarterly Revenue under contract (excluding Google)	8,495	8,842	9,313	9,722	10,621	11,503
Quarter to quarter growth (excluding Google)	7.6%	4.1%	5.3%	4.4%	9.2%	8.3%

 

Going forward, beyond Q1, we expect (guided by management) that revenues will grow by more than $1 million quarterly for the next several quarters, with approximately 70% falling to the EBITDA line.  As a result, we see EBITDA of $23mm in’08, including a run rate of $28mm by the end of the fiscal year, growing to $37mm at the end of ’09, and a run rate approaching $45mm at that time.  The numbers below, including capex, do not include the recently announced 3^rd Calgary data center, which is expected to be completed around June 2009.  Construction has not yet begun, and the company has not announced the size or cost of the data center.

 

Projections	2008	2009	2010
Total Revenue	71,722	95,994	128,369
EBITDAS	24,720	39,283	58,235
Stock Based Comp	1,705	2,282	3,081
EBITDA	23,015	37,001	55,154
Capex – Growth	(13,708)	(2,717)	(28,600)
Capex – Maintenance	(7,172)	(9,599)	(12,837)
Capex – Total	(19,172)	(9,599)	(37,837)
FCF before Growth Capex	15,843	27,402	42,317
FCF Net	3,843	27,402	17,317

 
Equinix, the clear market leader, is up for the year, and continues to trade at high multiples.  Equinix is primarily in the pure colocation business.  It leases cabinet space for servers and electronics to its customers and provides interconnection between its telco, Internet content and corporate clients.  Equinix benefits from a strong network effect, as it has become one of the core hubs of the Internet, providing major companies with direct access to the providers that serve more than 90% of global Internet routes.  Equinix also enjoys a low capex model, as it has a very scalable model within each site.  Maintenance capex is estimated at 3% of revenues.
 
Savvis is much more of a data center company, and has migrated into providing a range of services, including managed web hosting, Internet access, managed software applications, and a variety of fee for service professional services.  Savvis has had a disappointing year.  Its organic growth has slowed, it missed earnings estimates, and it has guided to much higher capex needs.  Its most recent guidance is that maintenance capex is 12-15% of revenues.

Some of the other competitors include Switch and Data, whose business model resembles Equinix, and Navisite, which looks a lot more like Savvis.

Q9 is somewhere in the middle, although its economics are much closer to Equinix.  Q9 provides collocation, plus what it calls managed services.  The biggest part of this is managing dedicated servers for clients, including firewalls, load balancing, managed virtual private networks and remote links, as well as maintenance and repair of servers.  However, the company does not host any applications, does not do web hosting, and does not provide any professional or custom services.  Everything is standardized, non-custom, and entirely recurring revenue.  The company’s guidance is that maintenance capex are 3% of colocation revenues and 11% of managed service revenues, for overall maintenance capex of just under 6% of revenues.

	Q.TO			EQIX	SVVS	SDXC
Scenario	Base	Conservative		Consensus est.
Stock Price	13.05			102.35	28.51	16.24
Currency	CAD			USD	USD	USD
Shares	21,322			36,300	53,000	33,900
Cash	42,878			407,500	256,900	45,900
Debt	-			1,058,600	494,800	61,000
Market Cap	278,252			3,715,305	1,511,030	550,536
EV	235,374			4,366,405	1,748,930	565,636
EV/EBITDA
2006	22.6	22.6		42.6	14.5	17.8
2007E	17.7	17.7		28.5	11.2	13.3
2008E	10.2	11.0		17.8	8.6	11.0
2009E	6.4	7.6		13.6	6.4	8.1
2010E	4.3	5.6		11.2	5.1	6.5
EV/EBITDA - maintenance capex
2006	30.6	30.6		46.5	96.0	20.0
2007E	23.4	23.4		31.0	35.0	14.7
2008E	12.5	13.6		19.3	21.7	12.2
2009E	7.5	9.0		14.6	13.3	8.9
2010E	4.9	6.5		12.0	9.9	7.0
Organic revenue growth
2007E	22%	22%		32%	4%	23%
2008E	27%	23%		26%	15%	21%
2009E	34%	24%		23%	16%	22%
2010E	34%	22%		19%	14%	9%

 

Note: Our base case scenario reflects reaching 70% capacity in Brampton and Toronto expansion centers by the end of 2010 and reaching 70% capacity in the new Calgary data center by June 2009.  These assumptions are slightly more conservative than management’s recent implied guidance, and equate to organic quarterly sequential growth in recurring revenue under contract of around 8%.  Our conservative case assumes 5% sequential quarterly growth

 

While the company does not immediately appear cheap on a trailing EBITDA basis, we find current valuations attractive for a very high quality business:

·        Highly predictable business model, with majority of revenue being recurring and under multi-year customer contracts and  with minimal customer churn and high switching costs.

·        After facility construction, low maintenance capital expenditure requirements of 3% for colocation revenues and about 6% of overall revenues.

·        After a facility is open, incremental EBITDA margins are 60-80%.

·        High-competitive barriers to entry due to the capital intensive nature of large datacenters, limited availability of appropriate real-estate, and the importance of Q9’s reputation in a business where customers are outsourcing a mission-critical component of their operations.

We also consider the valuation in light of several long term tailwinds:

·        Continued outsourcing of IT operations, and the strong value proposition of Q9’s network neutral collocation provider relative to competing options.

·        Growth in internet traffic and the increasing adoption of internet related products and services.

·        Proliferation of blade servers and the resulting higher power demands increases the attractiveness of Q9’s datacenters relative to an in-house option.

 

 

Other points

Company is buying back stock, with current program to buy back up to 10% of outstanding

Company has been, and will continue to, fund new data center construction and related Capex from free cash flow

Management very shareholder friendly, approachable

Potential to announce new centers, possibly in Ottawa or Vancouver

As long as it can continue to grow at recent rates, clear roadmap to $55 million of EBITDA in 2010, without adding any other data centers beyond Calgary 2.  In addition, as Ruby discusses, Q9’s original large customer (Google) is vacating 2,600 cabinets in early 2010, for which it is paying less than 1/10 of the current market price.  If the company is able to fill those cabinets at the current prices, EBITDA could grow to over $100 million.

We see the potential of 50-100% appreciation over the next year, and 3-5x over the next 3 years.

Risks

-company earns unusually high returns on invested capital, therefore risk of new entrants into their markets, which could dilute growth prospects

-economic slowdown impacting growth, especially in Calgary, where the economy is slowing slightly from a torrid pace, drilling activity is going to be down for the second consecutive winter

-introduction of virtualization software (VMware), which could slow or reduce server demand long term

-one of the most logical buyers was Savvis, but at its current EBITDA multiple, it is unlikely to be a buyer

-maintenance capex needs turn out to be substantially higher, undermining returns on invested capital and the overall business model

Catalyst

- Continued strong organic growth, as the newly-opened capacity is filled, with very high incremental profitability
- potential to enter new markets in Canada, most likely Vancouver and Ottawa
- potential to be acquired. Equinix is the most likely buyer today.