Value Investors Club / Switch and Data (SDXC)

Description

I am recommending a long position in Switch and Data (SDXC), a carrier neutral provider of colocation and interconnection services. SDXC is currently trading at 5x 2009 EBITDA, and I believe its operations will continue to show resiliency in the current economic environment. In fact, the company is seeing accelerating growth, has increased 2008 company guidance 3 times this year and last week providing strong 2009 guidance.

The company has been a victim of redemption selling, illiquidity and panic, despite continued strong ‘beat and raise’ performance over the past year. The stock was down 16% today and is now trading at its cheapest level since going public in February 2007. Given its relatively small market cap, the company is undercovered by the street – although a handful of analysts have picked up coverage this year. Additionally, the company has historically traded at a slight discount to its largest and more followed competitor – Equinix. Equinix, despite trading now at a price it also hasn’t seen in 3 years trades at 7.5x 2009 EBITDA. Obviously, this is not a ‘valuation focused’ market we are playing in. However, given the strong growth profile, economic resilience of the business model, limited competition, large barriers to entry, this is a stock that has been massively oversold, and is ripe for a strong rebound off its lows. Assuming an extremely conservative 6.5x multiple, the stock would be trading at $9, or 50% higher than current levels. Trading at a still discounted 7.5x multiple, the price would be at $11.50 or 90% higher.

The Data Center Industry

The various aspects of data center / colocation industry are often misrepresented and inappropriately comped to each other. Let me take a few moments to break down the various types of data centers and the respective players in each. There are far more specifics I could go into, but these are the general differentiating factors as I see them.

Carrier Neutral Data Centers: Examples of these companies are SDXC, EQIX, Telecity (TCY LN). These types of companies provide mainly enterprise and bandwidth intensive customers with a central access point to collocate mission critical servers, switches and routers and allow interconnection between themselves (content providers, financial service companies, ecommerce companies, application providers and any other industry) and multiple telecom companies and service providers. They act as access points to the internet, where companies can disseminate their services or content to a wide range of telecom providers. The core competency of these companies is not to perform data storage and backup for enterprise customers. The additional value add of these companies is the network affect of being able to interconnect not only with telecom companies, but also with each other in order to reduce latency between internet connections – ie: Google may be directly connected with AOL to more efficiently send ads to AOL sites. As more and more data intensive companies are in a facility, the greater the network effect is. These companies offer limited if any managed services or value added services, and are typically used by large corporations with sophisticated IT staffs. They do offer significant security at their facilities to safeguard their customers assets. They act in theory as landlords selling colocation, power and interconnection only – although they may and often do not own their own real estate. Services are typically sold with multi-year contracts offering significant visibility.

Data Center & Managed Service Companies: Examples of these companies are Internap (INAP), Navisite (NAVI), Savvis (SVVS) and to an extent Terremark (TMRK). The large incumbent telcos and CLECs (AT&T, VZ, LVLT, TWTC) are also involved in this business as well. These companies typically sell their services to less sophisticated companies, who require an ‘outsourced’ IT staff to manage various applications, servers and also the mission critical interconnection capability. Managed Service Companies typically (not TMRK) use proprietary networks, and do not offer redundancy of networks and the IP distribution that you would get at a Carrier Neutral Data Center. They also do not offer the breadth of interconnection between various tenants at the data center. I am generalizing here as the offerings and client base of AT&T is not directly comparable to that of a Savvis or Navisite. These services are also sold on a contracted base for multiple years, with sales cycles significantly longer and more variable than the carrier neutral players.

Server Farms / Enterprises: Companies that have their own server farms are the likes of AMZN, GOOG, MSFT, YHOO and are using their facilities to store massive amounts of data in servers. These server farms are then typically connected to a carrier neutral facility to dispense the data to the rest of the world. Cloud Computing is also allowing these companies to store data for other small businesses in their server arrays, which again would then be disseminated to the world typically through a carrier neutral facility. These companies may own their facilities or may lease them from Wholesalers (discussed below).

Wholesalers / REITs: These companies such as Digital Realty Trust (DLR) and Dupont Fabrose (DFT) – written up today also; provide literally the real estate for other data center players to locate their businesses in. They will build out facilities to specifications or in their most basic form and lease them to all of the above types of companies. These companies, aside from hosting server farms do not have direct enterprise or telco business.

Competition among these various types of companies is fairly limited. The Carrier Neutral companies will compete with the Managed Service Cos at the lower end of the spectrum or for companies that are less IP intensive than a typical carrier neutral customer. None of the others will compete with each other, because they each have a very different client base and offering that each support this ecosystem. For example, EQIX and SDXC are customers of DLR.

Another important point to understand is the supply/demand dynamic which is often talked about by analysts. The carrier neutral and to some extent the managed service players have a very favorable supply / demand dynamic. Supply has been constrained since the telecom bust in 2000. After multiple bankruptcies and massive over-capacity, eventually supply was reduced to a reasonable level, and then demand for IP solutions spiked. The players in the current market are now extremely diligent when planning and building out new facilities and have about a 2 year window to see what other capacity is coming online between the planning and opening of a new facility. These dynamics have allowed for favorable pricing, with increases ~3+% over the past few years which is continuing through the weak economic period. EQIX and SDXC in the US have been building steadily but not too rapidly to keep up with demand. When data center capacity comes online for wholesalers and server farm cos, it is essentially irrelevant (and often double counted for the wholesalers).

Company Description

SDXC as discussed above is a Carrier Neutral Colocation provider operating only in the North America in 34 facilities. The companies facilities are currently about 64% utilized, however this is skewed with much higher utilization in its largest 10 markets and its older facilities. The barriers to entry, especially in this environment are huge – a) access to capital b) multiple telecom carriers and other companies creating the network affect c) Power – SDXC utilizes massive amounts of power, which is then passed through to their customers d) Space – little availability in some of the most demand heavy cities – ie: New York, Chicago, Dallas etc.

SDXC focuses its attention on the service provider community, which they define as telcos, content providers and service providers. Examples of their customers in these sectors are AT&T, Verizon, BT, Telefonica on the telco side, Microsoft, Google and Yahoo on the content side and Akamai and Verisign on the service provider segment. Less than 5% of their revenues are ‘enterprise’ or less connectivity focused. The company has also said that less than 5% of its revenue base is small businesses – which they have been seeing some weakness around. The larger existing customers and new customers have been signing larger contracts and absorbing any excess capacity relieved by a small business, making the SMB weakness essentially irrelevant.

95% of revenues are recurring and entering any given year, the company has 80% visibility into its revenue stream. 75% of new sales come from existing customers who are buying additional space (colocation & power) or interconnection. Monthly Recurring Revenue from each ‘Cabinet’ last quarter was north of $1,900 per month. SDXC ended Q3 with 11,700 billable cabinets, which as mentioned are 64% filled.

The company continues to grow through IP traffic growth and more bandwidth intensive applications moving to the web, necessitating companies to need more interconnection (typically fiber or Ethernet transport) to more networks and more peers. Additionally, new builds or extensions of existing facilities provide more space for tenants.

The business in Q3 had EBITDA margins of 33%, up from 31% last year and trending towards 35-40% in the next few years. There is significant leverage in the business model as more capacity is utilized and additional revenue having 40-50% EBITDA flow-through. The company supports a strong balance sheet and by year end should have trailing Net Debt / EBITDA of 3.0x. Exiting 2009, the company should be generating enough cash to fully support its capex outlays, and has the ability to pull back quickly on discretionary capex to ramp FCF faster.

Stock Price	$6.07
Shares Oustanding	34.484
Equity Value	$ 209.3
Total Debt Oustanding	194.0
Cash Outstanding	25.0
Enterprise Value	$ 378.3

	2008	2009	2010	2011
Revenue	$ 172,406.9	$ 210,824.8	$ 262,097.7	$ 293,646.0
% Growth	25.2%	22.3%	24.3%	12.0%

EBITDA	56,184.1	74,262.2	103,852.3	115,940.3
% Growth	32.0%	32.2%	39.8%	11.6%
% Margin	32.6%	35.2%	39.6%	39.5%
EV / EBITDA	6.8x	5.1x	3.7x	3.3x

FCF incl Discretionary Capex		-$7,599	$8,765	$26,626
FCF Excl Discretionary Capex		$31,404	$50,749	$67,302
FCF / Share	$0.55	$0.91	$1.47	$1.95
P/ FCF	11.2x	6.7x	4.1x	3.1x
FCF Yield	8.9%	14.9%	24.1%	32.0%

Net Debt / EBITDA	3.0x	2.3x	1.6x	1.1x

On the most recent earnings call, the company continued to be optimistic about its strength in this economic environment. They are signing larger contracts (up 20% on avg size y/y), and for the third time this year increased guidance. Within their data centers, they are seeing traffic growth of 112%, almost double that of the rate of overall Internet traffic growth. During 2008, they have added capacity in Dallas, Vienna, Virginia, New Jersey, Sunnyvale and Toronto which will help support their growth into 2009, and lowering capacity utilization from 70% to 63%. Meanwhile, recurring MRR per cabinet has increased from $1,700 in 2007 to $1,917 this quarter. Much of this is from continuing pricing power as the limited supply relative to demand has allowed them raise prices ~3.5% in 2008 and expect another 3.5% in 2009. Other pricing power is coming from incrementally higher energy prices which are passed on to customers. Additionally, they are seeing significant growth from existing customers with Interconnections – which have almost a 90+% gross margin.

The colocation in these facilities is not discretionary IT spend, it is mission critical. Businesses located in their facilities cannot operate without the services they provide. This is also the only business I have seen where the limited churn that does exist 1.1% in Q3 (down from 1.5% in Q2) is welcomed – as there are customers waiting to fill the capacity at higher current rates than the exiting customers. Additionally, 85% of their 2009 revenue is currently under contract – with average contract length being 2 years. The company has also guided and recently reaffirmed a 3 year outlook 2008-2010 of Revenue growth of 24% and EBITDA growth of 35%.

The company has guided to $65 million of capex for 2009, down from $165 million in 2008. $10 million of this is maintenance, $40 million is for completion of a New Jersey build, and $10-$15 million is success based on customer installs. The company will use FCF as well as draw down its $22.5 million delayed term loan and if necessary its $15 mm revolver. They have fully hedged out LIBOR based interest rate risk.

SDXC should see a significant rebound in its stock price as redemption selling slows, and the price is recognized by the investor community as a bargain basement discount given the continued operating momentum, resilience in an economic recession, its mission critical offering and entrenched position in the market. Additionally, the company has a conservative balance sheet, with no debt maturities in the next 3+ years.

Risks to this story include the continued dislocation in the capital markets, trading illiquidity, an unforeseen slowdown in the companies operations due to the economic environment, and an unexpected reversal in the supply/demand dynamic.

Catalyst

Rebound from historical lows reached from redemption selling;
Continued economic resilience and operating performance ;
80% visibility into 2009 revenues, and ability to quickly curtail capex if necessary;
Additional sell side coverage

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			2008	2009
Price:	6.07	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	209	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT