A good set of results from Telecity $TCY which highlight how this stock benefits from the growth in internet traffic and cloud computing. Data centers are a very good ‘picks and shovels’ play and companies like Equinix $EQIX are seeing strong growth in end demand. Inevitably, this is causing increased capital expenditures as the data center providers expand capacity.
The potential downside here is that this ramping of capacity (the likes of Equinix and Telecity are expanding aggressively) will cause a supply glut which will lead to falling margins just as the data centers need cash flow in order to pay back the debt needed to expand capacity. No matter, right now, this doesn’t look like being a problem and investors will see the early signs when Telecity et al, start reporting slipping EBITDA margins. The growth in internet traffic is progressing at an exponential rate and increases in cloud computing will only strengthen the case.
Telecity is a Good Play on Cloud Computing
Turning to the expansion program, Telecity has nine simultaneous locations in development at the moment. Over the course of the last year, they expanded capacity to 68MW from 58MW last year. A further 10MW is expected to come online within the next six months and, longer term plans for a total of 124MW in three to four years are already in place. This is almost a doubling of current capacity, but Telecity has good reason for confidence over these plans.
For example, 95% of last year’s revenues were recurring and 60% of organic growth came from existing customers, with only mid single digits churn. Clearly, Telecity’s end demand is very sticky and they are seeing strong growth from existing clients who need expansion to meet their mission critical demand. Ultimately, this provides Telecity with a high visibility of earnings.
Telecity’s Growth Drivers
Moreover, the growth in internet traffic is broad based across sectors and, has proved to be recession resistant. This looks like a structural growth story and, will only increase as cloud computing and data traffic increases. Whilst, superficially, there is no moat in data center provision, it is in fact a mission critical application which requires substantial planning and trust on behalf of the clients.
An example of the broad base of Telecity’s clientele can be seen when looking at the breakdown of new customer wins by application type
- 29% content
- 24% financial
- 16% connectivity
- 16% systems integrator
- 15% cloud computing
Financial simply refers to financial transactions through the centers. The diversification in usage belies the growth potential for Telecity.
At a current price of 650p the stock is valued at £1287m. Telecity currently has £164m in net debt, which put together gives an Enterprise Value of £1451m. This stock is obviously not bought for its dividend, even though Telecity is promising to pay 20-25% of its earnings in dividends. For those interested, this would make 6p or 1% yield based on analyst forecasts for 2012. The company expects to commence dividends at the half year in 2012.
The key to Telecity is to think if it as a cash generating ‘annuity’ type stock. It is in the expansion phase now so, superficially, cash generation looks weak but the underlying picture is much stronger. At the full year, Telecity generated £106.5m in operating cash flow from £109.9m in EBITDA and, cash flow conversion has been similarly strong over the years. Telecity spent £109.9m in expansion capex but maintenance capex was only £21.8m. This means that the operating free cash flow was £106.5-21.8m=84.7m or 5.8% of EV.
Telecity Stock Analysis
The underlying cash flow generation is strong and investors should consider that it will, roughly, take four years for a location to reach peak demand. Therefore, the expansion now will generate future revenue growth in the next few years. Furthermore, the net debt situation of £164m is easily manageable given cash flow generation and a five year £300m debt facility hich was signed in May 2011. There is ample head room for more expansion.
The key thing here is that any investor will need to be confident in the long term growth rates of internet traffic and then try and ‘price’ in this confidence. The correct approach might be to watch gross margins across the industry and see that as a marker for over capacity. However, we are not there yet and Telecity’s stock price is probably at least capable of ‘doing its earnings’ for 2012. On this basis it is better priced at 750p then the current price of 650p.