Monday, May 30, 2011

Equinix and Telecity Offer Growth and Cash Flows

Equinix $EQIX and Telecity $TCY are two fast growing data center stocks that I believe are cheaply priced relative to their prospects. I hold both stocks but, in this article will focus on Equinix. However, investors can make similar analysis with Telecity as they are very similar.

In summary, data center providers are capable of generating very high Ebitda margins and are set for high growth in revenues. On an ongoing basis, both businesses (Equinix and Telecity) are already generating large amounts of cash flow and provided that operating margins remain the same and the expected growth materialises then these stocks are very good GARP candidates.

Growth Drivers
Data Centers allow business to store their information in a secure and scalable manner. In other words, they let companies focus on running their own business as opposed to setting up their own onsite mini ‘data centers’. Scalability is a key consideration, because I suspect many businesses will have been caught out by the massive increase in capacity necessary to handle increased mobile, video and global IP traffic. In addition, increasing usage of cloud based solutions will only add to data center usage. Industries such as financial services are generating an exponential increase in demand as the search for ever more complex trading systems continues apace.
In addition, the existing infrastructure of centralized provision supply business over great lengths (globally) is likely to run into quality difficulties as ever growing local growth in bandwidth applies strains upon it. All of which, should benefit companies like Equinix and Telecity, who provide local centers and seek to integrate data flow between corporations and the major hubs.
On a more negative note, data centers can be visualised as giant refrigerators so Telecity and Equinix are both exposed to rising energy costs.

Equinix’s Trading Numbers
In the following discussion I will utilise a recent presentation made by Equinix which is referred to in the source section below. The first thing to look at will be how Gross Margins are evolving over time.

Equinix200820092010Q2 2010Q3 2010Q4 2010Q1 2011Rolling
Gross Profit290,021399,089545,667133,512144,871151,685168,453598,521
Gross Margin41.2%45.2%44.7%45.1%43.9%43.9%46.4%44.8%

It’s not hard to see that margins are holding steady, in spite of rising energy costs. In addition, Equinix is keen to point out that gross cash margins (excluding non cash items such as stock options) are actually closer to the long term target of 65%  We can see this effect in the cash flow conversion.
Equinix200820092010Q2 2010Q3 2010Q4 2010Q1 2011Rolling
OP Cash Flow267,558355,492392,87256,906113,263122,891117,770410,830
% revs38.0%40.3%32.2%19.2%34.3%35.6%32.4%30.8%
Free Cash Flow-203,570-14,050-186,525-91,799-30,678-20,460-72,296-215,233

Whilst conversion to operating cash flow is very good, it is clear that Equinix are not generating free cash flow. This is a concern because with a share price of $100 the current market cap is $4.71bn and net debt is $1.67bn. In other words the Enterprise Value is $6.38bn and on a rolling year basis they have just had a cash outflow of $215m

However, the key thing to understand with Equinix is that they are currently in a high growth phase and are undergoing significant expansionary capital expenditures in order to develop revenue growth. With this sort of business it is useful to try and breakdown maintenance from expansionary capital expenditures. Rather conveniently, Equinix do this in page 13 of the linked presentation. Tabulating from their results gives...

Frankly, I think this means that the underlying cash flow is actually very good here. It would be remiss to assume that, going forward, margins and revenue growth will be strong enough to justify this level of expansionary capital expenditure. However, for the reasons articulated above, I think that with decent GDP growth that Equinix can go on to achieve strong revenue growth.
Longer term Equinix feels that maintenance Capital expenditures will come to around 5% of revenues. So, it is not inconceivable that when Equinix’s growth starts to moderate we could see them generating 20-25% of revenues in free cash flow in future.
Analysts have Equinix on 2011 and 2012 revenues of $1.54bn and $1.74bn respectively. This implies 26% and 15.6% revenue growth in the next two years.

In conclusion, I think a forward FCF/EV of around 5% is fair for this business which would give a price target of around $120. Equinix is a good GARP candidate. I hold.

I believe Telecity to also be attractively priced. By way of comparison, Telecity with a share price of 548p has a market cap of £1088m and net debt of £56.8m so the EV is £1144m. Turning to the operational metrics from the last results sees Telecity generating adjusted Ebitda margins of 42.4% and ‘operating free cash flow’ margins of 37.9%. This is very high and demonstrates the underlying cash flow generation. Last year Telecity spent £13.3m or 6.7% of revenues on operational capital expenditure and this figures compares well with Equinix’s long term target of 5%
If we use the underlying operational free cash flow of £74.4m as a benchmark then the underlying FCF/EV is 74.4/1144=6.5% For a business forecast to grow revenue at 18% next year, that is too cheap.


Forecast 2011
Discretionary FCF