Equinix Investors Should Brace Themselves

What do you do with a stock with which you fear near-term risk, but are confident in its long-term prospects? That's pretty much the problem that investors in data-center provider Equinix (NASDAQ: EQIX  ) are faced with right now. While its third-quarter results didn't bring lower full-year estimates again, they were accompanied by the sort of commentary that suggests the company is still facing headwinds.

Equinix responds to a changing market
In its previous quarter, Equinix had lowered its expectations for growth in the second half due to a combination of weaker conditions in Germany, a longer sales cycle within its enterprise markets, and a reduction in average deal size. Unfortunately, the narrative around the last two issues continued in the third quarter. Fortunately, Equinix is responding to these changing market conditions.

On its conference call, Equinix outlined that deal sizes continued to be smaller this year, and its intention was to do "more transactions every quarter" as it refuses to take on board larger scale work at unattractive price points. This is fine, but it increases the pressure on its sales team to find suitable deals in a market that is changing.

While there is little that Equinix can do about lengthening sales cycles, per se, its measures to extend contracts for 70% of its top 50 customers helps to secure long-term revenue streams. Moreover, it insulates Equinix from some future pricing competition and frees up management resources in order to chase other deals.

And finally, it's strengthening its relationships with partners like Amazon (NASDAQ: AMZN  ) Web Services, or AWS, and Microsoft's (NASDAQ: MSFT  ) cloud platform, Windows Azure. Both measures are intended to offer Equinix's customers more flexibility to build out their hybrid cloud infrastructure.

What is lengthening sales cycles?
The relationships with Amazon and Microsoft are important, because they help address what Equinix believes is the reason why the environment has gotten tougher. On its conference call, management outlined that more of its customers were seeking to build out more complex infrastructures, such as the hybrid cloud.

In plain English, the hybrid cloud just means an infrastructure where private and public clouds are working in combination. As a network-neutral data center, this shouldn't be a problem for Equinix. In fact, its co-location data centers benefit from these trends because customers can connect with various cloud service providers from within Equinix's data centers. However, the snag is that the increased sophistication of the hybrid cloud is lengthening sales cycles. Speaking on the issue on the conference call, management had this to say:

I don't believe they are really just driven per se by macroeconomic uncertainty or a broader enterprise anxiety or anything like that...just driven by the fact that the decisions of CIOs to move to sort of hybrid cloud infrastructures...And there are sales cycles that need substantive technical support.

In this context, the agreement with Microsoft to extend the strategic relationship by enabling connectivity to Windows Azure through Equinix's data centers makes a lot of sense. Similarly, Equinix has a deal with Amazon which allows Equinix customers to connect their IT infrastructure directly with AWS.

If customers are taking longer to define their hybrid cloud architectural needs, then these sorts of deals with Amazon and Microsoft will surely help them by granting them more flexibility. In addition, Amazon and Microsoft will benefit too.

What to do with Equinix?
In the long-term, Equinix looks set to be a net beneficiary of these changes. However, the problem is that it could come under near-term pressure. Moreover, it's a competitive industry in a high-growth expansionary phase. Indeed, rivals such as Telecity and InterXion haven't been slow in building out capacity. If sales cycles continue to lengthen, then pricing pressure could appear as the leading players start to fight to fill their growing capacity.

The current enterprise value is around $11.8 billion, and with a 2013 forecast of around $620 million-$640 million in adjusted discretionary free cash flow -- a useful measure that Equinix uses to demonstrate its underlying performance -- the stock looks like a good value. The potential for REIT conversion should turn this stock into a dividend favorite, and long-term demand conditions look good. However, the near-term uncertainty means investors should be aware that conditions could get worse before they get better.