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
Revenue704,680882,5091,220,334296,094330,347345,244363,0291,334,714
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
Revenue704,680882,5091,220,334296,094330,347345,244363,0291,334,714
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%
Capex471,128369,542579,397148,705143,941143,351190,066626,063
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.

Telecity
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.


Source:

Equinix
2008
2009
2010
Rolling
Forecast 2011
Discretionary FCF
200100
292000
278000
330000
400,000
DFCF/EV
3.2%
4.6%
4.4%
5.2%
6.3%

Monday, March 28, 2011

GameStop Set to Disappoint the Market in 2011?




GameStop $GME is a business that has been aggressively shorted over the last few years, but is it now becoming a contrarian play? Investors have been quick to sound the death knell for GameStop due to the ‘oncoming’ onslaught of online gaming sales, and according to Yahoo Finance the short percentage of the float was around 24% However, the recent results were superficially quite good and the stock rallied. Is it time to buy?

GameStop Earnings and Margins
A quick look at revenues over the years (year end to Feb)...


Sales ($m)20072008200920102011
New Video Game Hardware1,073.71,668.91860.21,756.51,720.0
New Video Game Software2,012.52,800.736853,730.93,968.7
Used Video Game Software1,316.01,586.72026.62,394.12,469.8
Other916.71,037.71234.11,196.51,315.2
Total5,318.97,094.08,805.99,078.09,473.7

...reveals that growth in the Used Video Game Software segment appears to be slowing. The importance of this can be demonstrated by a look at gross margins.

Gross Profit ($m)20072008200920102011
New Video Game Hardware77108.2112.6113.5124.9
gross margin7.2%6.5%6.1%6.5%7.3%
New Video Game Software427.3581.7768.4795819.6
gross margin21.2%20.8%20.9%21.3%20.7%
Used Video Game Software651.9772.6974.51121.21140.6
gross margin49.5%48.7%48.1%46.8%46.2%
Other315.2351.6414.6405452.6
gross margin34.4%33.9%33.6%33.8%34.4%
Total1471.41814.12270.12434.72537.7

Over the years, the used game segment has made up the bulk of profits but growth appears to be slowing.  I think this is an understandable issue and I would like to explore the reasons why.

GameStop Structurally Challenged?
There are four main challenges to GameStop and I think all of them are significant.
  1. Best Buy and Walmart are encroaching on their market share
  2. Online merchants are grabbing market share from in-store sales
  3. Software manufacturers are shifting to delivering the games online (avoiding piracy and protecting IP is a key driver here)
  4. They are being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not their forte
The likes of Best Buy $BBY and Wal-mart $WMT, as indicated in an earlier article, are seeing some of their traditional markets erode to online competition. Therefore, they are seeking new ways to sell to their captive audience of shoppers. Naturally, selling new and used gaming software fits perfectly into the sales demographic of kids making trips to their outlets. This competition is significant for GameStop.
Similarly, online competitors like Amazon are continuing to grab competition from GameStop. The advent of smart phones that can read bar codes and immediately compare prices will pressure margins for ‘bricks and mortar’ retailers. GameStop will still be able to offer the ‘retail experience’ of kids checking out new releases but as the tables indicate hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.
However, the key challenge for GameStop will come from how the gaming companies deliver files. With the advent of 4G and other ‘fat bandwidth’ provision, it will become feasible for games to be sold online. This has great advantages to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licences to the original purchaser. This helps avoid the kind of piracy that is rife in this form of Intellectual Property. This will be a significant problem for GameStop and I think will hurt them sooner rather than later.

A Value Trap?
I think there is a value trap here. GameStop are talking about closing 200 stores and opening 200 others in an attempt to restructure the business, but I think the decline and structural challenges are already showing in the numbers. Let’s look at sequential numbers...

Gross Profit ($m)Jan-10May-10Jul-10Oct-10Jan-11
New Video Game Hardware40.921.225.921.756.2
gross margin5.5%6.1%8.2%7.9%7.2%
New Video Game Software322.2174.5141.7182.4321
gross margin20.6%20.0%21.4%21.7%20.1%
Used Video Game Software360.7274.4260250.2355.8
gross margin46.4%48.1%46.0%47.4%44.2%
Other150.3100.789.292170.7
gross margin33.6%34.7%34.8%35.9%33.3%
Total874.1570.8516.8546.3903.7


..and margins are clearly falling in the used games category. However sales are doing ok (on a like for like comparison)

The reason for this is that I suspect Sales for the used game segment will do well for a while due to the hardware upgrading cycle causing lots of new inventory to become available. Unfortunately, for GameStop this will be sold off a lower margin and is likely to get lower still, as games shift to being delivered online. All of which creates a value trap for GameStop, they could be reporting good sales growth but I would keep an eye on used game software margins. I think they are set to fall aggressively.