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Executives

Kevin Mark Dotts - Chief Financial Officer

Analysts

Calvin Lam

Internap Network Services Corporation (INAP) Morgan Stanley Technology, Media & Telecom Conference February 25, 2013 7:00 PM ET

Calvin Lam

Okay. Good afternoon, everyone. We'll get started now. My name is Calvin Lam. I'm one of the investment bankers here at Morgan Stanley. I spent a lot of time in this Internet infrastructure space. With me today here, I have the pleasure introducing Kevin Dotts, the CFO of Internap; and Andrew from Investor Relations.

Before I started, I just want to read the standard disclosures. Please note that all important disclosures, including personal holding disclosures and Morgan Stanley disclosures appear on Morgan Stanley public website at www.morganstanley.com/researchdisclosures.

Well first off, I think it makes maybe some sense to just talk a little bit about the company. For those of you who may not be familiar with Internap, I think it's a great opportunity to sort of hear from Kevin, the CFO, who's joined there for, what, 6 months ago?

Kevin Mark Dotts

No, about 4 or 5 months.

Calvin Lam

4 or 5 months, sort of. Maybe you can talk a little bit about what attracted you to this opportunity, how you view Internap, sort of, what you were thinking about as you took this role?

Kevin Mark Dotts

Sure, sure. As Calvin mentioned, I've been here just going over 5 months. What I think that's attractive about Internap is, from a secular position, this is a very high growth market space in the data centers. Today, total probably as far as opportunity outsource [ph], IT, probably 75% to 80% of that is still managed within-house. I think, overall, the secular trends that, that will continue to be migrated out to folks like us, who offer Infrastructure-as-a-Service. And so, it's a big growing space. We -- Internap, we were originally built ourselves as an IP provider, and we added some secret sauce on top of that called our MIRO technology, patented technology. So effectively, we were reselling transit. Probably, back, let's say, 3 or 4 years ago, when the current CEO, Eric Cooney, had joined the company, they went through kind of a strategic review of what was going on in the company. And at that point, they made a very purposeful decision to move away from focusing on growing the IP part of the business and maximizing some of the assets they already had internally in the data center services segment. So we've been investing heavily for the past 3 years in building that data services segment into offering colocation, managed hosting services, as well as cloud services. And so, if you look at that transition, where does Internap stands today, we have roughly 63% of our revenues now are coming off of that data center services segment, as opposed to 37% off of the IP segment. When you break down that data center services, we have underneath that, what we call our core business, which is basically our company-controlled colo, managed hosting, as well as our cloud services. That has grown very rapidly, to my earlier point, about 20% CAGR over the past 3 years. And obviously, that is helping to move our margins up and to the right.

Calvin Lam

And how should folks think about when you talk about your data center services business? Sort of, when you look at some of the guys out there like a Rackspace or an Equinix, how does, sort of, Internap position itself and compete strategically against those guys?

Kevin Mark Dotts

Yes, we tend to talk internally and externally about what we call the 2 Ps. We talk about performance and platform. Performance from the perspective of we have this IP business that we've talked about that has the patented MIRO technology. It's a business that today has 2 benefits to it. It provides us, quite frankly, a cheap source of capital coming off the business. It makes good margins. It's been maintaining a 60% segment margin. It takes really little capital to run that business. It's a business that's under pricing pressure despite the amount of gigabyte demand that's out there in the market. And that business is kind of a relatively modest declining business. That capital then has been used to, along with leverage, invest in our data services segment to build that business up and out. When we invest in that, what we tend to do is talk about IP performance. That IP performance plays very well to customers who are looking for low latency, high reliability in their network, in their applications. So that is the performance aspect of it. Performance aspect is put together with our platform flexibility, and it goes back to the fact that we can offer colo, we can offer managed hosting and we can offer, again, cloud services. We are thinking that where the migration of the industry is going and where CIOs are going to want to go is to a hybrid answer on the data center services side. So going back to Calvin's question on why do we think -- what do we think when we come up in competition against the Equinix, the Rackspaces of the world or AWS, we tend to think about the fact that we can, today, offer that hybrid answer to what CIOs are looking for. We're not really competing per se on a price basis, but more on an overall platform and performance basis.

Calvin Lam

Okay. Great. Maybe if we just dive into that a little bit further and with this specific reference to your fourth quarter results, which were really phenomenal. But at least on the data center services side, there was really great growth in that segment sort of up 25% year-over-year. I mean, if we were sort of just to dig in a little bit, maybe you can talk a bit about -- some of your peers are seeing some pricing pressure, whether it be Rackspace's announcement earlier last week, but maybe you can talk about pricing, margins, the type of penetration you're making with new customers and the types of deals that you're signing up there, at least, on the data center services side?

Kevin Mark Dotts

Right. So on the data center services side, probably, over the past couple of years, cloud and managed hosting had gone through a relatively modest, very low-single digit type of pricing declines, but the market space is growing so fast, it really hasn't been such a relevant, per se, factor. I know that in the -- after the third quarter earnings, there was a lot of talk about, on the other end of the spectrum, on the wholesale side, a lot of pricing pressures and we saw companies like TFT, et cetera, coming out and talking about pricing downward in order to maintain share. As we have a company-controlled colo business is what we focused on investing over the past 3 years and have been migrating and expanded up into managed hosting or custom hosting and into cloud services, all that has kind of come together for us very well. We don't see a lot of actually pricing pressure on the colo business. And in fact, our ARPUs have continued to increase. They've continued to increase because we usually build into our contracts our price escalators on an annual basis. We tend to look at contracts over a 2- to 3-year basis with our customers. And then again, where pricing has come down slightly or more modestly on our, again, managed hosting and cloud services is just the fact that the market space is growing so rapidly, that's obviously been offset any type of decline. And at the same time, the cost structure within managed hosting and cloud services, as pricing has come down modestly, cost structure has also come down, allowing us to actually expand margins.

Calvin Lam

And do you see any change in the type of customers that you're going after? Are you moving up the stack towards more enterprise-type customers or...

Kevin Mark Dotts

Well, and it probably has 2 aspects to it. One is, again, as customers -- we like to get customers earlier in their cycle. When we bought Voxel last year, it allowed us to tap into a market space that we weren't very adept at getting, which was kind of lower end, startup type of situations that were looking for just a pure cloud services. Now as those customers, whether they'd be gamers or big data or other type of applications, as they tend to grow, we can offer them a platform that will grow with them and participate in. So at the same time, ARPUs have been going up. So it does speak to the fact that we are landing on -- more on the colo side, larger customers.

Calvin Lam

And then just more broadly on the Voxel acquisition, are you, sort of -- how do you feel about the integration management plan performance against budgets, sort of, a year into it, I guess, almost?

Kevin Mark Dotts

Right. So going back, let's say, 2 years ago, we had a very strong kind of colo investment -- company-controlled colo investment going on, built by managed hosting business, and then we're beginning to build out more cloud services. Voxel actually allowed us to leap forward to a product development, fill in a part of our product lineup that really was missing and it was only under development, so we're able to accelerate that product offering. At this point, the Voxel integration is pretty much over with. It's been a terrific acquisition for us. Somewhere in the third quarter, it actually became accretive to our overall EBITDA margins. Both from a people perspective, from a platform perspective, it's really been a success overall.

Calvin Lam

Great. Maybe we can talk a little bit about the other business, the IP network services business. And obviously, you mentioned in your comments sort of tough prospects there. So what sort of is the outlook or the game plan for that business in 2013?

Kevin Mark Dotts

So I think, at this point, what we've said and continue to say is the IP business that we sell and, again, as I mentioned earlier, right, it has 2 positive aspects for us, One, it is producing significant cash flows, which helped offset our ability to go out, lever up and then invest in growing out a company-controlled data center services business. At the same time, when we look at the IP business, we've also said very publicly that this is a business that from -- even though megabyte, gigabyte demand continues to go up because of mobile and other type of Internet applications, pricing in that space because there's so excess -- so much excess capacity from a transit perspective, pricing continues to come down. It's been coming down probably about 20% per year for the past several years at this point. We're not suggesting that, that's probably going to change going forward. We think that continues kind of going on that same track. So we would say you put that altogether and say, "Okay. Our revenues on our IP segment will probably decline in the $400,000 to $600,000 per quarter range, but at the same time, still produces." And costs are coming down commensurately. So we're able to maintain a 60-plus-percent margin rate -- segment margin rate on that business, still produces a lot of cash. And at the same time, that IP technology is still part of what brings data center customers to us. When data center customers come to us, basically, we have an attachment rate of over 90% with IP. So they're looking for, again, that performance to go with that platform flexibility.

Calvin Lam

When you talk about building out your data center services plan -- obviously, you had that big CapEx investment in 2012 and sort of coming down a bit with your guidance for 2013 CapEx, should we read anything into that in terms of decelerating CapEx? Is there -- are there less markets that you need to be in that? Do you feel like the company-controlled data center footprint is where you want it to be?

Kevin Mark Dotts

Yes, I think, overall, I would say that, right now, the data center services business is [indiscernible]. Overall, we feel very good about where the platform is today. Our data center services -- our company-controlled data centers are about 57% utilized. So I'd say our first priority for 2013 is really driving volume into that and driving up the utilization rate. With that 57% overall company-controlled data center services utilization rate, you'll have data centers, such as Dallas, which came on at the end of 2011, L.A. came on at the end of third quarter, we went through an expansion in Atlanta. So obviously, the utilization rates are going to be at the lower end. At the same time, we've also announced that we'll be putting in a brand-new, world-class data center into the New York Metro market at the end of 2013. And we're also doing expansions in Boston in the existing data centers that we're in, as well as in Santa Clara. Reason being is we kind of look out into the future, we kind of see what the take rates are, the fill volumes are within these data centers. And then as we can kind of see us approaching that 85% utilization levels, then we figure out now it's time to begin that investment process, to begin that expansion, to obtain more share within the market.

Calvin Lam

Do you have a target, sort of, company-controlled versus partner data center mix in mind? Or...

Kevin Mark Dotts

Yes. Well, again, if you break down the data center services -- so if you follow the math, which is about 63% of the revenues are data center services, 70% of that is company-controlled, managed hosting and cloud, 30% is partner. When we think about our partner business going forward, that's more of an opportunistic play. Getting a good return, better than our cost of capital, but at the same time, our salesforce is not going out trying to fill partner space. When Eric, I think, came into the business, again, 4 years ago, they had identified that there were customers, let's say, below the cost of capital or customers on the partner side that were actually upside down, they went through a period of about 2 years, that finished up in the first quarter of 2011 of proactively churning out that base in order to improve the overall margin rate for the partner strip [ph]. But we look at the partner business as kind of a flat business at this point, and the focus being on what we call our core business company-controlled colo, managed hosting and cloud.

Calvin Lam

And what about on the funding side of building out these data centers and meeting your CapEx budgets, so that you feel good with the revolver on-hand?

Kevin Mark Dotts

So, right prior to my arrival back, I think, in August of 2012, the company expanded its facilities at that point in time. And looking forward, what we said is in 2012, we spent $75 million of CapEx. In 2013, we gave guidance last Thursday evening that we would spend between $60 million to $65 million, of which $10 million to $15 million of that will be maintenance capital. The rest of that capital will be focused on building out, as I mentioned, the New York Metro market, Boston, Santa Clara. But at the same time, will also be success-based capital will be applied for growth within the managed hosting business. The reason, quite frankly, it's coming down as we don't see and need to build out further capacity within those markets, the 8 markets that we're in or the 11 data centers that we're already in. That's accommodated by the guidance that we gave. So I think right now the focus is as we go to market with an enterprise sales force inside sales, as well as e-commerce, we think, right now, focusing on those 8 markets, Boston, New York, Atlanta, Houston, Dallas, L.A., Santa Clara and Seattle, are the focus in driving up the utilization rates and providing the right cash returns.

Calvin Lam

Maybe just switching gears for a little bit and talking about the M&A side of things, both on the consolidation front. Obviously, a lot of your peers -- there's been a lot of people in your industry group, broadly defined, that have seen intense interest for whether it be telcos or sponsors or other technology vendors. How do you guys feel sort of being one of the last men standing?

Kevin Mark Dotts

Well, as the -- as you know, right, the telcos and as well as the MSOs, right, they've been focused on maximizing their voice data video. We probably see services like what we have as a natural expansion upon maximizing their existing networks, so it makes perfect sense as to why they've gone deeper within the space. The way I think we think about it internally, we are building what we think is a very attractive asset. And we could look at this both sides from a buy side or sell side. From a buy side perspective, certainly, there may be opportunities out there. We don't think we have a product gap, which is probably what Voxel will help fill us in. But there may be other geographic areas or some technologies that may be adventurous [ph] to us going forward. On a sell side basis, again, the telcos, the MSOs, et cetera or other strategics that are still out there, they'd also be attractive. So it's pretty wide open at this point.

Calvin Lam

And when you just mentioned geographic opportunities, are there certain markets overseas you're targeting on getting into? Or...

Kevin Mark Dotts

Well, I think we look at other kind of independents that maybe offshore that could well fit within the portfolio. When we think about North America, we like the 8 markets that we're in. There'd have to be a real differentiator. Pricing, as you know, is pretty frothy in this spot right now, given where we trade. So it makes it a little bit more challenging for us to think about that type of inorganic activity.

Calvin Lam

Okay. And maybe last question for me before we ask the audience, if there's any questions here. But, sort of, as you look into 2013, sort of what would you identify as your key priorities for Internap?

Kevin Mark Dotts

Right. And again, our key priority, I think, is really driving to filling up the existing capacity that we have in our data center services space and maintaining the margins on the IP business and at the same time continue to expand on the data center service margins.

Question-and-Answer Session

Calvin Lam

Okay. Great. Maybe we'll take some questions from the room, if there are any?

Unknown Analyst

How quickly do you think you'll fill the space if you're at 57%?

Kevin Mark Dotts

We've actually had some very robust fill rates within some of the major markets in Santa Clara, New York, et cetera. We tend to think about when we go into a data center that our investments pretty much are cash flow positive after about 3, 4 quarters, and then our paybacks are probably on a full data center startup at the 3 -- somewhere between the 3- and 5-year range. So they'll fill up relatively reasonably quickly. And then, you're looking at a net sellable square foot space that probably has a life that goes out initially at about 10 years and then could be as much as 3, 5 years beyond that. So 3-, 5-year incremental, so almost [ph] 25 years. Yes?

Unknown Analyst

How do you get comfortable when you're building out in Dallas or New York with the other supply coming to market and making sure that you see an opportunity, but there's 5 other people, CyrusOne is building out in Dallas as well, that you don't all bring too much capacity to market so that there's -- we get an oversupply situation?

Kevin Mark Dotts

Right. Certainly, there's a lot of work done before a decision is made in each of those markets. And right now, I think, as we've mentioned, we're really focused on these 8 markets that we're in. Probably not a big appetite at the moment to go into new markets because once you go into the new markets, then you're creating and looking -- new markets within North America, I should say, because then you're looking at, "Okay. I have to have the sales forces to support that market." So when we're going into the markets, we really have already a native sales organization that understands what's going on in that market. We've got a lot of the background as to what is going to take to be successful in that market certainly where we're competitor actions. But a lot of that will factor in to are we basically going to be able to get a good return? Now when we build a data center, let's say, up in the New York Metro market -- when we're going in there and there's a greenfield site, what we're bringing online is basically a portion. So if I have a total capacity, and let's say 50,000 to 55,000 net sellable square feet, we're pretty much bringing on the first 10,000 to up to maybe 15,000 square feet, let that fill up. And as we see a line of sight to that 85%, then we'll make that next capital investment. And that's exactly what we're doing in Boston, Santa Clara next year, 2013 -- this year.

Unknown Analyst

[indiscernible]

Kevin Mark Dotts

Right. I think our event of that was probably 2 to 3 years ago. As I mentioned, again, when they did the strategic review probably about 4 years ago, they realized that a lot of these partner sites were on the wrong side of cost to capital or even upside down. And that proactive term pretty much finished out in 2011 at the first quarter. So right now, it's been more a matter of just basically maintaining the partner revenues and focusing our growth on company-controlled data centers where our margin rates are far higher than what we're getting out of the partner sites.

Unknown Analyst

Can you comment on your consolidated gross margin, what you think will happen with that line over the next 12, 18 months?

Kevin Mark Dotts

Right. Well, if I can actually drop to the bottom line, what I can tell you is, as you saw the 130 bps increase year-over-year between 2011 and 2012, we would anticipate there's no reason why the business couldn't continue roughly on that trend. And again, it's because your IP business is probably going to maintain roughly that low-60% margin rate. Your partner data centers will be flat from a revenue perspective, and then the growth that we continue to see out of our core business, company-controlled, managed hosting and cloud, obviously, we'll be at a proportionally larger margin rate on a segment margin basis, and that will drive overall margins up.

Calvin Lam

It's interesting to note just back on the comment about Equinix and CyrusOne sort of most of your colocation peers have decided to either convert to a REIT or already are REITs, do you think that will provide them with any sort of inherent advantages when it comes to computing for colocation customers or colocation space?

Kevin Mark Dotts

We've looked at what the effects of a REIT would be. And I think we boil it down very simply to because the lower tax status it provides a cheaper cost of capital. Right now, Internap has a net loss carryforward of about $184 million. So that's shielding probably somewhere between $60-plus-million dollars worth of cash taxes. We don't see ourselves becoming a U.S. federal cash taxpayer in the next many years. So from that perspective, we seem -- we believe we have access to cheap capital at the moment. We're not going to be paying taxes. Right now, for our purposes, a REIT doesn't make a lot of sense. And so, I think keeping the business more simplified, focusing on filling up the data center services makes more sense than the financial engineering or a REIT.

Calvin Lam

And just relative to some of your peers too, you seem to have a little bit more lower leverage, less debt to EBITDA than they do. Sort of where are you comfortable with running the business on a target leverage basis?

Kevin Mark Dotts

Yes. So our net debt to EBITDA ratio at about 1.8x, I think we're a little bit below average of what the other competitors are in that space. I would look at that as a -- with the fact that we're not going to go out and need to take on additional capital facilities in order to execute the current organic plan is a good thing because it may provide us opportunities if the right inorganic opportunity came along.

Calvin Lam

Okay. Any other questions? I guess there's -- Okay. Great. Well, thanks a lot for your time, Kevin.

Kevin Mark Dotts

Okay. Thank you, everybody. I appreciate it.

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