Seeking Alpha
Profile| Send Message|
( followers)  

I initiate coverage on 21 Vianet (NASDAQ:VNET) with an Overweight rating and a DCF-based price target of $15, which values it at 15x 2012e EV/EBITDA and implies a 55% upside.

Investment Thesis

  • Rising Internet usage, weak Internet infrastructure, and the need for inter-carrier and inter-provincial connectivity will drive demand for carrier-neutral Internet data centers (IDC).
  • As the largest carrier-neutral IDC provider in China, VNET’s value proposition lies in its nationwide interconnectivity, reliable service, and technological innovation. As a result, VNET has a large loyal customer base and 10-15% more pricing power than its competitors.
  • VNET’s initiative of expanding self-built data centers and cabinets reduces its reliance on partnered data centers with the telecommunication carriers and its focus on managed network services (MNS) will bode well for margin improvement in the long term.
  • Valuation: VNET currently trades at 7.9x EV/EBITDA for 2012, which is in line with its North American peers Equinix (NASDAQ:EQIX) but at a 40% discount to Rackspace’s 13.1x.
  • Recommendation: Initate with Overweight rating and a DCF-based price target of $15.00.

Company Description

21 Vianet is the largest carrier-neutral Internet Data Center (IDC) service provider in China. The company’s hosting and related services provide customers with a reliable and secure Internet infrastructure, servers and networking equipment. The managed network services optimize data delivery over the Internet by using its data transmission network and BroadEx smart routing technology.

Business Model

VNET operates carrier-neutral Internet Data Centers (IDC) that provide hosting and managed network services to customers. The company has the largest market share in terms of revenue, according to the research firm International Data Cooperation.

Hosting services provide customers with a reliable and secure network infrastructure, which includes physical facilities, server management, data backup, interconnectivity, server load balancing, and managed hardware and software services for their network and computing needs.

Managed Network Services (MNS) utilize BroadEx, VNET’s proprietary network and routing technology, to optimize connectivity and facilitate data delivery over the Internet.

Revenue is generated from annual service agreement that has a renewal option with same term and condition, monthly fixed fee arrangement, or a plan based on bandwidth usage.


(Click to enlarge)

Investment Thesis

Rising Internet User Base to Drive Demand for IDC. In 2008, China surpassed the United States to become the largest Internet market in terms of user base. According to China Internet Network Information Center (CNNIC), China currently has 485 million Internet users, more than double the number in 2006. The total Internet user base is expected to grow at a CAGR of 7.5% to 2014, according to Euromonitor International.


(Click to enlarge)

As the number of Internet users increases, consumption of rich online media such as videos, gaming, and social networking services is also expected to rise rapidly. According to Cisco Visual Networking Index, Internet video IP traffic is expected to grow from 296 Petabytes in 2009 to 2,405 Petabytes in 2014 (CAGR of 52.1%), and mobile IP traffic is expected to rise from 1.5 Petabytes in 2009 to 201 Petabytes in 2014 (CAGR of 166%). The IDC market is expected to grow to meet the rising Internet usage as online media becomes increasingly resource-intensive, and mobile Internet becomes more prevalent.

Underdeveloped Infrastructure Offers An Attractive Growth Opportunity. The network connectivity in China is inadequate at both the national and the local level, a deficiency which presents a compelling growth opportunity for carrier-neutral IDC providers.

At the national level, there are three main network access points in Beijing, Shanghai, and Guangzhou, and a limited number of other local network access points. As Internet usage increases, these network access points have become bottlenecks that hinder Internet data traffic in China. In addition, efforts by China Unicom (NYSE:CHU) and China Telecom (NYSE:CHA) to control the network in northern and southern China, respectively, and to prevent one another from entering their market have hindered the network connectivity between northern and southern China.


(Click to enlarge)

On the local level, provincial telecommunication managers reserve the network bandwidth to meet their local clients’ needs because the managers are measured by their provincial level performance. Therefore, capital expenditures are allocated to improve intra-provincial connectivity, result in lack of development in the inter-provincial networks.

The demand for IDC providers is exceeding the supply due to the inadequacy of China’s Internet infrastructure. According to the research firm International Data Cooperation, Internet data center services market is expected to grow from $667m in 2009 to $1.9 billion by 2014, representing a CAGR 23.8%.


(Click to enlarge)

When choosing an IDC provider, customers often consider:

  • The interconnectivity between the provider’s networks
  • Geographic coverage since it allows greater interconnectivity and routing
  • Superior technology and value-added-services, such as technical maintenance, disaster recovery, and managed network services

VNET’s strength in nationwide interconnected network, reliable service, and technological innovation directly address the customers’ needs.

Nationwide interconnected network neutralizes the inter-carrier and inter-provincial obstacle.

VNET’s carrier-neutral IDC’s are not limited by carriers or provincial boundaries, so they can provide a standardized and efficient Internet connection to customers across the country. The company operates 58 data centers with over 6,000 cabinets and 40,000 servers located at 300 POPs across 36 cities in China. The company’s data centers are connected with networks that are operated by carriers and non-carriers, including China Telecom, China Unicom, China Railcom, and China Science and Technology Network. The nationwide interconnectivity directly addresses the inter-carrier and inter-provincial connectivity concern in China.


(Click to enlarge)

Currently, the company is building six additional data centers in major Internet cities such as Beijing, Shanghai, Hangzhou, Xi’An, and Guangzhou to meet the rising Internet data usage. Three data centers are expected to be completed by the end of 2011, with the remaining three are expected to be completed by the end of 2012.

Quality Customer Service + Superior Value Proposition = Strong Brand Equity.

VNET has strong brand equity due to its reputation in providing reliable services to clients. The company guarantees its customers 99.99% uptime for Internet connectivity and 99.99% uptime for power, and is the first company in China to pass the ISO 9002 RAB (U.S.) and UKAS (U.K.) quality system certification.

Each of VNET’s data center features:

  • Stable power supplies that are backed by uninterrupted power supply (UPS) and diesel generators
  • Advanced security with round-the-clock personnel, surveillance cameras, and controlled access
  • Sensitive smoke detector, and both water mist and gas-based fire suppression network
  • Air conditioning that ensures proper temperature and humidity
  • 24/7 support by on-site service team


(Click to enlarge)

Because of its superior service and reliability, VNET has a diverse client base and commands pricing power in the market. The company currently serves over 1,300 major Internet companies, blue-chip enterprises, SMEs, and government organizations. Customer loyalty is extremely high as indicated by the <1% churn rate and 0% churn rate among its top 20 clients over the past four years. Finally, VNET commands a 10-15% pricing premium over the products of its competitors.


(Click to enlarge)

In the future, VNET is likely to strengthen its brand recognition among customers and leverage its strength to acquire additional customers, and expand its market share.

Strong R&D capabilities breed an innovative culture.

VNET has always been at the forefront of technological innovation. The company currently has 2 patents, 8 patent applications, and 4 software copyright registrations, and also has an R&D team of 70 engineers, many of whom with 10+ years of industry experience.

VNET is the first company to build a carrier-neutral data center in China between 1999 and 2000, and is also the first company to introduce container data center. The container data center is portable and requires connectivity for electricity, chilled water, and network connectivity, ideal for remote locations or places where space is scarce. Each container data center could house nine cabinets or 900 servers.


(Click to enlarge)

The company also has a proprietary smart routing technology called BroadEx that optimizes data delivery and improves connectivity by constantly monitoring all available routes, and considers speed, performance, stability, and pocket losses to determine the optimal route for transmission. BroadEx achieves this through leasing bandwidth from the two main carriers, which allows VNET to quickly meet customer’s needs and expand its geographic presence. BroadEx has a great potential of improving user experience which ultimately result in customer loyalty and strengthened industry leadership for VNET, in my view.

MNS and Cloud-based initiative will likely expand EBITDA margin and further drive IDC growth. Because VNET leases its bandwidth from the carriers, the company’s EBITDA margin has been under pressure amid rising bandwidth cost.


(Click to enlarge)

While I believe that VNET could leverage its superior service and product offering to pass down the cost to the customers, a more effective solution would be to expand its self-built data centers and BroadEx’s Managed Network Services.

Self-built data centers will reduce VNET’s dependence on the carriers for data center facilities and bandwidth, and improve margins. According to management, gross margin on self-built data center is 31-34% compared to the gross margin of 21-34% on the partnered data centers.

VNET also hopes to expand its revenue mix on MNS, which carries around 40% gross margin and demands less bandwidth usage compared to hosting services. In September 2010, VNET acquired 51% stake in two MNS entities that resulted in additional 45 customers and 200 POPs to complement BroadEx’s product and service offerings. In December 2011, VNET exercised its option to acquire the remaining 49% equity interest in the two entities to further enhance its MNS offerings and meet the rising customer demand.

Finally, I believe that the cloud computing initiative will generate marginal demand for the hosting services. According to International Data Cooperation, Software-as-a-Service, SaaS, revenue is estimated to grow from $88.6 million in 2009 to $315.4 million in 2014, representing a CAGR of 29%.


(Click to enlarge)

Cloud computing allows business to run their application on servers managed by data center service providers. The platform features on-demand services, flexible pricing scheme, no hardware and software management and rapid deployments, which are cost effective for China’s fast growing SME’s.

Challenging But Manageable Issues

Despite its strength in nationwide interconnected network, reliable service, and technological innovation, VNET’s two biggest challenges are:

  • Reliance on carriers for partnered data center and bandwidth capacity
  • High revenue concentration from the Internet sector

Reliance on carriers for partnered data center (54% of VNET’s total cabinet count) and bandwidth capacity. VNET competes with China Telecom and China Unicom in the IDC market but at the same time depends on the carriers for hosting facilities and leasing bandwidth capacity. The merits of this partnership are that VNET can quickly meet the customers’ needs and expand its geographic presence. However, the shortcomings are that VNET is heavily dependent on the carriers for bandwidth capacity and could potentially lose its industry standing should the carriers become more aggressive in expanding into the IDC market.

Self-built Data Center

Partnered Data Center

Definition

Data center with company-owned cabinets and data center equipment housed in building leased from third parties

Data center space and cabinets leased from China Telecom or China Unicom through agreements

Lease Terms

Lease of power-based buildings

Lease of cabinets

Number of Data Centers

  • 3
  • 6 new data centers planned for construction
  • 44

Number of Cabinets

2,645 cabinets (46% of total)

3,105 cabinets (54% of total)

Costs

Include bandwidth cost, utilities and rental expenses for self-built data centers, payroll, D&A, equipment cost and others

“Telecommunication cost”, which covers bandwidth cost, rentals, utilities, and other costs in connection with the cabinets leased from partners’ data centers

Benefit to 21ViaNet

  • Higher return on capital invested
  • Reduced reliance on carriers
  • Leverage from economies of scale
  • 31-34% gross margin
  • Meet client demand quickly
  • Flexible in geographic location
  • 21-24% gross margin

In my view, carriers are unlikely to compete against VNET in the near term because:

  • VNET has a solid relationship with both China Unicom and China Telecom over the past ten years
  • The current supply/demand imbalance for the IDC market creates enough opportunities for both carrier-neutral IDC providers and the carriers to benefit from the overall growth of the market
  • IDC is not a key focus in China Unicom and China Telecom’s current growth strategy because the business accounts for approximately 1% of total revenue and carries only ~25% gross margin, compared to the telecommunication business which carries ~80% gross margin. In addition, the rising adoption of low-cost 3G handsets provides a more attractive opportunity for the carriers than the IDC business

However, I am encouraged to see VNET has taken the initiative to address its shortcoming by aggressively expanding its self-built data centers and managed network services so it can be less reliant on the carriers. From 2008 to the end of 2010, the percentage of VNET’s self-built cabinet has increased from 32% to 46% of the total cabinet count. I expect the portion to be 64% by 2013 based on the company’s historical investment in additional self-built cabinets.


(Click to enlarge)

The increasing number of high margin self-built cabinet should offset VNET’s dependence on carriers. In addition, the management is expanding its MNS business to mitigate the rising bandwidth cost that is negatively impacting VNET’s margins.

High revenue source from the Internet sector exposes VNET to concentration risk. In 2010, VNET generated over 70% of its revenue from the Internet sector, in which some of its biggest customers included portals, search engines, online media, ecommerce, and online gaming companies.

VNET’s Leading Customers and Their Respective Industries

Source: 21Vianet

A major risk with high revenue concentration in the Internet sector is that Chinese Internet companies are likely to build their own data centers to benefit from economy of scale, which can be seen in most North American technology companies such as Google and Facebook. Earlier this year, Tencent, VNET’s biggest client in the search engine/portal vertical, started to build its data center in Tianjin. The data center is estimated to be twice the size of Apple’s and is expected to be completed by 2013.

While the long term picture might seem pessimistic, the near term situation is not as bad given that:

  • China’s Internet sector is in its nascent stage of development and only a handful of large Internet companies have sufficient capital to deploy large scale data centers due to the capital-intensive nature of the initial start-up cost
  • Bandwidth cost is likely to remain high in the near term and will likely expand the cost beyond the land, buildings, and equipment. Even though large companies such as Baidu (NASDAQ:BIDU), Alibaba (OTC:ALBCF), and Tencent all have adequate capital for investments, it is questionable whether such investment is the optimal allocation of resources when a low-cost alternative in third-party IDC is readily available
  • Despite being able to meet the financial obligations of building a data center network, the large companies still lack sufficient IDC expertise and knowledge that address the inter-carrier and inter-provincial challenges. Ultimately, these companies will likely turn to third-party service providers for hosting and managed network services. VNET is likely to be their top choice due to its broad geographic reach, technical expertise, and superior product and service

Management Profile

Mr. Sheng Chen – Chief Executive Officer and Co-Founder

  • Over 20 years of experience in the Internet infrastructure sector in China
  • Founded VNET and started the China’s first carrier-neutral data center in 1999
  • Bachelor’s degree in Electrical Engineering degree from Tsinghua University

Shang-Wen Hsiao – Chief Financial Officer

  • Previously the Chief Executive Officer and Chief Financial Officer of Centuryfone 121 Networking and Communication
  • Certified Public Accountant since 1989 and admitted to the Pennsylvania Bar
  • Bachelor’s degree in Finance and Accounting from Temple University and Juris Doctor Degree from Rutgers School of Law

Jun Zhang – Chief Operating Officer and Co-Founder

  • Chief Operating Officer since 1999
  • Former vice president at Cenpok Inc., (sold to A-1 Netcom China in 1999)
  • Bachelor’s degree in Environmental Engineering from Tsinghua University

Executive officers and directors of the board collectively hold 43% of the companies, of which executive officers hold approximately 23%.


(Click to enlarge)

Financial Analysis

Given the current macro uncertainties involving the European debt crisis, a possible recession in the U.S. and potential hard landing in China, I conservatively modeled the net revenue to grow at a CAGR of 29% from 2012 to 2016, and CAGR of 16% for the subsequent five years from 2017 to 2021.


(Click to enlarge)

Hosting and related services will grow at a CAGR of 21% and MNS to grow at a CAGR of 40%, driven by aggressive expansion of data centers and acquisition of MNS entities. Beyond 2017, hosting and MNS are expected to achieve a CAGR of 12% and 19%, respectively, as the businesses approach maturity.


(Click to enlarge)

Gross margin will increase by 75 bps annually to 31% by 2016 due to the expansion of high-margin MNS services and the increased adoption of self-built cabinet and data centers. By then, I expect MNS account for 55% of net revenue while hosting services account the rest.

Operating expense is expected to decrease over the next 10 years due to economy of scale.

  • Sales and marketing expense is expected to decrease 40 bps annually by 2021 as less capital is required to raise VNET’s brand awareness.
  • General and administrative expense is expected to decrease by 50 bps annually as the company consolidates the MNS entities and cut overlaps to improve efficiency.
  • R&D expense is expected to increase 25 bps annually as the company develops its own cloud-computing platform and other innovative solutions such as BroadEx and container data center.


(Click to enlarge)

Adjusted EBITDA to grow at a CAGR of 28%, with EBITDA margin to be approximately 20% as rising R&D cost offsets the margin improvements from lower SG&A cost and high-margin products.

Capital expenditure is estimated to be at 22% and 20% of 2012 and 2013 revenue respectively, as the company aggressively expands its self-built data centers and cabinet and then stabilizes at 3 – 4% of revenue for maintenance capital expenditure.

EPS is projected to achieve a CAGR of 24% over the next five years.

Scenario Analysis

Price target of $15.00

Derived from base-case scenario

Bull Case

$23.00

27x Bull Case

2012e EV/EBITDA

Macro overhang dissipates sooner than expected, ramp up in IT spending, and cloud services take off:

  • Net revenue to grow at a CAGR of 36% from 2012 – 16e, in which hosting services to grow at CAGR of 30% and MNS to grow at a CAGR of 45%, as macro overhang in Europe, the US, and China dissipates sooner than expected, steady ramp up in IT spending, and take off of cloud services
  • EBITDA margin improves by 300 bps to 22% of net revenue due to higher revenue contribution from MNS and increased adoption of self-built cabinets and data centers
  • CAPEX declines to 3% of net revenue for maintenance CAPEX

Base Case

$15.00

15x Base Case

2012e EV/EBITDA

Steady growth from hosting and managed network services, and gradual increase in economy of scale:

  • Net revenue to grow at a CAGR of 29% from 2012 – 16e, in which hosting revenue to grow at a CAGR of 21% and MNS revenue to grow at a CAGR of 40%, as VNET gradually shifts its revenue mix and service offering to MNS and self-built cabinets
  • EBITDA margin to remain steady at 19 – 20% as cost saving and margin improvement are offset by rising R&D spending
  • CAPEX declines to 6% of net revenue for maintenance CAPEX

Bear Case

$7.00

4x Bear Case

2012e EV/EBITDA

Weaker than expected economy, increasing competition from the carriers and margin pressure due to rising bandwidth cost:

  • Net revenue to grow at a CAGR of 22% from 2012 – 16e, in which hosting revenue to grow at a CAGR of 20% and MNS revenue to grow at a CAGR of 25%, due to weaker than expected economic growth and IT spending in China, increasing competition from China Telecom and China Unicom, and rising bandwidth cost
  • EBITDA margin declines to 11% of net sale as VNET ramps up operating expense to counter the competition
  • CAPEX is projected to be 13% of net revenue due to increased number of self-built data centers and cabinets
  • Tax rate increases from 15% to 25% from 2014 onward as VNET fails to maintain its High and New Technology Enterprise (HNTE) qualification for preferential tax rate.

Source: Jiang Zhang

Valuation: DCF-based Price Target of $15 Implies a 55% Upside

My DCF-based price target of $15 per ADS implies a 55% upside from the closing price of $9.58.

DCF Summary

WACC

17%

Terminal growth rate

3%

Sum of Free Cash Flows (Year 1-10)

5,367

Terminal value

9,409

Total enterprise value

3,726

Net cash

1,461

Equity value (Rmb, mm)

5,188

CNY:USD conversion

16%

Equity value (USD, mm)

837

ADS outstanding (mm)

56

Per share value (USD)

$ 14.82

(Click to enlarge)


(Click to enlarge)


(Click to enlarge)

Source: 21Vianet: Banking On China's Internet Infrastructure