Equinix: Global Connection Hub for the Internet

Investment Thesis

Equinix (EQIX) is the #1 network neutral co-location provider in the world. Industry dynamics favor the company due to customer demand growth exceeding co-lo supply. This is primarily driven by the growth in internet traffic and bandwidth intensive content. EQIX has a highly defensible business model insulated by the benefits that customers receive from “inter-connecting” within EQIX data centers. Hence, the customer barriers to exit are high and Equinix garners a 95% recurring revenue stream. EQIX’s global footprint spans 39 datacenter in 10 countries across 3 continents. Shares have been hammered over the past 6 months, fueled by a misinformed report by Off The Record Research and the Street’s poor understanding of the business fundamentals. EQIX represents an attractive investment opportunity that we value at $130, almost 80% above current levels.

Company Description

Equinix is a provider of co-location datacenters that serve as the on-ramp to the Internet. Equinix’s data centers are located in key global markets housing safe and reliable storage as well as strategic interconnects for content providers, financial exchanges, online businesses, CDNs, and service providers. These datacenters serve as Internet hubs where businesses and service providers physically connect users to data, content, and information. Operating 39 datacenters, in 19 cities spanning 10 countries, EQIX is the pre-eminent global provider of network-neutral datacenters.

Equinix facilitates interconnection for its customers in two ways. The first is by providing direct fiber links between the cabinets of its tenants within the datacenter (1 to 1). The second is through direct fiber links to Equinix’s high speed routers inside the datacenter that redistribute the data to approved peers inside EQIX’s facilities (1 to many). Over the past 8 years, Equinix has secured an elite group of customers that today form a key strategic advantage. These customers are the most attractive from the perspective of interconnecting and peering due to the amount and type of IP traffic they generate. Hence, the customer mix within its datacenters are a source of the company’s competitive advantage.

Demand for co-location datacenter space is growing at 20% annually, more than 2x the rate of supply, according to Tier 1 research. Thus even if demand growth were to slow by 50%, new supply would still be fully absorbed. There are 4 main drivers of demand growth:

1. Increasing Internet traffic tied to video content, services, and information distribution.
2. The need to reduce latency (time delay) for mission critical applications, such as financial exchanges, e-commerce, video distribution, and software as a service (SaaS) applications.
3. Regulations now require several businesses to archive records digitally at multiple offsite locations.
4. Constantly increasing power and cooling needs of the latest servers, switches and routers is forcing businesses to look for more cost-effective and reliable storage facilities for IT equipment.

Equinix will NOT suffer in a recession.

Equinix’s facilities serve as a central hub to Service Providers/Networks, Content Providers, Government Agencies, Financial Exchanges, and numerous enterprises. Equinix enables its customers’ businesses to perform unlike any other provider or any customer could replicate internally due to the interconnection benefits. Hence, it is more cost effective for customers to co-locate in an Equinix datacenter than to construct their own. Over 95% of EQIX’s revenues com from recurring contracts that have an average life of 2-3 years. Quarterly churn is less than 2 percent, often driven by Equinix’s desire to replace less desirable legacy customers with higher margin new customers. Equinix has no 10% customers and its top 50 customers account for only 50% of sales.

The Datacenter market is composed of 4 main segments:

1. Wholesale Warehouses provide large amounts of secure space to relatively few customers, but they do not facilitate or promote the exchange of information/content among tenants. Often times these providers are REITs that resell large amounts of space to managed hosting providers.
2. Managed Hosting facilities provide not only reliable storage but also equipment management and content distribution via proprietary networks. These solutions are often preferred by companies that don’t have strong internal IT departments or sophisticated requirements for their operations.
3. Internal facilities can be quite large for some of the largest and most advanced technology companies. Google, Microsoft, HP, Amazon and others are making large investments for massive datacenters that can properly power and cool the servers and equipment that is critical for their businesses. Importantly, these Internal datacenters often utilize direct fiber links into Equinix facilities as they consider it mission critical to also have a significant presence inside Equinix as it provides the most complete and efficient distribution point, via direct and switched fiber links within its facilities.
4. Network Neutral datacenters, like Equinix’s, provide secure and reliable storage and direct physical connection for dozens of competing service providers (bandwidth, CDNs, etc…..hence the term Network Neutral) for the datacenter’s customers, and various businesses seeking highly efficient distribution of content, data, and information. The network neutral datacenter provides a central connection point to the global Internet. With over 300 service provider/networks housed in its facilities spanning 10 different countries, Equinix has built an ecosystem that is unparalleled in the industry.

The need for direct connection to peers and partners is driving demand acceleration for Equinix as it has the broadest array of Tier 1 tenants and it is also the sole provider with a global footprint.

The key strategic advantage that EQIX provides is direct, high-speed connections to the most important sources of IP data, content and distribution in the world. For the past 8 years, Equinix has focused on providing high-quality datacenters with maximum flexibility for its customers. As other co-location providers failed due to poor execution or over-investment at the beginning of this decade, Equinix’s superior management team remained focused, building the only global network-neutral co-location solution with facilities in 19 of the most critical markets. With over 1.8 million square feet of high-quality, saleable space, Equinix’s scale and customer base continues to attract the most desirable customers. With this unique global footprint, scale and customer base it is no wonder that online businesses and financial institutions pay significant premiums (often 20-30% higher) to co-locate inside EQIX’s prime real estate.

click to enlarge

Today, Equinix has over 1,850 customers. The table below provides a small sample of EQIX’s customer base broken down by category.

click to enlarge

Short Call drove a 50% sell off and Spike in Short Interest. Since posting all time highs in early November at $120, EQIX’s stock came under considerable pressure. The near 50% decline over the past 5 months is at least partially attributable to a short recommendation from Off the Record Research (OTR). At the heart of OTR’s short thesis is a belief that the co-location datacenter market is commoditized and the industry is adding excess capacity just as demand is about to dry up and pricing is about to crater. Supporting this argument, OTR cited anonymous co-location customers, most of who would benefit if this were actually true. While every management team, consultant, and sell-side analyst tied to the co-location market has refuted the arguments made by OTR, the fear of weakening demand in the face of capacity expansions, particularly from the financial customers, has driven a sharp sell-off and a 114% increase in the short interest in Equinix since November. Equinix’s Short Interest now accounts for over 35% of the float and 9 days of trading volume.

We consider the strongest evidence of demand relative to supply is price, and prices for Equinix, as well as its peers, continue to rise as demand outstrips supply. As the chart below illustrates, for the past 12 quarters, Equinix has dramatically increased the number of billing cabinets within its datacenters while simultaneously increasing the average Monthly Recurring Revenue (MRR) per cabinet. It should be noted that through the acquisition of IX Europe, at the end of Q3:07, EQIX added 14 datacenters in Europe with an average MRR of ~$1,100 per cabinet (therefore, the average MRR dipped in 4Q2007). Excluding the IXE datacenters, EQIX increased its cabinets by 1,500 Q/Q and its MRR (excluding IXE) was $1,581 (up 1% Q/Q). Importantly, EQIX’s backlog continues to grow even though its backlog-to-billings conversion time has dropped dramatically.

Monday, March 17^th, at the Citibank Small & Mid-Cap Conference in Las Vegas, Equinix’s Chief Business Officer Margie Backaus outlined the current market and competitive landscape, describing it as “the best it has ever been.” Ms. Backaus discussed the pipeline as being ‘solid’ with 85% of the backlog coming from existing customers. Within the current revenue stream, she noted that 35% comes from Service Providers/Networks, 34% from Enterprise/Government, 18% from Content, and 13% comes from Financials (including numerous global exchanges). It is worth noting, especially this week that within the financial sector no customer accounts for more than 2% of sales. Contradicting the OTR thesis, Ms. Backaus cited proprietary data collected from nearly 2,000 customers showing that demand for quality co-location space continues to grow at a faster rate than industry supply is coming on line. Importantly this demand forecast from EQIX’s existing customer base is the basis for EQIX’s capacity expansion plans (expansion plans are driven by existing demand).

Highly Attractive Business Model

The strong demand for EQIX’s facilities allows it to not only charge a premium to the competition, but it also fills its facilities faster, thus accelerating Return on Invested Capital and funding further FCF growth. For example: in its DC 4 facility in Ashburn Maryland, Equinix spent $60 million building the facility. After 12 months of construction, EQIX began filling up the datacenter with existing and new customers in March of 2007. In less than 4 months, the facility was cash breakeven, and within just 15 months since opening it will be full, generating over $28 million in FCF each year. The 10-year IRR is over 40%, before leverage. The recent Los Angeles, Chicago, and New York expansions are all progressing at similar or better rates.

Equinix gets 95% of its revenues from recurring fees on contracts that average over 2 years in length, thus providing the Company with tremendous visibility into its 90-day and full year revenue prospects. As discussed earlier, no single customer accounts for a significant portion of revenues (IBM is the largest at 6%). Because the revenue stream is so predictable (EQIX has beat revenue estimates each of the past 19 quarters), the primary variable for forecasting EQIX’s FCF is CAPX. We note that it is important to understand the difference between Expansion CAPX and Maintenance CAPX. Maintenance CAPX for EQIX is currently ~$50 million annually and Expansion CAPX is expected to be $285-$290 million in 2008. On a total CAPX basis, EQIX is predicting negative FCF of ~$50 million, however in 2008 the existing business FCF would be positive $200 million. It should also be noted that the Total CAPX in 2008 is fully funded and tied to growth opportunities (identified in the demand forecast) that the company believes can meet or exceed its 40% IRR target on all incremental capital investment.

Exiting 2008, Equinix expects to have $175-200 million in unrestricted cash. If for some reason demand were to soften (which the company again said on 3/17/07 was not the case), EQIX has the ability to rapidly (in less than 6 months) stop expansion and run the business on its existing base. Given the 70% Cash gross margins and 38% EBITDA margins, the company would rapidly move to positive FCF (>$200 million annually) if expansion was no longer justified.

Valuation

Trading at $74, EQIX has a market cap of $2.7 Billion and an Enterprise Value of $3.4 Billion. In 2008, the Company projects that it will generate $650 - $665 million in sales and EBITDA of $251-$257. Consensus Estimates are in the middle of this forecast, even though EQIX has consistently beat both metrics for the past 3 years. Looking into 2009, the Street is projecting sales of $803 million and EBITDA of $333 million. Given EQIX’s recurring revenue base, we believe a DCF is the appropriate way to value of EQIX. By forecasting the install rates and revenue per cabinet added for the next 10 years, and using a WACC of 10% and a terminal growth rate of 3.5%, we value EQIX at $130, roughlyt 80% above its current trading levels.

Disclosure: Author works for a Hedge Fund that is LONG Equinix (EQIX).

Comments

[bemink]

I know EQIX quite well and agree with the article. With EQIX customer "stickyness" due to peering, the most critical item facing EQIX is to execute and perform on CapEx on building out their sites.

They have done a good job of pre-selling at premium rates to their existing customers in existing markets.....which has been a winning proposition. If they expand TOO much (which, at this time, is a benefit over competitors, so long as the CapEx doesn't get out of hand), I may worry. If EQIX expands (outside of buying an operating company) in a city/country it is not familiar with, then I may sell for fear they are expanding too quickly in unproven territory.

For now, I am long (bought in the last 3 weeks) and expect to be for some time. 6 months from now (as Chicago gets sold), look for earnings to go up and stock price at 90-100. Year end around 120 or so, depending on news...I was a long term hold from 3.00 around early 2003 until late 2007, where I got out at 98. I kicked myself that it went up to 120., but very happy when it went down to 57., so I could get in again (a little higher than that).

One thing is for sure, EQIX is the industry leader and will continue to put some ground between them and their competitors. SVVS has stumbled (funny, the SVVS ceo used to be cfo at EQIX), and the others can't match cash on hand, infrastructure, peering or footprint...

EQIX is a solid buy !

[False Profit]

This co. trades at 8x revenues, doesn't generate profits or cash and hands out copious amounts of stock to their executives. All measures to value it rely on non-fundamental factors like EBITDA, "maintenance"... capex and pro-forma numbers. Incidentally, the concept of maintenance capex is a joke. Most of what they term expansion capex is really recurring capex to replace equipment. The shill game will continue for a while till they can no longer raise more debt. Then perhaps people will come around to valuing it on fundamental factors like earnings and free cash flow (both of which are negative), sending the company to bankruptcy.

[doublet83]

Good report. I own Q.TO which is kinda like the EQIX of Canada. I think they're a better and cheaper way to play this.