I'm putting a conservative $0.60 per share target on the stock, which represents about 12X estimated 2006 EBITDA.
The value disconnect in the stock reflects an inept management team, but therein of course lies the opportunity for potential acquirers and current investors (i.e. fire 5% of the upper executives at IIP and EBITDA goes up dramatically). In theory, the dramatic EBITDA growth in 2006 warrants a much higher multiple, but I'm not yet completely comfortable with the current new CEO´s ability to manage the financials here, so I'd rather be conservative and wait a quarter or two before assigning a higher multiple. As an aside, if the company seems capable of meeting the high end of EBITDA projections, as the year progresses, there is no reason not to assign a value of at least $0.90 per share to IIP.
Now onto the report. On the positive side was the increase in the customer base to 2,092 customers for net adds of 60 new customers during the quarter. For the full year, it would appear that IIP´s customer base grew by over 8%. Another positive for the quarter was that adjusting for certain non-cash items and negligible one-time charges, IIP appears to have actually generated cash during the quarter, even after capital expenditures and debt repayment. This is a major milestone for the company. Another positive for the quarter, was the excellent EBITDA growth guidance for next year. IIP is projecting about 60%-90% EBITDA growth next year. With cap-ex staying flat and debt repayment staying flat, that implies very nice free cash-flow growth in 2006. Finally, it was interesting to learn that IIP is only operating at about 75% capacity (based on data centers). This is extremely positive as it implies that the company can still grow dramatically without the need for adding additional fixed expenses.
Now on to the negatives, which are more important to the "casino" investor (i.e. managing risk is the first criterion for successful investing and gambling). A word of caution: don´t let the negatives scare you much. Problems are merely opportunities for further capital appreciation. The risks below are seemingly already reflected in IIP´s current stock price. So as the risks are minimized and removed, the stock can continue to rise.
First of all, IIP´s revenue growth is still anemic. For instance, it would appear that IIP´s full year 2005 customer growth was over 8%, but revenue growth clocked in at merely 6%. With other companies reporting high double-digit top-line growth, one has to wonder why IIP can´t seem to grow revenues. I don´t think the "bandwith" argument really holds any water anymore, so I´d love to hear from management why they can´t generate any meaningful pricing power. I suspect the company does a very poor job of upselling higher-margin services to existing clients, which is why it was positive to hear that management is realigning the workforce to allow for more client interaction and sales. Perhaps we´ll see an improvement in revenue growth in 2006, though management´s guidance was far from encouraging. I think the company really needs a more focused product strategy and presentation. Perhaps the $25 million spent on marketing and sales, can help the company develop a clear message and focused marketing and sales pitch that resonates with customers and employees. If you´ve visited Internap´s website recently, I think you´ll know what I mean by an unfocused product strategy and presentation. Bottom line: IIP´s marketing stinks.
Another negative point in the report is IIP's horrendous margins. Yes, strong EBITDA growth is forecasted for 2006, but IIP's EBITDA margins are terrible compared to others in the industry (again this risk is an opportunity for acquirers).
From what I can tell, both Equinix Inc. (EQIX) and Akamai Technologies, Inc. (AKAM) have EBITDA margins above 30%. For a variety of reasons, EQIX is in fact a better proxy for IIP, than AKAM, and EQIX has 30% Adjusted EBITDA margins. Assuming a best case scenario for IIP in 2006, one can project about a 11.5% EBITDA margin. That's 20 percentage points beneath EQIX´s margins!
What´s the deal you ask? Well for one is the aformentioned inability of IIP to sell higher-margin services. However, a more notable reason is IIP´s bloated SG&A expenses. EQIX's SG&A/Operating expenses clock in at about 30% of revenues, while IIP´s come in at an astounding 40% of revenues. While this is low compared to AKAM, IIP is and never will be an AKAM, so its SG&A should not be 40% of revenues. It´s hard to say what is going on here, but I suspect another nice reduction of upper level management can shave a good $10 million off of IIP´s expenses and bring its SG&A more in line with revenue capabilities. The bottom-line: IIP is either clearly underutilizing human resources or has too much human resource capacity at the upper levels of management. Which one is it it?
The final negative point for the quarter was that in the conference call the CEO mentioned growth thru strategic initiatives. What could he possibly mean by this? I can only guess that he is looking at acquisitions. One has to wonder how on earth this guy can think of strategic intiatives at this point in time. In my opinion, those words should not even be uttered until the CEO can show at least 4 quarters of decent revenue growth and EBITDA margin improvement.
In sum, IIP still appears undervalued, despite the risks and negatives surrounding the company. Price appreciation can still be substantial if IIP continues to deliver improving financials throughout 2006. Stay tuned.