Where Is The Free Cash Flow At Equinix?

| About: Equinix, Inc. (EQIX)
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As a telecom industry veteran, I'm all too familiar with companies that build data centers and networks for the future. All too often, service providers spent billions on networks that needed to be upgraded by the time they were installed.

These companies always promised huge earnings in the future. Massive free cash flows were always around the corner once this feature was added or this connection made. Unfortunately, the competition always had the same plan leading to quick margin erosion and evaporating profits.

While reading the Q4'11 earnings conference call transcript for Equinix (NASDAQ:EQIX), this statement in the opening remarks by CEO Stephen Smith got me thinking back to the internet bubble years.

We are executing on our goal of generating over $3 billion in annual revenues by 2015, while targeting positive adjusted free cash flow in 2013.

Think about that statement for a moment. Equinix has been in the data center services business since 1998 and the company expects free cash flow finally in 2013. I'm no expert on the past of this company, or whether free cash flow has been achieved off and on. Rather, the scary part is that a company valued at $6.5B is having such a difficult time keeping cash without having to immediately redeploy it for the latest networking upgrade.

In the very next paragraph, he highlighted the very problem in the industry.

I'd like to highlight how we invested in the business in 2011. We generated $587 million in cash from operations for the year, and reinvested $557 million in 20 key global IBX expansions with the same level of targeted returns. Ongoing CapEx was $128 million for the year, which included success-based installations, maintenance and value-enhancing initiatives.

Did everybody catch that? Equinix brought in nearly $600M in cash, but immediately turned around and spent nearly $700M.

The other concerning part of the original statement is that the CEO first focused on revenue. The company apparently has a revenue goal prior to focusing on cash generation.

The industry will tell you it is all about gaining scale. In the mid 2000s it was about upgrading the data networks, but now it's cloud services. In a few years, it will be something else.

Just check out Level 3 Communications (NASDAQ:LVLT). That company has been promising the profitable network of the future since the 1990s and it has yet to arrive.

Industry leader Raxspace Hosting (NYSE:RAX) appears to have the same issue as competitor Equinix. During its Q4'11 conference call, the CEO took until paragraph 4 to address the cash flow issue. At least he was able to point to positive free cash flow in Q4 though negative for the year.

Number two: adjusted EBITDA margins came to 33.9% for the year, up from 33.6% in 2010, and net income margins improved to 7.5% for the year, up from 5.9% in 2010. Number three: return on capital grew to 14.7% for the full year, up from 11.6% in 2010. Q4 return on capital grew to 17.2%. And number four: adjusted free cash flow was negative $7.4 million for the full year but turned positive in Q4 when we generated $19 million of adjusted free cash flow.

Also unsurprising is the industry still focuses on EBITDA long after it was a leading cause of the demise of the telecom sector back in 2000. EBITDA can be a valuable financial tool in some industries, but in a capital intensive sector where equipment does truly depreciate and interest expenses are required to fund networks, it is a worthless number.

Both Equinix and Raxspace have been on a tear this year, as cloud services have turned back into the hot sector. Watch these stocks for a short opportunity as cash flow generation will likely be pushed out into eternity if history repeats itself.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in EQIX over the next 72 hours.

Additional disclosure: Please consult your financial advisor before making any investment decisions.