Switch: Tepid Guidance Weighs On Good Results

Summary

• Switch beat Wall Street's top-line estimates in its Q4 earnings release, now putting the company at two for two since going public last October.
• The company's FY18 revenue guidance of $423-$440 million, however, points to only 12-16% y/y growth, versus 19% in FY17.
• Shares are down 12% in after-hours trading on the news.
• Switch faces the additional challenge of having its lockup expiration on April 4, putting additional pressure on the shares.

Switch (SWCH) is getting clobbered yet again after an earnings release that, on the face of it, exceeded Wall Street's estimates. Since going public last October, the datacenter colocation service provider has produced good results against consensus expectations, but evidently not good enough to satisfy investors' requirements. This time, Switch's post-earnings pummeling was especially pronounced, with shares falling 12% after-hours:

SWCH data by YCharts

Year to date, Switch has lost more than 20%. After rocketing up in the early days post-IPO (with bulls applauding its high-tech colocation business model and its superior reviews from customers), Switch has largely lost steam and is now down about 15% from its IPO price of $17. Complicating matters further, Switch's lockup expiration comes due on April 4 - meaning that for the first time since the IPO, insiders will be able to sell their shares on the open market, putting much of the company into public float. While the downward performance since IPO lessens the probability that a deluge of sell orders will hit the market on April 4, it creates some downward pressure on Switch that's difficult to recover from - at least through the April timeframe.

Since Switch went public, however, I've never been too enthusiastic on the name. The primary reason for this judgment is valuation-based, not due to a weakness in the company itself. Yes, it's true that Switch provides a cool service - for the unfamiliar, "co-location" is similar to hosting your servers in a third-party cloud infrastructure service like Amazon AWS (AMZN), but it's less full-service in the sense that you're still responsible for maintaining your own hardware. Essentially, you're primarily renting the space and bandwidth from Switch.

The company has built out cutting-edge datacenters that have won it the love of its customers, but is the stock worth the hype? Even now, after Switch's post-Q4 correction, shares still lean toward the expensive side.

A quick valuation check: Switch currently trades at a market cap of $4.0 billion. It also carries $367 million in net debt as of its fourth-quarter balance sheet ($591.8 million of debt, plus $21.8 million of capital lease obligations, less $264.7 million of cash). Adding this to Switch's market cap, we arrive at an enterprise value of $4.37 billion.

This represents a 10.1x EV/FY18 revenue multiple and a 19.9x EV/FY18 EBITDA multiple based on the midpoints of Switch's guidance ranges for the coming year - a steep multiple to pay for a company whose growth is decelerating into the low double digits.

The bottom line on Switch shares - don't chase a falling knife, especially as the lockup expiration nears. With so-so results and tepid guidance, shares are due for quite a bit more pain.

Steep deceleration baked into FY18 guidance

What gives with the lowball guidance? That's probably what most investors are thinking and what's causing the broad selloff in post-market trading. Recall that Switch spent a large portion of its IPO proceeds on capital expenditures to build out additional square footage of colocation facilities (which it calls its "Prime" locations).

In total, Switch spent $402.6 million on capital expenditures in 2017 - a huge amount, more than 100% of its revenues and a good amount more than the $260-$310 million that the company has indicated as planned capex spending in 2018. Most of this was spent on new capex; maintenance capex only amounted to $4.6 million of the total. And a lot of this spending was on facilities that are either operational or preparing to go live in 2018.

So after seeing all of this capital deployment into new and improved facilities, why aren't we seeing the corresponding lift on the top line? Switch guided to total FY18 revenues of $423-$440 million, implying +12-16% y/y growth over this year's revenue of $378.3 million. Considering that revenues grew 19% y/y this year, that's a steep deceleration curve for a company that just poured a lot of money into supposedly revenue-generating facilities.

Yes, one could argue that new facilities - especially something as massive and complex as datacenters - will take more than a year to fully ramp. But investors are, for better or worse, rather short-sighted - and unless Switch can meaningfully perform in excess of its current guidance, investors are going to balk at paying 10x revenues for a low-growth stock.

Guidance on the EBITDA front was light as well - the company is pointing to adjusted EBITDA of $220 million, implying just 13% growth at the midpoint. It also represents an EBITDA margin of 51%, indicating no margin improvement from FY17.

Good results, but altogether uninspiring

In light of the disappointing guidance, Switch's decent Q4 results were largely ignored in the selloff. See the company's fourth-quarter and full-year results below:

Figure 1. Switch Q4 results

Source: Switch investor relations

Top-line results were robust. Revenues grew 21.3% y/y to $99.3 million, a respectable 170 bps acceleration over 19.6% growth in Q3. The top-line strength was more or less expected, however, with Switch only marginally beating analysts' consensus expectations of $98.8 million (+20.6% y/y) by 70 bps.

One of the major drivers behind this revenue growth was a significantly lower churn, which I believe to be one of the more salient positive points in the quarter. As Switch is a recurring revenue business, churn - which the company defines as the reduction in recurring revenues due to customer terminations or non-renewals, as a percentage of total revenues in the prior - is one of the key success metrics for Switch to achieve. In the fourth quarter, Switch managed churn of just 0.3% - indicating barely any customer defections. This compares very favorably against 1.9% churn in 4Q16, and also continues the strong churn trends seen in Q3, where the company also managed 0.3% churn.

For the full year, Switch experienced 0.6% churn - a 50 bps improvement over 1.1% in FY16.

On the profit side, however, Switch largely underwhelmed. It's true that the company's deterioration in GAAP operating profits (widening from a loss of -$7.5 million in 4Q16 to -$54.8 million this quarter) is largely due to the uptick in stock-based comp now that Switch is a public company with a value attached to its stock grants. But the company's adjusted EBITDA - the primary yardstick for measuring its profit growth, and one that excludes the effects of stock comp - also grew just 25% in the quarter and represented only a 51% EBITDA margin, only a 1% improvement from its 50% margin in 4Q16.

With Switch forecasting zero improvement in EBITDA margin from the 51% it achieved in FY17, it's unclear why the stock carries such a hefty premium on both a revenue and EBITDA multiple basis.

Key takeaways

The key sound bite for investors: Switch continues to be an expensive, overrated stock. While the business and narrative are cool, it's not growing nearly as fast as other tech IPOs and barely showing the profit growth necessary to excuse a low double-digit growth range. Even despite the beating that Switch has taken in recent months after falling from post-IPO highs, Switch remains a stock to avoid.

The company's upcoming lockup expiration this week will put additional pressure on shares. There will likely be a time in the near future that Switch falls into buyable territory - at around $10, representing 7.4x EV/FY18 revenues, Switch would be reasonably valued. Until then, I'm content to stay on the sidelines.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.