Switch: No Longer Growing

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About: Switch, Inc. (SWCH)
by: Gary Alexander
Summary

Shares of Switch rose 7% after reporting Q4 results, despite missing revenue expectations.

Revenues grew just 4% y/y this quarter, decelerating one point from last quarter's 5% y/y growth.

Note also that churn has been on the rise, up to 0.4% from 0.3% in the year-ago quarter.

Despite the revenue weakness, investors cheered Switch's massive GAAP profitability ramp plus modest adjusted EBITDA growth.

Switch (SWCH), the operator of colocation centers and data facilities, has just reported a mixed end to its fiscal 2018. Since its IPO, momentum in this stock has lost substantial steam. Recall that when Switch went public in late 2017 at a share price approximately double where it was today, the story was all about a differentiated data center experience that was generating double-digit growth in recurring revenues via expanding to ambitious new campuses. Now, however, it seems that the company has hit the brakes and focused more on its profitability, as revenue growth has weakened to the single digits.

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In the year to date, Switch has recovered generously (40% YTD) from its December lows, but I find it difficult to believe that the stock can ever recover to its post-IPO highs in the mid-teens. Switch has largely lost the technology angle, and investors are viewing it more as a specialized real estate company that rents out server space to enterprises. While a profitability/EBITDA story has started brewing in light of a lower valuation (thanks to the stock's precipitous decline since the fall), it's challenging to invest in a company that is posting such anemic growth.

In my view, investors would be wise to continue avoiding this stock. Switch has been a constant underperformer since its IPO, and despite a modest valuation today compared to last year, the deterioration in the share price is a fair reflection of its lackluster prospects.

Can Switch hit even modest growth in 2019?

Let's look ahead to Switch's fiscal 2019. The company's latest guidance summary is below:

Figure 1. Switch FY19 guidance

Source: Switch Q4 earnings release

Its revenue guidance range of $436-445 million represents a growth range of 7.5-9.6% y/y against this year's revenues of $405.9 million, and is several points lower at the midpoint relative to Wall Street's consensus of $449.9 million (+10.8% y/y). Yet, if we look at this quarter's growth rate of 3.9% y/y, we have to wonder if Switch can even hit its high-single digit growth target for the coming year.

By far the most important source of growth for Switch is the addition of new "Primes," which is what the company calls its colocation facilities. Erin Morton, company president, gave a useful update on the Q4 earnings call on the progress of facility construction:

During 2018, we opened one sector at our Core Campus and two sectors at our Citadel Campus. We also significantly expanded the land footprint of The Citadel Campus with the acquisition of 722 acres of land. An additional sector in The Pyramid Campus was also opened in 2018. Most importantly, we advanced construction on The Keep Campus in Atlanta. The walls of the first data center are up, and it is on schedule to be opened for customer deployments in late Q4 2019."

Essentially, Switch currently has plans to expand into just one new Atlanta location in 2019 and only in the fourth quarter of next year. The rest of the growth has to come from a pickup in business in its existing facilities.

Even this is not a guarantee. Last quarter, CFO Gabe Nacht disclosed that utilization rates at the Pyramid campus declined as the company built out the facilities.

The bottom line here: how can we expect Switch to suddenly maneuver to ~8-10% y/y growth in FY19 when it exited Q4 at a 4% growth rate, and when the only new campus is expected to go live in the fourth quarter of next year? Unlike many recent IPOs, Switch isn't exactly a conservative guidance giver: the company has missed revenue expectations on multiple occasions. The same situation is very likely to recur in 2019.

Q4 download: GAAP profits dazzle, but churn weighs on revenue miss

Here's a deeper look at its fourth-quarter results:

Figure 2. Switch 4Q18 results

Source: Switch Q4 earnings release

Revenues grew just 3.9% y/y to $103.2 million, missing Wall Street's expectations of $104.2 million (+4.9% y/y) by 1 point. Note also that Switch has a long history of missing revenue expectations, and this is the fourth quarter in a row that the company has disappointed investors (as shown via its earnings history on Seeking Alpha - screenshot below):

Figure 3. Switch earnings history

Source: Seeking Alpha

One of the biggest factors to watch here is churn, which is a measure of customer retention. Switch's churn rate ticked up to 0.4% this quarter, up from 0.3% in the year-ago quarter. While this rate is still below the company's three-year average of 0.7%, it's still a large percentage increase that can have an impact on revenue growth.

Consider the fact that big deals drive the majority of Switch's business. CFO Gabe Nacht commented as follows on the Q4 earnings call:

Our 15 largest customer transactions in Q4 accounted for 78% of total contract value and resulted in incremental annualized MRC of more than $7 million."

Switch is subject to classic customer concentration risk - churn from any of these large customers could have an outsized impact on Switch's financials. A similar failure by Cloudera (CLDR) to keep up its retention rates earlier in 2018 caused the stock to plummet nearly 50%. We've seen from commentary surrounding the Pyramid campus that utilization rates can also drop as facilities expand. A single non-renewal could have disastrous impacts on Switch's 8-10% y/y growth targets in the coming year.

Profitability, on the other hand, was the counterweight that prompted many investors to cheer for Switch's fourth-quarter print. Adjusted EBITDA rose 5% y/y to $53.7 million, representing a 52.0% margin - up 60bps from 51.4% in the year-ago quarter:

Figure 3. Switch Adjusted EBITDA

Source: Switch Q4 earnings release

Note also that GAAP net income swung positive this quarter to $2.6 million, up from a loss of -$67.0 million in the year-ago quarter. One risk to watch out for here, however, is interest rates. Switch's total debt and capital obligations as of the end of Q4 amounted to $606 million, or approximately 2.8x its forward EBITDA projections, making it a fairly leveraged company. Further capex requirements to build out the Atlanta campus may require additional debt financing. The company's floating-rate debt is subject to the expectation of continually rising LIBOR rates; at current debt levels, a 1-point rise in LIBOR could swing GAAP net income by $6 million.

Key takeaways

There's little reason to invest in Switch as it returns above the $10 mark. The company has effectively ceased growing, with its top line slipping to just single-digit growth, and with a facility expansion not expected to hit until the fourth quarter of the coming fiscal year, this story isn't likely to change much in FY19. Steer clear of this stock.

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.