Switch: Switching Off The Momentum; More Downside Ahead

Summary

• Switch reported Q4 results that were below expectations and continued on the revenue deceleration trend seen since Q1.
• 2021 revenue and adjusted EBITDA guidance were both meaningfully below expectations.
• This is a capital intensive business and with net leverage currently at 3.4x and rising, the company may need to raise some debt to remain competitive.
• Valuation is currently over 15x forward EBITDA, which seems a bit higher for a 6% EBITDA growth company with utilization trending down and leverage trending up.

Switch (SWCH), a co-location company that rents out server rack space to other enterprises, reported a disappointing Q4 in addition to providing 2021 guidance well below expectations. The stock enjoyed a nice 70%+ run after their March 2020 lows as the buzz words of "cloud" and "digital transformation" resonated in the market. However, the company simply provides the servers and real estate capacity to handle companies transition to the cloud and do not directly help companies move their applications to the cloud.

Q4 revenue grew 6% compared to the year ago period, though missed consensus expectations for ~9% growth. While EPS beat by $0.01 during the quarter, there are more concerns around future growth. 2021 revenue guidance missed consensus by ~$25 million, or ~5%. In addition, the company is forecasting adjusted EBITDA growth of only 4-8%.

Not surprisingly, the stock has taken a big hit since reporting earnings, trading well below their recent high of ~$19. However, I believe the pullback was overdue considering the company has consistently seen their revenue growth decelerate since Q1.

2021 revenue guidance was well below expectations and adjusted EBITDA growth of 6% is not very impressive. On top of that, the company is expecting another year of capital expenditures running higher than adjusted EBITDA. When combined with their $50 million of annual dividend payments, I would not be surprised to see the company raise additional debt, on top of the $1+ billion debt level and ~3.4x net leverage.

With valuation currently above 15x forward EBITDA, I believe investors would continue to be better off on the sidelines and waiting for a better entry point. The company has potential long-term growth considering the number of enterprises moving to the cloud, but this is a capital intensive business which has been under some pressure as of recently.

Q4 Earnings and Guidance

Revenue during the quarter grew 6% to $127.7 million, which was ~3% below consensus expectations for ~$131.4 million. The company has seen their revenue growth decelerate rather quickly from the ~19% growth in Q1. Management noted that part of the revenue miss was due to two customers migrating to the public cloud, however, this could be a sign for more customer migrations to happen in the future.

Fourth quarter 2020 revenue was affected by two customers opting to migrate a portion of their application stack to a public cloud environment. This resulted in an approximate $3 million reduction in fourth quarter revenue and an approximate $18 million reduction to 2021 projected revenue. The full effect of these customer reductions will be realized in the first quarter of 2021. (source: company presentation)

It's important to note that these two customers saw value in moving to the public cloud given some of their workloads were low power density and had low security requirements. While some of their applications will remain with Switch, there are many enterprises around the world who are not only looking to move to a cloud model, but likely deploying a hybrid-cloud model. With the low power workloads better suited for the public cloud, the company could be faced with lower demand from companies looking to completely outsource their applications to a private cloud.

Source: Company Presentation

Adjusted EBITDA during the quarter grew 22% and represented a 55.2% margin, up from the 47.8% margin seen in the year ago period. While this is good progress in terms of margin expansion, the company could face some heightened pressure in future margin expansion.

Source: Company Presentation

The company's billed utilization rates dipped to 69%, the first time the company has seen them below 70%. As the company continues to build new facilities, they are struggling to fill their servers with enough demand. This could put the company in a situation where they garner a lot of real estate and server capacity, but are unable to fill that demand, leaving them with slimmer margins. While some may argue that the company is building out capacity for future demand, we saw just this part quarter that revenue can become volatile if customers leave for the public cloud.

Source: Company Presentation

The company provided 2021 guidance, which included revenue of $540-555 million, which represents 7% growth at the midpoint, though came in well below expectations for ~$573 million. Management also noted that they are in good position when it comes to their inventory and anticipates any supply constraints to be alleviated by 2022.

From an inventory standpoint, a significant amount of space and power is being reserved for our record backlog of large customer installations, which reduces the remaining quantity of sellable capacity in 2021. We fully anticipate that these capacity constraints will be alleviated over the course of this year and into 2022, driving a normalization of our growth rate in future periods. (source: company presentation)

However, I believe their backlog may take a long time for them to actually implement. In fact, management has even talked about how COVID has impacted the timing and magnitude of their backlog conversion. Even though the company's backlog and wins seem to imply growth in future years, this is a capital intensive business that carries some risk.

For 2021, management is also expected adjusted EBITDA of $278-290 million, which is only ~6% above 2020 adjusted EBITDA. This implies adjusted EBITDA margin of ~51.9% for 2021, slightly below the 52.5% margin seen in 2020. The biggest concern I have is the company continuing to spend more on capex than what they generate in adjusted EBITDA. 2021 seems to be a similar story with capex (excluding land acquisitions) of $330-370 million.

Capital Structure Review

With the stock down over 20% since the company reported earnings, I believe investors might take a closer look at not only the future growth of the company, but the capital structure and capital intensity. Revenue and adjusted EBTIDA growth will be slower in 2021 and it appears that even as the company expands their footprint, their utilization continues to tick down.

Source: Company Presentation

At the end of Q4, the company boasted a rather large debt balance of $1.05 billion, which is pretty large considering the current market cap is ~$3.35 billion. With the company's cash balance now at $91 million and 2021 expecting to be another large year in capital expenditures above adjusted EBITDA, they might need to raise some additional debt at some point.

In addition, the company notes their net leverage to be 3.4x at the end of Q4, however, the company's calculation only annualizes the most recent quarterly EBITDA. If we were to look at the 2020 adjusted EBITDA of $268.3 million, this would imply a net leverage closer to ~3.6x.

When looking at valuation, it's best to look at EV/EBITDA multiples as this helps adjust for the company's large debt levels. In addition to looking at historical multiples, we can take a comparative look at Equinix (EQIX), one of the company's most direct competitors.

The company current has a market cap of $3.35 billion and net debt of $958 million as of the end of Q4, leaving the company with a current enterprise value of ~$4.3 billion. With the company guiding to 2021 adjusted EBITDA of $284 million at the midpoint, this implies a current 2021 EV/EBITDA multiple of ~15.1x.

In my view, this is a rather expensive multiple to pay for a company who guided to 2021 adjusted EBITDA growth of ~6% on top of the company's net leverage continuing to increase. At this rate, the company may need to look at other debt vehicles in order to fund their capital expenditure requirements, which remain above their projected adjusted EBITDA levels.

On top of capital expenditures, the company also pays a quarterly dividend of $0.05 per share, which equates to nearly $50 million of additional capital outflow per year. I believe the company will have to reduce their capital expenditures by spending less on facilities and/or expansions, cut their dividend, or raise some additional debt, which could be expensive given the company's current leverage.

For now, despite the 20% pullback in the stock since reporting earnings, I believe the stock could be under continued pressure over the coming quarters. Yes, the movement to the cloud has benefitted the company, but if companies decide to use more of the public cloud for their applications, demand could suffer a bit. I would not look to buy the dip at these levels and believe the stock could be on a path towards a sub-$10 price in coming weeks.

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.

Comments

[Slade_01]

In retrospect, not too great a call. Bearish, and it went up over 100%.

[Zzzen]

Great earnings posted today. Looks like a team of you have been posting short garbage here for months but this stock is resilient and doesn’t fall. It must frustrate you. Keep eating the crumbs fed by your overlords 😂😂😂

[getrichslow]

This writeup was published within 48 hours of the 52 week low. Up roughly 25% since then.

[Slade_01]

@getrichslow It just kept going up, what a terrible call!

[Long_investing_horizon]

@getrichslow
And more than a double up these days! The Author nailed a bottom pretty well:)

[GCBanalyst]

“While some of their applications will remain with Switch, there are many enterprises around the world who are not only looking to move to a cloud model, but likely deploying a hybrid-cloud model. With the low power workloads better suited for the public cloud, the company could be faced with lower demand from companies looking to completely outsource their applications to a private cloud.”

This statement demonstrates a clear lack of understanding of how Switch and other Colocation providers fit into the overall hybrid cloud ecosystem. Switch’s data centers provide the space, power, cooling, and telecommunications infrastructure that enable enterprise customers to deploy their own “private clouds” using hardware from vendors such as Dell, VMware, Nutanix, Cisco, etc. Colocation data centers like Switch are increasingly the preferred way for enterprises to establish a “hybrid cloud” footprint as they offer low cost, secure connections between the enterprise’s “private cloud” and a third party public cloud like AWS, Azure, or GCP. Switch also provides data center space to the public cloud players themselves, making enterprise hybrid cloud workloads even more seamless, secure, and resilient given the physical proximity between the enterprise user and the public cloud compute nodes. To sum it up - if you are bullish on hybrid cloud, you should be bullish on Switch.

To your point on capex - yes, the data center colocation business is capital intensive. It’s key inputs are concrete, steel, electrical circuits, and fiber optic cable. This industry is a far cry from software and thus should not be analyzed or valued as such. In comparison with its peer group (EQIX, DLR, CONE, COR, QTS) Switch has the lowest net debt to EBITDA ratio, a below average capital intensity ratio (CapEx / Revenue), and industry leading returns on capital.

Valuation - when valued through the lens of a high growth software framework, sure, 15x EBITDA may seem expensive for a company growing revenue low double digits (11.5% 5yr CAGR, all organic). But compared with its peer group Switch trades well below the peer average valuation of over 20x EBITDA. This is despite having the highest organic growth and by far the highest per share growth since it’s IPO, as it has not once needed to issue dilutive equity to fund its growth or dividend payout.

Full disclosure - I am VP of Investor Relations at Switch. I would appreciate the opportunity to speak with you (the author of this article) to establish a dialogue about the company and colocation industry at large. Prior to Switch I was a sell-side analyst for several years covering data center and cell tower REITs, and believe I could help improve your knowledge of the sector. I have no issue with you publishing negative opinions on the company, but it will benefit both of us if your research is free of factual inaccuracies and a more informed industry viewpoint. Please message me back or look me up on the Switch IR website if you would like to connect. Thanks

[jhojho]

@GCBanalyst I stopped reading after this -

However, the company simply provides the servers and real estate capacity to handle companies transition to the cloud and do not directly help companies move their applications to the cloud.

[GCBanalyst]

@jhojho Switch does not provide servers or any other form of hardware for our enterprise customers. As I mentioned in my response, Switch provides the space, power, cooling, and network connectivity infrastructure for the customer to deploy its own hardware. Our revenue is based on the physical footprint, power capacity, and connectivity that a customer requires to operate its workloads. This is an important distinction, because the data center infrastructure Switch builds is a long lived asset on our balance sheet with a decades long useful life. Hardware, such as servers, is a 2-3 year asset that needs to be replenished frequently, which results in a high degree of ongoing "maintenance capex". The actual data center infrastructure has very little ongoing capital requirement once the building is fully completed. This allows Switch to use the free cash generated by each mature data center to provide growth capital for funding construction on new data centers, creating a portfolio that is constantly harvesting cash from seasoned, high return assets into new assets that will eventually fill and flow cash, so on an so forth.

[theCash]

@GCBanalyst Thank you for your enlightening comments!