Description

21Vianet Group (VNET)-NASDAQ

Company Overview

21vianet is China’s leading independent IDC (internet data center) player. It offers carrier-neutral IDC and networking solutions to internet clients. It started with traditional co-location IDC business (aka Equinix), and in 2013/2014 introduced cloud partnership with MSFT/IBM by offering cabinets to the public/private cloud services. In H2 last year, it carried out a series of acquisitions, including CDN provider iJoy, broadband ISP company Aipu, and regional VPN provider DYX. We estimate at the moment on run rate basis traditional IDC biz is down to <50% of its topline, with the rest from cloud, CDN, VPN and ISP.

In late last year, it was attacked by short seller report Trinity Research, with the share price dropping from peak of $30 to trough of $15. It later introduced strategic investors Xiaomi/Kingsoft etc to re-boost investor confidence and mitigate financing risk.

Summary of Views

Share price had dropped 10% sharply due to poor Q1 results, but soon after rallied 20% in the past few days. We believe the market is significantly overvaluing VNET and missing a few fundamental points, by pricing in an unrealistic buyout scenario:

- Privatization is not doable, due to structural/regulatory hurdle

- Organic growth is much lower than what's reported on paper

- Co will likely miss FY results despite maintaining the guidance blindly

- Cash flow pressure is mounting in 12 months, despite recent equity financing injection

Overall our analysis shows, excluding any buyout speculation, with the weak organic growth, muted cloud performance and mounting cash flow pressure, VNET should currently trade at 12-13x EBITDA (or $14-15 per ADS), a near 30% downward potential from current trading. We recommend a SHORT.

Privatization is near impossible due to license/regulatory hurdle

The market has seen quite a few US-listed China stocks to privatize and return to home market (CMGE, TAOM, WX etc). We believe VNET is currently priced in a privatization scenario too, despite the weak Q1 results and Q2 guidance.

A main reason for the recent wave of Chinese ADRs privatization is the huge multiple arbitrage potential by re-listing in the domestic market (Take IDC and CDN peers for example, VNET is trading at 15x EBITDA'2015 vs peers Wangsu and Sinnet at 30-50x EBITDA). Note that VNET is not in a distressed valuation, and re-listing in other markets such as HK wouldn't be attractive enough.  PRC domestic market exit has to be the preferred option for a take-private to work.

However, only 2 types of company structures are allowed to IPO in China domestic market: wholly domestic onshore structure, or sino-JV structure. VIE structure is not allowed, with no precedent. Therefore, companies are all rushing to remove the VIE structure and become one of the two structures (a well-known case is Focus Media, which after the privatization, removed its VIE and is close to re-list in domestic market, with financial sponsors close to double their money in 2 years, per our check).

Then there is a problem. internet infrastructure companies such as VNET operate on telecom VAS licenses, and these rarely allow foreign ownership (people familiar with VIE structure would understand it was invented exactly for this purpose so companies in the sensitive/restricted industries can get around to list overseas). Our checks with multiple IDC, CDN and Cloud computing players confirm that there is no precedent case of IDC license owner with foreign equity ownership. It has not been done, and possibly can't be done. Those we disagree are welcome to approach the IDC players or local regulators.

What this means is, for VNET to re-list in China, all its major investors today with offshore entities (including Xiaomi, Kingsoft, Temasek, Fidelity etc) do not qualify. They would either object to any deal (~40% voting power), or they would not roll over but sell out, which means 1) terminating Xiaomi/Kingsoft strategic biz collaboration, and 2) the required source of capital for a buyout is much bigger/more challenging. We believe it would be hard for mgmt to accept 1+2 together.

The same reason would also limit the buyer universe to funds with PRC vehicle / RMB buying power (who are able to exchange to USD to invest overseas). This is a much smaller buyer universe.

Finally, we also note that room for financial engineering is limited due to current high leverage. Given the aggressive capex expansion plan, any potential LBO bidders may not be able to bid as high as market expects. Our math says $20, but it’s early to tell.

Board member change

Current buyout speculation may also be partly fueled by the announcement of two newly appointed Directors, Erfei Liu （ex banker）and Steve Zhang (CEO of Asiainfo, which was taken private in 2013). While market may believe these seem like preparations for potential take-private, our objective analysis tends to believe that Steve is likely appointed by Temasek as its representative, not necessarily for privatization. Our search resulted in a potential link between Temasek and Steve, as our study shows Temasek was a consortium member in taking Asiainfo private, where Steve was CEO and now vice Chairman (see company website).

As for Liu Erfei, we believe he is brought in to replace Jenny Lee who was early VC investor before IPO and just stepped down as fund life is expiring (but with ~5% to sell down still). A banker-for-venture-capitalist swap is understandable to strengthen the financial expertise of the Board, given that financing is a key topic of such infrastructure biz.

Organic vs M&A growth

On first glance people may think the Q1 and FY guidance is fine (30-50% growth YoY). However, a closer look is quite scary. People need to understand that the company has undertaken major M&A deals in H2 last year. At Q1 earning call, CFO admitted the IDC segment numbers include DYX VPN contribution, and MNS segment includes Aipu ISP contribution etc.

On pro forma basis, core IDC biz likely only grew ~10% in our estimate (deducting last reported run rate numbers from acquired biz), which is shockingly low for so-called industry leader in a structurally high-growth industry (+20%). Compared to the +50% growth of domestically listed domestic peers, VNET is falling behind.

Cloud Mystery

In the Q1 earning call, CFO quoted MSFT Cloud Q1 revenue of $10m and FY target of $50m. We do not understand what the market is so excited about this, as implied QoQ run rate is just 10%, compared to other cloud service peers in China (Ali Cloud planning +20% QoQ).

Given the sequential run rate, we believe it is either due to MSFT is struggling to penetrate the mass market hence is driven by a few key accounts, or that MSFT is really paying VNET service fee income rather than volume-linked revenue sharing. Either way, we believe it highlights the difficulty for MSFT Cloud to ramp up in China (our checks suggest that up to 70% SOE and gov-related entities are buying WPS instead of Office 365, and MNCs procurement are being placed from their global HQs which does not come to VNET China part), when its competitors AliCloud, UCloud and Kingsoft Cloud are all growing rapidly.

We therefore believe the Cloud premium should be rather limited on the stock. If our hypothesis is true, cloud is becoming a managed service fee income for VNET, instead of high-growth transformative biz as people anticipated.

Lastly, our channel checks show that cloud is also impacting the IDC biz. While people focus on recent development of Alibaba cloud entering CDN market and slashing price, Alibaba Cloud is also enhancing its capability to serve the SME and new start-ups, which over time will eat into traditional IDC biz, in our view.

Cash flow Gap

Though it appears at first sight the co has a lot more cash on BS by Q1, a closer look will conclude otherwise. As we try to project the cash flow math, we come to realize a future funding gap by end of 2016:

- Aggressive IDC capex plan: to meet growth target (likely 250-300m RMB per quarter, calculated based on the quarterly cabinet new add plan)

- M&A earn-out: Aipu/DYX mgmt is entitled to put back remaining stake to VNET for 2 years post first closing, likely 1.5b RMB

- Likely pressure to re-pay historical Dongguan gov JV cash deposit and HK wireless spectrum fees (estimated +RMB 1b), as no progress has been reported on those initiatives for almost a year, progress is likely slow or stopped

- We estimate the first Dim Sum Board re-payment will also be due in 2016, at +200m RMB

Assume VNET can generate the EBITDA it guides, RMB 750-800m per year. Given its latest reported net cash position of 700m RMB, it should run into funding gap by end 2016 / early 2017

We estimate its current credit stats is already tight, likely 4-5x net debt / EITDA and 2-3x EBITDA/Interest, so the co has little room to raise further leverage to finance growth.

Annual Guidance

Despite Q1 and Q2 weak guidance, the co maintained initial FY guidance, arguing the H2 would be stronger. However, our reading of the results indicates the weakness is broad-based, not only on traditional IDC (possibly sequentially flat) and MNS (continue to drop rapidly), but also newly acquired biz (iJoy CDN, Aipu ISP and DYX VPN).

Take the original MNS biz for example, CFO commented it will be flat in 2015, we disagree as it has shown as number of quarters continuous decline, and our channel check indicates the bandwidth pricing drop is continuing, so we struggle to understand why MNS is down sequentially but would manage to remain flat on FY basis.

We tend to believe it is not a co-incidence that the company just started consolidating results from newly acquired biz Aipu/DYX, and suddenly it missed its guidance for the first time since IPO. Since theoretically the IDC biz would be quite steady with good visibility, the only logical explanation would be it is due to the new business beyond their own control and budgeting capability, especially Aipu and DYX which is run by separate mgmt teams.

We note the ongoing open-up of broadband access market and view it negatively in the short term for existing ISP biz like Aipu (a sizable portion of VNET topline). If without sufficient funding to grow subscriber base (with the cash flow constraint above), existing ARPU will continue to fall to pressure topline. Similar story for DYX's VPN biz. We remain negative on the outlook of this two business, and believe mgmt made poor M&A decisions. Despite the earning and equity dilution cost to finance the deals, they have not shown strategic benefits or bandwidth cost reduction that mgmt claimed.

We therefore believe VNET is highly likely to disappoint again next quarter with weak Q3 guidance and hence likely to miss FY guidance. Our own analysis by quarter and segment suggests 720-750m RMB of EBITDA is more likely for FY2015 (vs guidance of 850m)

Overall Conclusion

The current $20 share price would imply 18x EBITDA, which is very aggressive compared to global peers like Equinix. We believe given the weak guidance and weak organic growth engine, a 12-13x multiple is more deserved, which implies $14-15 share price instead.

We argue that the company no longer deserves a much higher multiple premium given 1) its slow organic growth, and 2) it has become more diversified to include broadband ISP, CDN and VPN. Traditional IDC biz (which has higher visibility) is only ~50% of total run rate now, in our estimate. A SOTP analysis would support our argument (especially with slower Cloud growth).

We therefore see price target of $14 and near 30% downward pressure at current price of $20.

Catalyst

People realize regulatory hurdle to achieve take-private and A-share exit arbitrage

Weak Q2 results and subsequent lowering FY guidance

Subsequent signs of cash flow constraints, Cloud weakness, and other biz execution issues (ISP, VPN etc)