Description

Summary Overview

CyrusOne (ticker “CONE”) is the data center subsidiary of Cincinnati Bell (ticker “CBB”).  CBB recently closed an IPO of ~30% stake in CONE as a REIT on January 24, 2013.  CyrusOne is a high quality business: recurring revenues under multi-year contracts, diversified & sticky customer base, high returns on capital, and ~20% growth with favorable secular trends.  CyrusOne is a better business than comparable data center REITs and should grow faster, yet trades at a significant discount.  I believe this opportunity exists because of: (1) management’s incentive to price shares conservatively in the IPO (discussed later) and (2) equity research has not been available until very recently (February 12^th) (banks involved in the IPO must wait 25 calendar days from pricing before publishing research).  I estimate shares are worth $32-35 within 1 year (approx. 45-55% upside).  I also believe there is likely significant strategic interest in CONE from companies such as Digital Realty and CoreSite, which could derive significant financial and strategic benefits including an improved footprint, higher growth, and earnings accretion due to synergies and relative valuation discrepancies.

Quick Business Overview

CyrusOne owns / operates a portfolio of 23 data centers, which are mostly located in Texas (Houston, Dallas, Austin) and Greater Cincinnati.

• 1.63M of net rentable square feet, of which ~896K is colocation space, powered by 125 megawatts of power
• Space is currently 78% utilized
• Diversified customer base with no one customer >7.3% of revenues
• Top 20 customers (~60% of revenues) have weighted average lease term of 2.6 years remaining
• Largest end market is energy (~40% of revenues).  CyrusOne counts 5 of the 6 “Supermajor” oil companies as customers.  Industry pundits generally believe North American energy will be an area of secular growth.  Based on our checks, large energy customers have little desire to spend capex on in-house data centers, which they view as non-core.

CyrusOne benefits from several secular tailwinds:

• Explosive growth in internet traffic – IDC estimates end user-generated Internet traffic to grow at 63% CAGR through 2015
• Increasing demand for outsourcing – IDC estimates that only 10% of large U.S. enterprises use 3^rd party data center colocation

Basic financial info:

• LQA Revenue: $227M as of Q3 2012 (LTM revenue growth rate 20%)
• LQA EBITDA: $114M as of Q3 2012 (50% margin) (note: this is PF for additional stock-based comp that will be flowing through the P&L)

I view LQA as a good way to show run-rate earnings given recurring nature of earnings and high growth trajectory.

Investment Thesis

CyrusOne is a better business than data center REIT comps, but trades at a discount to the comps:

• CyrusOne has industry-leading Return on Assets (which we measure as LQA EBITDA-Maintenance Capex / Gross Real Estate Value excluding developments):
  • CyrusOne: 14%
  • CoreSite: 10%
  • Digital Realty: 9%
  • DuPont Fabros: 8%
• CyrusOne has superior organic growth prospects because run-rate expansion capex, relative to the size of the company, is much larger compared to peers.  If we compare run-rate growth capex as a % of EBITDA:
  • CyrusOne: 217% (based on $240M of 2012E growth capex)
  • CoreSite: 119%
  • Digital Realty: 100%
  • DuPont Fabros: 97%
• If they can generate 14% cash on cash yields, this adds $240m x 14% = $33.6m of EBITDA (note: maintenance capex requirements are minimal) or 30% increase to run rate earnings.  Of course it may take some time to ramp leasing and maybe their future ROA compresses, but even so, growth should be pretty robust.
  • A natural question is how do we know there is enough demand to fill new expansion?  Based on discussions with management, ~70% of growth comes from the existing customer base.  Thus, the company has a pretty good pulse on current customer needs, and this informs the capex pipeline.  CyrusOne also recently disclosed their largest revenue backlog ever Furthermore, I believe CyrusOne was previously capital constrained as a wholly-owned subsidiary of CBB because growth capex was being funded at the parent telco’s high cost of debt and equity.  I believe CONE is playing a bit of “catch-up” on capex build now that it is now a self-funding independent REIT.
• However, CyrusOne currently trades at a discount to its peer set.  TEV / LQA EBITDA multiples:
  • CoreSite: 18x
  • Digital Realty: 17x
  • DuPont Fabros: 15x
  • CONE: 14x
  • CoreSite and Digital are the most relevant comps.  DuPont Fabros has idiosyncratic customer concentration issues: its 3 largest tenants (Yahoo!, Facebook, and Microsoft) account for 55% of rent.  These are customers which probably have the ability, and perhaps even the desire, to in-source some data centers.  DFT recently announced some unfavorable lease restructuring for some of its largest customers in Q3 2012.

I believe there would likely be strategic interest in CyrusOne from companies such as Digital Realty and CoreSite

• Digital Realty has the lowest cost of capital in the sector.  In January 2013, they issued 12yr unsecured notes at 4.25% and in September 2012, they issued 10yr unsecured notes at 3.625%.  Digital has also expressed a desire to do more acquisitions, and CyrusOne would be a very complementary fit.  Digital could acquire CONE in an accretive deal at significantly higher prices.
• CoreSite is the least levered name in the space.  The company has explicitly stated it intends to increase its leverage level from 1.6x debt to annualized EBITDA to 4x.
• In general, further industry consolidation would decrease the risk of potential over-supply

Margin expansion opportunity

• CyrusOne is currently operating close to all-time low utilization (~78%) while it used to operate pretty consistently in the high 80%s.  As the company continues to lease up its assets and approach higher utilizations, we would expect margins to expand.

Longer-term opportunity to optimize balance sheet

• CyrusOne is currently among the least levered data center REIT, with Net Debt / LQA EBITDA of 2.2x.  Leverage levels for comps:
  • Digital Realty: 5.8x
  • DuPont Fabros: 5.2x
  • CoreSite: 1.6x (however, as mentioned earlier, the company intends to reach 4x)
• CyrusOne’s net debt of $247M is comprised of $612M of debt and $366M of cash.  CyrusOne intends to use its balance sheet cash to fund future capex, so net debt will increase over the next few quarters.  But assuming run-rate EBITDA is $144M by the end of 2013, and net debt increases by $200M for growth capex, CONE is still 3.1x Net Debt / LQA EBITDA, which is still under-levered relative to the comps.  Depending on the company’s future capex plans, there may be an opportunity to lever up and repurchase shares, especially if the company’s trading multiple remains low.
• CyrusOne recently issued unsecured bonds in November 2012 at a 6.375% coupon.  This coupon is high given the predictability of cash flows and low leverage.  CONE would likely be able to refinance these at a lower rate in the future.  These bonds currently trade at 106% with 5.4% YTW.

Why Does This Opportunity Exist?

• CyrusOne was formerly wholly-owned by Cincinnati Bell (CBB).  CBB also owns a mature (but cash generative) telco that is highly levered.  CBB’s stated intention is to continue growing CONE and sell additional stakes to the public after the 1yr lockup to de-lever the parent telco.  Thus, I believe management’s incentive was to price shares conservatively in the IPO because (1) CBB still retains a large stake, (2) management likely wants to ensure a shareholder base that would receptive to buying shares in the future.  The CONE IPO was reportedly extremely oversubscribed.
• Equity research was not available on CONE until very recently (February 12^th).  Banks that participate in the IPO must wait 25 calendar days after IPO pricing before they can publish equity research.  Morgan Stanley and Bank of America were book-runners on the IPO.  The co-managers were: Deutsche Bank, Barclays, Citigroup, Keybanc, RBS, and UBS.
• Small public float of ~$420M.  CBB owns ~69%, most of which is in the form of OP units.

What is the Opportunity?  (1yr Price Targets)

• I estimate that LQA EBITDA will be ~$120M in Q4 2012
• If we assume 20% growth in 2013, CONE will run rate $144M in EBITDA by end of 2013
• I estimate company will spend ~$200M in growth capex in the next year, bringing net debt balance from $247M to $447M

• If CONE trades in-line with comps:
  • $144M EBITDA x 17x = $2,448M TEV - $447M of net debt = $2,001M of equity value / 62M shares/units = $32.28 (45% upside)
• If CONE trades at the high end of the comps:
  • $144M EBITDA x 18x = $2,592M TEV - $447M of net debt = $2,145M of equity value / 62M shares/units = $34.60 (56% upside)

Catalyst