Thesis

Equinix, Inc. is a buy and worth $360, over 75% upside by the end of 2014. EQIX is in the process of converting into a REIT structure which will result in a multiple expansion as the Company will distribute at least 90% of its taxable income to its shareholders, avoiding corporate federal and state taxes.  Additionally, EQIX is one of the best ways to play the growth in big data as its infrastructure is a critical component to the internet and mobile.  For many years, EQIX has outspent cash flows as it was ramping up new data centers and increasing capacity.  These expansion projects have led to IRRs in excess of 30% and the Company is now at an inflection point, as 2013 will be the first year of positive free cash flow. 

EQIX  will grow topline by over 17% annually (80% of the topline growth is already counted for from announced capacity expansions) and expand margins by 500bps (from increased interconnection which come in at 100% incremental margins, CPI price adjustments in contracts over the next three years, and convergence of pricing in Europe to US and Asian markets).  REITs get valued on an AFFO (adjusted funds from operations) basis and by 2015, the Company will generate about $20/share in AFFO.  Given the stickiness and pricing power EQIX has, it should trade at a premium to the wholesale datacenter REITs (a more commoditized business), such as DLR and DFT and, at a minimum, more in line with its other communications peers, such as AMT, COR and CONE, who currently trade at 20x AFFO.  On 2015 AFFO, using a discounted average multiple of 16.5x-18.5x (a discount to peers for arguably a better business), EQIX is worth over $360 a share. 

 Business Description

Equinix, Inc. is a premiere global operator of data centers (currently 97 data centers with about 7MM square feet across 31 markets) for the retail collocation market.  The Company leases out data center space (cabinets, cages, suites) and provides additional value-added services such as equipment installation, maintenance and repair. Through its Platform Equinix, the Company connects more than 4,000 enterprise, cloud, content and financial services companies including 900 network service providers, with no one customer accounting for over 2% of revenues.  With a sticky revenue base, approximately 95% of revenue is recurring in nature, with average contracts for 2-3 years.  Equinix’s customer base includes cloud/IT service customers such as Amazon, Microsoft and IBM (24% of rev); content and digital media including DTV, Google, Hulu, Sony, Yahoo (20% of revenue); finance customers including Bloomberg, CBOE, JPM (22% of revenue); network customers including AT&T, Comcast, Level 3, Verizon (25% of revenue); and enterprise including Gap, Booz Allen, Deloitte & Touche (9% of revenue).

Why now?

In the last two months, EQIX has seen its share price decline from a peak of $231.56 to a low of $176.13 on purely exogenous non-fundamental information.  Investors are overreacting and not taking into the long term secular tailwinds EQIX has, in addition, to its strong, disciplined management team, its global footprint and its ecosystems, which cannot easily be replicated or replaced.   EQIX hit a low of $176 which puts it in line from a valuation perspective with non-REIT datacenter names such as Telecity (TCY LN).  The three recent events that created the volatility was 1) an announcement by Iron Mountain that has created some uncertainty on the potential for a REIT conversion, 2) the spike in the 10-yr yield and 3) Jacobson’s  Ira Sohn presentation on shorting Digital Realty (which is a wholesale data center REIT – but investors don’t differentiate despite EQIX having a very different business model). 

 IRS Working Group – REIT Conversion

On June 6, 2013, Iron Mountain (IRM), who was also waiting for a private letter ruling (PLR), reported earnings and stated that it had a tentative adverse ruling and that the IRS had formed a working group to study which assets should be considerable REIT-able, and that, as a result of this working group, other companies, including EQIX, waiting for a PLR could find their ability to convert delayed.  This led to an immediate decline of over 5% in EQIX’s stock price.  While EQIX is also waiting for a PLR, what happened to IRM is not indicative or should not affect EQIX’s ability to convert to a REIT.  First, EQIX’s planned conversion is for January 2015, giving it 18 months to get the PLR (vs. less than 6 months for IRM who wanted to convert January 2014).  Second, unlike IRM, EQIX has a number of peers who have already converted to REITs.  CyrusOne (CONE) IPO’d and converted to a REIT less than a year ago and the IRS ruled that interconnect would be considered qualifying income.  Additionally, Coresite (COR) which became a REIT in 2010, recently (May 24, 2013) received approval for interconnect revenue to be acceptable as REIT income.  Given that there is already precedent on recent conversions as well as already converted data center RIETS, it is unlikely the IRS working group has any impact on EQIX’s conversion other than delaying PLR.  Third, while it might be prudent business practice (and audit insurance), it is not even necessary to receive a PLR to convert to a REIT.  Fourth, IRS doesn’t make tax code, so it is limited in its ability to make sweeping changes as to what is considered a REIT.  EQIX management is still preparing for its REIT conversion by making significant investments in technology/systems and any other preparations that need to be made (they have not changed/delayed IT system conversions – so clearly management is confident in the conversion – having reiterated the expectation of conversion by 2015).  We have consulted several tax experts, including Robert Willens, and also believe EQIX should convert as expected by January 2015.  We also believe you could get a positive PLR by Q4 or Q1 next year so this is a non-issue.

Rising Interest Rates

On May 22, 2013, Federal Reserve Chairman Ben Bernanke made comments during his congressional testimony indicating that the central bank could begin tapering back its bond purchases (QE) as early as September 2013.  These comments resulted in the rapid rise of US Treasury yields from 2.03% on May 22^nd to a high of 2.63% on July 8^th (an increase of 60bps) and the subsequent decline of the stock market with the biggest hits to the homebuilders, building products and yield stocks including REITs.  EQIX, although not yet a REIT, began to trade in sympathy with REITs and other yield stocks, which along with the above discussed IRS issue, put increased pressure on the name.  REITs, in particular, fell about 13% in a one month period and have only recently stabilized as the Fed has become more dovish in its commentary.  If rates continue to spike – it’s unlikely that this investment works in the intermediate term (note you can hedge a spike in rates against this name with other REITs – DLR for example).  However, given that rates are still relatively low – we believe a gradual change in rates would be positive for REIT/MLP/dividend yielding stocks (especially those that are able to grow at double digit rates with long-term secular tailwinds).

 Jacobson Presentation on DLR

We agree that the wholesale data center category is more commoditized but we don’t agree with his concerns of capex being understated relative to the depreciation of the assets.  I won’t go through a lengthy discussion on this but we believe the economic life for data center REITs are much longer than the useful life used for GAAP purposes and therefore the annual depreciation is a poor proxy for recurring capex.  This will also be relevant for EQIX as recurring capex is much smaller than total capex and annual depreciation. 

Investment Highlights

• Strong Secular Tailwinds

Significant Growth in Global IP Traffic

EQIX is and will continue to benefit from the strong growth in big data and growing global IP traffic, which is expected to increase annually by 30% over the next few years.  As IP traffic increases, more data centers are needed to keep that information flowing. One of the biggest drivers of that IP growth is mobile, from the increased penetration smartphones and tablets.  In 2012 alone, global mobile traffic grew by 70% reaching 885 petabytes per month by the end of 2012 up from 520 petabytes per month at the end of 2011, according to Cisco’s Visual Networking Index (VNI) from February 2013.  The big picture – mobile traffic last year was 12x the size of the entire global internet in 2000 and it continues to grow.  VNI expects that by 2017 global mobile traffic will exceed 10 exabytes with the number of mobile connected devices greater than the world’s 2013 population.

The rapid growth of IP traffic as well as the increased costs to build and maintain in-sourced data centers (including increased power and cooling requirements) is driving demand to outsourced data centers who can offer these services in a more cost efficient manner.  Currently, only about 15% of racks are outsourced on a global basis but that is expected to grow.  One consultant stated that “we’re two years into a 20 year cycle. That demand alone will blow this industry up as far as need goes for real estate for datacenters…demand is gigantic.  EQIX is one of those companies that will get its share.”

 Similarly, cloud computing is also growing rapidly. Currently, the cloud only makes up 11% of data center traffic but should increase twelve-fold in the next five years.  According to the Gartner Group (February 2013), global spending on cloud services is expected to have a CAGR of 17.7% by 2016, further driving demand for EQIX’s global platform. Cisco industry research concurs with this finding, stating, “Global data center traffic is firmly in the zettabyte era and will nearly quadruple from 2011 to reach 6.6 zettabytes annually by 2016. A rapidly growing segment of data center traffic is cloud traffic, which will increase six-fold over the forecast period and represent nearly two-thirds of all data center traffic by 2016.”  Illustrating the magnitude that this revenue growth could have on EQIX’s margins – over the last five years alone, EQIX has increased sales by over 2.5x while also increasing EBITDA margins by 1000 bps.  The company saw the 2^nd largest quarterly booking in its history last quarter.   Many investors confuse this issue and believe that the growth is cloud is a negative for EQIX. In actuality, EQIX is structurally part of the foundation of the cloud as it is the hub of the hub and spoke model (enabler of cloud) and thus will be a beneficiary of the growth trends we are starting to see. 

• Only Provider With a Global Platform - Creates Sustainable Competitive Advantages:

While there are regional datacenter players, EQIX is the only one with a global platform, a structural competitive advantage and barrier to entry.  As noted above, there is rapidly growing demand for infrastructure that can handle the explosion of data usage on a global basis. The charts below indicate that it is the emerging markets, notably Asia Pacific, that are expected to witness the largest growth in mobile data and cloud computing in the next 4-5 years.  With 97 data centers in 31 markets, EQIX is uniquely positioned to handle this growth, while its platform currently allows multi-nationals to deploy internet infrastructure around the world in major markets through only one provider.  59% of their customers are deployed in multiple markets and make the customers highly dependent on EQIX for mission critical IT functions.  EQIX has strategically grown its business and has recently acquired Ancotel (in Germany for Europe) and Asia Tone (Hong Kong, Shanghai and Singapore for Asia) to further increase its international footprint.

• Strong Interconnection Offering and Development of Data Center Ecosystems

Perhaps one of the strongest barriers to entry and competitive advantage that EQIX has is its strong interconnection offering and the development of its ecosystems.  In order to reduce latency and improve speeds and connectivity, customers want to co-locate with their customers/partners.  EQIX offers a carrier-neutral way to do this at extremely high margins.  From its large base of customers, communities or ecosystems (companies that rely on reach other/are partners) have formed and EQIX has organized these by industry vertical including networks and financial services. By putting these customers together, EQIX has created a key differentiator between itself and its competitors and will help to drive interconnection growth. It is this interconnectivity that increases the stickiness of EQIX’s revenue base and increases switching costs, giving EQIX the ability to take some annual pricing, further leveraging its fixed cost base.   Switching datacenters, particularly those with mission critical data, is extremely difficult and costly.  A company would, in essence, need to have two datacenters running simultaneously to test before switching.  It would cost the customer at least 2x for 6-12 months at least – a plus for EQIX has it helps to reduce churn. 

 Additionally, EQIX’s clients see the ability to connect to their customers as a revenue generating activity and thus prefer EQIX as a provider.  About 15% of EQIX’s revenues come from its interconnection offerings currently and as EQIX grows its customer base, the network effect becomes even a greater barrier to entry and increases the stickiness of their offering.       

• Operating Leverage is Underappreciated:

Whether or not EQIX has one customer or one hundred customers doesn’t change the operating expenses much.  This is a high fixed cost business and every incremental customer flows through at very high incremental EBITDA margins (last year as high as 57%).  The full potential of current EBITDA margins is being masked by costs related to EQIX’s REIT conversion, which are one time in nature.  On its current operating base, EQIX should continue to see leverage from improved utilization, increased pricing as well as increased sales force productivity and expects to reach consolidated adjusted EBITDA margins of 50% by 2015 (from 46% in 2012.)  My analysis only uses 47% EBITDA margins for conservatism but the Company has repeatedly reiterated this 50% target by 2015, so there is significant upside to my numbers.  Every 100 bps margin improvement in EBITDA increases AFFO/share by about $0.60 amount.

 Utilization is currently running around 76% so there is plenty of room to add incremental customer while the EQIX continues to add about 5-7% in cabinet capacity.  Additionally, pricing continues to be strong as the Company has been able to consistently raise prices over the last two years. One consultant stated that “[EQIX] hasn’t had pricing pressure. EQIX has been able to maintain and expand margins b/c cost has gone down to build or lease…they are in a very good spot.” Recently the MRR/CE (monthly recurring revenue per cabinet equivalent) has been 4-6% in North America, 5-13% in Europe and 6-11% in Asia.

 In the last two years, EQIX has gone from 100 person sales force at the end of 2010 to 200 at the end of 2012 (expected to end 2013 with 230 sales people).  This huge ramp up has increased operating expenses but the Street is ignoring the significant productivity and sales improvement EQIX should experience going forward as the sales force ramps up to its full potential.  This boost in the sales force should benefit both the sales and operating margin sides of the business.   

•  Strong  and Disciplined Management Team and Strong Brand Reputation

EQIX has a very well regarded management team, considered disciplined and thoughtful by both industry peers and in the investment community.  Former employees and competitors all spoke of management’s disciplined approach to real estate and even to converting to a REIT. As one employee stated, re: REIT conversion, “management did not want to pump the stock. It was a long decision including third parties and advisors.”    Additionally, a former senior manager at competitor DLR noted that “[EQIX] was his favorite strategy and management team in the space and that the team had done a great job with the right people and successfully transitioned to over $1bn [in revenue].”  Investors have also noted how conservative the management team is in their guidance.

 From a client perspective, it’s about reliability, security, and connectivity.  EQIX excels in all three plus has a global platform and has a strong reputation in the industry as the place to store mission critical data or data that requires high connectivity/low latency.  The former DLR employee noted that “ultimately [it] boils down to the difference in service on customer levels. Easier said than done. [EQIX] has made that transition.”  The management team and EQIX’s reputation for reliable service and security are the reasons clients choose EQIX over other peers.

 Well-regarded Shareholder Base

EQIX has a strong base of well-regarded shareholders including a number of Tiger cubs such as Lone Pine Capital and Blue Ridge Capital.  These and other investors, such as JAT Capital and Viking Global, tend to be longer term fundamentally focused. In June 2013, SPO Advisory, a firm known for its long term outlook and few concentrated positions, took a 5.6% passive stake. 

 Valuation

• REIT Conversion Result In Multiple Re-Rating

EQIX is fundamentally a well-run business with a strong management team, a sticky revenue stream and strong secular tailwinds. 

 EQIX filed for its PLR at the end of 2012 and expected to convert to a REIT by 2015 at the latest but with a possibility for 2014.  By 2015, EQIX is expected to generate approximately $20/share in AFFO and $3bn in sales up from $1.9bn in 2012 (about 16.5% CAGR over the next 3 years). This assumes incremental margins at 55% which would expand EBITDA margins to near 50% from 47% currently.   EQIX’s datacenter REIT peers include traditional wholesale datacenters, those that also have retail colocation and the tower companies.   Given the stickiness and pricing power EQIX has, it should trade at a premium to the wholesale datacenter REITs (a more commoditized business), such as DLR and DFT and, at a minimum, more in line with its other communications peers, such as AMT, COR and CONE, who currently trade at 20x AFFO.  On 2015 AFFO, using the average multiple of 16.5x-18.5x (a discount to peers), EQIX is worth over $360 a share, or 75% upside from today by the end of 2014.   Potential upside to the multiple includes the possibility that EQIX would be added to the REIT indices, making it part of the benchmark so REIT investors would have to own it. This would happen in the first year or so after the conversion.

 While management won’t discuss the REIT conversion process itself (no updates since PLR files), we remain confident that EQIX will convert into a REIT, given the strong precedence of other datacenter REIT conversions – most recently CONE and COR.  The CEO of COR stated that it, DLR and EQIX are all in front of IRS right now to get IRS to recognize interconnection revenue as REIT income.  COR’s management felt confident about the chances that interconnect could be considered reit-able income, another benefit to EQIX.  Nevertheless, if EQIX is unable to convert to a REIT, downside is limited given its strong business trends and on an EV/EBITDA basis would be worth $290 at the end of 2014 – huge risk reward. 

Even without a REIT conversion, EQIX is a great value, trading at 25% discount on an EV/EBITDA basis vs. non-REIT datacenter peers.   Thus, there is limited downside to the name at current prices based on valuation, but also because of its long term secular tailwinds, strong, disciplined management team, global footprint and ecosystems, which cannot easily be replicated or replaced.  

Risks

• EQIX does not receive PLR or convert into REIT
• Interest rates continue to rise – at a similar rapid pace
• Churn was 3% in Q4 which is still low but this could tick up due to macro or other factors
• Pricing has been robust but with industry capacity increasing this could slow

• EQIX receives PLR/converts to REIT
• Earnings announcement - July 24, 2013