Description

Internap (Ticker: INAP), dba INAP

$0.96/share

Bankruptcy or multi-bagger. 

Warning: This is a pure speculative event bet and is a nanocap company. It is heavily distressed. Bankruptcy is reasonably likely, but...

When crawfordsville wrote INAP up last summer, I was less fundamentally optimistic than him, though already interested. My view was and remains this is essentially an attractive option on non-bankruptcy and should be treated and sized as such. At the time, my primary worry was the recent (spring 2019) credit facility amendment was quite restrictive.  Since then, the credit facility has been favorably re-amended to provide another year of runway. Default remains a real risk. 

crawfordsville’s write-up gives helpful background on the company and management, and I build from there. The stock has fallen 70% since crawfordville’s write-up, and I think it merits a position as a mispriced option that is spring loaded to an M&A exit.

INAP is currently undertaking a strategic review its clock is ticking. Its stock has fallen from $21 to $1 over the last three years.  Next stop, zero?

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In my opinion, INAP has this year to sell itself, or prepare to be in covenant default on its credit facility in early 2021.  Given the levered equity stub is trading at <0.25x adjusted EBITDA (with 7.4x debt in front of it), returns could be explosive if a deal gets done.  These types of businesses are bought for anywhere from 8-12x. Obviously, given the potential for default and ongoing cash burn, a zero remains possible.  

I frame Internap as a 30:70 bet on a “5x or zero”, which gives you a 1.5x probabilistic return over the next year. It is a mispriced option with wide potential return dispersion. In the meantime, the stock price will be extremely volatile. As with all option like scenarios, risk of loss is very high.

As an aside, if you can buy the term loan at its recent Bloomberg price in the mid-50s, I think you are creating the company at extremely defensible multiples and an attractive upside. Those prices imply an equity wipeout. 

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The Situation:

INAP (Internap) is a datacenter and related services business (Network (IP) and Cloud). It should not have been public in the first place.  It is subscale, pursues a lumpy sales strategy that is not conducive to quarterly forecasts, and has meaningful, expensive debt, while needing to issue equity to fund its transformation and growth.  

Yet INAP is public and has undertaken an overhaul and clean-up of its business under the bright light of quarterly expectations, much to the detriment of its share price.  It brought in new, experienced management three years ago and gave them a mandate to fix the business. CEO Peter Aquino has attempted to do just that. I believe he has largely completed the clean-up portion of the turn, and yet its completion arrives at a point of maximum pain (opportunity?) for shareholders.  

Unfortunately for INAP, this is not a business that will quickly bounce back and it is holding a short fuse. It takes time to sign net new customers, have those customers install, and ramp revenue. With a penny stock share price and a difficult debt burden, it has become negatively reflexive. The low stock price has reduced the degrees of freedom and therefore the probabilistic expected value.

Internap equity obviously has real risk to it, but it also has the potential to be a many-bagger.  

IMO, very few data center businesses should be public during their equity-issuing rapid growth phase. In particular, if you are wholesale or hyperscale focused (i.e., large customer contracts), closing new business is extremely lumpy and your sales cycle is hard to predict.  As a result, wholesale operators regularly miss quarterly numbers (even as they do a reasonable job on longer term forecasts).  This creates more stock price volatility than business volatility. Because these companies are large capital consumers during growth phase, most of them must periodically issue equity (and debt) to fund their development program and are thus heavily reliant on capital markets. When those equity raise needs coincide with a missed quarter, you eat a lot of dilution. In a bad case, this can create a downward spiral.

This happened to Internap during Q1 of 2019, and again with its Q2 report.  The equity has been obliterated, as it entered a negatively reflexive cycle. The equity stub now trades for <0.25x 2019E adjusted EBITDA (with 7.4x debt in front of it).  As of Q3 2019, the company has $699 million of total debt, of which $270 million are capitalized finance leases. It also had $10.5 million of cash. I expect during Q4, it burned another $5 million or so of cash, and will continue to do so, as creditors effectively sweep all potential equity value through interest expense until there is resolution through a sale, recapitalization of some kind, or clear improvement in operations.

With its Q2 report, Internap reduced its adjusted EBITDA guidance to $95-105 million from $120 million (which originally assumed INAP made an acquisition to gain scale). $95 million was basically the 1H 2019 multiplied by two, which I felt was a reasonable baseline. Even today, it is hard to see growth for another year, though stabilization seems reasonable. During Q3, management unsurprisingly zoomed in on the low end of the guidance, bracketing $94-96 million of EBITDA for 2019.

In a sale, it’s not hard to imagine Internap sold for 9x or more.  All else equal, in the 9x instance, the equity would be a 6x from here. I view that as an in-play upside case. The balance of the probability is probably somewhere between 7x (the equity is a zero) and 8-8.5x (the equity is a 2-4x).

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The Business:

At some level, the business description of INAP is superfluous as the event nature of the situation dominates the business fundamentals. That said, I find it helpful to understand why an event may occur. 

INAP (Internap) is a datacenter and related services business. Increasingly the industry is evolving from local providers to national and global providers. With that scale comes the ability to not just operate more efficiently, but also become more of a holistic solution to your increasingly sophisticated customers.  

INAP’s historic customer base was largely SME-focused (“retail”) but it increasingly is focusing on larger enterprise (“wholesale”) and cloud businesses.  It currently does not serve hyperscale offerings (e.g., Microsoft or Google contracting large, multi-megawatt deals).  

Its business can loosely be bucketed in three offerings:

1. Colocation: At its core, colo means you lease “space and power” to your customer, inside a secure cage.  This is a real estate business. For one reason or another (such as customer size), the customer does not want to build their own standalone datacenter, and so they rent space in INAP’s and build out a presence inside that footprint.  Much like the commercial real estate business, where the tenant generally does their own build out and buys their own office furniture, when a customer leases space and power, the customer provides and manages its own servers. With wholesale customers, this type of colo agreement is generally a 3-5 year contract with 1-3% annual escalators.  INAP itself leases its colo facilities from other providers (such as Digital Realty), rather than owning the buildings outright. Its leases with building owners are very long term leases (often multi-decade) with long term extension options, and are represented by the large Finance Leases on its balance sheet. INAP offers additional services beyond this basic description of colo (such as monitoring and security).  It can also include interconnection between different tenants in a colo facility, though that’s a smaller part of this business than others like Equinix.

2. Cloud / Services: This can mean a variety of things, but the biggest one for INAP is providing cloud based storage and compute.  If your company has “back-up servers” at a datacenter somewhere, there is a decent chance you are actually using a retail services offering (rather than physically installing and maintaining your own servers).  You have dedicated, but virtual, space on someone like INAP’s servers. Cloud services can also mean offerings like providing remote storage or a multi-cloud environment.  

3. Network: INAP has its own fiber network (owned and leased/IRU) that connects its data centers to each other as well as to important POPs throughout the world (like Ashburn, Va - internet capital of the world). It also offers edge services (e.g., CDN).

On a global basis, INAP’s Colo and Cloud businesses are similar size revenue scale, with Network much smaller.  In its US segment, Colo is approximately as large (by revenue) as Cloud + Network combined. In its international segment, Cloud is by far its largest revenue driver.  Colo and Network are inherently higher contribution margin businesses (and often sold as a bundled package) vs. Cloud, and so the US segment currently has higher margins than International.  Colo also tends to be lower churn.  

INAP’s history was as a network-oriented retail data center business.  It was poorly run and management was replaced three years ago, when CEO Peter Aquino was brought in to turnaround and transform the business.  

This historic Network centricity is an important variable.  Disclosure around the profitability by product type is limited, but my work has led me to believe that the Network business has some extremely profitable legacy contracts that are well above market.  As those valuable, high margin Network deals conclude, that revenue will churn (either hard churn or repricing lower). INAP has an uphill battle to replace it with Colo and Cloud revenue and margin. Unfortunately, INAP doesn’t disclose profitability by product type, but instead segments by US and International.  This worries me. 2019 will be an even larger step down in Network revenue, with the segment on pace for <$57 million.

INAP has tacitly acknowledged the need for replacing Network margin and reorganized itself around selling customers on Colo and Cloud during the past two years. The above graphic shows the secular decline of the Network offering, coupled with halting but gradual growth of Colo.  It’s worth noting that in 2H 2018, Internap made the decision to exit unprofitable customer relationships in several of its smaller colo facilities, which created a temporary revenue headwind for that segment’s comps in 2019.

Going forward, the company’s hope is to begin to outrun Network’s declining profitability with Cloud and Colo growth.

Note that in 2018, INAP acquired a cloud focused business called SingleHop, which brought ~$48mm of revenue with it (INAP owned SingleHop for about 9 months, so the $37mm increase in sales in 2018 largely reflects SingleHop’s contribution). This would turn out to be a momentous decision, as its $132 million all cash (aka, “debt”) funded purchase price of >8x, stretched INAP’s balance sheet for a B quality asset. This self-inflicted wound has likely hampered the turnaround under Aquino, as financial flexibility has since been heavily restricted.

Balance Sheet:

As mentioned above, INAP takes very long-term leases on data centers (or parts of others’ wholesale data centers) and then sublets that space (or Cloud services) to end customers.  Perhaps a loose analogy would be Regus, where Regus leases office space from a building owner at a wholesale rate then turns around and re-leases the space in smaller chunks to end users.  

INAP’s lease commitments are capitalized and siton the balance sheet.  They generate amortization (non cash) and interest expense (cash), which means they should generally be (and are) part of the net debt used for enterprise value calculation purposes.

Most of INAP’s debt comes from a high cost term loan credit facility (provided by Angelo Gordon, Carlyle, and others), maturing in 2022.  As a subscale player borrowing from hawks, INAP’s terms on this facility are less attractive than a larger player would be able to garner.  Quite similar to mid-market buyout loans, a well capitalized acquirer could immediately and accretively lower the cost of capital. INAP has amended the term loan several times, including twice in 2019: first in the Spring of the year, then again with the Q3 earnings. The first amendment of the year increased the interest INAP pays to L + 625 in cash and 75 bps of PIK (with Libor ~1.75%, this is an 8.75% stated yield.  

Short Fuse:

In its current state, the interest expense resulting from the debt outlined above consumes all of the “EBITDA less CapEx”, leaving equity owners with nothing (actually, burning $3-5 million per quarter). As I describe below, the company has about a year to sell assets to de-lever (or otherwise inject equity), amend its credit agreement further, replace the term loans with a more friendly liability, sell itself, or default.

The most recent October 2019 credit agreement amendment gave INAP a little time to breathe, improving what was a strategic mistake in the prior amendment, which had allowable net leverage ratios declining to suffocating levels early this year.  That was changed in Q3. 

Per page 11 in the Q3 2019 slide deck, the most recent reported covenant net leverage multiple was 6.6x vs. a max threshold of 7.25x.  That threshold will remain 7.25x for all of 2020, then declines sharply in Q1 2021, implying a need for deleveraging or further amendments by then.

[Dear Reader, Please note that the covenant definition of net leverage excludes certain lease obligations after GAAP accounting standards changed (see the June 28, 2017 Amendment to the Credit Agreement).  The amendment clarified that INAP's liabilities pursuant to any lease that was treated as rental and lease expense at that time, and not as a capital lease obligation or indebtedness as of the closing date of the 2017 Credit Agreement, would continue to be treated as a rental and lease expense, and not as a capital lease obligations or indebtedness.  This means that reported debt is higher than covenant debt and reported EBITDA is likewise higher than covenant EBITDA.]

Covenant Debt: 

$699 million of stated leverage - $10.5 million of cash - $172 lease adjustment = $516 million of covenant leverage as of Q3.

Covenant EBITDA:

As of Q3 2019, TTM reported Adjusted EBITDA was $99 million.  However, we also have to adjust that to subtract “rent” expense related to those excluded leases.  INAP doesn’t specifically disclose that adjustment, but we know from page 11 in the Q3 slide deck that the covenant leverage ratio was 6.6x, which allows us to impute Covenant EBITDA.  $516 / 6.6 = $78.2 million of Covenant EBITDA. From that, we can deduce $21 million of additional adjustments to the $99 million of reported adjusted EBITDA. Going forward, I plan to use $21 million of rental expense and $172 million of related capitalized leases.

Realistically, I believe INAP has to sell the whole company.  De-scaling by selling assets would only provide a temporary reprieve and will leave the remainco in a very challenging position.  The question is, will there be a buyer that puts the equity in-the-money?

When it amended the agreement in spring 2019, INAP knew it had a time challenge and indicated a goal of replacing the facility in conjunction with buying a bolt-on acquisition that provided scale.  During the Q2 call, INAP disclosed that at one point during the quarter, it had a company under LOI which ultimately didn’t turn into a signed deal.  

It seems clear to me that buying a company was and is not a practical solution, given INAP’s stock price and existing credit burden. INAP would not likely be the best buyer for quality assets and any transaction that did require equity would be prohibitively dilutive.

That leaves us with three primary positive options: 1) perform (lease-up excess capacity to generate EBITDA growth); 2) sell assets at accretive prices to buy time for #1; or 3) sell the business.  

Lease-ups take time, especially on the wholesale side, which is where the promise of significant growth really lies.  From the time a wholesale customer signs a contract, it may take several months before it actually becomes revenue generating, and then an additional 3-12 months to “ramp” to steady state revenue.  

While organic revenue and EBITDA growth may come, we have yet to see that in the numbers.  Relying on that improving in the next few months would very much be a hope strategy and require a sales massive inflection - keep in mind that new sales need to outrun churn, which is quite heavy in its legacy Network business.  Regardless, it’s virtually impossible to grow organically fast enough to outrun the increasingly stringent total indebtedness covenants (discussed below). More likely in a “return to growth” scenario, lenders gain the confidence to improve INAP’s terms. The bottom line is that while lease-up should continue, it will take too long to impact cash flow and strategic action will need to come sooner. 

While piecemeal asset dispositions are an alternative, they are governed by the amended credit agreement. Significant asset sales will require waivers from lenders.  Certainly a highly valued disposition could buy more breathing room, and the CEO specifically stated he is considering them, but piecemeal sales are unlikely to fundamentally solve the problem.

All of this adds up to an attempted sale of the entire business.

Covenant Challenges:

Below are the leverage ratio covenants from the most recent credit agreement amendment.

I also included a third column that calculates: if covenant net debt stays flat, what is the minimum adjusted covenant EBITDA required to pass the test?  If we assume covenant net debt grows by $20 million from Q3 2019 through Q4 2020, INAP’s covenant debt will be at $536 million. At 7.25x, it would need to generate $74 million of covenant EBITDA in 2020 to stay on sides.  That is basically flat to 2019E - not a ton of room for error.  

With ~$20 million of quarterly interest expense (see “Debt” below) and $8 million of quarterly CapEx required for maintenance and some hope of replacing churn, INAP needs $28 million of adjusted EBITDA (less if you back out PIK) vs. its recent $23 million runrate.  

If we assume 60% incremental margins on new revenue, then INAP needs ~$8 million of net new quarterly revenue to stop the bleeding. On $72 million of quarterly revenue, it’s not out of the realm of possibility, but it requires a reversal of trend and it will take time. 5% growth for two years would do the job. But we don’t have two years and we aren’t growing yet.

Debt:

As described above, INAP’s current debt capitalization is a mix of credit facility, revolver, and leases (Operating and Finance).  Its lease interest expense is disclosed in its financials, and comes out to basically $40mm per year, while interest on its facility and revolver comes out to another $38mm (inclusive of PIK, so cash is closer to $35mm).  On the Term Loan, INAP pays L + 625 in cash and another 75 bps of PIK. With Libor around 1.75%, the total cost currently is 8.75%.

Total Interest Expense: $78 million

2019 adjusted EBITDA guidance post-Q3 was for $94-96 million.

2019E EBITDA: $95 million

I expect 2019 CapEx will be around $31mm, leaving $64 million to pay interest.  That is not enough. It is worth noting that as much as I’ve been pooping on INAP, if it were an unlevered business, the $64 million of pre-tax FCF on a $720 million enterprise value would be a reasonable FCF yield. It would also be able to play offense much more aggressively. I’d like to think that means this is a solvable problem.

Until the “problem” is solved, INAP will likely continue to draw on its revolver.  This began in Q2, as it drew $6 million on a $35mm revolver (another $3.7mm is tied to letters of credit).  In Q3, INAP drew another $8 million on its revolver ($14 million outstanding). Revolver capacity is obviously tight and perhaps has another few quarters of runway. INAP also has another $25 million it can call on its primary term loan facility.

Given cash burn, I expect net debt grew by ~$4 million during Q4.

The Bet:

With enough runway, the equity bet on INAP would have been: a) it has significant fallow colo capacity that it can lease up in a capital efficient manner (i.e., high returns on incremental capital); and b) as its financial performance improves, its cost of funding comes down substantially (every 1% improvement on its term loan = $4.3mm of pre-tax FCF on a $25mm market cap!).  With a tiny market cap and a low equity stub multiple, a small change in sentiment could drive massive equity returns.

However, the runway is very short.  The company raised $40 million of equity in November of 2018 at nearly $10/share and has used that up.  INAP obviously doesn’t have the credibility to do a traditional follow-on, but could theoretically raise a massive equity infusion from a financial sponsor or via a large rights offering. Unlikely..

The equity bet at this point is that a strategic buyer could afford to pay a substantial premium, given 1) lower cost of funding; 2) massive synergies on corporate overhead and sales; 3) buying unused capacity at a discount; and 4) acquiring customers that the buyer could cross-sell into its existing portfolio. A financial buyer could also be at play, though the creditors would have something to say about that. While precedent data center transactions are almost all in the double digit run-rate EBITDA multiples, it is hard to apply these to INAP given we don’t know the EBITDA mix from its three segments.  Publicly traded data center companies are generally trading in the high teens multiple of run-rate EBITDA, while struggling telcos like CLECs trade in the mid single digits. Zayo, which is also a mix (but superior to INAP) was bought for 10-11x by financial buyers.  

Given the Sword of Damocles is hanging close and the ongoing challenge of declining high margin network revenue, well under 10x is the right way to think.  For example, INAP bought its managed services business, SingleHop for 8.25x ($132 million / $16mm of run-rate EBITDA). At 8.25x, the INAP equity would be worth close to $3.50/share.  Given a strategic buyer could likely take out massive synergies, that could be a reasonable purchase price. 

On the high side, while INAP is struggling with its balance sheet, its underlying business appears sound (decent business with a bad balance sheet). It also is one of the rare bite-sized companies that has a diversified customer and asset base.  It’s plausible this allows for process competition, raising the acquisition multiple. At 10x, the equity would be ~$10/share, or 10x the current price. I am not making that bet, but it’s worth understanding that each incremental turn of purchase price multiple would be 4x to the equity.

If the company doesn’t announce a sale and instead chooses to go it alone, they will be walking into a battle with their creditors.

In its 2019 Q1 report, INAP announced hiring both Moelis and LionTree advisors as it pursues strategic alternatives.  Those alternatives originally included hunting for targets. They have since come to realize that acquisitions are unlikely. 

Per CEO Aquino on the August 6th conference call, “[selling] non-core asset sales are still interesting for us, because 1 or 2 assets definitely could help us de-lever. We have always had interest in a data center here or there or a smaller business unit in our body here or there, and I think with putting everything on the table as part of the complete review, we're going to start making some decisions on what are the best things to act on in the coming weeks/months. The sooner the better, so we're working on it every day. It's clearly an initiative that's taking a lot of time, but worth every minute getting to where we want to get to for 2020.” (emphasis added)

Additional Note:

Executive turnover.  The finance team has seen two exits in the past few months, as the Corporate Controller left in the spring and the CFO leftt.  The CFO had been at INAP for just about a year and owns ~75,000 shares (CEO Aquino owns ~1,000,000 shares). The new President and CFO recently began and is an alumnus of RCN with Aquino and the board of Lumos, which was also a mixed legacy/modern telco in Virginia that was sold to a sponsor. He received a grant of 150,000 options.

Beware:

Truly, this is an option and the most likely outcome is a zero. Please be careful.

Catalyst

Bankruptcy or M&A.