Description

INXN

INTERXION HOLDINGS

Investment Thesis: Interxion Holdings (INXN), a  Netherlands based, Pan-European colocation datacenter company, is a compelling long investment offering significant upside potential (~50%+) over the next 6-18 months. As a premier European colocation datacenter company, Interxion is an obvious take-out candidate as the data center industry consolidates globally. In the interim, it is benefitting from strong and accelerating sector tailwinds due to both cloud adoption, as well as the fact that Europe is experiencing rapid cloud growth on a lagged basis vs. the US., a trend that should persist, going forward. The stock recently came under pressure after its largest shareholder, Baker Capital distributed its entire position (~30% of the float) to its LPs for non-financial reasons providing a compelling entry point into the stock. Recent performance and public statements of competitors such as Equinix (EQIX), and customers such as Amazon’s AWS segment validates the long-tailed secular growth story in datacenters. Top-tier colocation datacenter service providers such as Interxion enjoy a strong network effect, or moat, that should enable Interxion to grow profitably for many years to come. Interxion’s free cash flow yield to its equity (net of expansion cap-ex) on our 2017 estimates exceeds 10%; meanwhile, we believe EBITDA can grow in the range of high teens to low 20s over the next few years. At a free cash flow yield of 7% on ’17 estimates, equivalent to the average of where its peers trade, Interxion would be worth $40.45/share or 48.4% above current prices.

Description

Founded (and headquartered) in the Netherlands in 1998, Interxion is a leading Pan-Europe carrier-neutral colocation data center services provider. The company connects to over 500 carriers and 20 internet exchanges across its footprint, delivering services across 39 data centers in 13 cities and 11 countries in Europe, giving its ~1,400 customers access to more than 77% of EU GDP. All of Interxion’s data centers are located in near-city center locations (<10 miles) giving customers direct and low-latency access to Europe’s leading businesses and residential centers.

The company’s core offering is carrier-neutral colocation services: provision of space and power within a secure environment to house customers’ computing, networking, storage and IT infrastructure. The company typically offers contracts for colocation space together with support services and other managed services. Most contracts have an initial term of 3-5 years; auto-renews for one-year intervals unless specifically terminated, and gives a 90-day notification period for any terminations. 

As of 2Q’15, ~95% of total revenues are recurring revenues, and ~33% of revenues come from top 20 customers. Utilization rate has  been inching upwards from ~73% in 1Q’13, to ~78% in 2Q’15, increasing steadily YoY, signaling strength in demand for its offerings, even as the company expanded its footprint by ~17% YoY.

Target segments and example “magnetic clients” include (as a percentage of monthly recurring revenue):

·         Network providers: 32%

o   Level3, Zayo, AT&T, VZ, Deutsche Telekom, Cogent Communications, TeliaSonera, Telefonica

·         Managed service providers: 26%

o   Amazon Web Services, IBM Softlayer, SalesForce, Microsoft Azure, Oracle, SingleHop, Cisco

·         Financial Services: 12%

o   BATS , London Metal Exchange, Weiner Borse, Barclays, Deutsche Borse, InteractiveData, FixNetix

·         Digital Media: 10%

o   Internap, Akamai, Edgecast, LBi, Mindark, Overon, Deluxe

·         Enterprises: 9%

o   Mergermarket, SHT, AC Hotels Marriott, Carreos, Milanuncios

Out of the above, the highest growth segment would be that of managed services and network providers—in which selected providers are deploying cloud platforms to capture the exponential growth in cloud computing. Interxion, like Equinix (a global provider of interconnection/colocation services), focuses on building “communities of interest” within its campuses—in which customers are located in close proximities within each other in order to rapidly (and securely) deliver content to consumers. As a result, its ecosystem results into a virtuous cycle of reinforcement, increasing stickiness amongst its customer base, and promotes the recurring revenue model. Because this moat is brought about by years of efforts to build upon its clientele base, and housing “marquee, magnetic clients”, we believe that this moat presents itself a relative high barrier of entry, one in which is difficult to replicate.

We believe that Interxion presents an opportunity to buy shares of a reasonably-priced business, with NTM intrinsic value north of 50% higher, in a sector that is facing tremendous secular tailwinds with an attractive annual cash return of 26% across fully-built-out properties. Aside from the secular tailwind, we expect to see continued M&A within a fragmented European market and see Interxion as a prime take-out candidate due to its attractive European assets. 

Why this opportunity exists

Broken deal with Telecity

On 2/11/15, Telecity and Interxion entered into an all-share merger of the two entities to become Europe’s largest carrier-neutral colocation service provider. The deal effectively valued Interxion at a deal multiple of 15x EV/EBITDA.

On 5/29/15, Equinix outbid Interxion by announcing a deal with Telecity (TCY), offering to purchase TCY for ~15x 2015 EV/EBITDA.

Exit of 15-year PE owner, Baker Capital

Shortly after Equinix announced the deal with Telecity, Baker Capital (who used to own ~30% of Interxion’s  float) announced that they were going to distribute Interxion’s shares to the shareholders of its fund due to the end of the fund’s life-cycle. Immediately, Interxion’s stock came under immense pressure due to the large seller and the disorderly nature of Baker’s distribution to its investors, creating a technical dislocation, and in our opinion, an attractive entry point.

Negative ARPU comps

Bears may point to the negative ARPU comps in 2014, which some may perceive as Interxion losing traction or pricing power.

Our perspective

We have been invested in a close competitor of Interxion’s, Equinix, for the past 2 years. Equinix is a global version of Interxion, and is the dominant player in the global colocation market. We believe that several factors will continue to buoy growth and demand in retail colocation, especially low-latency, highly-interconnected offerings: 

1)      We believe that worldwide retail colocation revenue is poised to continue to grow healthily, due to the continued phenomena of outsourcing IT spend (industry estimates ~30% of US IT spend is outsourced, and ~10% for Europe region), as well as the growth in data consumption via cloud, big data and mobile, which will grow demand for colocation and datacenter services. Outsourcing in general has become a preferred model as cloud has made businesses more nimble/agile with their IT spend, and helps to reduce cap ex spend and shed non-core IT infrastructure, whilst maintaining stable, recurring operating expenses.

a.       According to Synergy Research, worldwide retail colocation revenues will continue to grow at ~10%+ CAGR, with Netherlands, Germany and the U.K. markets growing at above average rates

b.      China is expected to grow at more than double the average (we’ve looked at 21Vianet very briefly, but its accounting scandals make it difficult for us to own the equity comfortably)

c.       We also recommend reading Cisco’s 2014 Annual Global Cloud Index, for those who are interested:

                                                               i.      Anticipates data center traffic to nearly triple on the back of cloud growth in the next 5 years, at a CAGR of 23% (similar to IDC’s projection), along with growing internet access for the world and consumer cloud usage

2)      We believe that Europe, in particular, is facing relatively higher growth (to the US) in the IT outsourcing/cloud computing business. From various industry sources, North America has ~30-40% of IT spend outsourced, and the European equivalent is somewhere around 15%. We also look at Equinix’s cabinet equivalent billings, a metric that tells us how quickly sign-ups for its cabinets are growing over time. Some observations:

a.       North American cabinets are growing at mid single digits YoY in the past 8 quarters, but have recently accelerated to +9% YoY in 1Q’15 and 10% in 2Q’15 due to the growth in cloud computing.

b.      Growth in Equinix’s European business has exceeded that of N.A. since 2011 (the time we started looking at the business). In FY’13, Equinix’s European growth rates have consistently been around 400-700bps higher than that of North America’s.

c.       Most recently, European cabinet billings have increased by 11% YoY in 4Q’14 (while North American billings increased by 5% YoY), and accelerated to 18% in 1Q’15 (N.A. at +8%) and 20% (N.A. at 10%) in 2Q’15.

We expect  European IT-outsourcing and cloud migration to be poised to play “catch-up” (company estimates ~12-24mths lag vs. US) and Interxion, as a pure European datacenter, will be a key beneficiary of the trend of heightened IT outsourcing, and positive colocation demand tailwind. 

3)      While it is true that, enterprises are pushing and more and more IT workloads into the cloud which may potentially reduce spend on its own data centers—we do not think this will reduce demand for colocation services. Rather, we expect this to  increase colocation spend as it will allow enterprises to both deploy private (proprietary) cloud and securely connect to public cloud offerings such as AWS, IBM Softlayer, Microsoft Azure in an efficient hybrid manner, in close proximity, ensuring low latency and security

a.       As such, the move of workloads into the cloud actually helps to spur demand activity from retail colocation users, especially from various types of service providers:

                                                               i.      Cloud, IT, Telecom providers, Content providers

b.      For example, the more the demand for AWS’s services grow, the more AWS will likely grow within the retail colocation provider’s footprint (e.g. Interxion, or Equinix) – and the numbers prove it, as managed service providers portion of recurring revenue has increased by 200bps (24-26%) on a y-o-y basis

Hence we believe that that the growth in various “cloud offerings” help to enhance demand for Interxion’s services. 

4)      Negative ARPU comps in 2014: we think that negative ARPU comps is a natural course-of-business due to the fact that Interxion  increased the amount of operational real estate by ~17% in 2014, and ~14+% thus far in 1H 2015:

a.       Initially, customer will contract for space and modest power reservation

b.      As a customer’s workload increases and consumes more bandwidth, ARPU will ramp up accordingly, and margins will expand as more “add-ons” are sold, such as power reservation, managed services, connectivity (interconnections), and other services (historically margins have increased by over 100bps YoY from 2011-2013

c.   This graph sums it up nicely:

Going forward, we are confident that ARPU should trend back up as the life cycle of the new customers mature 

5)     Regarding the Equinix-Telecity deal: Previously, an Interxion -Telecity deal would allow the merged entity to leapfrog Equinix to become Europe’s largest colocation provider. We believe that Equinix was essentially forced to buy one of them, before the combined Interxion-Telecity entity became too large a competitive threat for them. We believe that Equinix chose Telecity over Interxion ultimately because of the assets’ strategic fit:

a.       Telecity shares dominance in the London market with Telehouse, owning Telecity will give Equinix access to prime (and complementary) real estate in London. Interxion doesn’t have as strong a presence in London

b.      Telecity also overlaps with Equinix in Paris, Amsterdam, Frankfurt

c.       International nature of Equinix’s business would pivot it to want to be able to expand into marquee markets (such as London) in which Equinix can feed international traffic into

Interxion’s Footprint

Approximately 63% of Interxion’s revenues come from the “big 4” geographies: France, Germany, the Netherlands and the UK. Out of the big four, Interxion’s strength is concentrated in France, Germany and the Netherlands.

Using data from www.peeringdb.com, a leading community database for developers and IT/sales professionals to compare and contrast facilities, the database is generated and updated based on developers and professionals to help inform others about the peer facilities worldwide.

To study the competitive landscape, we look into Interxion’s positioning in these core markets:

Germany:

France:

Amsterdam:

UK:

From the above, we see that Interxion is the top provider in Germany (in terms of how “vibrant” its ecosystem in, measured via the number of participants in its facilities), and is usually a top player in other markets—an enviable position in the colocation data center business due to the reinforcing virtuous cycle that attracts more customers to its data centers.  We think that Germany is Interxion’s “crown jewel” property as data sovereignty laws are the most strict there (to our understanding), and Interxion has the densest ecosystem in all of Germany. 

Industry Consolidation

The datacenter industry has matured and become a global business as information is constantly being parsed across borders. Large multinational companies seek datacenter colocation providers that have both a global footprint and a vibrant in-house ecosystem with many participants. This trend is forcing existing data center companies to either bulk up by expanding their real estate coverage, and/or engage in M&A activity. Presently, we expect Interxion to be acquired by a larger player with global aspirations, both because of its attractive real estate footprint as well as its vibrant ecosystem. 

In recent months, we have gathered anecdotal evidence that DLR (Digital Realty, a wholesale data center provider growing its colocation business, most recently via an outright acquisition of US-based TelX) is focused on expanding in Germany for expansion:

“We’ve already stated publicly our intentions to expand our footprint in Europe…We’ve declared Germany as a key battleground that we’d like to be in”

– Cowen Conference 5/27/15

We view that as an affirmation of Interxion’s value proposition, as Interxion is the top colocation provider in Germany, and view Digital Realty as a potential acquirer of the company as it seeks to move into colocation services to augment its wholesale datacenter business, with a strong focus on Germany.  

In addition, due to increased worries about data-spying, the European Union has been working on instituting laws such as the Network and Information Security (NIS) Directive and the General Data Protection Regulation (GDPR)- expected to be in force within the next 2-3 years, aimed to protect information that is parsed through the EU region. As a result, international corporations and local European companies alike, have been very sensitive about ensuring that they remain compliant by ensuring that data is stored within local data centers, increasing the demand for European datacenter services. Germany, in particular, has been at the forefront of the effort, and because Interxion is Germany’s largest colocation provider with the densest network of all, we believe that Interxion is poised to grow as large, multinational corporations which want to be “connected” to Germany will choose to co-locate latency-sensitive applications and data within Interxion.

Turning it into numbers

Looking forward, we expect Interxion to expand modestly. 2014-2015 has been a major investment/growth period for the company as the company adds space to meet increasing demand from customers. Beyond 2015, using current growth plans, we estimate a +11% and +10% capacity increase, mostly from campus expansions within its existing footprint. We assume that RGUs increase and ARPUs increase post 2015 as new space revenues “gear up” with increasing traffic/bandwidth consumption.

For reference, the company’s long term revenue CAGR guidance is ~14% and EBITDA CAGR is ~18%.

Valuation:

We use P/AFFO (due to the REIT characteristics of the underlying assets) and EV/EBITDA to value Interxion. Using P/AFFO on 2017E, at ~7% FCF yield, and a 13% growth in RGUs (revenue generating units), there is ~48% upside. Using EV/EBITDA, there is 67% upside at 15x multiple on 13% growth in RGUs. Assigning 50/50 weightings to both methods results in a blended upside return of ~58%  in a sector that has substantial secular growth tailwinds. 

Using its nearest comps’ preferred valuation method of P/AFFO (EQIX, COR, CONE etc.):

The industry has been undergoing a wave of consolidation. Notable (and public) deals include:

Other assets and liabilities

These have been noted as part of the capital structure (but did not include in Net Debt), albeit making sure we highlight them here again:

1)      Capital lease obligations and purchase commitment obligations of 138M euros

2)      Operating lease obligations of 334M euros

Notable holders (as of 06/30/15):

1)      Eminence Capital: 7.6% of float

2)      Paulson & Co: 3.7%

3)      Abrams Capital Management: 3.4%

Risks

1)      Global recession (however, it’s cheaper to outsource IT to the cloud)

1)      Competitive dynamics I.e. Equinix/Telecity deal taking away market share from Interxion

a.       Switching costs however, are extremely high (have to move all servers and set up brand-new interconnects in a different facility etc.)

2)      New entrant bringing new supply online

a.       However such new entrant will bring on “dead” supply that doesn’t possess a moat

3)      Market multiples compress

4)      Significant interest rate increases

a.       Interxion is not a REIT, but many of its nearest comps are (e.g. Equinix, CoreSite, CyrusOn)

Catalysts:

1)      Acceleration of IT-outsourcing and cloud adoption in Europe

2)      Stronger data-sovereignty laws being passed in the EU, within each country of Interxion’s footprint

3)      Continued M&A activity in the datacenter space

4)      Buyout offer for Interxion

5)      Continued execution, strong comps and margin expansion – Good earnings

Catalyst

Catalysts:

1)      Acceleration of IT-outsourcing and cloud adoption in Europe

2)      Stronger data-sovereignty laws being passed in the EU, within each country of Interxion’s footprint

3)      Continued M&A activity in the datacenter space

4)      Buyout offer for Interxion

5)      Continued execution, strong comps and margin expansion – Good earnings