Description

KINX is the only pure-play data center operator listed in Korea. The stock has no official sell-side coverage, trades at dramatic discount of 45-70% relative to global data center comps (14x 2020e P/E and 6.4x EV/EBITDA), and has a strategic plan to expand capacity by 300% in two years with no shareholder dilution. We think the combination of >300% earnings growth and valuation re-rating could lead to a multi-bagger investment. Please note the stock has a ~US$200 million market cap and trades between US$0.5 to $4m per day at the time of posting.

Background

KINX (pronounced K-I-N-X) is an initialism for Korea Internet Neutral eXchange. The company provides internet infrastructure services in South Korea including internet data centers (IDC), internet exchange services (IX), content delivery networks (CDN), and cloud services. 75% of KINX’s revenue is from IDC, 17% from IX, and 8% from CDN, cloud and other services. The company was founded in 2000 by a collective of 16 internet service providers as the first carrier-neutral IX in the country. KINX was then acquired in 2007 by Gabia Inc, and IPOed on the KOSDAQ in February 2011. Gabia, (079940 KS) Korea’s largest domain registrar and web hosting company (i.e. the GoDaddy of Korea), currently owns 36.3% of KINX. The Chairman and CEO of Gabia are also on KINX’s board of directors.

KINX operates IX and IDC services from seven sites in the Seoul area, with the main hub in Dogok, a ward of Gangnam. KINX also operates PoP (point of presence) sites in Tokyo and Hong Kong, which are mainly used to interface with overseas content providers and direct traffic to Korea.

KINX has IDC capacity of approximately 1,700 server cabinets (equivalent to 3 MWh) located on 4,270 square meters (1,294 pyung) of space across the seven domestic sites. Around 25% of the capacity is at the self-owned IDC in Dogok, and the other 75% is at the other sites, which are leased from other IDC operators such as LG CNS and SK Broadband. KINX has been increasing leased IDC space in recent years to meet growing customer demand. This strategy should allow KINX to continue growing 10-15% p.a. for the next few years by increasing leased space, but management has plans to build a large new self-owned IDC to meet growing demand. The new IDC, which will be located about 30 minutes south of the Dogok site, will dramatically increase the company’s IDC capacity, and also increase the ratio of owned capacity vs. leased.

IDC and IX Market and KINX’s Competitive Position

There are only four Internet Exchange Providers (IXPs) in Korea, three of which are the major telecom operators: KT, LGU+, and SK Broadband. These three telcos all have their own IXs, but KINX is the only carrier-neutral IXP in the country, which means it offers customers a neutral choice of interconnection path and cross-connections with other KINX customers. This often leads to faster connection speeds and lower latency for content providers. KINX is the primary IXP for approximately 15% of internet subscribers in the country, which is the national broadband subscriber market share of MSOs (multiple system operators – i.e. broadband businesses of cable operators such as Hyundai HCN, Tbroad, and Hellovision). KINX is also the IXP used by numerous domestic and overseas content and cloud service providers because of the benefits of using a carrier-neutral IX. Large content provider customers include Naver, DaumKakao, Amazon, Alibaba, and Google. KINX’s top 10 customers account for about 30% of revenue, with none of the top 10 being significantly larger than the others. Amazon is a top three customer and overseas customers account for 20% of total revenue.

Internet data traffic is growing an estimated 30-40% p.a. in Korea with this trend expected to continue for at least the next few years. There were 158 data centers in Korea at the end of 2019, of which 68 are publicly-owned and 90 are privately-owned. Of the 90 private data centers, 41 are commercial colocation IDCs and 80% of those are in the Seoul/Kyounggi area. There are 32 new data centers planned to be built by 2025, of which 24 will be for collocation services.

KINX is a niche player in the Korea IDC market with IDC colocation revenue market share of approximately 7%. Around 60% of the IDC market in Korea is controlled by the three telco operators and 20% is controlled by system integrator companies associated with chaebols (Samsung SDS, LG CNS, SK C&C, etc). The remaining 20% is controlled by a handful of smaller independent companies including KINX, Sejong Telecom (036630 KS), and Dreamline (unlisted). Equinix (EQIX) entered the Koran market in 2019 with 6 MWh of capacity leased from Samsung SDS, and Digital Realty is planning to build a 12 MWh data center in Seoul to be completed in 2021.

Industry forecasts from the Korea Data Center Council suggest that colocation IDC capacity will increase about 50% between 2019 and 2021. Experts we spoke to believe this capacity can be readily absorbed by demand growth driven by data traffic for cloud and other services.

Financial Performance

KINX has grown revenue consistently since the 2011 IPO, driven by increased IX traffic and increased IDC capacity, mostly through increased leased IDC space. Revenue and EBIT have grown at a CAGR of 16% and 18% respectively. Margins have been expanding due to increased demand for cloud services and operating leverage from higher amounts of traffic and data transmitted. Management is guiding for 10-15% sales and profit growth p.a. for the next three years, until the new IDC comes online in late 2022 or early 2023.

KINX is generating a respectable return of equity of nearly 20%, despite having an over-capitalized balance sheet. ROCE excluding excess cash is 25-30%. KINX has not been paying a high dividend historically and cash has been accumulating on the balance sheet. Net cash has accounted for 40-50% of shareholder equity in recent years.

Most IDC operators around the world have leveraged balance sheets because they have predictable, contractual cash flow streams. KINX is highly cash generative, and the company has converted more than 100% of net income into free cash flow since the IPO. We expect free cash flow conversion to fall during 2019-22 while the new data center is being constructed, but this should be viewed positively because the company will be investing excess cash into a high return capacity expansion.

Gwacheon Capacity Expansion

KINX has a plan to significantly expand its self-owned IDC capacity with a new site in Gwacheon Knowledge Information Town, which is about a 30-minute drive south of Gangnam, Seoul. The total cost of the new IDC will be W120 billion (~US$100m), of which W16b was spent on the land in 2019. Gabia and affiliates are also investing in land at the same site in order to build a new headquarter office, but KINX will own 100% of the new IDC at the site with 6,942 sqm (2,100 pyong) of space.

Construction of the new IDC is expected to be complete in late 2022 or early 2023. Management is planning to add 2,000 more server cabinets at the new IDC, but these racks will have higher power capacity than existing cabinets, so it will allow KINX to increase IDC collocation revenue by around 300%. The new IDC will have approximately 10 MWh of capacity. Importantly, the Gwacheon IDC will dramatically increase KINX’s self-owned IDC capacity, which should justify a higher valuation multiple.

KINX has W35b of net cash on the balance sheet and generates more than W15b of operating cash flow per year. The company should be able to fund the remaining W104b of capex for the Gwacheon IDC over the next two years with cash on hand, operating cash flow, and a modest amount of debt.

Valuation

KINX trades at a steep valuation discount to global data center peers. KINX trades at a ~70% discount to peers on EV/EBITDA and P/E and a ~45% discount on Price/Book. While some level of small cap valuation discount is probably warranted, we think KINX is likely to have superior earnings growth over the next five years because of the large step change in capacity planned for 2023. Therefore, we think the stock has plenty of re-rating potential and could be multi-bagger investment.

Lack of Sell-Side Coverage

A few Korean sell-side brokers like Shinhan have published brief notes on KINX in the past year but no brokers officially cover the stock. We see potential for the stock to receive more sell-side attention as the Gwacheon capacity expansion nears, especially if the stock’s market cap and liquidity continue to increase. As the only pure-play data center play in Korea, the stock could eventually demand a scarcity premium in the local market.

Corporate Governance

Corporate governance is always a concern in Korea, but we haven’t identified any major red flags at KINX. Gabia is a controlling shareholder, but they haven’t done anything historically to harm minority shareholders. The dividend payout ratio is below 10% and cash has piled up on the balance sheet, but the company has been accumulating cash to prepare for the capacity expansion which should generate a high return on investment.

There are some small related-party transactions between KINX and Gabia. Gabia leases some IDC space from KINX for its hosting business, but this only accounts for 3% of KINX’s revenue. KINX also purchases some IT security software from one of Gabia’s subsidiaries, which accounts for about 1% of KINX’s costs. Neither of these related-party transactions seem concerning.

Risks

Delays: Perhaps the biggest risk to the investment is a delay in the construction or leasing of the Gwacheon IDC. The IDC is expected to be ready for operation at the end of 2022 or early 2023, which is a somewhat long-time horizon for the short-term focused Korean market. Any timeline slippage could hurt the IRR of the investment.

IDC overcapacity in Korea could hurt pricing and utilization rates. Experts we spoke to believe demand will continue to grow in-line with supply and the market will remain balanced, but capacity is expected to grow 16% p.a. through 2025 so any major slow down in demand could result in oversupply.

More Carrier-Neutral IDCs: KINX has historically operated as one of the very few carrier-neutral IDCs in Korea but more competitors are opening carrier-neutral IDCs such as Equinix and Digital Realty. Macquarie Infrastructure has also announced a possible IDC investment in Korea. KINX’s management does not currently view these new players as a major threat because of the strength of KINX’s IX, and Eqinix has installed a KINX network PoP inside their Seoul IDC. However, this is a risk to monitor over the next several years.

Lease renewal: KINX currently leases ~75% of its IDC space on 1-2 year duration leases. We understand the majority of the space is leased from LG CNS. It is possible that KINX could fail to renew a lease or could be subject to rental rate hikes which pressure margins. Management doesn’t believe this is likely in the near-term, and clearly the company’s operating margins have continued to increase in recent years despite continuous lease renewals during that time. Additionally, the new Gwacheon IDC will significantly increase the mix of self-owned IDC capacity and reduce this risk going forward.

Catalyst

Capacity Expansion, Earnings Growth, Sell-Side Coverage