Description
Internap Corporation (INAP) is small cap company in the IT infrastructure sector that significant earnings and cash flow upside as it fills its significantly underutilized company controlled datacenters. The stock is off of its highs recently due to a weak start to the year which resulted in the CEO leaving. However, INAP has the opportunity to generate about $1.00 of FCF/share in 2016 (before growth capex), and is an possible target for acquisiton in the growing data center industry. A takeout price could be $14/share which represents 55% upside.
Company Description
Internap competes in the large and fast-growing market for Internet infrastructure services (outsourced data center, compute, storage and network services). Three complementary trends are driving demand for Internet infrastructure services: the growth of the digital economy, the outsourcing of information technology (“IT”) and the adoption of cloud computing.
Widespread adoption of mobile Internet devices combined with rising expectations around the performance and availability applications places increasing pressure on enterprises to deliver a seamless end-user experience on any device at any time at any location. Software-as-a-Service (“SaaS”) models have changed data usage patterns with information traditionally maintained on individual machines and back-office servers now being streamed across the Internet. These applications require new diligence and focus on predictable performance and data security. Finally, the growth of big data analytics is giving rise to a new breed of “fast data” applications that collect and analyze massive amounts of data in real time to drive immediate business decisions – for example, real-time ad bidding platforms and personalized e-commerce portals.
As distributed applications, security concerns and compliance issues are placing new burdens on the traditional IT model and driving new costs and complexity, IT organizations are increasingly turning to infrastructure outsourcing to free up valuable internal resources to focus on their core business, improve service levels and lower the overall cost of their IT operations.
Amidst this environment, the emergence of public cloud Infrastructure-as-a-Service (“IaaS”) offerings has accelerated digital innovation by lowering the barrier to entry for new business creation. IaaS offerings allow new enterprises to procure and pay for infrastructure on an as-needed basis while minimizing upfront operating expenses, reducing complexity and increasing agility.
The Internet infrastructure services market comprises a range of infrastructure offerings that have emerged in response to shifting business and technology drivers. Internap competes specifically in the markets for retail colocation, hosting and IaaS. Different customer use cases and business requirements dictate the need for specific services or a combination of services enabled through hybridization.
Business Segments
Data Center
Data center services segment includes colocation, hosting and cloud services. Colocation involves providing physical space within data centers and associated services such as power, interconnection, environmental controls, monitoring and security while allowing our customers to deploy and manage their servers, storage and other equipment in our secure data centers. Hosting and cloud services involve the provision and maintenance of hardware, operating system software, management and monitoring software, data center infrastructure and interconnection, while allowing our customers to own and manage their software applications and content.
INAP offers services located at 52 data centers across North America, Europe and the Asia-Pacific region. 16 of these facilities as “company-controlled,” where INAP controls the data center operations, staffing and infrastructure and have negotiated long-term leases for the facilities. The remaining 36 data centers as “partner” sites. In these locations, a third party designs and deploys the infrastructure and provides for the operation and maintenance of the facility.
INAP has been strategically moving away from partner sites in favor of company controlled sites which offer over 2X the margin, and are more predictable. Furthermore, INAP controlling its data centers offer significantly more strategic value to an acquiror.
INAP competes against large cloud providers such as Amazon Web Services, as well as colocation providers such as Equinix. INAP differentiates itself from competitors in that it targets customers who require high performance and low latency who have evolving needs over time. These customers are in media and entertainment, gaming, advertising, as well as Healthcare. There is no customer over 3% of revenues.
We believe that the Data Center business can grow 15%+ year driven by the above mentioned drivers. Furthermore INAP's recent underperformance we believe places a low hurdle to achieve sales growth. Last quarter, the Data Center business only grew 1% year over year.
The incremental margin in this business is can be large as INAP is only operating at 54% of capacity and can effectively run as high as 85% at its existing locations. Thus only a 10-15% increase in sales can result in 25+
Internet Protocol Services (IP)
IP services segment includes INAP's patented Performance IP™ service, content delivery network (“CDN”) services and IP routing hardware and software platform. INAP routs traffic with redundant, high-speed connections over multiple, major Internet backbones. The IP services provides high-performance and highly-reliable delivery of content, applications and communications to end users globally.
INAP's patented and patent-pending network route optimization technologies address inherent weaknesses of the Internet, allowing businesses to take advantage of the convenience, flexibility and reach of the Internet to connect to customers, suppliers and partners, and to adopt new IT delivery models in a scalable, reliable and predictable manner.
What is important to note is that 95% of INAP's Data Center customers also use the IP services so this service can be viewed as complementary.
The IP segment is a misunderstood segment because revenue has been declining due to consistently lower pricing in internet connectivity. INAP essentially resells internet connectivity to its customers through its proprietary route optimization. While the amount of data that its customers are transmitting is going up, the pricing to do it is declining which pressures revenues and margins. So higher data throughput is offset by lowering pricing. This results in declining revenues of about 5% in our model.
Financial Projections
| |
2015 |
2016 |
| Total Data Center Revenue |
250 |
278 |
| Total IP Revenue |
84 |
80 |
| Total Revenue |
334 |
358 |
| |
|
|
| Operating Expenses |
|
|
| Direct Cost of Sales and Service |
130 |
135 |
| Direct Cost of Customer Support |
40 |
43 |
| Sales and Marketing |
41 |
44 |
| General and Admin |
35 |
35 |
| Total Operating Expense |
246 |
257 |
| |
|
|
| EBITDA |
88 |
101 |
| Margin |
26.4% |
28.2% |
| Interest |
27 |
28 |
| |
|
|
| Maintenance Capex |
17 |
18 |
| Growth Capex |
57 |
57 |
| Total Capex |
74 |
75 |
| |
|
|
| EBITDA-Interest-Maintenance |
44 |
55 |
| Per Share |
.80 |
1.00 |
Balance Sheet
| Cash |
16 |
| Debt |
312 |
| Capital Leases |
58 |
| Net Debt |
354 |
What just happened
Former CEO Eric Cooney left the company abruptly after a weak Q1 where the data center segment grew only 1% YOY. While Cooney did a good job in transforming INAP from partner data centers to company controlled data centers, and set the company on course, sales have recently languished. Board member Mike Ruffalo took over and immediately focused on initiatives to drive sales and reduce churn. He held an investor meeting on June 8th where the company re-affirmed their 2015 goals.
The stock is off because of the Q1 miss, the CEO leaving, and more recently there has been an activist unsuccessful in getting the Board to start a formal process in starting a sale of the company.
Valuation
In a take out scenario, INAP could be taken out from 10-12X EBITDA. Comparable transactions in the data center space have occurred from 10-18X EBITDA. INAP deserves to trade at the low end of that range because a portion of its revenues are derived from IP services which a strategic acquiror might not have any need for. In addition, INAP has not been growing. On the positive side, INAP has significant capacity and could benefit from a strategic acquirer who could help ramp sales.
At 10X 2016 EBITDA, INAP would be worth $12/share, and 12X FCF less maintenance capex. At 12X, INAP would be worth 15.6/share or 15X FCF less maintenance capex.
Likely strategic acquirors could be Zayo, Centurylink.
It is also worth noting that INAP has over $200 million net operating loss carryforwards (NOLs) which may also carry additional value to shareholders.
INAP has also recently been subject to activism. In April an activist suggested that INAP could be worth 16-19/share and was pushing for a sale of the company.
Risks
INAP's sales haave been underperforming the industry. This could continue despite the company's renewed focus. The space is competitive where INAP competes against large competitors such as Amazon for some parts of its business. INAP must differentiate its services and products.
INAP is highly levered and is spending cash to grow. At nearly 4X leverage, the company is at risk if the company misexecutes.
DISCLAIMER
This is not a recommendation to buy or sell shares. The views expressed above are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this recommendation. The information above is from various public sources. The author has not independently verified this information and makes no representations as to the accuracy or correctness of any such information. Any forecasts made in this writeup are estimates and may not come to fruition. The author takes no obligation to update any opinions or information above which may change in any way at any time.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.
Catalyst
Getting acquired
Executing on sales growth.
Activism