Value Investors Club / INTERXION HOLDING NV (INXN)

Description

Summary:

Interxion is a premium, carrier-neutral colocation data center services provider in Europe with a simple, attractive business model, a wide economic moat, limited downside and substantial upside for investors over the next two years. This write-up is not too "number heavy," but I'm happy to dig into specifics during the Q&A.

Company Background:

Established in 1998 and based near Amsterdam, Interxion operates 32 data centers in 13 metropolitan areas in 11 countries, serving over 1,200 customers. Such coverage gives Interxion a larger pan-European footprint than any of its competitors. With over 400 carriers and ISPs and 18 internet exchanges, Interxion is the connectivity leader in Europe. In Jan. 2011, Interxion IPO’d on the NYSE as a foreign private issuer.

Pricing Power:

Companies are increasingly seeking to be accessible to their customers on any device at anytime, and the only way to do this is to put everything on a network. This strong underpinning of demand coupled with general supply discipline in the industry indicates Interxion has significant pricing power.

Demand Side

A number of factors are driving and will continue to drive significant demand for high-quality carrier-neutral colocation data center services. Some of these include:

- Decreased cost of internet acces

- Increased broadband penetration

- Increased usage of high-bandwidth content

- Increased number of wireless access points

- Growing availability of internet and network-based applications

Data center IP traffic is expected to grow at a CAGR of 31% for the next 4 years, as is global consumer internet traffic. I would encourage you to read Cisco's latest report for more info about data center demand going forward: http://www.cisco.com/en/US/solutions/collateral/ns341/ns525/ns537/ns705/ns1175/Cloud_Index_White_Paper.pdf

As a result of the above trends, the growth in internet traffic, cloud computing, and the use of customer-facing hosted applications are significantly increasing demand for data center services. For most companies, the cost of funding such complex solutions in-house can be prohibitive, and these companies will continue to outsource the CAPEX and inconvenience of running a data center in-house. Finally, the lack of available substitutes and the presence of high switching costs leave European data center customers with little bargaining power.

Supply Side

According to a CBRE report on the European Data Center industry (available here: http://www.cbre.eu/portal/pls/portal/res_rep.show_report?report_id=2099), following two years of relatively low activity, the total supply of European data center space has risen in 2012, but only by 6%. Retail supply has increased by 18,000m² in the past year, but retail take-up over the same period has increased by 30,000m². In other words, the need for new supply has been dictated by a sustained flow of demand that has outpaced the rate of replacement stock, resulting in a supply-constrained environment and significant pricing power for Interxion.

Pricing and competitive dynamics are rational, the supply pipeline is struggling to keep up with demand, and despite continued macroeconomic headwinds in Europe, the data center industry continues to experience rapid growth.

Strong Operating Model:

High Visibility into Future Performance

Interxion’s business model is characterized by extremely stable and predictable cash flows, multiple growth drivers, and low churn. The company’s recurring revenue model, long-term contracts with customers and suppliers, and largely fixed cost base all provide significant visibility into its future financial performance.

Successful Use of Operating Leverage

Data centers require a fixed number of personnel to operate, regardless of the company’s utilization rate. Thanks to management’s successful allocation of growth CAPEX, the relatively high operating leverage inherent in the business model has led to continuously increasing operating margins. Indeed, Interxion has experienced 23 consecutive quarters of organic growth in revenue and EBITDA since 2006. EBITDA margins are 40+%, and EBITDA is growing faster than revenue, which shows the operating leverage at work.

Diversified Revenue Base and Superior Location of Data Centers

Interxion targets companies in five different segments and has a well-diversified customer base:

% of Monthly Recurring Revenue

2011 2012

Network Providers 36% 36%

Managed Service Providers 15% 18%

Financial Services 12% 13%

Enterprises 12% 11%

Digital Media & Distribution 11% 11%

No single customer accounts for more than 5% of Interxion’s monthly recurring revenue.

Interxion operates data centers in Europe’s major metropolitan areas (London, Paris, Frankfurt, Madrid, Amsterdam), and its data centers are primarily city center-based, close to power sub-stations, and near the intersection of telecommunications fiber routes. These locations, just outside city centers, enable Interxion to avoid more stringent environmental regulations and simultaneously allow customers to benefit from the close proximity to content delivery network providers and internet exchanges, which in turn enables them to rapidly deliver content to consumers.

In addition, Interxion’s exposure to those European countries facing the most severe economic challenges is limited:

Equippable Space Geographical Breakdown

As of Dec 31, 2011

Sqm % of Total

Big Four

France 13,200 19%

Germany 11,200 16%

Netherlands 9,700 14%

UK 5,200 8%

Subtotal 39,300 58%

Rest of Europe

Switzerland 6,400 9%

Belgium 4,800 7%

Austria 4,700 7%

Spain 4,000 6%

Denmark 3,500 5%

Ireland 3,500 5%

Sweden 1,900 3%

Spain and Ireland comprise only 11% of Interxion’s total equippable space.

Competitive Advantages:

Interxion enjoys a number of competitive advantages that create a wide economic moat for the company.

Customer Captivity

The financial costs, operational risks and general inconvenience involved in relocating one’s networking and computing equipment are often prohibitively high. As a result, Interxion’s customers are faced with high switching costs and are incredibly sticky. The average churn is less than 0.5% per month.

Network Effects

As Interxion increases its customer base, its customers enjoy increased connectivity to carriers, ISPs, and, most important, to other customers. These networks of customers, carriers, ISPs, and internet exchanges – dubbed “Communities of Interest” by Interxion – generate powerful network effects that enrich the value and attractiveness of the customer community to both existing and potential customers. This network effect ultimately reduces Interxion’s customer acquisition costs and churn and increases its pricing power and long-term margins.

Superior Know-how

Interxion possesses a deep understanding of the European regulatory landscape and can effectively navigate the design and permitting requirements of each country.

Significant Barriers to Entry

The above competitive advantages create significant barriers to entry. As a result, there has been no new sizable pan-European entrant into the market in the last 10 years.

Management/Ownership:

Private Equity Controlled

Baker Capital, a New York-based private equity firm, owns ~30% of Interxion’s equity and occupies a majority of the board seats. As a result, Interxion’s nominating and compensation committees do not meet the independence standard of the NYSE manual.

David Ruberg, Interxion’s CEO and a former partner at Baker Capital, left his role at Baker to take the reins at Interxion in 2008. Mr. Ruberg is the former CEO of a broadband communications services provider and has a Master’s degree in Computer and Communications Sciences. His deep knowledge of the IT, technology and communications sectors has played a large role in his ability to attract and serve customers during his tenure.

Executive Compensation

Mr. Ruberg’s compensation for the year 2011 totaled €2.19m, 26% of which was in the form of his base salary, 35% of which was in the form of a bonus, and 39% of which was in the form of equity. Mr. Ruberg currently owns 850,000 shares of Interxion and holds options covering an additional 600,000 shares, bringing his stake in the company to just over 2%. He is well-incentivized to increase the share price and a majority of his options have not yet vested, minimizing the chances he will leave the company.

History of Successful Capital Allocation

Management does not commit to any expansion projects until it has identified future customers and has the capital to fully fund the build out. Expansion projects are done in phases in order to better manage the timing and scale of CAPEX and to reduce risk and maximize ROIC.

Management currently has no intention (or need) to issue more equity, so shareholders need not fear any dilution.

Valuation: Please note that Interxion reports its financials in Euros but I have converted them to USD, based on today's exchange rate.

The below table provides an overview of the multiples paid in recent data center acquisitions:

Acquiror Target Date Closed Deal Value ($mm) EV/Revenue EV/EBITDA

Century Link Savvis July '11 3,200 3.2x 11.0x

Time Warner Cable NaviSite April '11 251 1.9x 11.6x

Verizon Terremark April '11 1,902 5.4x 24.7x

Windstream Hosted Solutions Dec '10 310 5.0x 10.0x

Cincinnati Bell CyrusOne June '10 525 7.2x 12.5x

Equinix Switch & Data May '10 683 3.0x 9.3x

Mean 4.3x 13.2x

Median 4.1x 11.3x

Applying to Interxion the average EV/EBITDA multiple (13.2x) paid in recent transactions implies a total enterprise value of $1.87bn. Subtracting debt and adding back current cash and cash equivalents implies a market capitalization of $1.7bn, or $25.45 per share (representing a ~20% increase from today's price).

INXN EBITDA (ttm) 141.7

Implied INXN Takeover Value 1,871

Implied INXN Takeover Equity Value 1,723

Implied INXN Takeover Share Price $25.45

However, many of the above data centers lack some of the characteristics that give Interxion its competitive strengths, such as the strategic locations of its data centers and the network effects it offers its customers by virtue of the depth of its connectivity. As a result, Interxion should fetch a premium in any acquisition.

A look at Interxion’s closest comps, Equinix and Telecity, also supports that idea that Interxion is undervalued. Currently trading at 11.4x LTM EBITDA, Interxion is 2 turns below Equinix and almost five turns below Telecity. Applying a conservative multiple of 13.5x implies a total enterprise value of $1.91bn, or $26.08 per share.

Closest Comps Market Cap EV/EBITDA P/E

Equinix 9,500 13.5x 86.7x

Telecity 1,700 16.2x 36.2x

Interxion 1,460 11.4x 33.1x

Assumed EV/EBITDA 13.5x

EV 1,914

Mkt Cap 1,765

Share Price $26.08

REIT Optionality

Interxion is a firm with REIT characteristics but with fundamental growth drivers that are far more powerful than those associated with traditional real estate investments. As Interxion’s growth rate eventually declines, it will begin to throw off significant cash and could convert to a REIT. Regardless of whether it does so, the nature of its business model is likely to cause it to trade as a REIT, based on REIT metrics. The recent conversion of many data centers to REITs will help speed this along. When we compare INXN to its comps using REIT multiples, things look even better. Interxion is 5 and 6 turns below Telecity and Equinix, respectively:

Closest Comps Mkt Cap P/AFFO

Equinix 9,500 20.4x

Telecity 1,700 19.1x

Interxion 1,460 14.3x

With a current AFFO yield of 7% and a significant amount of new revenue generating space expected to come online in the back half of 2013, I expect Interxion’s AFFO yield to pass 10% next year.

Attractive Merger Candidate:

Interxion also presents a great option for other data centers looking to expand into Europe. While Baker Capital would have the capability of vetoing any deal, there is nothing to indicate it would reject an offer that is in the interests of shareholders.

Other Attractive Investment Characteristics:

Modest leverage employed

Interxion employs modest leverage relative to its peers and has funded further expansion plans by issuing debt without ever jeopardizing its ability to cover its operating expenses. It has a well-capitalized balance sheet with no near-term maturities.

Understated earnings

Interxion depreciates the value of its buildings based on a useful life of 10-15 years. Its peers, however, have assigned a useful life of 20-50 years to their buildings. As a result, Interxion is likely depreciating its assets more quickly than appropriate and its true earnings are therefore understated.

Risks:

1. Operating leverage risk:

- A longer than expected sales cycle on newly added square meterage could lower utilization rates.

- It is difficult to reduce operating expenses in the short-term, so operating results are particularly sensitive to fluctuations in revenues.

- Operating margins are tied directly to the utilization rate.

Mitigant: Management has historically used operating leverage very effectively, as evidenced by Interxion's consistently increasing margins.

2. Lease risk:

- With three exceptions, INXN does not own the property on which its data centers are located. Instead, it leases the space for its data centers, and certain leases in France, Belgium, Ireland, and the

U.K. currently do not have automatic options to renew or extend the lease contract.

Mitigant: Interxion's leases are typically for 10-15 years and the company has had no problems renewing lease contracs in the past.

3. An overly aggressive expansion plan could result in excess capacity and erode pricing power.

Mitigant: Management has historically deployed growth CAPEX conservatively and effectively.

4. Increased competition over time as more players enter the European market.

Mitigant: Significant barriers to entry make this unlikely to pose a threat to Interxion.

5. Technological advancements in server technology could obviate the need for data centers.

Mitigant: The need for data centers is driven by a profound, long-term shift toward the Internet and digital busines models, and this is not likely to change.

6. Commodity price risk:

- Interxion has exposure to increases in electricity prices, which it cannot control.

Mitigant: Approximately 60% of Interxion's customers by revenue pay for power on a metered basis, which eliminates the bulk of this exposure. Interxion's contracts with the remaining 40% enable it to recoup increased expenses if the price of electricity increases.

7. Off-balance sheet liabilities:

- Interxion has significant off-balance sheet liabilities in the form of operating leases. This understates Interxion's leverage ratio.

Mitigant: Interxion’s historically stable utilization rates have kept provisions for onerous lease contracts at low levels.

Conclusion:

An investment in Interxion gives investors a piece of a company with a wide economic moat in an industry with secular growth tailwinds, all for a price below industry average multiples. The downside is minimal, and as data centers begin to trade on REIT multiples, substantial upside will be realized. I realize there is no hard, near-term catalyst here, and that Interxion, while undervalued, is not outrageously cheap. But it is a great business that is easy to understand, has durable competitive advantages, a competent management team, and enjoys powerful secular tailwinds. It is not easy to find a business displaying all these characteristics simultaneously.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Continued execution and margin improvements

- Long-term, powerful, secular tailwinds

- Possibility of M&A activity

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			2012	2013
Price:	21.28	EPS	$0.57	$0.74
Shares Out. (in M):	68	P/E	0.0x	0.0x
Market Cap (in $M):	1,461	P/FCF	0.0x	0.0x
Net Debt (in $M):	148	EBIT	0	0
TEV (in $M):	1,609	TEV/EBIT	0.0x	0.0x