Switch reported its fourth quarter and full-year 2017 earnings after the bell Monday. It was the last US data center provider to report, possibly because it’s still adjusting to its new life as a public company after operating for 17 years as a closely-held private firm.
Six months ago, the much-anticipated Switch IPO was initially met with high demand from eager investors, who bid up shares to $17.00 versus the underwriter's price range of $14.00-$16.00 per share. A frenzy of buying on the first day of trading last October drove Switch shares as high as $24.90 prior to closing at $20.24.
Since its October IPO, Switch has traded in a range of $13.24 to $24.90 per share, closing near all-time lows on April 3, after it reported the 2017 results.
Why Did Guidance Disappoint?
After adjusting for non-cash and one-time items, Switch’s Q4 2017 and full-year revenues appear to have been mostly in line with or slightly better than consensus estimates. The investor disappointment that sent its shares tumbling down seems to have stemmed from the Las Vegas-based company’s 2018 revenues, EBITDA, and Capex guidance.
The timing of an IPO is influenced by many factors. Ideally, a company has recent history of revenue and earnings growth to help attract the investment banks that underwrite most Wall Street IPOs. The slide below shows that Switch’s public offering was timed well in that respect.
The comparisons between the 2017 results released this week with the prior year are shown above as part of the five-year CAGR charts.
The results for 2017 were certainly in the ballpark of what investors had expected:
- Revenues for 2017 were up 19 percent year over year versus a 22.7 percent average growth rate and pretty much in line with analyst estimates.
- Notably, adjusted EBITDA (a metric similar to REIT funds from operations) grew at an impressive 27 percent rate compared with the 19.5 percent five-year average.
- Switch also racked up strong EBITDA margin growth, improving from 48.1 percent in 2016 to 51.5 percent last year, an increase of 340 basis points.
Additionally, three other metrics reported by Switch for 2017 were particularly impressive:
- Maintenance Capex was $4.6 million, or just 1.2 percent of revenues;
- Churn of just 0.6 percent in 2017, down from 1.1 percent the prior year; and
- The ratio of net-debt to adjusted EBITDA (balance sheet leverage) was just 1.7x as of Dec. 31, 2017.
I believe all three of these metrics to be industry leading when compared to the five publicly traded US data center REITs.
A Chink in the Armor?
However, management's guidance for 2018 was for a significant deceleration in growth rates of both revenue and adjusted EBITDA compared with 2017.
Switch provided guidance for total revenue in the range of $423 million to $440 million. The midpoint of $431.5 million represents just 14.2 percent growth year over year, a significant deceleration from 2017, and well below the five-year CAGR of 22.7 percent.
Guidance for 2018 adjusted EBITDA was for a range of $216 million to $224 million. The midpoint of $220 million represents a 12.8 percent growth rate compared with 2017, also well below the five-year CAGR of 19.5 percent.
EBITDA margins for 2018 were guided to be 50 basis points lower at 51 percent. During the call, management explained that 51 percent is also the company's long-term target. I think analysts who expected margins to continue to improve as Switch scaled its campuses were surprised.
Capital Allocation Matters
Switch spent about $400 million in 2017 on new data centers and expansions. The guidance for 2018 was for total capital expenditures in the range of $260 million to $310 million. However, keeping track of where the money is being spent on a percentage basis could be more important than the changes to the overall budget, (which is partially driven by the rate of cabinet sales).
In 2017, about $200 million or half of all expansion capex was spent at the Switch Las Vegas campus. This is a mature campus, where each incremental dollar spent will yield the highest returns on invested capital.
During his prepared remarks on the earnings call, Switch president Thomas Morton mentioned "19 percent cash flow yields" as the ROIC metric achieved by the company for 2017.
The table above highlights how utilization at The Core Campus in Las Vegas is many times higher than either Reno/Tahoe or Grand Rapids.
The investment required to develop the early phases of a massive data center campus will typically have the lowest returns. ROIC will increase over time, as scale and operating leverage come into play.
During the earnings call Q&A, Morton was asked by Cowan & Co. analyst Colby Synesael to estimate where the 2018 capex budget would be spent. He broke it out as follows: Atlanta $60 to $70 million, Las Vegas $60 to $70 million, Reno/Tahoe $65 to $75 million, and $30 to $35 million spent at the Pyramid Campus in Grand Rapids. Notably, management shared on the call that after the end of Q4'17 the balance of the vacant space in Grand Rapids was leased.
Clearly, the Las Vegas portion of capex in 2018 will represent a much smaller percentage of the total spend and much smaller figure year over year. The Keep Campus in Atlanta is a new ground-up development going from $7 million last year to about $70 million to fund the site work and infrastructure and construct the initial data center improvements in 2018. It will not be generating any EBITDA until 2019 and beyond.
It is common sense that near-term cash flow yields will be declining, since a larger percentage of the capex is allocated to newer campuses with low utilization rates.
Earnings Call Highlights
Some key takeaways from the Switch Q4 2017 earnings call and SEC filings:
- Switch is sponsoring the largest solar project in the US, "Rob Roy's Gigawatt Nevada," which will enable the firm to sell customers renewable energy at $0.049 kW/hour.
- Hulu was mentioned by name as a major new customer win for Switch. The Switch 100 percent green energy profile will reduce Hulu's carbon footprint by 265,000 tons, or equivalent to taking 50,000 cars off the road each year, Morton said.
- Switch announced that it was now partnering with Rackspace to provide customers pay-as-you-go private cloud, managed services, and connectivity options to multiple public cloud providers.
- Switch offers "double-digit" telecom network offerings in Reno/Tahoe, Grand Rapids, and expects a similar number in Atlanta. Notably, The Keep property in Atlanta is near a large Google campus, which required substantial fiber infrastructure and is a magnet for carriers.
- Tenant concentration: One customer accounted for 18% of accounts receivable as of December 31, 2017, per Apr 2, 2017 10-K filing. Switch's largest customer eBay represents ~11% of revenues, down from 13% in 2016. Top 10 tenants for Switch accounted for 38.5 percent of revenues in 2017.
- During the Q&A, Credit Suisse analyst Sami Badri asked about details regarding the large eBay/PayPal deal. Evidently, the deal was signed for seven years, with a set schedule to take down space and pay for it. However, the initial ramp-up will result in a $9.4 million revenue adjustment during the first half of 2018.
The Switch prepared remarks on the earnings call often focused on the bigger picture.
Notably, there’s no mention of the words “data center” in the Switch mission statement, which reads: "Switch is a technology infrastructure company powering the sustainable growth of the connected world." In a sense, this could be part of the disconnect between the Switch C-Suite and Wall Street, where most investors view the company primarily as a colocation data center operator.
Several investment banks published research notes after Switch reported earnings. Raymond James maintained an Outperform 2 rating with an $18.00 price objective. BMO Capital Markets also maintains an Outperform on Switch, lowering its price target to $20 from $23 per share. Additionally, Jefferies analyst Scott Goldman reiterated a Hold rating on Switch shares but lowered his price target to $16 from $20 per share, according to Marketwatch.com.
Hopefully, at some point, Switch management will become more transparent around key metrics like number of cabinets billed, cost per MW to develop MODs, and perhaps schedule an Analyst Day to share longer-term goals with investors, along with a roadmap for achieving them.
Note: Investors should also be aware that the IPO 180-day insider share lock-up expires in April 2018, which could create more volatility for the Switch common share price.