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Equinix (EQIX) Investment Write Up

Equinix (EQIX) Investment Write Up

EQIX is the largest retail colocation data center operator globally, with a 20% market share. EQIX was founded in 1998 by Al Avery and Jay Adelson to help scale the growth of the internet by allowing competing networks to connect and share data (check out Tubes for a great description of the physical internet). EQIX provides customers with space and power (colocation revenue), the ability to interconnect with other customers, and operational support and installation assistance. EQIX operates 227 IBX (International Business Exchange) data centers in 63 markets across 26 countries. As of March 26th, EQIX had a market cap of $60bn, and the company generated $6bn of revenue and $2.9bn of EBITDA in 2020. Importantly, 94% of EQIX’s revenue is recurring with EQIX’s sources of revenue described below. From an operational perspective, EQIX's data centers have 99.999% reliability, which is crucial for its customers.

EQIX global footprint

Sources of revenue:

Colocation (71% of revenue): Customers pay a monthly recurring fee for the physical space for customer hardware as well as power, cooling, and the physical security of customer equipment. Customer space can range from shared cabinet space within a cage, to a private suite for a larger customer. Monthly charges are roughly $2,000/month depending on the geographic region and amount of space rented.

Interconnection (17% of revenue): Interconnections allow customers to connect and privately exchange data between their networks, either physically or virtually using software. Interconnecting leads to many customer benefits including reduced latency, lower costs to transport data as opposed to through long-haul networks, and data security benefits for enterprises connecting directly with large cloud providers. While most of EQIX’s interconnections are performed physically, the company provides virtual interconnections as well. EQIX charges a monthly recurring fee of $100-$200/month per interconnection, and this revenue generates extremely high margins (~95%), as there are minimal ongoing expenses once the interconnection is made. Interconnection is one of EQIX’s most important attributes and is described in more detail below.

Other recurring-revenue (6% of revenue): This is primarily made up of managed infrastructure services to support their operations such as on-site technical support, and customer access to operational and environment information within a given IBX footprint. This category also includes rental income from tenants and subtenants.

Non-recurring revenue (6% of revenue): Non-recurring revenue is primarily made up of installation revenue, equipment procurement, and operational support service for remote management and troubleshooting customer equipment.

Retail vs. Wholesale Model

There are two primary business models within the colocation market, retail, and wholesale, with EQIX focusing on retail. In the retail model, the data center operator leases colocation space and power to customers, and the customer retains ownership of hardware such as servers, storage, and networking devices. Retail contracts are typically 1-3 years in length with annual renewals, and customers are collocated in the same data center.

In the wholesale model, contracts are typically 5-10 years in length, and the customer leases the entire building or shell from the data center operator. Wholesale customers include hyperscale cloud providers (MSFT, AMZN, GOOG) as well as large content and media/entertainment providers.  Returns on capital are much higher in the retail model (15-25%) compared to the wholesale model (9-11% returns on capital), as customers have less purchasing power, and the retail model also allows customer to interconnect, a high margin revenue stream. While the retail model is more attractive, EQIX has expanded into the wholescale market through its JV with GIC (Singapore’s Sovereign Wealth Fund), to expand its international presence and increase its offerings aimed at hyperscale customers.

Diversified Customer Base

As mentioned, most of EQIX’s revenue is recurring and revenue is diversified by customer, geographic region, and by industry. EQIX has more than 10,000 customers, with the largest customer contributing 2.5% of revenue, the top 10 customers contributing 18.6% of revenue, and the top 50 customers contributing 39% of revenue. On a geographic basis, 45% of revenue is from the Americas, 33% from EMEA, and 22% from Asia-Pac. Finally, from a sector perspective, revenue is diversified across 29% Cloud & IT providers, 24% Networks, 18% Enterprises, 16% Financial Services, and 13% Content & Media. Here’s a representative customer list from EQIX’s 2018 Investor day presentation:

EQIX customer segments

Competitive advantages

EQIX benefits from several competitive advantages including network effects driven by customer interconnections, high customer switching costs, and economies of scale given its largely fixed cost structure.

Network effects

The interconnections between EQIX’s customers create network effects for EQIX, as numerous customer segments can benefit from interconnection. Internet service providers (ISP’s) connect with each other to form internet exchange points which reduces costs and improves routing efficiency. From there cloud service providers (CSP’s) look to interconnect to access these communication networks. This in turn attracts large enterprises who store substantial amounts of data with CSP’s, and other enterprises looking to connect directly for secure business transactions. As a result, the more ISP’s and cloud providers are in EQIX data centers, the more demand there is for other customers to collocate in the same facility, thus creating a network effect.

For example, a media company can interconnect with an (ISP) such as Comcast or Charter, which reduces latency and leads to a better customer experience such as faster streaming ability. Or a global energy company can interconnect with CSP’s such as Amazon or Microsoft to access their data on a single platform using EQIX’s cloud exchange, creating added redundancy, and allowing the energy company’s employees to quickly access data regardless of their geographic location.

EQIX is by far the market leader in interconnection revenue with a 65% market share globally, and 3x more interconnects than DLR. EQIX generated $900mn from interconnections in 2020 from its 392,000 interconnects. EQIX customers can also interconnect virtually across any of EQIX’s global data centers using software. Of EQIX’s 392,000 total interconnections, 29,600 are virtual connections, up 31.5% y/y.

EQIX interconnection market shareSource: https://www.c8k3.com/blog/interconnection-update-q3-2020

High switching costs

High customer switching costs are driven by the relatively low monthly fees EQIX charges relative to the cost for customers of moving their equipment to a competitor. The estimated cost to move cabinets is $10K, compared to EQIX’s colocation and interconnection charges of roughly $2,000/month. If a customer could save 10% by switching to a competitor, it would take them more than four years to break even! As a result, EQIX has relatively low quarterly churn rate of 2.5% despite a short average contract length of 1-3 years, with annual renewals.


EQIX’s global operations also create high switching costs as 88% of its customers are in more than 1 metro, 74% in more than one region, and 62% in all three regions. Even disregarding the cost of switching to a competitor, for many of EQIX’s customers it is preferable to deal with one data center operator, then having to cobble together agreements with multiple data center operators. While small and midsize enterprises may not need access in multiple regions, EQIX focuses on multi-national enterprises serving 54% of the Fortune 500 and 40% of the Global 2000.

Economies of Scale

Finally, EQIX enjoys economies of scale as fixed costs (labor, rent, maintenance, and some percentage of consumables and other) make up at least 60% of EQIX’s operating expenses. EQIX’s largest variable expense is power, which historically has made up 11-12% of total revenue over time and 22% of overall expenses.

As a result of economies of scale, EBITDA margins have slowly improved over time from 45% in 2010 to 48% in 2020. While management has guided to a slight decline in EBITDA margins to 47% in 2021 due to increased growth-related expenses, management expects EBITDA margins to improve to a 50% run-rate level in a couple years. Given the high margins on stabilized data centers (68% gross margins), EBITDA margins could eventually increase above 50% as a higher percentage of data centers become stabilized.

EQIX EBITDA margin

Strong Returns on capital

As a result of EQIX’s competitive advantages the company has consistently generated attractive returns on capital at the development level and corporate level. Additionally, EQIX has generated strong growth in Revenue, EBITDA, and AFFO (Adjusted FFO) over the past 5 and 10 years through its strong capital allocation.

Attractive per development IRR’s

Development level returns are extremely attractive as illustrated below. A new 2,000 cab data center costs roughly $100mn to build, comprised of $20mn for the core and shell (physical site and property), $50mn for building improvements, $25mn for equipment (HVAC systems, generators, security, etc.), and $5mn for other. However, not all of these costs are incurred at once. Construction/acquisition of the core and shell and phase 1 construction represents most of the investment (60%). The new phase takes 6-12 months to reach cash flow break even and 12-18 months to fill. Typically, EQIX will begin construction of additional capacity within two years of completing the prior phase.


Data Center image

Based on the margins, utilization rates, and time frames EQIX has provided for new developments, I have shown estimated financials for a new development over a ten-year time frame. This project generates a 23% IRR over ten years and breaks even after 5-6 years. I’ve assumed an 80% utilization rate is achieved by year 5 and that MRR/cab increases 2%/yr. By year 6 annual unlevered returns on this project are 28%, which is in-line with EQIX’s 27% yield on stabilized projects as of 4Q20. This compares to a 20% yield on expansion projects.

Project IRR

Strong Company level ROIC’s

On a company level basis EQIX has generated an average Return on Invested Capital (ROIC) of 17% from 2010-2020, and an average Return on Incremental Invested Capital (ROIIC) of 15% from 2011-2020. ROIC has trended downwards over time, partially reflecting EQIX’s large acquisitions over the past few years. As of YE20, EQIX had 147 stabilized data centers, 47 in the expansion phase, and 15 new data centers. As the new and expansion data centers stabilize margins and returns on capital will improve.

EQIX ROIC

Capital allocation priorities

You can see EQIX’s sources and uses of capital since becoming a REIT in 2015. The company has been able to fund most of its capex through CFO but has needed to issue $12.6bn of debt and equity to fund its acquisitions and its dividend.

Capital sources and uses

EQIX has made numerous acquisitions over time to build out its global footprint and acquire new capabilities. Specifically, EQIX acquired Telecity Group for $2.9bn in 2015, which included 34 data centers, 7 new metro regions and 1,000 new customers. EQIX’s largest acquisition was a portfolio of 29 data centers from Verizon for $3.6bn in 2017, which also expanded EQIX’s geographic reach and added 600 new customers. More recently, EQIX acquired CPX India to expand into India, and announced the acquisition of 13 data centers in Canada from Bell for $750mn. EQIX also acquired Packet Host for $335mn in 2020, which allows customers to access EQIX’s bare metal servers on demand, eliminating the capital and operational requirements of owning the hardware.

Going forward I expect EQIX to continue taking part in M&A as the data center market remains fragmented. As mentioned EQIX is the largest Data Center operator with a 20% market share, but there are over 1,200 data center operators globally. EQIX vies M&A as an attractive means of entering new markets, expanding interconnections, and adding new services and capabilities such as the Packet Host acquisition. EQIX sees opportunities to expand in regions where the company doesn’t have a strong presence currently such as Latin America, South Africa specifically and Africa more broadly, and South East Asia.

EQIX market shrae

Strong Historic Growth Rate despite weak MRR growth

As shown below EQIX has generated strong growth in Revenue, EBITDA and AFFO over the past 5 and 10 years. Over the past 5 years all of EQIX’s revenue and EBITDA growth was driven by growth in cabinets billed which grew 17%/yr. over that time frame while MRR/Cabinet was flat and margins only slightly improved. Over the past 10 years, cabinets billed grew 14%/yr. while MRR/Cabinet grew 2%/yr. and margins improved slightly during that time frame as described above.

EQIX growth drivers

Interestingly, MRR/Cabinet, a proxy for pricing power, has not increased much over the past decade despite EQIX’s numerous competitive advantages. However, it is challenging to parse out EQIX’s pricing power, as MRR/Cabinet has been negatively impacted by acquisitions and by new and expansion developments.

EQIX MRR by Region

Numerous Secular Growth Drivers

Going forward, data center operators will be positively impacted by numerous technology trends including Digital Transformation, 5G Networks, Internet of Things, Digital Payments, Artificial Intelligence, and Augmented/Virtual Reality. Each of these trends will increase data storage needs as well as the need for improved latency and data security, which are key attributes of EQIX’s colocation data centers and customer interconnections.

EQIX Tech Trends

 

As a result of these trends, the colocation data center industry is expected to grow revenue by high single digit to low double-digit growth over the 5 years based on a variety of estimates. For example, Barclays and the 650 Group estimate that the Colocation Industry revenue will grow roughly 10%/yr. through 2024.

Colo industry growth Barclays

Similarly, in late 2019 Credit Suisse estimated that data center revenue would grow 8.5%/yr. through 2023 but noted that this estimate is likely conservative given that CSP revenue is expected to grow 16.7%/yr. through 2023 and is a key driver of data center revenue growth. Credit Suisse estimated that interconnectivity revenue would grow 12.1%/yr. through 2023.

Data storage moving off premise to data centers

One of the key drivers of increased data center revenue will be data center storage moving off premise away from enterprises to data centers. As of 2019, 61% of IT infrastructure and 44% of workloads were still on premise and businesses can realize numerous benefits moving off premises including greater efficiency, reliability and physical security. Barclays and Group 650 expect on premise servers at large enterprises to decline by 8.4%/yr. through 2024, while data center servers grow by 9.9%/yr. and cloud servers grow 20.7%/yr. Whether those workloads migrate to wholesale or retail data centers, EQIX is well positioned given its strong market share of hyperscale cloud edge nodes.

EQIX hyperscale market share

Hyperscale represents a growth opportunity for EQIX

Currently, hyperscale represents roughly 30% of the data center industry’s revenue and as is expected to grow at a faster rate than retail colocation revenue. In 2019 EQIX created the xScale JV with GIC aimed at entering the hyperscale market. The JV structure allows EQIX to play in the hyperscale market while preserving most of its capital for higher returning retail projects. The xScale JV was initially formed to address the European hyperscale market, and in late 2020 EQIX entered into a second JV with GIC aimed at the APAC hyperscale market.

As of YE20 the JV has over $1bn of assets including data centers in London, Paris, Frankfurt, and Japan, and currently has projects under development in Brazil, France, Japan and other markets. Currently, the xScale JV represents less than 1% of revenue for EQIX, but it will become a more meaningful driver of AFFO over time. EQIX plans to spend $225-$275mn in xScale in 2021. At its 2018 Investor Day, EQIX projected that its hyperscale investments could add $80-160mn of NOI over 5 years. I expect EQIX will provide an update on its xScale program at its upcoming Investor Day in June 2021.

Edge computing

Another key trend is edge computing, where data processing and storage is distributed and located closer to the end users as opposed to in centralized hyperscale data centers. The need for additional edge computing is driven by the growth of interconnected devices and Internet of Things. Edge computing creates the need for improved latency and creates data privacy and security issues as devices may be less secure than a centralized system. Both data center operators and Tower companies (AMT, CCI) should benefit from increased edge computing.

Relatedly, EQIX expects worldwide interconnection bandwidth capacity to increase 45%/yr. through 2023, due to increased global data usage. EQIX is well positioned due to their substantial lead in interconnections relative to their peers. EQIX is also very well positioned in the U.S., with 80% of the U.S. population 10 milliseconds away from an EQIX data center. Additionally, there may be opportunities for EQIX to develop smaller and more localized data centers to address data storage needs.


EQIX interconnection growth

Current projects in development

EQIX has 44 major builds underway in 30 markets across 20 countries, which includes 8 xScale JV projects. Most of these projects are expansions of existing data centers, where EQIX is adding additional cabinet capacity. Expansions are much lower risk projects, as a large portion of the capex for the property core and shell and building improvements have already been made. EQIX will be adding a substantial amount of cabinet capacity through 1H22 in the EMEA region (16,850 cabinet capacity), APAC region (10,550 cabinet capacity), and less so in the Americas (4,850 cabinet capacity), given EQIX’s large footprint in that region. As noted above, increased cabinet capacity has been by far the key revenue and EBITDA/AFFO driver over the past 5 and 10 years.

Risks

Improved computing power reduces data center demand

The biggest risk to EQIX is improved computing power such as improved network speeds which reduce latency, or storage and hardware improvements that outpace data usage growth. These improvements would reduce the amount of space customers need, which ultimately reduces EQIX’s pricing power and utilization rates. Upgraded equipment may also allow customers to reduce their physical interconnections, pressuring interconnection revenue and EQIX’s profitability. However, demand has shown no signs of slowing down, and EQIX has guided to 10-11% revenue growth for 2021. Furthermore, existing customers have been expanding their existing footprint with EQIX, with 90% of bookings from existing customers. Furthermore, both the retail collocation and hyperscale markets are expected to grow at high rate over at least the next 5 years as described above.

Increased adoption of virtual interconnections

Another risk to the sector is increased adopt of virtual interconnections, also known as software-defined interconnection (SDI’s), which allow customers to connect virtually. SDIs in theory lower the barriers to entry and creates opportunities for other data centers to increase their interconnections. Increased penetration of SDI’s could also decrease customer need for having a physical presence in an inter-connected hub. However, physical interconnections are still required for cross-connects that require maximum performance and security. Additionally, EQIX offers its own SDI, Equinix Cloud Exchange Fabric, and is by far the largest player in virtual interconnections. As a result, EQIX is well positioned if SDI’s become more popular.

Valuation:

At $668/share, EQIX trades at a 4% 2021 FFO yield, and a 4.5% 2022 FFO yield. Based on the company’s strong growth prospects described above, I believe EQIX can grow FFO/share by 8-10% per year over the next 5 years. Beyond that time frame, I expect EQIX will still be able to grow at a high single digit growth rate driven by the trends described above. As a result, EQIX should deliver 12-14% IRR’s over least the next 5 years.

Financials:
EQIX Financials

 Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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