I love it when rain keeps falling on a company whose future is sunny.
News that the Internal Revenue Service was scrutinizing this company's application to become a real estate investment trust (REIT) sent the shares down 5.5% in one day last month. Regardless of whether the company is allowed to change its corporate status, the fact that it's applied to do so means upward of $420 million in additional taxes over the next four years.
This company's shares also took a beating on April's first-quarter earnings report, plummeting 12% when revenue and profits missed lofty analyst expectations. Even though revenue increased 17% over the previous year and the company's gross margin was an outstanding 50%, analysts expected 7 cents more in earnings per share. Investors punished the stock, and short-sellers are swarming, with almost 17% of the shares outstanding borrowed and sold.
But all this just gives investors a chance to pick up a growth story that might soon be announcing a 10% special dividend. This company is in one of the hottest sectors of the tech world, and it's made a commitment to returning money to shareholders.
The Growth Industry That Doesn't Have To Pick Sides
The tech world is notoriously competitive, and investors usually have to pick the winner of the next software or hardware battle.
Witness the battle over mobile supremacy between Apple (Nasdaq: AAPL) and Samsung (OTC: SSNLF). Growth in the sector doesn't necessarily mean that both will profit as they fight over prices, software and rounded corners.
Investors in Internet search giant Baidu (Nasdaq: BIDU) understand this all too well. Rival Qihoo 360 (NYSE: QIHU) has stolen Baidu's spotlight and helped drive a 40% loss in BIDU over the past two years. Almost 400 million new Internet users in China since 2006 could not keep the country's largest search engine from losing the battle between PCs and mobile devices.
The growth in data center needs means that providers are not forced to compete in a no-holds-barred deathmatch. The number of Internet users worldwide doubled between 2006 and 2011, from 1.04 billion in 2006 to more than 2 billion users, and that still leaves 5 billion people to be connected. The number of smartphones in use around the world is expected to jump 400% to 2 billion by 2015.
With growth happening everywhere, investment for new centers and equipment is expected to exceed $35 billion this year. These are not services that can be outsourced to one or two locations around the globe -- they must be built close to clients. When your clients are every Internet and data user on the planet, then you're going to need more data centers.
In this industry, it's a race to put up enough locations to serve exploding demand.
Equinix (Nasdaq: EQIX) is an $8.7 billion provider of data center services to protect and connect the information assets of enterprises and network providers across the globe. The company serves more than 4,000 companies with managed IT infrastructure and co-location services, as well as connecting companies directly to their customers with its own interconnection platform.
In September 2012, Equinix's board approved the conversion to a REIT, with January 2015 as the target conversion date. Converting to a REIT could save Equinix between $55 million and $130 million a year on taxes.
News broke that the IRS was scrutinizing the company's eligibility for REIT status last month, and EQIX was hit hard. It's now down 20% from its $230 peak this year.
At odds with the IRS is the treatment of interconnection fees Equinix receives for services like power and telecom networking. The fees brought in $272 million in 2012, or about 14% of total revenue. Other data center REITs like CoreSite Realty (NYSE: COR) do not account for these fees as tax-exempt, so to qualify for REIT status, the company may need to change its accounting and pay taxes on the portion of revenue. Three other data center companies -- CoreSite, Digital Realty Trust (NYSE: DLR) and DuPont Fabros Technology (NYSE: DFT) -- are already operating as REITs, so there is a powerful precedent for Equinix's approval.
The downside to filing for REIT status is that the company will need to pay between $340 million and $420 million in depreciation recapture taxes for reclassifying its assets as real estate. The amount is payable over four years and already modeled into the company's projections.
Revenue in 2012 came from a broad variety of services, including networking (26%), cloud and IT services (24%), financial services (21%), content and digital media (20%), and enterprise (9%). Revenue has grown by an annualized 28% since 2008 while costs have grown at a slower 24% pace, meaning that margins are improving with higher sales. Gross margins are expected to be an outstanding 68% for 2013, about the industry average.
Ownership in the stock is at 115% of shares outstanding because of extremely strong institutional holders and the 16.8% of shares shorted. Some big hitters own Equinix, including Coatue Management (8.9%), Goldman Sachs (4.9%), Lone Pine Capital (4.6%) and Paulson & Co. (4.2%). The fact that more shares are owned than issued means that any strength in the stock could quickly lead to a short squeeze as short-sellers are required to cover their borrowed shares. This could happen on any favorable notice by the IRS.
Make A Quick 10% Return And Keep The Shares For Your Dividend Portfolio
On top of its regular distribution once it's been granted REIT status, Equinix expects to issue a special distribution of $700 million to $1.1 billion in undistributed accumulated earnings and profits. The annual report lays out the plan to do this in a combination of 20% cash and 80% stock after a favorable ruling from the IRS, with the distribution to be mostly completed before 2015. Splitting the difference on the $700 million to $1.1 billion, a special distribution of $900 million would amount to $18.75 a share, or just over 10% of the current share price.
An analysis of the company's cash flow backs up the argument for a healthy dividend.
This amounts to a dividend of $10.91 per share and a yield of 6% on current price. Although most companies do not pay out all distributable cash, a distributed cash flow-to-dividend ratio of 1.5 is common and would yield a $7.25 dividend for a 4% yield. This yield should easily be sustainable and still leaves plenty of cash for capital expenditures and growth.
Analysts at Wells Fargo agree. They estimate that the company is worth much more, giving it an "outperform" rating and a valuation range of between $277 and $293 per share.
Risks to Consider: Even with the 20% drop in the shares, the stock is trading at an expensive 61 times trailing earnings and could fall further if the IRS declines to grant it REIT status.
Action to Take --> Other data center companies have been allowed to convert, and it should only be a matter of time before Equinix receives good news. The stock has some strong upside catalysts and could be a good addition to your REIT portfolio.