This Stock is Locked in a Battle -- Here's How You Can Play Both Sides...

David Sterman's picture

Wednesday, October 6, 2010 - 3:41pm

by David Sterman

It is the job of every Wall Street analyst (known as a "sell-sider") to convince clients to buy stocks on their buy list. Those clients -- hedge funds and mutual funds also known as "buy-siders" -- give the ideas a listen, but often form differing opinions on those very same stocks.

And right now, the two camps are clearly divided on one of the strongest tech stocks of the past 10 years. That stock is Equinix (Nasdaq: EQIX), which operates massive data centers that host major companies' websites and enterprise servers. Right now the company's detractors, largely on the buy-side, are showing the winning hand: shares fell an eye-popping -33% on Wednesday after the company reduced quarterly guidance.

At first glance, that sell-off may seem unwarranted as management simply shaved guidance by a very small amount. And the damage appears largely confined to just two customers, both of which asked for some price concessions on a new contract. Management was quick to note that business is otherwise trending well.

Sell-side analysts, which have always been very supportive of this stock, were quick to come to its defense. Even though shares fell from $105 to $72, Deutsche Bank still expects shares to move back to $100, Piper Jaffray's price target was lowered from $124 to $110. Merrill Lynch? Standing by its $130 price target, despite Wednesday's news.

To understand why analysts remain so bullish about this stock's future, you need to look to the past. Equinix developed a brilliant business strategy where major web servers from different companies sat right next to each other and are also plugged right into global Internet traffic points, known as co-location. The whole move to data centers has been an obvious one for IT managers, as it saves money and headaches, and Equinix's co-location services made the offer all the more compelling.

As Equinix's selling proposition lured customers in droves, the company's sales took off and EBITDA margins soared, steadily rising from 12% in 2005 to 40% in 2009. Not that Equinix has much to show for those impressive operating metrics -- the company has continually poured all of its cash flow back into the business, and as a result, has generated negative free cash flow for each of the last four years.

Sell-side analysts have never had much problem with that, as they have assumed that once investments are complete, free cash flow would be bounteous. And in the next year or two, that is indeed expected to finally be the case. But the company's detractors hold a much more dim view of the long-term. They note that this is still a price-sensitive business, and they think that this week's modest shortfall -- highlighted by some price concessions -- is a harbinger of things to come.

In addition, bears say that major global phone companies such as AT&T (NYSE: T) hold the strongest long-term hand, since they actually operate the Internet's backbone and can set the pace on pricing. As of yet, that scenario hasn't played out, as Equinix's sales power ever higher.

To keep sales rising, Equinix has been making some fairly hefty acquisitions and is rumored to be planning another, this time for a European company known as Interxion in the coming weeks.
Not everyone on the sell-side is convinced that Equinix can keep pulling away from the competition. Citigroup just lowered its rating from "Buy" to "Hold," citing concerns about stagnant growth at a recently acquired division and rising customer turnover. It thinks this week's modest pre-announcement is "an early sign-post that revenue growth for its core demographic in the U.S. may be slowing sooner than we anticipated."

Kaufman Brothers believes that digital content companies such as major media firms may actually look to move away from the use of data centers and start hosting more servers on their own corporate sites. That would be a real blow to the data center industry. But most sell-side analysts remain quite bullish, and will probably keep pounding the table for the stock in the days ahead.

Action to Take --> Equinix is scheduled to meet with the investment community on November 11th. Ahead of that event, shares are likely to rebound from here as the sell-side talks up the big disparity between the current price and their price targets. So despite this news, shares may now be a short-term buy, but they increasingly look like a long-term sell. Shorts made a killing on this week's plunge, and many have likely covered their short positions. But as shares rebound, they are bound to attract fresh short interest. You can look to go long on this name now, and perhaps reverse course if shares move back into the $80s or $90s.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.