This Technology Stock Offers Growth And A Huge Moat

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors know that to generate alpha, one must constantly seek out new opportunities and new ways of looking at the same things. Alpha can be created by capitalizing on public information that other investors cannot easily process (think footnotes of a 10-K). Building a better mousetrap (think a better trading or valuation model), achieving a better understanding of how the market works (an in-depth understanding of the company and its drivers), or exploiting structural impediments of the market (think cross-methodological work and post-earnings drift). In this article, I will explain why I like Equinix (NASDAQ: EQIX) and detail its main growth drivers and the reasons why I think Equinix is a solid investment.

Equinix has big data centers that other companies use to put data storage equipment (like servers) in and store data. This company sets itself apart by having 4000 customers and allowing one customer’s network to connect to another's. Equinix is like Grand Central Station for the Internet. This is the definition of cloud computing and the company is playing a leadership role in this technological revolution. Equinix customer list is so good it’s like something somebody made up (Google, Microsoft, Amazon, GE, Verizon, etc). These networks are tied to each other through Equinix, so you’re probably traveling through EQIX’s “stations” all the time without even knowing it. Maybe right now. I think the fact everybody can connect to each other on the Equinix global network (called IBX or International Business Exchange) is the key to Equinix’s success.

Equinix has been achieving continued business momentum with its critical mass of customers and the resultant network effect within its IBX centers. Direct interconnection with its aggregation of networks, which serve more than 90% of the world Internet routes, enables customers to increase the efficiency of their IT infrastructure, remove some complexities of administering and
managing their infrastructure, while significantly reducing costs. Service offerings, such as Equinix Exchange and Equinix Internet Core Exchange significantly reduce the cost of critical transit, peering and traffic exchange operations by eliminating the costs of private peering or local loops. The difficulty and cost associated with changing infrastructure providers is advantageous in the long-term, increasing the loyal customer base in every single month.

In the illustration below we can see that Internet growth will continue in the next years driven by increased Internet device sales.

<img src="/media/images/user_13232/equix_1_large.png" />

Equinix's narrow economic moat is defined by network effects. As the largest network-neutral provider of data centers and the true leader, Equinix's customers can connect to more than 625 network providers. Furthermore, many of these customers connect directly to each other via Equinix facilities, for needs such as cloud computing, desktop virtualization, or content distribution. Equinix offers reliability and increased speed by controlling the number of "hops" on the public Internet; they can also connect to private networks, or Equinix's Ethernet exchange, having the ability to choose their own network provider. Predictability, reliability, and security are more important than price per cabinet for these customers. Equinix's scale and track record for reliability, including 99.9999% uptime, are powerful traits.

Demand for its services has rocketed, as businesses have increased their reliance on EQIX to manage their internet traffic and mobile applications. Further evidence of this increased reliance is that the company, through its internet business exchanges, routes over 90% of the world's internet traffic. The earlier than expected announcement of a possible REIT conversion has surprised most analysts. However, the majority view is that the stock will continue to trade higher on the news, which has already shown substantial gains since the start of the year. REITS are required by law to distribute 90% of their taxable income as dividends, and they are subject to lower taxes, which is one of the reasons why companies aim to acquire REIT status in the first place. The company, expecting to achieve the more tax efficient REIT status in the beginning of 2015, will make a special distribution to its shareholders of approximately $0.7-to-$1.1 billion, which it will finance through a combination of cash and equity issue. A significant portion of the above-mentioned distribution is expected before 2015, with the balance to be paid out after its REIT conversion.

Equinix competitors are Rackspace Hosting (NYSE: RAX) and InterNAP Networks (NASDAQ: INAP) among other firms. Equinix builds and owns state of the art data centers which provide collocation and infrastructural services to public and private clouds. It is the ultimate ‘picks and shovels’ play on cloud computing. Rackspace mainly provides managed hosting services although, it also provides data center services as part of the mix. The key difference is that Rackspace offers a high level of ongoing support and, its business model involves significant capital outlays on customer gear in order to support top line growth. I don’t think its cash flow profile is as attractive and investors need to keep an eye on how this develops. Trading at a market cap of just $380M, InterNAP is a much smaller company but it is worth taking a look considering it is expanding its data centers.

Equinix is a growth story, with a staggering revenue growth of 40% since FY2007. On average, the company has been able to generate a revenue growth of over 30% per year for a number of years now. This growth is in line with the company's goal of generating over $3 billion in annual revenues by FY2015. In the financial year ended 2011, revenues came in at $1.6 billion.
Gross margins are high, and they have been rising consistently. In the year 2007, the company posted gross margins of 37%, and as at financial year ended 2011, they have expanded to over 45%. The same growth can also be seen in its bottom line, with a quarterly earnings growth of 37%.

<img src="/media/images/user_13232/equix_4_large.png" />

Apart from the strong results announced by the company, the stock also got a big boost from the management's recent upward guidance. For the third quarter of the year, EQIX is expecting to generate revenues between $492 million and $498 million, above consensus expectations of $485 million. For the full fiscal year, the company is also expecting higher than sell side estimated revenues of $1.92 billion. I believe the company has a strong potential for further growth.The stock has performed exceptionally well since the start of the year, up almost 80% on a YTD basis, versus the Telecom ETF being up only 10%. EQIX has a forward P/E multiple of 47x, which looks expensive but is below its historic average P/E of 98x. Considering the high growth nature of its business, the valuations are not that high. Also, P/S (4.4x) and P/B (3.5x) are at a discount to its industry.

I think that Equinix combine a superb moat, diversified customer base, growing earnings and a shareholder oriented management team (reflected in the REIT conversion plan). This is a must-have stock in any technology oriented investor.

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