09:49am EDT 5-Oct-99 FAC\Equities ISLD-Initiating Coverage with a Buy
October 5, 1999 Previous Research Flash: 10/05/99
F A C/ Equities
A division of First Albany Corporation
INSTITUTIONAL EQUITY RESEARCH FLASH
New Stock
Digital Island, Inc.
(ISLD)
Rating
Buy
FY Sept
Price $25 3/16
52-Wk Range $40 7/16-$8 21/32
Shares Out. 35.9 mil.
Avg.Dly. Vol. 593950
Market Cap. $904.2 mil.
Debt/Capital 2.3%
Div. Yield 0.0% EPS may not add up due to rounding. EPS numbers may not add up
due to rounding.
3-Yr EPS Gr.
Earnings per Share P/E Rev
Q1($) Q2($) Q3($) Q4($) Yr($) Prev($) Ratio ($mil)
1998 (0.18) (0.19) (0.26) (0.31) (0.96) N/M 2.34
1999E (0.32)A (0.49)A (0.40)A (0.65) (1.94) N/M 12.08
2000E (0.69) (0.68) (0.66) (0.64) (2.67) N/M 46.73
2001E (0.64) (0.65) (0.64) (0.61) (2.54) N/M 121.96
ISLD-Initiating Coverage with a Buy
We are initiating coverage of Digital Island, Inc. with a Buy rating. The
company, founded in 1994, provides distinctive network services and a global
"application hosting and content distribution" service. We think these services
are crucial to companies that require secure network management, b-commerce
solutions, and reliability in international markets.
The Digital Island network includes five data centers with direct connections in
19 countries. In addition, the company has 10 content distribution sites around
the globe to pull content from an original server, deliver information quickly,
and improve the performance of bandwidth-intensive applications. Services such
as application hosting and network management are securely delivered over a
private network. Each time any data is sent across the network it is sent in two
"hops," it is sent twice, and it is verified.
Key Reasons to Buy
1. Early-stage entry as high-quality provider in international markets
2. Strong growth in enhanced services, implying a positive shift in profit mix
3. Network is largely fixed-cost so there should be strong P&L leverage
4. Compelling valuation. Our estimated target price range for the shares is
$35-$45
Company Services
Digital Island focuses on bringing high-quality Internet hosting services to
corporations with global operations. The company's product line addresses many
of the public Internet's reliability and security deficiencies that are
compounded in international environments. The company has a dedicated (private)
global network, or "overnet," that functions exactly like the Internet, but
transports data far more efficiently and securely. Digital Island charges a
premium (an estimated 20-40%) over the connectivity rates of traditional Tier1
ISP telcos (UUNet, GTE Internetworking, SprintNet, etc.), but in return, the
ISLD clients receive enhanced reliability, tracking, security, and high
performance.
Digital Island's Application Service Extensions (ASEs) are products designed to
facilitate and "accelerate the deployment of new e-business application
services." Examples include electronic commerce, online customer service,
software document and multimedia distribution, sales force automation and online
training. Recently, the company introduced an ASE called Traceware, a
verification and tracking program with "geographic intelligence." Traceware's
tracking feature recognizes the Internet consumer's country of origin and
enables e-business applications to deliver appropriate content to the customer.
Traceware also authenticates the destination for compliance with local laws and
distribution rights. This feature is also critical to Digital Island's new audio
and video streaming product targeted to the Production/Media/Entertainment
industry and developed in partnership with Inktomi (OTC: INKT-$114 11/16) and
RealNetworks (OTC: RNWK-$105 13/16). The service_combining a private broadband,
local content caching, and authentication_may also be one of the first
significant attempts to overcome the technological and legal barriers associated
with streaming audio and video.
Customers
Digital Island's services target four vertical business segments: technology,
software, financial services, and publishing/media/entertainment.The Digital
Island client base includes corporations in the $25 million to $2 billion range
that require international communications services but without the traffic
volume to justify leasing its own lines directly. Customers include: Autodesk
(OTC: ADSK-$21 1/16), Cisco (OTC: CSCO-$70 5/16-Accumulate), E*TRADE (OTC:
EGRP-$23 1/8), National Semiconductor (NYSE: NSM-$32 5/16), and NetGravity (OTC:
NETG-$31 5/8-Accumulate). To date the company has about 80 customers. Average
revenue per customer per month is over $16,700.
Company Growth Components
We forecast the company will grow revenue 283% from an estimated $12.1 million
in fiscal 1999 (September) to $46.7 million in fiscal 2000; in fiscal 2001 we
expect revenue growth of 161% to $122.0 million. In fiscal years 2002 and 2003
we think revenues of $244.7 million and $411.1 million are achievable.
From December 1998 to March 1999, average customer revenue per month increased
42% from $11,783 to $16,743. We expect the trend in customer sales to continue
as the company penetrates new geographical areas and launches new services.
Customer contracts typically span one to three years; we think customers are
likely to subscribe "up" the value chain to additional Digital Island services,
and that these customers are less likely to churn.
Gross margin should reach a new low in the present quarter as Digital Island
engages in a significant expansion of its facilities and lines. Cost of revenues
consists primarily of leasing transoceanic lines from telecommunications
providers, with the additional cost of leasing local circuits between the data
centers and the company POPs. For fiscal year 1999, we estimate gross margin of
-144% dropping to -47% in fiscal 2000, turning positive in the first half of
fiscal 2001, and ultimately reaching 55-60% or more in five years.
We predict EBITDA margin will also trough in the current quarter at -493%,
resulting in a -413% margin for full fiscal 1999. EBITDA margin should improve
to -192% in fiscal 2000, and increase from there to -58%, -8%, and 15% in fiscal
years 2001, 2002 and 2003, respectively. In five to six years we think the
company could reach EBITDA margin levels of 25-30%.
Balance Sheet
Digital Island raised $69 million from its IPO in June of this year, and the
company also has a $7.5 million line of credit. At the close of the offering the
company had about $2.13 per share in available cash and negligible long-term
debt. The company has stated it will have sufficient funds for operations,
working capital needs, and capital expenditures for the next 12 months. The
company policy is to lease lines rather than own them, however, it will have to
spend capital on networking equipment as it continues to expand markets. With
EBITDA losses of $20-$23 million over each of the next five quarters, we think
the company will need to seek outside capital from either equity, debt or
strategic markets fairly soon.
Valuation
For valuation purposes, we use 2002 EBITDA for a base across all of the
companies in our coverage (though for Digital Island we are using fiscal 2003);
this is consistent with our view that the industry will grow on a more
"normalized" basis relative to the size of the participants at that time. We do
not think companies should be "penalized" for aggressive growth tactics that
impair profitability at this early stage in the expansion of the industry. We
justify our Buy rating relative to our estimated target price range of $35 to
$45 per share based on 20-25x our EBITDA estimate of $62.4 million (or $1.74 per
share) in fiscal 2003.
Risks
A. Competition. Digital Island's market is extremely competitive with few
barriers to entry. The competition includes IT and Internet outsourcing firms,
Internet Service Providers, and global, regional and local telecommunications
companies. Major players include ISLD's own partners_telecommunications giants
with deep pockets such as AT&T (NYSE: T-$43 3/4), MCIWorldCom (OTC: WCOM-$71
5/8), GTE (OTC: GTEC-$0.03), Exodus (OTC: EXDS-$66 1/16) and Frontier
GlobalCenter.
B. Regulation. ISLD has exposure to both domestic and international regulatory
issues. Generally, the Internet industry has enjoyed a hands-off treatment by
regulators, but we think this may change as services become more pervasive and
"abuse" stories regarding privacy and fraud inevitably surface. Regulators have
addressed Internet issues only by implication, through mediation in the telecom
industry on issues such as competition between long-distance and local, CLEC and
ILEC. Some media/content topics have been addressed, however, many issues
remain and may slow industry growth in service penetration, profit margins, and
sources for additional revenue.
C. Internet Valuations. Market valuations of Internet companies remain
relatively high when compared to historical segment valuations and to the market
in general. Investors must appreciate the risks involved with these issues and
maintain a longer-term investment horizon in these speculative offerings.
San Francisco, CA-based Digital Island, Inc. provides network services for
globalizing e-business applications. These services include content hosting and
content services along with high bandwidth access. The company has five regional
data centers servicing 19 countries with 10 worldwide local content managers.
The company went public on June 29, 1999, raising $29 million through a
$10-per-share offering.
First Albany makes a market in shares of NETG. First Albany underwrote an
offering for NETG within the last three years.
More information is available on request. First Albany makes a market in shares
of this stock. The material herein, while not guaranteed, is based on
information believed reliable and accurate. It is not to be deemed an offer or
solicitation on our part with respect to sale or purchase of any securities.
Our corporation or its officers, directors, or stockholders, or members of their
families, may at times have a position in the securities mentioned and may make
purchases or sales of these securities while this report is in circulation.
Due to differing disciplines and criteria utilized, our quantitative and
fundamental analysts may have differing opinions on these securities. Should
you have any specific investment questions, please contact your First Albany
Financial Consultant. Our main office is located in Albany, NY.
First Albany Corporation, Member New York Stock Exchange, Inc. and other
principal exchanges. Copyright c 1999.
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