Vik Grover's recommendation as of 10/24
PSINET, INC. (PSIX $7 9/16)
RATING: STRONG BUY
YEAR-END 2001 PRICE TARGET: $57
MANAGED SERVICES – THE NEXT FRONTIER
We Anticipate Strong Web Hosting Growth Will Drive Solid 3Q00. We expect Web hosting
revenues, driven primarily by demand for managed services and applications hosting, to
grow significantly for PSIX in 3Q00 to an annualized run rate of more than $180 million
($45 million quarterly run rate), up 80% from annualized revenues of $100 million+ in 2Q00.
This would mark a third consecutive quarter of accelerating growth in PSIX’s Web hosting
business. Note that our estimate is at the mid-point of management’s guidance (see
www.psi.net/news/pr/00/sept15.html). The company has met a very strong reception for this
offering since its launch in 1999, coming off QoQ growth in Web hosting of 59% in 2Q00 and
35% in 1Q00. More mature facilities, such as Los Angeles, are filling up well ahead of
management’s guidance, which calls for each center to completely load after three years of
operation. In fact, Los Angeles is more than one-third full after being launched only this February,
suggesting it will be full within 18-24 months. Further, the company is currently moving
collocation customers out of its New York center to accommodate strong demand for managed
services on the part of new and existing corporate customers. In our view, the managed services
business is the real growth engine for PSIX. In total, the company [currently] intends to activate 18
Tier I data centers, each expected to be capable of generating roughly $200 million in revenues and
$120 million in positive free cash flow in the fourth year of operation (estimated average revenue
per gross square foot of $2,500). We think this activity bodes well for PSIX building a significant
high-margin business line, which should help right the company’s battered shares and reignite
interest from momentum-oriented investors and “value” Internet shoppers going into the holiday
season.
We think new management, including recently hired CFO Larry Hyatt, has set investor
expectations well below PSIX’s true Web hosting trajectory. We anticipate significant
outperformance from this portion of PSIX’s business, relative to consensus estimates, will soon
drive a new round of investor interest and an expanded valuation for the company, which trades at
a washed out EV/2001E revenue multiple of only 2.2x (we remind investors that most of PSIX’s
“peers”, such as Verio, Concentric Network, Splitrock, Digex – DIGX $58 7/16 – and IBM’s –
IBM $92 7/8 – Global Network, have been acquired under various market conditions for multiples
on revenues of 4-8x). Note that many Internet bellwethers, including Exodus (EXDS $34 1/8;
trades at an EV/2001E revenue multiple of 10-15x depending on the time of day), are rushing to
the managed services space because of its extremely high growth rate and opportunity for fat profit
margins as brick and mortar companies deploy complex e-business solutions during the next several
years – we think this kind of activity validates PSIX’s bundled services strategy and highlights the
inherently positive outlook for the company’s Web hosting division.
Using management’s guidance, we estimate that all 18 centers will be complete by year-end 2001
and full by year-end 2004. Given these circumstances, and assuming (1) no additional centers are
opened (we think PSIX will ultimately open many more centers than 18); (2) existing square footage
is not expanded (in general, these facilities are modular and can be expanded to beyond initial
capacity); and (3) that there will be no expansion of the company’s yield per square foot (which we
think is conservative, given the significant anticipated reductions in form factors for servers and
related technology and the increased complexity of applications hosting and e-business solutions
and rising need for design, integration and transaction processing services on both the front end
and the back end); we estimate 2005 free cash flow from the [initial] 18 hosting facilities of $2.16
billion. Using a 10x multiple, a 15% WACC, estimated year-end 2000 net debt/preferred of
roughly $3.9 billion, a 20% public/private market discount (to reflect Street views that
management is not prone to selling the company anytime soon), and 210 million diluted
shares generates a target public market value for PSIX’s common equity of roughly $6.8
billion, or $32-35 per share, during 2001. Our target valuation excludes PSIX’s $1+ billion
transport and access business, 600,000 subscriber consumer ISP Inter.net (annualized revenues of
more than $100 million; accounted for 40% of PSIX’s EBITDA drain in 2Q00), $200 million run
rate Transaction Network Services unit (gives the company a top share of the online transaction
processing market), a venture portfolio worth several hundred million dollars, a $1 billion systems
integration/Web solutions business, and a global network with roughly $2 billion in PP&E. In
total, we believe these assets/operations represent more than $16 billion in value, or $57 per share.
Source: Company Reports
Management’s presentation at the KBRO Emerging Communications Conference last
Friday left us with the belief that PSIX will give the Street details of exactly when and how
it intends to close its funding gap of $600 million, first reported to investors at the company’s
analyst conference several weeks ago. We continue to look for the company to fill this “gap” by
monetizing portions of its venture portfolio, selling its consumer ISP (potentially to the likes of
EarthLink – ELNK $7 11/32 – whose MindSpring operation purchased retail subs from PSIX a
few years ago), and raising guidance for EBITDA on the heels of strong high-margin Web hosting
growth. Avoided by many and off the radar screens of most, PSIX is a core Internet holding for
followers of our universe of coverage. We think the upside to the company’s story will
become painfully apparent to doubters over the near term, especially going into the New
Year when investors will likely seek out those names poised to benefit from significant
operating leverage inherent in their business models and move through a period of
accelerating EBITDA growth. We maintain our STRONG BUY recommendation and
year-end 2001 $57 goal. |
