Full report Part 2:
WE THINK PSIX DESERVES A SCARCITY PREMIUM
Despite its battered stock price and negative Street perception, we believe PSIX is still very much in the race to become one of these
supercarriers, either on a standalone basis or as part of a much larger organization with deep pockets. True, the company’s funding
situation caught us off-guard, has become an issue, and poses a near-term risk to PSIX’s go-it-alone strategy. But we think the company’s
significant portfolio of assets includes many non-core pieces that can be disposed of over the near term to meet is funding gap. We have
read our competitors’ valuation of PSIX’s assets and allegations of negative equity value of its shares and likelihood of
bankruptcy proceedings. Simply put, we disagree completely and would be buyers of the stock while followers of those claims
sell-out for next to nothing.
Highly leveraged competitive local exchange carriers (CLECs), such as GST (filed Chapter 11 several months ago and was sold for a sub-1x
multiple on PP&E to Time Warner Telecom – TWTC $68 3/16) and ICG Communications (ICGX $7/16; appears to be on the verge of
filing for protection from creditors), have blown up, due in part to their overly ambitious network builds and their exposure to price
competition in core markets. These examples saw their businesses precipitously fall into distress. In the case of GST (and likely ICG),
asset-driven valuations provided zero protection to common shareholders, since potential suitors waited to pick the company’s bones for
pennies on the dollar out of bankruptcy proceedings. Note that these CLECs had/have huge networks with replacement values that
were/are below historical cost. Potential suitors could either replicate them through partnerships with infrastructure providers (like
MFNX) and/or buy more vibrant, less leveraged CLECs, including over two dozen publicly traded names. But unlike the cases of GST
and ICG, PSIX has a defensible position. The company is a unique standalone asset with no true peer – the company deserves a
scarcity premium that, we believe, protects shareholders from being zeroed out through a Chapter 11.
IT’S BAD, BUT IT’S NOT A DISASTER! – PEEL THAT NASTY ONION…
So, with that said, we have revised our earnings model for PSIX, although admittedly there is limited visibility to our numbers. But maybe
there is more visibility to the company’s success than meets the eye. Specifics of the company’s quarter have already been commented on
ad nauseum by our competitors and the media, so we’ll leave out all the gory details of the period, highlighting the following:
Average new contract value for business accounts accelerated to $15,000 in 3Q00 from $9,800 in 2Q00, evidence of strong
gains in high-margin product lines during the September period and reductions in commitments to low ARPU collocation and shared
hosting services customers.
PSIX is entering the busiest period for its Transaction Services business, the Holiday shopping season, which is highly driven by
point of sale (POS) transaction processing services. In 3Q00, the unit generated gross margins of 43-45% and EBITDA margins
approaching 30%, which we think bodes well for PSIX’s 4Q00 performance.
PSIX continues to grow its Hosting business at a healthy clip – this was a major bright spot of the company’s 3Q00 results,
with hosting revenues hitting an annualized run rate of roughly $160 million. Hosting infrastructure at year-end 2000 will
encompass 14 centers with an estimated 1.0 million gross square feet of space and four additional data centers under
construction scheduled to be fully operational by mid-2001. The centers have estimated annualized revenue potential, if
fully loaded, of $3.5 billion and annualized EBITDA potential, if fully loaded, north of $2.0 billion. We look for this unit to
post strong growth in 4Q00 and approach an annualized run rate in revenues of $200 million, not far behind industry leader Digex
(DIGX $44). We footnote that PSIX now boasts 2,500 hosting customers with annualized new contract value of $354,000, up very
sharply from $245,000 in 2Q00 and ahead of DIGX’s $281,000 average annualized new contract value and Exodus’s (EXDS $33
9/16) $299,000 average annualized new contract value (DIGX commands an enterprise value of roughly $3 billion; EXDS commands
an enterprise value of roughly $15 billion). New center activations in Toronto, Amsterdam and Seoul, coupled with accelerating
annualized new contract value growth and increased penetration of existing customers, promises to move PSIX’s hosting business
through a steep growth curve in 2001, in our view, which should help right the company’s story on the Street (we estimate 2001 and
2002 hosting revenues at $365.9 million and $838.8 million, respectively, representing utilization rates of existing and planned centers
of 13% in 2001 and 25% in 2002).
PSIX has 3,500 sales and marketing personnel worldwide. We think the company’s huge direct sales and marketing force,
coupled with its significant indirect distribution capabilities, provides a significant competitive advantage and should
enable PSIX to sharply accelerate growth of its hosting business during the next several quarters. We note that the company
is now compensating sales people for sales of high-margin products, unlike prior period compensation plans that were based primarily
on quota carrying reps hitting revenue goals. PSIX’s sales and marketing organization significantly exceeds the units of DIGX, which
boasts 121 quota-carrying salespeople and total employees of 1,191; and EXDS, which boasts 599 sales and marketing people and total
employees of 2,769. So PSIX’s sales and marketing organization is almost as large as the entire personnel rosters of DIGX and EXDS
combined! We footnote that both DIGX and EXDS are poised for major expansion of their own sales channels through strategic acquisitions and/or partnerships (e.g., DIGX pushing its offering through WorldCom’s – WCOM $18 1/8; STRONG BUY –
global organization; EXDS has agreed to buy GlobalCenter from Global Crossing – GBLX $21 7/16 – for $6 billion).
We think PSIX will try to close its funding gap by selling non-core assets, including but not limited to its stakes in XPDR and
non-core Metamor assets (estimated worth $200 million, or 0.5x revenues); non-core telecommunications assets (e.g., independent SS7
network of TNS, worth an estimated $50 million, or 2x revenues); consumer accounts in Inter.net (600,000 subscribers worth an
estimated $100-150 million, or 4-6x revenues); components of its PSIVentures portfolio (includes shares in Metrocall – MCLL $1
19/32; Omnisky – OMNY $12 13/16; Breezecom – BRZE $24; and numerous private companies poised to go public – see
www.psinet.com/news/pr/00/aug14.html).
Although details of the opportunity are unclear, management indicates that a sale/leaseback transaction could be
performed on PSIX’s data centers, which could further strengthen the company’s working capital situation and trim its funding gap.
We note CFO Larry Hyatt’s significant experience in the real estate/property marketplace, which could provide a leading indicator for
success in such a maneuver (formerly employed by Marriott).
DÉJÀ VU
We admit PSIX’s story has taken on a high-risk profile, in light of the significant variance between results and guidance and a need for
funding by mid-2001. By monetizing non-core assets worth an estimated total of $200-300 million, trimming back cash capital
expenditures by $100-200 million, focusing on the delivery of high-margin services, and pursuing certain strategic opportunities, we
anticipate that the company will make it through this transition period and, like it did three years ago, prove all doubters wrong. PSIX is
not for the faint of heart, but then again we never believed this name was appropriate for risk averse investors – if you are losing
sleep over the story try to calmly dollar cost average into the name through year-end 2000.
Because the company has a unique portfolio of assets, we think PSIX is more likely to join forces with a deep-pocketed carrier in 2001 than
to continue trying to go it alone. While we are unenthusiastic about the involuntary massive revisions we have had to make to our
estimates for the company, we continue to believe PSIX has the potential to become a leading player in the increasingly IP-centric
communications marketplace. Current prices for PSIX equity and debt, in our view, are the result of reckless selling by investors
that are failing to see the strategic value PSIX has created as a unique independent facilities-based IP asset.
We recommend long-term investors (i.e., 2001-focused investors, not investors focused on the close of trading each day) double-down on
their positions in PSIX, noting (1) that the company has several months of liquidity even in a worst case scenario, giving management time
to decide whether to go it alone or hit the bid of a large telco; (2) that recent downgrades and massive selling pressure may turn into strong
buying interest if/when sentiment on the name and the communications sector changes; and (3) that the company has significant non-core
assets available for sale that could help it meet its 2001 funding gap.
Given these circumstances, we would purchase PSIX’s equity and debt at current levels. To reflect the increased risk of the
story, we are lowering our rating on PSIX to BUY from STRONG BUY. We are cutting our year-end 2001 price target to $20
from $57, which represents an enterprise value of $7.6 billion, or 5.0x 2001E total revenues and 7.3x 2001E “core” revenues
(excludes all consulting). We think this valuation, which uses an estimated WACC of 17% and no public/private market
discount, is a very realistic price tag for the last independent global commercial facilities-based ISP around. PSIX is a key piece
of the Internet, the communications mechanism of the future – there’s a lot of value down here.
regards,
cg |
