Take a look at the latest (PSIX)
Quite Simply, The Largest Global ISP Pure-
RATING: Top Pick Change: None 12-Mo. Target: $85
VIEWPOINT: We are resuming coverage of PSINet (PSIX*) with a Top Pick
rating and an $85 target price. PSINet is the largest global Internet
Service Provider (ISP) pure-play. In fact, after America Online (AOL#) and
UUNET (part of MCI WorldCom (WCOM*)), it is the largest ISP of any kind.
PSINet focuses on business customers, although it does have domestic
wholesale and international consumer segments. The company has assembled a
global network of owned and leased fiber which is leading to dramatic
margin expansion. The core strategy is based on being a Top 3 ISP in the
Top 20 telecom markets around the world, and the company already has a
major presence in 13 of the 20. Its acquisition and integration track
record is solid and its operating performance has been equally good. Don't
overthink the complexity of an ISP in 13 countries offering a wide range of
services through a wide range of sales channels. PSINet is a global,
recurring revenue, expanding margin play on the Internet, with 60,000
corporate customers and a rising revenue per customer. Our kind of company.
We rate PSIX a Top Pick, with a target price of $85, just 15% above the
stock's recent high. We consider the recent pullback to be a terrific
opportunity to by a true leader in the Internet space.
INVESTMENT THEMES
1. PSINet is large-Take any four comparables public ISPs and sum up their
revenue. You'll find its less than PSINet and the sum of the market caps of
these same companies is probably double or triple that of PSINet. Scale has
always mattered in telecom and the $420 million run-rate makes PSINet the
largest independent by a factor of two. The company is experiencing good
margin expansion as a result of this scale.
2. PSINet is global-The company operates in 13 countries out of the Top 20
and plans to enter all 20 eventually. The basic strategy involves buying a
toe-hold company in each country and then integrating its operations.
PSINet has integrated 18 companies to date and has turned even the worst
bottom-line performers into EBITDA positive entities. The company is the #1
ISP to businesses in Canada, #2 in Japan, Korea, and the U.K., #3 in the
U.S. and Hong Kong, and Top 5 in Germany, France, and several other
countries, so it is well along in its "Top 3 in Top 20" goal.
3. PSINet is business-focused-The company has 60,000 corporate customers
around the world. Average revenue per annual contract is now over $7000.
Additionally, existing customers are using more and more service, giving a
good "same store comps" profile. Business customers churn less, pay more,
and are easier to upsell as new services roll out.
4. PSINet has a global fiber network-The company owns a 2.5 Gbps fiber
network on IXC in the U.S. It owns capacity on Hermes in Europe.
Furthermore, the company has purchased capacity on major undersea cable
system literally connecting its properties all around the world, including
FLAG, AC-1, and Japan-U.S. Finally, PSI bought SF Bay Area and New York
connectivity from Metromedia Fiber (MFNX*+) since these areas are the two
highest Internet traffic corridors in the world. We believe this network
will be a key strategic asset for quality of services and margin expansion.
Also, any potential acquirer will benefit from this asset since operating a
global IP network is among the most complicated tasks in telecom.
5. PSINet is on track for profitability-The company continues to hit the
numbers in our model, including 1Q99 which was just reported earlier this
weeks. EBITDA breakeven is still slated for mid-year, and we have a $400K
positive EBITDA estimate for 3Q99. We believe Internal revenue and customer
counts will continue to grow 40%, with international outpacing domestic.
Capital expenditures, mostly in the form of capital leases, will remain
high at $325 million-plus for the next couple of years to finish the
network to all its operating countries.
6. PSINet has a strong balance sheet-The company just completed a roughly
$404 million equity offering and a $400 million convertible offering,
leaving it with $1.2 billion of cash ($81 million restricted). We have seen
over and over, in long distance resellers, CLECs, and other communication
businesses, that cash is a strategic weapon, not only for acquisitions and
growth capital expenditures, but also for downside protection when
financing windows close. With the new money, PSINet is here to stay, even
in a prolonged downturn in Internet or telecom names. It has an advantage
over all but the large telecom competitors is seeking acquisitions
globally.
1Q99 WAS RIGHT ON TRACK
PSINet delivered very strong 1Q99 financials across the board. The company
beat our estimate and the Street on the top-line by almost $3 million with
$104.8 million in revenue. We remain confident that the company will turn
EBITDA profitable in 3Q99. For the quarter the EBITDA loss was ($6.8) down
from a loss of almost ($9.9) sequentially. Also, on the bottom line the
company beat EPS estimates coming in at a loss of ($1.11) versus consensus
estimates of ($1.20). We were impressed by the solid trends in industry
metrics, as the company reported a steady 81% annual customer retention
rate and increase in overall average new contract value to $6,200 up from
$6,000 in 4Q98. Furthermore, the total number of corporate customers was
reported at 59,700, up almost 80% in comparison to a year ago. Besides
improvements in gross margin and EBITDA, the mix continues to shift toward
high-margin enhanced web services such as hosting, with this area growing
100% annually, versus 40% for access. In our model, we have PSINet exiting
the year with a full five percentage points of improvement on the gross
margin line, largely due to moving traffic on-net, but a faster revenue mix
shift toward web-hosting could provide some upside surprise. Due to a
shortage of dial-up ports, wholesale customer counts were lighter q/q than
previously, but 2Q99 has already seen a huge pickup (probably twice 1Q99
adds).
VALUATION
Since Internet valuations are part art, part science, we prefer to take
multiple looks at this topic. In keeping it simple, we also do a Discounted
Cash Flow (DCF) valuation on our companies. With 14% discount rate, 12
times EBITDA in 2009, and a 15% private-to-public discount, we get an $85
target. Taking another look, this equates to 10 times year 2000 revenue, at
the low end of the comparable group of ISPs and web-hosting companies. We
recognize that relative valuation is a tool fraught with risks, but it has
clearly become the Internet standard and the ISP standard in particular.
Still, we are comforted that there is a bottoms-up DCF that works well to
support our target. Furthermore, the company continues to find synergistic
value in acquisitions bought for much lower multiples, and we believe there
is even some upside in the margins in 2000 and beyond, since we use 25%
EBITDA margins in the terminal year. Finally, there are other valuation
positive events that could occur. With many larger companies (Level 3
(LVLT), Qwest (QWST*+), etc.) lagging far behind PSI and others in IP
revenues, there is always a takeover scenario, which would close the
valuation gap to private market value. Looking out beyond 1999, it is
conceptually possible that a European listing could make sense, since over
50% (and growing) of the company's revenue comes from outside the U.S. We
rate PSIX Top Pick rating with an $85 target price for 12 months. |
