Equinix: A Great GARP Stock With Short Term Catalysts

Please see the Disclaimer associated with this blog.  I own shares in Equinix and may trade in and out of it without posting new information.  You should consult with a professional where appropriate.

Those familiar with my work know that with growth stocks, my main concern is about momentum in fundamentals continuing.  Not only do I believe this to be the case with Equinix (EQIX), but I also think fundamentals and positive earnings surprises are now set up to potentially accelerate.

Equinix operates data centers.  The company divides up space in these datacenters into cabinets. Customers effectively pay monthly for space and power.  Customers also pay a monthly fee for each connection they make with other Equinix customers. The beauty of Equinix’s business model lies in the fact that it has the leading position in almost all of its markets.  When Equinix opens a new datacenter in a given market, it makes sure to tether that new building to all of its existing datacenters in that same market.  Because customers prefer to be located close to other customers, they usually are willing to pay a premium to be in an Equinix data center versus the space offered at competitors.  The significant bandwidth savings most customers get from being able to cheaply interconnect to other Equinix customers more than offsets the premium they pay.  Furthermore, once a customer goes through the trouble of placing its servers, storage and Telco equipment in an Equinix data center, the costs and potential disruption involved in switching to a different provider is very high.  All this gives Equinix a strong competitive advantage and pricing power that only grows as the company gains even more scale.

The Company has consistently beaten its guidance.  In early 2011, EQIX said that 2013 revenue would be greater than $2b when the Street was 9% below this figure.  Consensus for 2013 is now at $2.25b and (as I will argue below) is still too low.  EQIX is now guiding for 2015 revenue of at least $3billion.  Like in early 2011, the Street remains skeptical and is well below management’s long term guidance.  Equinix is planning to convert to a REIT in 2015.  REITs are typically valued using Adjusted Funds From Operations (AFFO), which is a proxy for operating cash flow less maintenance capital expenditures.  Other datacenter REITs like Digital Realty (DLR) currently trade at about 16x 2013 AFFO.  Wireless tower companies like American Tower (AMT) trade at over 20x AFFO.  I estimate that at $3b of sales, Equinix can generate AFFO of at least $21 per share in 2015.  At 15x, this would imply an end of 2014 target of at least $315 or over 64% upside from current levels.

The Company guided for Q3 revenue of $492-498m and the Street is currently modeling $494.5m.  This represents a sequential increase of $16.5m versus Q2 excluding the impact of acquisitions.  This compares to the $14m sequential increase in revenue from Q2 versus Q1.  The Street does not appear to be modeling much improvement in new revenue generation in Q3 versus Q2 despite several positive changes:

1)      Lower churn.  Last Q, customer churn was higher than normal at 3.2%. Most of the increase in churn was because of Equinix’s “optimization efforts.”  In hot markets, Equinix tries to proactively churn out older customers who may be less profitable.  It then quickly sells out the newly available space to higher paying customers.  Eqinix’s CFO stated on its last quarterly conference call that churn would “moderate down to between 2.4% and 2.8%” in the 2nd half of the year.  I estimate that a 0.6% lower churn rate implies at least $2m of incremental revenue in Q3 versus Q2.  Moreover, because some of the vacated space will likely be quickly filled as per the company’s plan, Q3 should have an additional $1m+ or so revenue from new bookings associated with that available inventory.  The Company has done these optimization efforts in the past, and each time the vacated space was sold very quickly to much more profitable customers.   On the Q2 conference call, President of North America Charles Meyers stated, “Typically, we are able to resell capacity quite quickly… these are into high-demand assets with high levels of fill in.”

2)      Significant Capacity Additions and Sales Force Productivity.  Equinix expanded its sales headcount by about 50% over the last 18 months. The Company said that bookings last Q were the 2nd highest in its history.  Q1 bookings were the highest.  Nevertheless, the sequential growth in recurring revenue was actually higher in past quarters.  I believe the reason for this discrepancy is because some of the bookings in Q1 and Q2 were for pre-sales of space in new datacenters.   On the EQIX’s investor relations page, the company offers a PDF that details its expansion plans. 7 new datacenters were scheduled to open in Q3 making the quarter one of the most important for capacity expansion in the Company’s history.  I don’t remember a time when this many new data centers opened in a single quarter.  To put this into even more context, the same sheet only shows that only 2 new data centers opened in the entire first half of 2012.  It takes time for new sales people to become productive and it appears that Equinix may have perfectly timed productivity increases from new sales people hired over the last 18 months with the significant new capacity.  Even modest assumptions of new sales associated with this new capacity should lead to upside.

3)      Currency.  When the Company gave guidance at the end of July, management said they expected currency to be a sequential drag of about $4m in Q3 after being a $3m sequential headwind in Q2.  At the time, the Euro was 1.21 to the Dollar.  It currently is over 1.30.  Other currencies have also appreciated.  I estimate that instead of being a $4m sequential headwind, currency will actually be a slight tailwind in Q3.  Therefore, all other things being equal, currency effects alone would imply over $4m revenue upside.

4)      Acquisitions.  In July, the company closed a couple of important strategic acquisitions in markets outside of North America.  Equinix’s CEO stated that Q3 would have about $13-15m of revenue associated from these acquisitions.  However, this figure does not take into account cross-sell opportunities.  Many of Equinix’s customers do business globally.  When the company made foreign acquisitions in the past, it was able to sell some North American capacity to newly acquired foreign customers.  It was also able to sell the newly acquired foreign capacity to existing Equinix customers.  “Revenue synergies” take some time to materialize, but it is another positive variable for Q3 that was not in Q2.

Given the factors above, I am fairly confident in Equinix delivering short term revenue upside.  And, given the very high operating leverage of this business, even small top line upside can yield very large upside in earnings.  Moreover, due to the high recurring nature of Equinix’s revenue, any upside in the short term would flow through to upside for future quarters.  Finally, improved sales force productivity and a higher pace of capacity additions will not be unique to Q3.  Q4 is expected to have 5 new data centers and Q1 is also expected to have 4 new centers.  This new capacity combined with synergies from recent acquisitions and lower churn will likely drive an acceleration of growth over the next few quarters.

A stock price is a function of earnings and the multiple applied to its earnings.  Earnings estimates are likely to be revised upwards and, in my experience, growth stocks that show accelerating fundamentals typically get rewarded with improved earnings multiples.

Risks to monitor are changes in the Company’s schedule for new datacenter openings, currency movements and competitive industry pricing.  There is also the risk that the IRS will deny Equinix’s application to become a REIT although I think the probability is low and the IRS is unlikely to even comment until the middle of 2013.

Corning: Short Term Catalysts / Long Term Value & Optionality

Please see the Disclaimer associated with this blog.  I own shares in GLW and may trade in and out of it without posting new information.  You should consult with a professional where appropriate.

Those who are familiar with my work know that I like it when investment ideas remind me of prior decisions that have worked out well.  Corning (GLW) reminds me of other cyclical stocks that have done well once earnings estimates first start to get revised upwards.  A year ago, the Street was expecting Corning to earn $2.00 per share in 2013.  Today, the consensus expectation for 2013 EPS is $1.43.  In early 2011, Corning was trading above $22.  It is now below $13 which puts it at 9x 2013 EPS and below book value.  The company recently increased its dividend (yield of close to 3%).

Corning is involved in several businesses, but most of its earnings currently come from LCD glass.  The LCD glass industry went into oversupply, because of two simultaneous events.  First, the weak economy caused demand to be weaker than expected for LCD TVs, computer monitors and laptops.  Second, the industry started a transition to using thinner glass, which effectively increased supply.  The industry is currently half-way through this transition.  The oversupply caused pricing pressure and market share loss for Corning and was the primary reason for the dramatic cut in earnings expectations for the company.

Corning responded by taking close to a quarter of its own capacity offline.  Since Corning has about half of the industry’s supply, this move resulted in a moderation of pricing pressure.  On the company’s Q2 earnings call, CFO Jim Flaws stated, “Our quarter two price declines for LCD glass were indeed much more moderate than the previous two quarters.”  During the question and answer session of the call, Flaws also stated, “I’m delighted by the Q3 pricing that we basically have reached agreement with almost all of our customers already.” With pricing more of a known variable, the company appears to be set to beat earnings expectations in the short term for several reasons:

1)      Demand has turned out to be better than expected.  Since Corning’s last earnings call, there have been many industry data-points that imply strengthening business conditions.  AU Optronics (AUO), one of Corning’s largest customers, reported September quarter revenue that was better than expected.  When AUO initially gave Q3 guidance at the end of July, it expected large panel shipments to be flat sequentially from Q2.  Actual shipments wound up being up close to 5% sequentially.  A couple of weeks ago, Nippon Electric Glass (NEG), the number 3 manufacturer of LCD glass, also revised upward its expectations for the September quarter.  Retail TV Demand from China during its Golden Week Holiday appears to have been better than expected.  This is important since Corning’s CFO specifically highlighted Chinese demand as the biggest risk-factor during the Q2 earnings call.  He stated, “I feel our biggest risk is our television forecast is China.”  Despite all these positive industry data points, consensus estimates for Corning’s Q3 have barely changed.

2)      Currency has gone in Corning’s favor.  Something many people usually miss is that the company prices much of its LCD glass in Japanese Yen.  The Yen has strengthened versus Q2.  The stronger Yen will not only help the company beat short term expectations, but it will also give even more confidence to bulls who are looking for continued moderation in pricing pressure.

3)      The company has become more aggressive with returning capital to shareholders.  It recently increased its dividend by 20%.  Corning also bought back close to 2% of its total shares outstanding in Q2.  This was at a faster pace than Q1.  The Street does not appear to be accurately modeling Corning’s share buyback going forward.  Most expect the company’s share count to increase going forward when it should be decreasing.

People who are bearish on Corning will point out how the stock has recently risen from slightly below $11 to about $13 per share in a couple of months.  They will affirm that recent data points are already “priced in.”  The problem with this point of view is that it is fails to take into account the larger context.  While the stock has done well recently, it has still underperformed massively over the last couple of years.  A large portion of industry supply has been taken off-line and the most painful part of the transition to thin glass is in the rear-view mirror.  At the current valuation, the stock is not priced like a company that is expected to beat earnings expectations.  The price-to-earnings multiple at 9x can only go up from here and it should go up given the improved certainty around industry pricing and the return to growth.  Q4 should be the first quarter in a long time when revenue and EPS inflect back to positive year-over-year growth.  This is usually a positive for the multiples of cyclical companies.

Longer term, there are several potential positive scenarios for the company.  I do not necessarily have a strong view about any of these, but at the current valuation, I think of the stock as a cheap call option (Actually, it’s better than a call option, because instead of paying premium, I get paid close to a 3% dividend to wait).  The positive scenarios:

1)      Large new business opportunities and diversification should help the stock’s price-to-earnings multiple.  Corning is an R&D company that has regularly reinvented itself over its long history.  During the dot-com bubble, it was primarily known as a supplier of fiber optics and it is currently viewed as a manufacturer of LCD glass.  The company’s labs are constantly churning out new technologies.  It is only a matter of time until one or more of these new products become another big business for the company.  Furthermore, because some of the technologies Corning is working on leverage its existing manufacturing facilities, there is the potential that its success leads to better industry supply conditions and pricing for LCD glass.  The company’s effort in glass for solar panels is one example.  Corning is working on lightweight glass that would protect solar panels but also would make them much more efficient at generating electricity.  Since the Street is not modeling anything from this new business, any success in this area would be a source of earnings upside.  Moreover, since solar glass would be made with LCD glass factories, success in solar glass could also lead to upside in pricing for LCD glass.  Even without a large new explosive business, corning’s earnings should become more diversified over time as other businesses are expected to grow faster than LCD.  In an upgrade note published in mid-September, Goldman Sachs noted that it expects Corning’s LCD business to account for 74% of earnings in 2013 down from 96% in 2009. The diversification should lead to less cyclicality and increased predictability over time.  This, in turn, should improve the stock’s multiple.

2)      Replacement demand and a housing recovery could drive an upturn in LCD TVs.  According to the company, the average LCD TV is replaced about every 6.5 years.  This replacement rate implies that a very small amount of current TV demand is for replacement.  However, that will change in a couple of years.  In 2008, there were about 118 million LCD TV units sold.  Replacement demand for these units could drive an upturn in overall TV demand in 2014.    Furthermore, while many expect housing to recover, current TV demand expectations assume little to no correlation to housing. Therefore, any positive correlation could lead to upside.  I hypothesize that the correlation is higher than people think.  I personally bought a new TV when I recently moved into a new apartment and I know several other people where this was also the case.  Since industry supply has been taken off-line, any significant upside surprise in demand could cause pricing to actually go up for a short-period of time.  This has happened in the past and there is no reason why it can’t happen one day again if demand improves.

3)      Windows 8 could drive an improvement in PC demand.  While most believe that the PC market is secularly challenged, there is an argument that PC demand is also cyclically depressed ahead of the launch of Windows 8.  Any significant cyclical improvement could lead to upside to industry demand projections.

Of course, there is also the risk that Christmas demand for TVs and PCs is very weak.  Retail demand will be the main variable to monitor.  The Japanese Yen is another variable to keep an eye on.  As of now, channel inventories appear to be in good shape and I feel relatively confident with the stock’s risk / reward.  A stock’s price is a function of earnings and the multiple applied to its earnings.  Both the earnings and the multiple are more likely to be revised upward than downward after Corning’s Q3 results are reported.  I am apparently not alone in thinking this.  A few corporate insiders have bought stock at around this same price over the last several months.

 

Why Stocks Tend To Decline Much Faster Than They Rise

The chart of Caterpillar (CAT) stock from 2002 to 2008 is an example of a cyclical stock that people became enthusiastic about and then subsequently sold in a panic.  Notice how the stock steadily rose from the end of 2002 to the beginning of 2008 and then gave up a substantial portion of those gains in less than a few months.  People generally feel twice as much sadness or pain when something is lost than when something of equal value is gained.  Humans have evolved to be this way, because when the world was more resource constrained, our ancestors’ survival depended much more on keeping what they had than getting something new.  The emotions that arise from loss are from parts of the brain that evolved much earlier than the parts responsible for rational thought.  This is the main reason why stocks go down faster than they go up.  People tend to get depressed and want to capitulate much faster than the time it takes for them to get euphoric.  Furthermore, as a stock rises, many people quickly sell to lock-in their gains.  The shareholder base gradually transitions from distressed and value investors, who contest momentum, to growth investors, who typically invest hoping to ride a trend.  When a stock goes down and its momentum shifts, the only people that would be interested are the distressed or value investors.  Since these types of investors tend to be less impulsive and generally more risk averse, they are usually slow to accumulate shares.  After all, they know that betting against a current trend often results in initial losses.   Distressed or value investors are in no rush to build fully-sized positions.

The above is an excerpt from my book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance

ASML – A Reasonably Priced Monopoly

Please see the Disclaimer associated with this blog.  I own shares in ASML and may trade in and out of it without posting new information.

ASML is the world’s largest manufacturer of semiconductor equipment. It  makes lithography equipment, which is the most critical / costly machinery a chip-maker buys. In 2011, ASML had systems sales of EUR 4.9 billion out of a total lithography market of EUR 6 billion and a total fab equipment market of EUR 25 billion. Over the last 10 years, ASML has grown revenue at about an 11% CAGR. This growth has largely come from lithography consistently taking share of semiconductor capex budgets and from ASML taking market share from other lithography players.

I like it when investments remind me of patterns that worked well with other securities in the past:

1) ASML is becoming a monopoly in a winner-take-all industry. In some sub-sectors of technology, the leading company in the niche ends up with virtually all the market share. This is partially because the leading company is the only one in the industry that can afford to invest in the research and development necessary to drive technology forward. ASML’s market share went from about 30% to 80% in the last 10 years. The company spends about 5 times more in R&D than Nikon, its closest competitor. This has resulted in 90%+ share for the most advanced lithography tools. Intel is currently Nikon’s 2nd biggest customer and recently decided to make a large investment into ASML. The street seems to be underestimating the long term implications of this move. It pretty much guarantees that ASML will be a monopoly in the not-too-distant future. I also think that it is interesting that ASML’s gross margins are currently significantly lower than the gross margins of Intel and many other chip companies. ASML will earn much higher gross margins long term as it benefits from its monopoly position.

2) Opportunities usually arise when investors get overly concerned about short term cyclical weakness and forget about secular growth. Intel recently lowered its 2012 capex budget. The memory companies (DRAM and NAND) have also basically stopped spending money on anything other than technology improvements. They are not adding any wafer capacity. Recently, there were rumors that Samsung would significantly reduce its capital expenditures for 2013. Several sell-side analysts have lowered growth expectations for semiconductor capex for both 2012 and 2013. I expect that semiconductor capex will very likely be weak through the rest of the year. However, for cyclical stocks, the best time to buy is when business is weak in the short term. Next year should be a better year and the worse that 2012 is, the better 2013 growth will be. The memory segment cannot spend much less than what they are spending now. Furthermore, SSD adoption and tablet demand will likely drive an upturn in memory-related capex at some point next year. In addition to the rumored iPad mini, several Android based tablets are expected to be launched by the end of the year. Microsoft will also start selling its Windows based tablets. Intel usually grows its capex in the first year of a line-width shrink, which bodes well for 2013 spending. PC demand may also benefit somewhat after new version of Windows is released. While Intel lowered capex in the short term, one should remember that Intel is now facing a much more competitive environment. Intel dominated the PC processor market, but the convergence of tablets and laptops and Intel’s ambitions for new end markets like mobile phones put it on a collision course with many other Arm-based chip companies like Qualcomm, Broadcom and Apple’s own internal semiconductor design division. This new competition will likely make Intel’s business more capital intensive over the next several years. Rumors regarding Samsung’s capex are also misunderstood. Like other memory companies, Samsung’s memory related capex can’t go do down much. If Samsung were to reduce capex significantly, it would have to come from its logic-related capex. Samsung’s logic spending would only go down significantly if Apple moved to a different supplier. If this were to happen, the spending would just shift to someone else like TSMC. Lithography’s share of semiconductor capex is also set to accelerate over the next few years. In his initiation report of ASML on June 21, 2012, Bernstein analyst Pierre Ferragu stated that he expects lithography’s share of logic semi capex will rise from about 11% to at least 17% from 2012 to 2015. This is because the lithography step of semiconductor manufacturing gets more important with every successive generation of chip technology. According to Ferragu, “Modernizing a logic fab from 45nm to 32nm represents in our estimate a minimal EUR 23m net incremental spending on lithography, assuming no wafer capacity increase. A modernization from 32nm to 22nm would cost EUR 400m.”

While the above two patterns remind me of other technology stocks that turned out to be good investments, ASML is still very unique. It is the only company I have ever seen where the industry’s top 3 customers actually became shareholders. Intel, TSMC and Samsung will own a combined 23% of ASML. These customers have also agreed to fund a significant portion of ASML’s R&D. They realize that ASML is the only viable long-term player for lithography equipment. Rather than trying to fight the trend by continuing to keep Nikon alive, they have decided to give in and participate in ASML’s upside by being investors in the company. They agreed to fund close to EUR 1.4 billion of ASML’s R&D over the next 5 years because they desperately need ASML to deliver newer generation equipment. Despite this momentous news, ASML’s stock is trading only slightly higher than the price these chipmakers will pay. The stock trades at 12.5x 2013 EPS and at a mid-teens multiple of 2012, which is reasonable given that 2012 is likely going to be the cyclical trough for the company. For those that are concerned about the 22% revenue growth rate expected by the Street in 2013, note that the company doesn’t need much, if any, industry capex growth to make those numbers. Virtually all of the incremental revenue modeled by the Street can be explained by new products that the company already has orders for. Furthermore, since these new products are “development tools” (equipment customers are buying initially for R&D purposes), they will not be cannibalizing other equipment ASML makes. Margins will actually be depressed in 2013. The street correctly is modeling gross margins to come down because these new products will initially have low profitability. Gross margins should rise again in 2014 as the new products achieve higher scale.

Putting possible short term news aside, a long term investment in ASML at a reasonable valuation and at almost the same price as its three largest customers should work out well. The company has a very large and sustainable competitive advantage, which should drive share gains and margins long term. The coming war between Intel and Arm and the explosion of NAND based devices will make the semiconductor industry more capital intensive. Lithography has steadily taken a larger share of overall semiconductor capex and there are some reasons to believe that this trend will accelerate over the next few years. Finally, the company offers a 1% dividend and has consistently bought back stock. ASML’s management has stated that the company will resume buying back shares after the 3 chip manufacturers become investors.

The main risk is timing-related. I do not know when the upturn will start and it is certainly possible news gets worse before it gets better. Technically, ASML’s chart is bullish above all moving averages.  I suggest taking an initial position now and leaving room to add on weakness.