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Thursday, October 7, 2010

Equinix (EQIX): Look Out Beloooow! A Lesson in the Perils of High Multiples and Market Revaluation

Per our Who's Driving the Bus? post, we still plan on sharing a bit more on stocks versus bonds as a follow-up to our earlier discussion on this topic. But, thanks to trading action in Equinix (EQIX) on Wednesday, this post briefly relays the perils of investing in and/or holding high multiple stocks.

Let's give a look at what happened to shares of the company in this one-day chart from Google Finance (GOOG):

Down 33%? Wow - this is quite a decline, particularly when the overall market was flattish and the Nasdaq was only down marginally. What happened to EQIX? Technically speaking: not all that much. More specifically: expectations for upside to top-line forward estimates were squashed -- the wind behind the momentum sails went away, for now.

On Tuesday after market close, Equinix revised forward guidance, lowering its revenue outlook while raising its bottom-line forecast (partially on lower selling expense that would have been higher if revenue were higher). A Reuters article summarized the news, but directly from the Equinix press release:
  • Equinix now expects third quarter revenues to be in the range of $328.0 to $330.0 million, the midpoint of which is 2.2 percent lower than the midpoint of its previous outlook, and total revenues for the full year to be approximately $1,215.0 million, which is 1.2 percent lower than the midpoint of its previous outlook. This updated guidance is due to underestimated churn assumptions in Equinix’s forecast models in North America, greater than expected discounting to secure longer term contract renewals and lower than expected revenues attributable to the Switch and Data business acquired in April 2010.
  • For third quarter 2010, Equinix is increasing its adjusted EBITDA outlook to greater than $140.0 million. For the full year of 2010, the adjusted EBITDA outlook is also being increased to approximately $540.0 million. This increase in expectations is due in part to better than expected gross margins and lower than expected cash selling, general and administrative expenses.
SO, the company went to great pains to convey that its 3Q10 revenue forecast is only a smidgen lower (just 2.2%) than the company's prior outlook while the bottom-line is actually somewhat better. No matter.

Prior to the news, shares -- at $105 -- were trading at a healthy 42 times consensus 2011E earnings. Now, at $70, the forward P/E compressed to 28 times this figure. We acknowledge that many investors likely value the capital-intensive, telco-like Equinix based on multiples of cash flow, yet suffice to say these multiples experienced similar compression. Estimates from Yahoo Finance (YHOO) - likely pre-revisions:

THUS, sudden news of higher-than-expected customer defections and pricing pressure reoriented investors on key risk factors, away from visions of incessant growth buoyed by favorable secular trends - more and more Internet traffic and content/items that require hosting in data centers.

While we believe barriers to entry are reasonable in this business -- location, security, cooling, telco connectivity, etc. -- continual technology improvements bring higher performance per "box" and simultaneously offset at least some incremental demand for hosting space. Further, telecom carriers and other service providers all view this segment as a lucrative line of business and are actively chasing multi-year deals with pricing likely a key variable. Finally, many large companies are constructing their own data centers.

What's the lesson in Equinix? We've previously discussed the perils of high multiple stocks and, conversely, the merits of low multiple stocks:
Of course, the "Market" always places a premium on growth and shares of certain companies such as Amazon (AMZN) may keep charging upward so long as fundamentals move in the right direction with upside to Market expectations. In this case, Amazon's growth and franchise remain dazzling, preserving the company's rich valuation. Likewise for Netflix (NFLX), which we discussed the other day. Shares of numerous other growth companies have delivered amazing performance over the past 1.5 years, including Baidu (BIDU), MercadoLibre (MELI), Salesforce.com (CRM). Moreover, we agree with investor great John Neff that growth tends to keep investors out of trouble.

Nonetheless, by maintaining valuation discipline and, thereby, avoiding complacency (e.g. "the trend is your friend, stick with it"), we strive to avoid dramatic sentiment changes that often come when businesses garner extremely rich multiples of earnings and free cash flow. In other words, negative surprises aren't fun. Fortunately, they can be mitigated.

Here's one approach: play the other way - (1) purchase out-of-favor, low-multiple companies when sentiment is poor, (2) remain patient, and (3) then benefit from the usually inevitable shift back to positive sentiment that brings healthy multiple expansion. At that point, (4) sell into strength and (5) start over again. In all cases, aim for average holding periods in years rather than months or quarters. Aside from the rapid recovery since spring 2009 across virtually all sectors, wealth creation through equities typically takes years.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2010 Jeffrey Walkenhorst
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