NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a first time 'BB' IDR to Equinix, Inc. The Rating Outlook is Stable. A complete list of rating actions follows at the end of this release. Fitch's rating actions affect $4.2 billion of existing debt ($3.2 billion funded plus the $1 billion undrawn revolver) and $1.7 billion of expected debt to support the acquisition of Telecity. The expected debt to support the acquisition of Bit-isle and convertible notes have not been rated.
The ratings and Outlook are supported by Equinix's leading market position and world-class reputation in data center colocation, geographically diverse and network-dense footprint, central position in the emerging hybrid cloud ecosystem, secular demand drivers for data center outsourcing, recurring revenue and stable customer base. Rating constraints include negative free cash flow from capital intensity and required REIT dividends, modest expected deleveraging over the rating horizon, high operating leverage, debt-funded acquisitions, competitive nature of the data center industry and low unencumbered asset coverage.
KEY RATING DRIVERS
Globally Diversified, Network-Dense Data Center Footprint
Equinix is the largest retail colocation provider in the world. The Company's 105 data centers span over 11 million square feet across the Americas, EMEA and Asia Pacific, are carrier-neutral and have locations in each of the 10 largest global data center markets. A connected network of facilities in major cities and internet traffic hubs across the world allows Equinix to house customers' IT equipment close to their offices, reducing latency and travel time for IT staff. Large enterprises often require a geographically diverse provider such as Equinix to distribute their infrastructure optimally for their global employee and customer bases. In situations where milliseconds amount to millions of dollars, such as with electronic trading or advertising exchanges, seamless application performance and 99.999% uptime are paramount. Fitch believes Equinix's scale, network density and reputation distinguish it from its peers, and are key advantages when competing for new business.
Interconnection Business Creates Network Effects and Upside to Margins
Equinix has 168,700 cross-connects, growing 17% year-over-year. A key driver of this momentum has been the emergence of cloud exchanges, or private connections between cloud service providers and their customers inside Equinix data centers. With a number of enterprises reluctant to use cloud services due to security or bandwidth cost concerns, a direct connection in an Equinix data center provides a means to bypass the public internet and store data in the cloud securely and cost effectively. Equinix customers can connect to the cloud exchange while maintaining their private servers for more sensitive workloads, creating a hybrid environment where colocation and cloud complement rather than compete with each other. As more cloud service providers and enterprises join Equinix, the value of the ecosystem (i.e. the number of cross-connect opportunities) for all participants increases. The result is an interwoven ecosystem of carriers, cloud service providers and enterprises, with Equinix at the center, and an enhanced value proposition to attract new customers. An increasing mix of interconnection revenue is also a positive driver for Equinix's profitability, as the low cost of installation results in high incremental margins.
Recurring Revenue and Stable Customer Base
Over 90% of Equinix's revenue is recurring and supported by fixed rate contracts with 2 - 3 year terms. Quarterly revenue churn of around 2 - 2.5% is higher than in the wholesale segment, but low compared to other communications sub-verticals. Common reasons for churn include customer consolidations or financial distress. Price competition is not a major driver of churn as the risk of data loss or disrupting operations usually outweighs the savings on price. In some cases, larger customers that outgrow retail space may move into a wholesale facility or build their own. These larger churn events are often telegraphed, providing Equinix with time to backfill the vacant space. The impact of a large churn event is further mitigated by Equinix's low customer concentration (its largest and top 10 customers account for 3.2% and 16% of total revenue, respectively). Low churn and customer contracts create stable and predictable revenue, which increases confidence that Equinix will meet its forecast and service its debt.
Secular Demand Drivers Balance Oversupply Risk
The decision to outsource the construction and management of data centers is being driven by exponential data growth, which is making it increasingly expensive for businesses to manage data in-house. Over the next five years, Cisco expects data center traffic to nearly triple, with 76% of that traffic attributable to the cloud. Fitch believes data center traffic growth, combined with an increasingly positive enterprise sentiment towards hybrid deployments, will favor carrier-neutral providers with strong interconnection offerings and cloud exchanges. Even amid this favorable backdrop, the fragmented nature of the data center industry has kept it susceptible to pockets of pricing pressure, often the result of excess inventory from new builds or sudden large customer churns. While builds are not nearly as speculative as they were in the past, oversupply will remain a risk as long as there is a need to start building months or years before signing new customers. Fitch believes Equinix is better protected against this risk than smaller providers, as its premium offering and diverse footprint should cause its financial profile to more closely track macro industry trends.
Fragmented, Competitive Industry
The data center colocation market comprises retail providers such as Equinix, wholesale providers, telcos and other carriers. Competition can be intense, especially in top markets where there are over 20 providers. Equinix has the largest market share with 8.4%, (ex-Telecity and Bit-isle) followed by wholesale provider Digital Realty with 5.7% (ex-Telx).
Wholesale providers for years have generated a portion of their revenue from retail-sized deals, but not enough to meaningfully impact premium retail providers such as Equinix. In July 2015, Digital Realty announced the acquisition of retail colocation and interconnection provider Telx, raising speculation that wholesale providers will compete more aggressively in the retail segment. Fitch believes wholesale providers may gradually increase their focus on retail, but the ability to do so without diluting margins or FFO metrics will temper that pace. Telcos and other carriers have been buyers of data center assets over the past several years, but now find themselves divesting these assets to deploy capital elsewhere. In the broader market for data center services, Equinix competes with managed hosting and cloud service providers. If enterprises embrace offloading more critical applications in managed or cloud-only deployments, those dollars would likely come at the expense of colocation. Fitch believes concerns around network performance, bandwidth cost, data security and compliance largely mitigate this in the medium-term, and favor a hybrid environment.
Capital Intensity and Dividends Constrain Free Cash Flow, Slow Deleveraging
Colocation is Equinix's core business, comprising 75% of total revenue. To support this business, Equinix must add capacity as cabinet utilization increases. Building new capacity is capital intensive, costing from tens of millions to over $100 million for a single phase. Construction can take from a few months to several years, with no guarantee that breakeven cash flow will be reached on schedule. Equinix's total capex has averaged around 27% of revenues over the last two years, resulting in free cash flow margins of less than 2%. Fitch expects free cash flow to turn negative over the rating horizon, as the Company's required REIT dividend distributions plus capital expenditures will exceed cash from operations, likely requiring ongoing revolver draws or incremental debt. As a result, Fitch expects only 1x-1.25x of deleveraging by the end of 2018, from a peak of about 4.8x (rent adjusted, based on most recent LTM financials) pro forma for the Telecity and Bit-isle transactions. While Equinix's leverage is low compared to similarly rated REITs, Fitch believes the Company's comparatively low unencumbered asset coverage reduces its leverage tolerance relative to those companies. Fitch's forecast assumes that a portion of the proceeds from the sale of assets related to the Telecity transaction will be used to repay debt, such that the impact will be leverage neutral.
High Operating Leverage
Equinix's cost structure is largely fixed. Its main cash expenses include labor (38% of total), power (22%) and rent for its leased data centers (9%). Within these categories, variability is mostly limited to sales commissions, which correlate with bookings. The Company enters into contracts to purchase power at fixed prices over several years at a time. The average maturity on Equinix's data center lease portfolio is 21.5 years (including extensions), significantly longer than the 2 - 3 year contract terms for customers in those facilities. The Company's high fixed cost base can magnify margin deterioration should it experience a sustained period of elevated churn, or have difficulty reaching target utilization levels for added cabinets.
Debt-Funded Acquisitions
In May 2015, Equinix announced it will acquire Telecity for an aggregate equity value of $3.6 billion (16.4x LTM 6/30/15 EBITDA). The transaction will be funded with about 50% cash / 50% stock, and is expected to close in the first half of 2016. To obtain regulatory approval, Equinix and Telecity committed to divesting facilities comprising about 4% of combined revenue for the nine months from January through September 2015. Under the terms of its credit agreement, Equinix is required to use proceeds from the asset sales to repay debt or reinvest in the business. The acquisition combines the top two data center providers in EMEA, further separating Equinix from others in the region. In September 2015, Equinix announced it will acquire Bit-isle, the number four provider in Japan, for an aggregate equity value of $280 million (9.6x LTM 6/30/15 EBITDA). The Company completed a cash tender offer for 97% of the equity interests in Bit-isle in November 2015, and will acquire the remaining shares before the end of the year. The transaction will be funded through an existing bridge facility until longer-term capital is put into place in 2016. Acquiring Bit-isle catapults Equinix from the 15th to the fourth largest provider in Japan, and adds a complementary enterprise customer base. Fitch believes Bit-isle's 51% utilization level and roughly 30% EBITDA margin increase financial and execution risk, but expects both figures to increase as Equinix leverages the large expected demand / supply delta in Tokyo and Osaka to fill the vacant space. While Fitch believes the strategic rationale for these two transactions warrants the temporary increase in leverage, future transactions will be evaluated independently, and may pressure the rating.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
--Average pro forma annual revenue growth of about 8-9% over the rating horizon;
--Overall cabinet utilization between 78-80% per year
--Stable overall MRR per cabinet;
--EBITDA margin expands 25 bps per year to reflect benefits of increased scale;
--Tax rate of 10 - 15% per year, reflecting taxes paid from taxable REIT subsidiaries;
--Expansion capital expenditures of $50,000 per cabinet install; recurring capex of 4-4.5% of revenue per year; capital intensity (capex/revenue) approaches the low 20% range over the rating horizon;
--Dividend payout ratio between 45%-60% of AFFO;
--Free cash flow negative over the rating horizon; deficits financed through revolver draws and incremental debt
RATING SENSITIVITIES
Future developments that may, individually or collectively, lead to a negative rating action include:
--Debt-financed acquisitions that increase leverage or dilute margins; financial impact will be considered in context of strategic rationale
--Fitch's expectation of leverage (rent adjusted) sustaining above 5.0x
--Increased liquidity risk, potentially resulting from limited revolver availability as debt maturities approach
Future developments that may, individually or collectively, lead to a positive rating action include:
--Fitch's expectation of leverage (rent adjusted) sustaining below 4.0x
--Unencumbered asset coverage of about 2.0x
--Consistent positive free cash flow generation, but still allowing for sufficient capital investment to maintain market leadership and premium offering
LIQUIDITY
Fitch believes that negative free cash flow over the rating horizon will cause Equinix to rely heavily on external funding to support its liquidity needs. As of 30 September 2015, the Company had $957.3 million available under its $1 billion revolver ($42.7 million LOCs and $0 drawn). Required REIT dividend distributions will make it difficult for Equinix to add meaningfully to its cash balance ($335.5 million of cash and cash equivalents as of 30 September 2015). Fitch expects that Equinix will limit its revolver borrowings by raising new debt within the next few years. Failure to do so may result in heightened liquidity risk as debt maturities approach, and may result in a negative rating action.
While other REITs can often leverage unencumbered assets to address liquidity needs, Equinix's data centers are mostly leased, limiting sources of contingent liquidity. Its owned facilities, however, are mainly in top global markets, which should imply a lower capitalization rate in a sale or financing. Excluding Telecity and Bit-isle, Fitch estimates unencumbered asset coverage of about 1.5x, assuming a 25% haircut to Company-owned net operating income (NOI) to account for ground leases on six of its 23 owned facilities (Equinix does not disclose NOI by facility). This figure is subject to change, however, once there is more clarity around pro forma owned asset composition and associated NOI. Equinix's ability to leverage owned facilities may be limited by the availability of mortgage capital for data centers, which is not as deep compared with other commercial real estate property types.
FULL LIST OF RATING ACTIONS
Equinix, Inc.
--Long-Term IDR 'BB'; Stable Outlook;
--$1,000 million senior secured Revolving Credit Facility 'BBB-/RR1';
--$476 million multi-currency senior secured Term Loan A 'BBB-/RR1';
--New $700 million senior secured Term Loan B 'BBB-/RR1';
--New $1,000 million unsecured Senior Notes 'BB/RR4';
--$2,750 million of unsecured Senior Notes due 2020 - 2025 'BB/RR4';
Date of Relevant Rating Committee: 23 October 2015
Additional information is available on www.fitchratings.com.
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869362
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT Credit Analysis (pub. 25 Nov 2014)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=821568
Additional Disclosures
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Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=994238
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