Investors Should Avoid This Data Center Play

Switch Inc. (SWCH, Financial), a data center infrastructure company, reported rather disappointing quarterly results last week.

While the company's revenue grew 9.6% from the prior-year quarter to $97.7 million, it missed expectations of $100.6 million. Earnings per share were 2 cents, just shy of the estimates of 4 cents.

During the quarter, Switch secured a colocation deal with an international streaming player. The streaming corporation is planning to use Switch’s North American data centers to host its services. The value of this contract, along with another government contract, exceeds $100 million in incremental revenue. By the end of the first quarter, Switch had more than 800 data center customers with 36.2% of the revenue coming from top 10 customers.

For full-year 2018, Switch is guiding for mid-point revenue of $431.5 million, in line with the analyst consensus of $431.31 million. Nonetheless, growth has been slower than expected. The market reacted to soft earnings as the stock declined 9.6% in after-hours trading last Monday.

Slowdown in growth might be a concern

Switch posted single-digit revenue growth for the first quarter, which might be indicative of increasing competition. Revenue from connectivity services – that includes revenue from cross-connects, broadband services and external connectivity – increased 14.9% year over year, while colocation revenue, including licensing of cabinet space and power, grew 8% compared to the same quarter last year.

It is obvious that colocation revenue is weighing down on the company's overall revenue. Decelerating growth might be an indication of a bigger problem as Switch is falling behind the industry. Global colocation spending is expected to grow at compound annual rate of 12% to reach $47.4 billion by 2020. Another research firm predicts the colocation market to reach $62.3 billion by 2022, a CAGR of 14.6%. With 8% growth in the colocation market during the first quarter, Switch might not be gaining the post-initial public offering traction it was hoping for.

It’s worth mentioning that aggregate leasing volumes from counterparts like Digital Realty (DLR, Financial), CoreSite (COR), Equinix (EQIX, Financial) and CyrusOne (CONE, Financial) were up nearly 30% on a year-over-year basis, while rising approximately 50% sequentially. Despite high leasing volumes from competitors, Switch managed to increase its revenue by 9% during the quarter. Moreover, full-year growth guidance stands at 14% as compared to an 18% increase last year and a CAGR of 22.3% over the last four years.

To review, Switch's growth is slowing down, which isn’t a good sign as the company is in its early stages of growth with low earnings.

Switch is a small player with a concentrated customer base

Switch is a small player in the global data center colocation market, commanding just over 1%. Moreover, the revenue is concentrated among a limited number of customers. The company generated around 36.2% of its revenue from its top 10 customers during the first quarter of the year. Due to Switch’s limited market share, it might not be possible for the company to fully benefit from the industry's growth prospects.Â

Regarding the concentrated customer base, it does not appear to be in jeoparday as the churn rate is less than 0.1% while customers continue to add more services. Note that 51% of the incremental revenue for the first quarter came from Switch’s existing customers. As a result, the risk of customer loss is quite low. While existing revenue is protected, however, the same cannot be said for revenue growth.

It's not all bad, though

The data center infrastructure market is set to grow at a double-digit pace going forward. Switch offers high-density data-center infrastructure solutions that reduce the total cost of ownership for customers. The company also focuses on renewable energy, which might drive benefits in the form of improved brand image and tax credits.

Is Switch worth buying?

The short answer is no. For starters, the company isn’t delivering revenue growth. Even if Switch manages to post double digit-growth going forward, it isn’t trickling down to the bottom line. Analysts expect earnings to reach 32 cents per share next year, which puts Switch’s investors in a difficult position.

Earnings of 32 cents per share in 2019 translates into a forward price-earnings ratio of 39.5. Given earnings are expected to grow 18% per annum over the next five years, a forward price-earnings rat of around 40 seems expensive.

Furthermore, stock-based compensation will continue to put pressure on earnings over the next couple of years. Switch is expected to record approximate $74 million in stock-based compensation expenses over the next three-and-a-half years. If the GAAP-basis is ignored, stock-based compensation will still result in the dilution of outstanding shares to the tune of 13%. Assuming all restricted stock units and common stock units vest, Switch’s common shares will increase by 6.7 million. The point is that stock-based compensation, one way or another, will negatively affect earnings.Â

The valuation also paints a bleak picture for Switch’s stock.

Assuming 18% per annum earnings growth between 2019 and 2022 and 3% growth in perpetuity, the valuation reveals a price target of $8.6. As the stock is trading around $12, Switch is priced approximately 35% above its fair value. Even when disregarding stock-based compensation, Switch stays overvalued as the price target comes in at $9.8 after removing the dilution effect.

Bottom line

Given subpar growth, increasing competition, generous equity-based compensation and a rich valuation, investors should avoid this stock currently.Â

Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.