Equinix (EQIX) was founded in 1998 by two researchers who saw an increasing need for data centers to support the burgeoning Internet. In 1999, the company built its first International Business Exchange™ center in Ashburn, Virginia, a place that now, more than any other, can be called the center of the Internet in America, largely thanks to the progress of Equinix’s platform. The company completed its initial public offering in 2000. Equinix stock reached an all-time high of about $500 soon after. It managed to survive the dotcom bubble thanks to its importance to the Internet itself, and bought data centers during the broader sector decline.
Since then, revenues have been consistent and far-reaching geographically. Its first profitable year was in 2008, a time when other companies were feeling the strains of recession, and profitability has been improving since. Stock price growth has also been extraordinary compared to the broader market, as the stock bottomed at $2 in 2003 and hit its post tech-bubble high of over $200 recently. Meanwhile, trends such as the growth of cloud computing, which will require central networking more than ever, are still favorable.
Equinix continues to invest heavily in new endeavors. The company looks on track to spend another $700 million, or so, on property, plant and equipment this year. Indeed, Equinix has been spending much more money than it generates through operations for this purpose. But there is a major change looming that would alter the way that Equinix spends the cash it generates.
Equinix first announced that it was deliberating on a REIT conversion earlier this year, following the ambitions of other tech companies, such as Iron Mountain Inc. (IRM), which offers document storage. A conversion by Equinix would not be that unusual, as there are already data center companies structured as REITs, such as Digital Realty Trust (DLR) (which held its IPO in 2004). Equinix’s board approved the move this September. The new structure will likely take hold in 2015.
The conversion may reflect a transition from a growth company to a mature entity aiming to distribute dividends. Equinix’s main competitor, Rackspace Hosting (RAX), has attested to increased competition in the data center industry lately. The REIT structure fits a mature company as well, as REIT distributions are tax free, and thus an attractive way to return value to shareholders. Since REITs are required to pay out 90% of their income as dividends, this will also lower the amount of cash Equinix generates that can be used on capital expenditures.
REIT, or no REIT, Equinix still expects the top-line to swell to $3 billion by 2015, almost double that of 2011. For those who doubt that the REIT structure can support expansion, the CEO of American Tower Corp. (AMT) described its conversion as a growth company taking advantage of a REIT structure. It is part of a string of atypical REIT conversions (American Tower Corp. owns cell phone towers) that has been drawing good and bad attention lately, most recently at Value Line in our article entitled “Is the Jump in REIT Conversions a Bad Sign for REITs?” In the article, we noted that these atypical conversions may result in an unintended backlash from regulators looking to bolster government coffers. Equinix, for one, stands to save tens of millions of dollars annually.
At first, however, conversion to a REIT will produce an immediate tax liability of $340 million to $420 million. A REIT must own assets as real estate, which is not depreciated for tax purposes. If it decides to be a REIT, this means that Equinix will have to “un-report”, in a way, all the tax-shielding depreciation expenses it has been claiming so far on its properties, generating the liability. Besides, there are various costs (including compliance costs) just to transition to a REIT format, which will likely total $55 million to $85 million. Another strain on cash resulting from the conversion will be a distribution of about $1 billion of value, 80% in stock and 20% in cash, of accumulated earnings to shareholders.
Besides input from tax authorities, the conversion will also require shareholder approval. This is likely as investors have been pushing this stock up higher and higher on news of the conversion, which implies that the investment community thinks that the conversion would be beneficial. If so, management would have an incentive, too. CEO Stephen Smith, for example, recently received stock awards valued at over $5 million.
The story of Equinix is a fascinating tale of large-scale growth during a decade that otherwise saw a lot of economic stagnation. Its stock price movements have been equally dramatic, giving investors the opportunity to achieve, in some cases, 100 times their initial investment. Early investors will also be rewarded for their resolve as, even if the conversion implies maturation, the company will likely continue to generate plenty of cash and distribute it to shareholders foregoing corporate taxation in a REIT structure. The moral of the story may be to pick stocks showing strong growth, powered by secular trends.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.