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Switch: Red Flags Becoming More Apparent

Enthusiasm for Switch (NYSE:SWCH), the colocation provider that rents out server rack space to companies, is slowly beginning to fade. In the years since its IPO at $17 per share, Switch has tried to sell itself as a technology company, closely tied to the trends of companies moving their infrastructure off-premise and unloading more into the cloud. Over the past few quarters, however, Switch has gravitated more toward its true colors as a quasi-real estate business, one that takes on a substantial amount of debt to build out capacity that it then rents out to corporate tenants.

After posting its weakest-ever revenue growth rates in Q2 (that calls into question its heavy capex development), shares of Switch dropped about ~10%:

ChartData by YCharts

The fact that Switch shares are now more than ~50% up from their March nadir tells me that there’s a lot more downside to go. To me, this is a company that continues to blow investor cash on huge facilities – yet in spite of this acceleration in investment, Switch’s revenue growth rates remain feeble, and utilization rates aren’t seeing much improvement.

In my view, several more red flags have emerged after seeing Switch’s latest quarterly update. Investors would be wise to remain on the sidelines.

Growth decay falls short of expectations

Switch’s basic premise is that it continues to spend heavily on capital expenditures in order to keep up with growing enterprise demand for offsite cloud hosting. We haven’t seen a resurgence in revenue growth, however, justify the investments that Switch has made.

Take a look at Switch’s latest growth trends in the slide below:

Figure 1. Switch revenue trends

Source: Switch Q2 earnings deck

Switch’s revenue grew only 13% y/y to $126.9 million, slightly falling short of Wall Street’s consensus expectations of $127.2 million and decelerating a sharp six points versus 19% y/y growth in Q1. Switch is a company that prides itself a lot on low churn rates, meaning once customers are installed, they have a tendency to stay. And while churn did remain low at 0.2% (flat to 2Q19), if Switch really was as stable as the company claimed to be, it wouldn’t have seen this sharp of a revenue deceleration amid the coronavirus.

In fact, we’ve actually seen Switch’s billed utilization rates drop to the low 70s. This means that as Switch brings new facilities online, it’s not really filling its “Primes” with enough business to operate at full capacity.

Figure 2. Switch utilization trends

Source: Switch Q2 earnings deck

Largely as a function of the fact that Switch plans to expand its Atlanta campus in the back of the year, management has also noted that utilization rates will likely trend downward from here (at least temporarily). In commenting specifically on utilization on the Q&A portion of the earnings call, CEO Gabe Nacht noted as follows:

As far as Atlanta utilization, we’ve signed 4 new customers this last quarter, and the utilization percentage, remember is based on our open sector right now. The second sector is slated to open prior to year-end. So that will obviously increase the floor space in the cabinet availability in that facility and drop the utilization rate. So trying to predict where the utilization rate is going to end up this year is really tough for us to do, and it’s not something that I’m able to do at this point.”

It’s great that Switch’s investments and projects are coming to completion – this is a leading indicator that Switch can lift its revenue growth rate from the current lows notched this quarter. However, management’s commentary above seems to suggest that it doesn’t have commitments lined up to fill the space. And in a time when few businesses are really focused on expanding their infrastructure, Switch may continue to struggle filling up its new capacity while still paying for the costs to operate it.

Already-indebted balance sheet will be strained even more by dividend increase

What was additionally surprising about Q2 was the fact that Switch decided to boost its quarterly dividend by ~70% to $.05/share. To me, dividend increases should be accompanied by actual earnings strength – but in Switch’s case, I’m afraid it will only further strain Switch’s balance sheet.

Here’s a snapshot of where Switch’s balance sheet landed at the end of Q2:

Figure 3. Switch capital structure

Source: Switch Q2 earnings deck

This is a company with a sizable $896.3 million in debt at ~3.6x trailing EBITDA, as shown in the chart below (Switch’s math meanwhile focuses on annualizing its most recent adjusted EBITDA, which gets to a slightly milder 3.1x number). While it’s true that Switch’s leverage ratio is approximately in line with other data center REITs that it competes with (Equinix (EQIX), one of Switch’s most recognizable competitors in the colocation space, has approximately a ~4x debt/EBITDA ratio), Switch’s debt levels have been trending upward thanks to the company’s aggressive spending to open new facilities. Its EBITDA growth has not kept pace with its balance sheet expansion. Year to date, in 2020, Switch’s adjusted EBITDA has grown only 16% y/y, while its net debt levels have soared 49% y/y to $864.6 million at the end of Q2. At its current pace, it won’t take long for Switch to catch up to or exceed peers’ leverage levels.

ChartData by YCharts

Dividend aside, Switch’s capex already consumes a tremendous amount of cash. In 2019, Switch consumed $308 million for capex, and in 2020, the company has guided to a capex range of between $290 and $340 million – all of which has caused Switch’s debt levels and leverage ratios to creep upward throughout the past year, as can be seen in the table above.

Because of Switch’s large capex requirements, looking at Switch’s dividend payout ratio alone isn’t a good way of sizing whether it’s strong enough to support its dividend. Wall Street is projecting $0.26 in EPS for next year, which would put the $0.20 annual dividend (assuming the $0.05 quarterly dividend gets annualized) at a 77% payout ratio – which isn’t fantastic, but still doable.

When factoring in capex, however, the picture becomes much worse. With roughly 240 million shares outstanding, a $0.20 annual dividend will cost Switch roughly $48 million. Adding ~$300 million in annual capex means that Switch’s cash requirements to satisfy both capex and its dividend sum up to roughly $350 million.

Even if we look at adjusted EBITDA – Switch’s primary and most optimistic measure of profits – we find the company’s bottom line insufficient to continue supporting this level of cash expenses without incurring additional debt. The company’s FY19 adjusted EBITDA came in at $231 million, and for this year, the company is guiding to $251-$261 million in EBITDA (+11% y/y at the midpoint).

Figure 4. Switch adjusted EBITDA trends

Source: Switch Q2 earnings deck

Note that adjusted EBITDA obviously excludes interest expenses, which is another major outlay for a company as indebted as Switch. Given that quarterly interest expense tallies up to roughly $7 million, we find it difficult to believe Switch can really sustain this dividend increase while maintaining current capex levels – at least, not without taking on more debt as the company has consistently been doing already.

Key takeaways

With unimpressive revenue trends and extremely high expense requirements across capex, interest, and the newly increased dividend, I find it difficult to believe that Switch won’t eventually get swallowed in its debt – which, even prior to the dividend raise, was already on a continuous rise.

Investors should maintain extreme caution here.

For a live pulse of how tech stock valuations are moving, as well as exclusive in-depth ideas and direct access to Gary Alexander, consider subscribing to the Daily Tech Download. For as low as $17/month, you’ll get valuation comps updated daily and access to top focus list calls. This newly launched service is offering 30% off for the first 100 subscribers. 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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