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Tech biz: Verizon's "data center deal" with Terremark



Terremark Internet Exchange data centers
Terremark Internet Exchange data centers
The Tech M&A market recovered from the financial crisis over the course of 2010, both in terms of valuations and in number of deals, and 2011 is already off to a strong start.

As always, market trends (and fashions) are driving the avidity of both cash rich trade buyers and financial players, together with the fear of missed opportunities. Anything involving the word “Cloud” is getting keen interest, as numerous large tech companies – including telcos –aggressively battle for position in cloud services. More broadly, as demand for data center rack space continues to outpace supply, “deals for data centers” will likely be an important part of the action.

A case in point: the friendly offer of Verizon, a big telco with big ambitions in cloud computing, for Terremark, a well respected provider of data center co-location and managed services, including cloud computing.

THE FACTS

On January 27, 2011, Verizon announced its intention to acquire Terremark for 1.4 billion dollars in cash, reflecting a premium of +35% over the market. The tender offer was officially launched on February 10. Despite legal action by at least one disgruntled investor, a majority of shareholders are expected to tender their shares, allowing the deal to close in March.

Terremark has grown rapidly over the past five years but has also run up an unbroken string of losses. Since the company is highly leveraged, with debt of around 600 million dollars, Verizon is arranging 2 billion dollars of financing for the acquisition.

The two companies already work together in the Infrastructure as a Service (IaaS) market for SMBs, with Terremark delivering basic computing on demand services sold by Verizon.

Verizon intends to operate Terremark as a subsidiary, keep the management and maintain the brand, eventually bringing in its own data centers and its Cybertrust security services business.

DUQUESNE GROUP ANALYSIS

Overall, Duquesne Group sees this acquisition as somewhat “pricey”, with the most immediate benefits going to Terremark and its shareholders.

On the Verizon side, we see it essentially as a “data center deal” for the Cloud. Although the company has positioned the acquisition more generally as an “accelerator” for growth in cloud services, we expect that its impact on the competitive landscape will be limited.

A somewhat “pricey” deal

Verizon’s tender offer of $1.4 billion cash values Terremark at nearly 5 times sales for the fiscal year ended March 31, 2010. Using expected 2011 revenues, the valuation ratio is around 4 times expected sales. Factoring in the company’s exceptionally heavy debt load would, of course, result in a significantly higher multiple.

A comparison with several other hosting companies offers some perspective.

NaviSite: on February 2, Time Warner Cable announced plans to acquire the modest sized NaviSite for 230 million dollars, in order to build a cloud offer for SMBs. NaviSite has not been growing and only returned to modest profitability in 2010. The price per share reflects a premium of 33% over the previous market close, very close to that paid by Verizon. The deal, however, values the company at somewhat less than 2 times annual sales.

Rackspace: this fast growing hosting company – well positioned as a cloud provider - is significantly larger than Terremark. It is also somewhat profitable and has relatively little debt. Rackspace’s market cap of 5 billion is over 6 times annual sales.

Savvis: this is a large hosting company that has been growing, but also running losses for the last three years. It is valued by the market at nearly 2 billion dollars, around 2 times annual sales

It should of course be borne in mind that the latter two companies are both “moving targets”, given the current speculation about more buy-outs in the data center space.

Looking at the Terremark acquisition in this context, it seems clear that the deal reflects a “very attractive valuation”, as the CEO of Savvis famously said shortly after the announcement.

As might be expected with so much money involved, at least some shareholders think the exact opposite and believe that the price in fact undervalues the company. They may have a point in that, whatever the fundamentals, a full scale bidding war might have resulted in a higher price. As noted earlier, at least one investor has initiated legal action, claiming breach of fiduciary duty by the Board in failing sufficiently to shop the company.

On our side, we see the valuation as somewhat expensive for a heavily leveraged hosting company that is still running losses, as it has done for the last few years. Nonetheless, the price of 1.4 billion dollars (plus 600 million in debt) remains affordable for a big telco like Verizon.

Immediate benefits for Terremark’s shareholders and for the company

We think that Terremark’s shareholders are big winners in this deal. While the share price more than doubled in 2010, the company was certainly not in solid financial shape. The shareholders get an exit strategy that locks-in the 2010 gains and provides a hefty additional 35% premium.

With Verizon as its new parent, the company itself benefits in several ways:

Financial salvation

Terremark’s heavily leveraged balance sheet was not sustainable. For a company of that size, servicing 600 million dollars of debt is a big handicap that would sooner or later compromise operational business performance, limiting resources that could be needed on the commercial side, for the technology platform or for customer service.

Not only has Verizon eliminated the financial handicap from the past, it has the deep pockets that may be needed to finance continued high growth in the future.

Commercial muscle

The difference between being a respected player and a real market success often comes down to sheer commercial muscle, which the deal with Verizon should be able to deliver. Verizon has a large and aggressive direct sales force, with established access to big corporate accounts.

Execution will be key, including establishing the commercial rules of the game between Terremark and its parent.

More future as a Verizon company

Operated as a subsidiary, Terremark will play a big role in Verizon’s business development in cloud services. While it is not yet entirely clear how all of the responsibilities will be sorted out, becoming a Verizon company will doubtless offer a better future to the people of the company than slogging on alone.

A “data center deal” for Verizon

Verizon has positioned the acquisition primarily as a “growth accelerator” in cloud services, language which usually suggests a market share play. Nonetheless, while cloud computing is central in Terremark’s image and business plans, for the moment it only represents around 35 million dollars per year, about 10% of the company’s revenues.

In this deal, Verizon did not really buy market share, but it did buy a nice set of data centers.

The US telco has been straightforward about the rationale for the acquisition. Verizon has big ambitions in cloud computing and expects to need significant new data center capacity.

Management saw this as a classic make/buy decision. While building might have been less costly, it takes time and Verizon is in a hurry. In addition, they do not see building data centers as a core Verizon competency.

Most of Terremark’s data center capacity is recent and quite modern in terms of power density, efficiency and security. A striking example is Terremark's flagship data center, the NAP of the Americas, a "Tier IV" facility of around 70,000 square meters. It was purpose built in Miami to link Latin America with the rest of the world, offering direct backbone access to the world's major carriers.

According to the two companies, Terremark’s aggressive investment program in modern data centers has given it “good headroom to support growth”, both in terms of built-out space and of adjacent land available for building if needed. Geographical locations are also complementary with those of Verizon.

However reasonable all of this may be, in our opinion it does not add up to a big boost to Verizon's growth in the Cloud. We have two main comments.

First, scale is of course an important cost factor in the increasingly commoditised business of IaaS, and the acquisition is a sensible way to ensure that Verizon will have the capacity it needs as it ramps up in cloud services. Revenue growth, however, also depends on many other factors. As noted earlier, Verizon has not bought cloud market share in this deal and Amazon is still the overwhelming market leader.

Second and perhaps more important, while the deal is focused on infrastructure services, however lightly or heavily managed, we see a much better opportunity for a big telco like Verizon in high value services and solutions delivered from the cloud.

“Software as a Service” (SaaS) will likely be a much bigger market and certainly more profitable. In this area, we have not yet seen big progress, with the notable and quite positive exception of the company’s managed security services.

CONCLUSION

The acquisition is clearly positive for Terremark. Existing shareholders get a good exit strategy and the company itself gets a new parent with commercial muscle and financial firepower. On the Verizon side, management has made a reasonable, albeit somewhat expensive, investment in data center capacity to support its cloud ambitions. The impact on the overall competitive landscape, however, is likely to be limited.

The deal is also a sign of the times. The tech M&A market has come back, the Cloud is hotter than ever and the data center space is heating up. More action is possible.

Sunday, February 13th 2011
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Duquesne Advisory

Duquesne Advisory Ltd is a European firm, headquartered in the UK, dedicated to researching, understanding and advising clients worldwide on opportunities and trends in Information and Communications technology.

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Duquesne Advisory delivers in-depth analyses of Information and Communications Technologies, their implementations and their markets. Research is based on critical observation of the market by the analysts and their on-going contacts with the vendor community, together with hands-on, practical experience in consulting engagements.

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The analysts of Duquesne Advisory leverage the Firm’s ongoing market and technology research to undertake high added value consulting engagements for both ICT users and ICT providers. Focused on client service, their approach is rigorous and methodical, and at the same time pragmatic and operational.