Cyrusone: Illusions Of Value

As I started my due diligence on Cyrusone (CONE), I was excited. Here was a stock that had a good story - it rents out space in datacenters, has a dividend yield and trades at a low valuation while showing decent growth.

Using Equinix (EQIX) and Rackspace Hosting (RAX) as comparables, I was pumped up. CONE was projecting $135 million in EBITDA for 2013 (at the midpoint of guidance). On a $445 million market capitalization with $277.7 million in net debt, it traded at an EV/EBITDA of just 5.4 times. Compare that to EQIX at 13 times or RAX at 15 times. This was a bargain and growing revenues at a 18% clip year-on-year, too, above EQIX's 10% or RAX's 15%.

While going through the business, it was obvious that this was not a direct cloud computing services purveyor. Instead it rents the infrastructure where other entities can collocate their servers and build their clouds. Still, the attractiveness was obvious, as long as there's more demand for data and cloud computing, there will be more demand for the infrastructure CONE provides.

Indeed, a bullish thesis could even be conceived in which selling the picks, shovels and denim might well turn more profitable than participating in the cloud computing gold rush. In short, it was all coming together:

The story - associated with cloud computing, profiting from it;The valuation, both in absolute terms and when compared to other similar competitors;And the growth, which came from opening new data centers and filling them up, relentlessly.

It was perhaps too good to be true

The birth of CONE was non-effusive; it came from the spin-off and IPO of the datacenter unit of Cincinnati Bell (CBB). Perhaps one could believe that not being a green field company, people didn't go as gaga on it. It came from a telecom dinosaur, after all.

But that wasn't really the main problem with CONE. In a market so infatuated with anything tech, there had to be some kind of reason for institutions not to transform this cloud computing stock into a roc! ket. And indeed, there is a reason. The reason has to do with how CONE is structured. The following is from a company presentation:

(click to enlarge)

This structure has deep implications. It means Cincinnati Bell still holds 8.5% of the quoted CONE stock, but most importantly, it still holds 66.1%, or 2/3rds, of the operating entity. Think about it for a second, CBB still holds 2/3rds of the business.

Now, since CONE doesn't yet have much in the way of net earnings, the impact from this is not very evident in its P&L, as we can see below (Source: Q2 2013 10-Q, red highlight is mine):

(click to enlarge)

Indeed, at this point the CBB's interest in the operating subsidiary even reduces the net loss.

But the valuation impact is massive. This stems from the fact that when we're calculating an EV/EBITDA, the EV has to account for minority interests in the business, and CBB holds 2/3rds of the operating subsidiary. Either that, or one has to consider that 2/3rds of the EBITDA really doesn't belong to CONE, which is the easier way to correct it.

And if 2/3rds of the EBITDA doesn't belong to CONE, then its supposedly cheap EV/EBITDA of 5.4 times is actually an EV/EBITDA of 16.2 times, which is more expensive than either EQIX or RAX. So much for the valuation argument.

CONE remains an interesting business in that its story is in the right sector to attract speculators, and it's posting enough growth that such speculators might well make their entrance. At the same time, at $445 million in market capitalization any speculative interest will easily take the stock higher. But for a sensitive valuation-oriented investor knowing the structure of this business removes most interest.

Conclusion

At ! first sig! ht CONE seems attractive in terms of story, valuation and growth, but a careful analysis of its organizational structure shows that CBB still owns 2/3rds of the underlying business. This means that the company is not as attractively valued as it might seem. Indeed, it's more expensive than either EQIX or RAX.

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Still, it wouldn't be surprising in the present feverish Fed-infused market for CONE to attract speculative interest. It's just that the illusive valuation removes the interest for valuation-sensitive investors.

Source: Cyrusone: Illusions Of Value

Disclosure: I 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. (More...)