Co-location data-center company Switch Inc (NYSE:SWCH) went public at $17 a share in October 2017. SWCH stock briefly rose above $20 in its first few days of trading, but it has been nothing but down since then.
Now, SWCH stock is priced around $13, representing approximately a 35% decline since its early days on Wall Street.
Why the big selloff in Switch stock?
The data-center company, which had sky-high growth rates prior to going public, has been victim to a consistent slowing growth trend.
That was most apparent in the company’s recent first quarter earnings report, which is the catalyst that recently sent shares plunging more than 10%. In that report, revenue growth was just 10%, versus a 20%-plus growth rate that had become norm over the past several years.
Clearly, SWCH is having troubling growing its business. That makes SWCH stock, trading at a still-rich 25-times fiscal 2018 earnings multiple, look risky even after the recent selloff.
Here’s a deeper look.
Why Switch Stock Is Dropping
Switch stock is dropping for one very scary reason: slowing revenue growth.
Between 2013 and 2016, Switch was growing revenues at a near-25% pace thanks to robust and growing demand for data-center capacity.
As hyper-scale data-center operators like Amazon.com, Inc. (NASDAQ:AMZN), Microsoft Corporation (NASDAQ:MSFT) and Alphabet Inc (NASDAQ:GOOGL, NASDAQ:GOOG) built out their data-center capacity, they needed space to host all that data. That is where Switch stepped in and made a killing selling data-center space to these hyper-growth cloud service providers.
Revenue growth, however, slowed to 20% in 2017. While that isn’t shocking, it was a slightly worrisome sign that the best may be over for SWCH stock.
That sign turned into a red flag with the company’s first quarter earnings report. In that report, revenue growth was just 10%.
In other words, revenue growth at SWCH has gone from 25% to 20% to 10% over the past several years. That is a steep step down that implies there are troubles in the company’s core business model.
There might be. Switch isn’t the only data-center provider in the world. It is just one of many, many data-center providers fighting over contracts with companies like Amazon, Microsoft and Google. As such, competition in the co-location data-center market is fierce, meaning that robust overall data-center market growth won’t necessarily translate into big growth at SWCH.
That is what’s happening right now. And it is a troubling sign of competition eroding SWCH’s growth narrative not only now, but into the foreseeable future as well.
Why Switch Stock Could Keep Dropping
Despite recent struggles, I expect growth at SWCH to pick up over the next five years.
Right now, the company is investing big into PRIME data centers, and those big investments have yet to yield material results. Over time, however, these investments will turn into more contract wins and stronger growth. That is why over the next five years, I think revenue growth at SWCH can run around 15-20% per year.
I’m much less confident in the company’s ability to maintain margins. The co-location data-center market has a ton of competition, and as such, contract pricing is highly volatile. That is why SWCH’s adjusted EBITDA margins have swung wildly around 50% over the past several years.
Assuming SWCH can maintain an average of roughly 50% EBITDA margins over the next five years, I think that this margin stabilization plus 15-20% revenue growth should get the company to about $0.50 in earnings per share in five years. A market-average growth multiple of 20 times forward earnings on $0.50 implies a four-year forward price target of $10.
Thus, at around $13, I think SWCH stock is unreasonably overvalued.
Bottom Line on SWCH Stock
Slowing growth and margin headwinds continue to weigh on this stock. Until revenue growth or margin trends turn around, SWCH stock will continue to head lower because the valuation is still rich.
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As of this writing, Luke Lango was long AMZN and GOOG.
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