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Switch Spikes on IPO: Should You Get In?

- By Soid Ahmad

Switch Inc. (SWCH), the provider of data center infrastructure, is up 23% since it announced pricing for its initial public offering on Thursday. The company asked for a price of $17 per share, raising $531.3 million while becoming the third-largest IPO of the year. The market took the IPO quite well and pushed the shares north of $21 during the first day of trading. Switch was initially valued around $4.2 billion.

Switch is a technology infrastructure company involved in designing, constructing and operating data centers. The company is known for its high-power-density data centers with efficient cooling, and uses renewable energy to power the data centers.

Switch has more than 800 customers, including big players like Amazon.com Inc. (AMZN), eBay Inc. (EBAY) and Paypal Inc. (PYPL). The company primarily serves digital media companies, cloud service providers, financial services providers and telecom companies.

The company holds more than 350 patents in the technology infrastructure. Switch has more than 10 colocation facilities and is planning to add more going forward.

Let's explore whether the spike is justified or if it is too risky to get in.

How do financials look?

The company posted revenue of $318.4 million in 2016, translating into a compound annual growth rate (CAGR) of 24% between 2013 and 2016. Net income was around $31.4 million for 2016. Disregarding nonrecurring expenses, net income was around $58.4 million, which translates into a price-earnings (P/E) ratio of approximately 71. Net income is expected to reach approximately $81 million based on annualized first-quarter 2017 results.

Note that more than 56% of the company's revenue comes from customers with a term of more than five years. Moreover, the churn, that is the reduction in recurring revenue, is around 1.4%.

What about the competitive advantage?

Switch believes its patented technology results in reduced operational costs for the company. From a customer's perspective, high-power-density saves space, leading to reduced total cost of ownership. The use of renewable energy and sustainability is another competitive advantage for Switch.

What are the industry prospects?

The need for data consumption, processing and storage is rising. The data created per person is expected to increase 38% p.a. until 2020. Consequently, the demand for data center infrastructure will increase.

Global colocation spending is expected to grow at CAGR of 12% to reach $47.4 billion in 2020. Another research firm predicts the colocation market to reach $62.3 billion by 2022, a CAGR of 14.6% from 2017 to 2022. Between 2014 and 2016, the market grew at a CAGR of 12.5%, according the Statista. It appears the pace of the growth will pick up going forward.

Overall, the data center infrastructure market is set to witness double-digit growth going forward. Switch managed to post a CAGR of 24% when the growth rate was a bit lower than current forecasts. The company will do better in terms of growth going forward as growth forecasts are also higher.

Is Switch worthwhile?

The industry is in the growth phase with double-digit growth expected over the next several years. Switch is already beating the industry in growth. The company demonstrated more than 20% p.a. growth over the past three years. The growth rate will improve as industry growth accelerates.

On the flip side, based on a $4.2 billion valuation, the stock is trading at 51 times forward earnings, which is not exactly a value proposition. Moreover, the company is a small colocation player compared to bigger players who command a higher share of the market. Note, Switch holds around 1% of the colocation market.

Another concern is the company's customer base is concentrated. Switch generated around 38% of its revenue from its top 10 customers in 2016. Ebay is responsible for approximately 10% of the company's revenue. The point is revenue can be hit materially if one of the top customers decides to not renew its contract.

From a valuation perspective, the company is expensive on an EV/EBITDA basis. Despite higher growth in first-quarter 2017, the EV/EBITDA for CyrusOne Inc. (CONE) and CoreSite Realty Corp. (COR) were lower compared to Switch, indicating the stock might be expensive.

Overall, Switch has demonstrated decent top-line growth in the past, which is expected to continue given the industry's positive growth trajectory. The company also has some competitive advantages, including lower cost of ownership for customers, lower operating costs and sustainable development.

Red flags like aggressive valuation, corporate governance issues and a concentrated customer base make it risky from an investment perspective. A 20% spike on the first day adds more to the valuation concerns. As there are other alternatives in the data center space, investors should stay away from Switch at the current price.

Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.

This article first appeared on GuruFocus.