2 Cloud-Computing Buys

Equinix (Nasdaq: EQIX  ) helped murder cloud-computing stocks yesterday.

By itself, Equinix fell 33% after reducing third-quarter and full-year guidance. But many other somewhat-related stocks also took a beating. Here's a partial list:

Company

Yesterday's Return

Citrix (Nasdaq: CTXS  ) (14.07%)
F5 Networks (Nasdaq: FFIV  ) (12.52%)
Rackspace Hosting (NYSE: RAX  ) (11.14%)
SAVVIS (10.36%)
NetSuite (NYSE: N  ) (10.17%)
Internap Network Services (9.8%)
VMware (NYSE: VMW  ) (8.99%)

Source: The Wall Street Journal's markets data center.

Not all of these sell-offs make sense. But before we get into the buying opportunities created by Mr. Market's spasmodic irrationality, let's briefly review what happened.

Churn and burn
Equinix's management cited churn and discounting as two of the major forces eating away at its short-term outlook, while also reiterating its belief in the long-term growth opportunity available to the company as a provider of data center and interconnect services.

Equinix's data centers provide the physical connections between providers of cloud computing software and data network providers, such as AT&T (NYSE: T  ) . As goes Equinix's data centers, so goes a big chunk of the cloud -- that's the thinking, anyway.

That idea isn't entirely wrong. But if Equinix loses some big customers to lower-cost data center operators, that's not even remotely a knock on VMware, a virtualization specialist, or Rackspace, which operates an entirely different model for hosting. Both are worth buying as a result of this sell-off. Here's why:

  • VMware is more important to cloud computing than Equinix is. Without virtualization -- the ability to transform one physical server into many virtual servers -- cloud computing would be economically unsound. Many years of growth await this business.
  • Like Equinix, Rackspace provides hosting services, but that's where the similarities end. Rackspace isn't a data center operator, nor does it own land or facilities, as Equinix does. Because of this, Rackspace had at one point been an Equinix customer, members of the finance team confirmed in an interview yesterday. Assuming these two companies share the same risk profile is a mistake.

More than anything else, debt makes Equinix risky. It has to keep making interest payments even when tenants leave its facilities. For Equinix, those payments aren't small: $205 million over the last 12 months.

But it gets worse. Equinix doesn't just have debt; it has expensive debt. According to Capital IQ, the company has several short-term loans and credit lines charging 7% or more, including an 8% mortgage loan. But even the cheap loans aren't as cheap as they appear. Take Equinix's 4.75% convertible bonds, due in 2016. Not bad, right? Well, it wouldn't be if management were producing higher returns on capital (ROC). Instead, ROC sits around 4% today. Equinix is a capital destroyer.

By contrast, neither of my picks faces this sort of debt dilemma, yet each is also a front-line foot soldier in the cloud-computing revolution. Buy them before Mr. Market realizes how crazy this sell-off is.

Now it's your turn to weigh in. Is yesterday's cloud computing sell-off a buying opportunity? Please vote in the poll below and then leave a comment to explain your thinking. And if you're interested in Equinix, click here to add it to your Foolish watchlist.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Rackspace Hosting and VMware are Motley Fool Rule Breakers recommendations. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. The Motley Fool is also on Twitter as @TheMotleyFool. The Fool's disclosure policy isn't for sale, but if it was, it'd be a bargain.


Read/Post Comments (8) | Recommend This Article (23)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 07, 2010, at 3:57 PM, portefeuille wrote:

    You could also buy EMC shares (EMC is the parent company, holding around 80% of the outstanding VMW shares) instead of VMW shares.

  • Report this Comment On October 07, 2010, at 5:51 PM, since62 wrote:

    Silly sell off - VMware will be back up to 85 before the month is out!

  • Report this Comment On October 08, 2010, at 8:27 AM, lctycoon wrote:

    You could also buy Microsoft or a data carrier like LVLT (or AT&T, Verizon, etc.) to play the cloud. After all, both of these firms will be getting a lot of money if cloud computing grows.

  • Report this Comment On October 08, 2010, at 1:10 PM, MegaEurope wrote:

    As usual, this puff piece on cloud computing totally ignores valuation.

    The correction is not very impressive yet - just wiping a month or so of gains off for most stocks.

  • Report this Comment On October 08, 2010, at 3:04 PM, TMFMileHigh wrote:

    @MegaEurope,

    Thanks for writing.

    >>As usual, this puff piece on cloud computing totally ignores valuation.

    Sorry, but ... Hogwash. The usual carping about cloud computing valuations entirely ignores the advantages and expectations built into the pricing of these stocks.

    Also, in this case, it's ironic. Here I am arguing that an industrywide sell-off ignores economic realities, and your response is, in effect, to criticize me for addressing economic realities.

    Let's just take VMware. I'd agree that a 100+ P/E is expensive and unsustainable in a vacuum, but it's an altogether different matter when VMware has been priced at more than 100 times earnings for most of its history as a public company. And in that time, free cash flow has consistently come in higher than earnings -- and at a multiple to earnings in more recent years.

    Platitudes count for nothing in investing, as you rightly point out. The over-arching "cloud computing is overvalued" argument is that sort of platitude, and is as full of nonsense as the blindly bullish investor who buys Starbucks because he likes the coffee.

    FWIW and Foolish best,

    Tim

    TMFMileHigh

    @milehighfool on Twitter

  • Report this Comment On October 09, 2010, at 7:20 PM, MegaEurope wrote:

    So are you denying that your article ignored valuation?

    Is the entirety of your justification for high multiples that other people have been willing to pay them recently? Or have you done some kind of DCF analysis?

  • Report this Comment On October 09, 2010, at 7:30 PM, MegaEurope wrote:

    By the way, calling your article a puff piece was a little harsh. I definitely agree with your negative comments on EQIX. And I agree that VMW will see more significant growth than the rest of this overhyped, overpriced sector.

  • Report this Comment On October 09, 2010, at 7:40 PM, MegaEurope wrote:

    "Here I am arguing that an industrywide sell-off ignores economic realities, and your response is, in effect, to criticize me for addressing economic realities."

    OK one last comment. I didn't criticize you for addressing economic realities, I criticized you for not addressing valuation. I think there is a significant difference.

    Your claim that the sell-offs don't make sense obviously depends on the idea that extremely high multiples (some within spitting distance of all time highs) do make sense.

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