Did Equinix Deserve This Haircut?

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer too. But even I have to admit some growth stories are bogus, hence this regular series.

Next up: Equinix (Nasdaq: EQIX  ) . Does this data center operator deserve the 33% haircut it received yesterday? Let's get right to the numbers.

Foolish facts

Metric

Equinix

CAPS stars (5 max) **
Total ratings 223
Percent bulls 68.2%
Percent bears 31.8%
Bullish pitches 14 out of 25
Peers On2 Technologies, PHOTOCHANNEL NETWORKS, Artificial Life

Data current as of Oct. 7.

Equinix took a beating after reducing guidance in a press announcement late Tuesday. The cuts reduced the mid-point of third-quarter revenue guidance by 2.2% and full-year guidance by 1.2%.

"This updated guidance is due to underestimated churn assumptions in Equinix's forecast models in North America, greater than expected discounting to secure longer term contract renewals and lower than expected revenues attributable to the Switch and Data business acquired in April 2010," the company said in a statement.

Many Fools rating the stock in CAPS yesterday and this morning believe the sell-off was an overreaction. "Even if they come in with these weak numbers for 3Q, 4Q, and [year-end] they are still killing it," wrote Foolish investor soulever yesterday in recommending the stock. This CAPS member sees today as the beginning as of an extended rally:

As management settles in with its typical [collocation], hosting, and network deals I am sure they will land a couple global strategic relationships that will make up for missing plan. If we are all smart we jump in and enjoy the ride back to $100 before the end of the year.

Among professional analysts, Oppenheimer is the only one weigh in on the announcement so far. The All-Star firm yesterday downgraded the stock from "outperform" to "perform."

The elements of growth

Metric

Last 12 Months

2009

2008

Normalized net income growth 30.2% 294.4% Not measurable
Revenue growth 29% 25.2% 68%
Gross margin 45.9% 45.2% 41.1%
Receivables growth 57.9% (1.9%) 9.9%
Shares outstanding 45.6 million 39.3 million 37.7 million

Source: Capital IQ, a division of Standard & Poor's.

Who's right? There's an equal mix of good and not so good trends represented in this table. Let's review:

  • Revenue growth has been decelerating from a couple years ago, not what I like to see as a growth investor. The good news? There's still plenty of growth to be had; Wall Street expects Equinix to improve earnings 23% annually over the next several years.
  • Gross margin is inching upwards, indicative of favorable pricing trends. The bad news is this may not last. Equinix cited unexpected discounting in revising its revenue outlook.
  • Receivables worry me. When revenue deceleration meets higher receivables, it can mean that write-offs of unpaid bills are looming. We don't know that's the case with Equinix -- it's way too early for such hysteria -- but I'd advise owners to keep a close watch on the company's balance sheet.

Competitor and peer checkup

Company

Normalized Net Income Growth (3 yrs.)

AT&T (NYSE: T  ) 11.6%
Digital Realty Corporation (NYSE: DLR  ) 53.2%
DuPont Fabros Technology (NYSE: DFT  ) Not available
Equinix Not measurable
Internap Network Services (Nasdaq: INAP  ) Not measurable
SAVVIS (Nasdaq: SVVS  ) Not measurable

Source: Capital IQ. Data current as of Sept. 30.

I've one word for this: uuuuuuggggggglllllyyyyy.

Losses throughout the sector have left just AT&T and Digital Realty, a San Francisco-based real estate investment trust (REIT) whose principal business is operating and renting data center space, looking good. Apparently, consistency isn't Equinix's forte.

Grade: Unsustainable
After yesterday's sell-off, a short-term boost in Equinix shares is certainly possible and may well be deserved. But looking at the structure of the underlying business, I see a company paying plenty of interest on increasingly higher levels of debt while producing moderate and even low returns on capital. That's a recipe for poor stock returns.

Now it's your turn to weigh in. Do you like Equinix at these levels? Let the debate begin in the comments box below. You can also ask Tim to evaluate a favorite growth story by sending him an email, or replying to him on Twitter.

For further Foolishness featuring Equinix:

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.

Fool contributor Tim Beyers is a member of the Motley Fool 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. Its disclosure policy thinks Monty Python is sustainably funny.


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