Deal Economy Forecast

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Cloud computing, smartphones, video streaming and other trends are pushing more bits over the Internet, increasing the demand for companies that own key pieces of the infrastructure that carries the data. Private equity firms have been active buyers and sellers of both fiber network operators and data center companies, in some cases entering new investments shortly after flipping old ones. Traditional phone companies have also been active acquirers in these two sectors, pushing valuations to prerecession levels, and sometimes reaching double-digit multiples of Ebitda.

But mixed with the enthusiasm and buoyancy has been some trepidation. Equinix Inc., which acquired Switch and Data Facilities Co. in one of 2010's benchmark deals, rattled the data center sector in October when it tweaked its guidance. Shares of Equinix and several of its peers suffered double-digit declines during a single trading session over what was ultimately a modest reduction in sales forecasts. While the event did not indicate a data center apocalypse, it did reflect the jitters of investors who can remember the bad old days of telecommunications.

But whatever unhealed wounds may linger, Internet infrastructure companies are in vogue. After all, Verizon Wireless is adding the iPhone, meaning 93 million more Americans will have a new incentive to indulge in mobile media. Manufacturers introduced a legion of wireless tablets at the January International Consumer Electronics Show in Las Vegas. And research group Gartner Inc. expects worldwide cloud services revenue to reach $81.3 billion in 2011, up from $68.3 billion in 2010.

As a result, fiber networks and data centers, which were the busiest segments of telecom dealmaking in 2010, are expected to remain active in 2011. As Bill LaPerch, CEO of fiber network operator AboveNet Inc., puts it, information needs to live somewhere, which is where data centers come in. And it also needs to get places. Enter fiber networks.

"When it goes to that data center, it needs to get back to the trading floor, to the hospital, to the media center, to the social networking site, wherever it is going," LaPerch says. "I look at the fiber companies as the transport infrastructure that makes that happen."

LaPerch's company is the latest fiber network operator to attract private equity investment. Boston firm TA Associates Inc. purchased a minority stake for an undisclosed amount in mid-January.

One of the largest of the metropolitan fiber operators, White Plains, N.Y.-based AboveNet targets "Tier 1" cities such as New York, Boston and Los Angeles. The company, formerly known as Metromedia Fiber Network Inc., went through Chapter 11 bankruptcy during the dot-com meltdown, and it is now one of the few metro fiber operators in public hands.

LaPerch says the company has looked at many of the fiber assets that have been auctioned in the past 12 to 18 months but has passed. "There aren't that many targets out there that give me 100% of something new. They are something that I already have or something I can already do," he explains. "Not that these fiber companies aren't worth a lot, but they aren't worth as much to me."

Other companies, however, have been eager buyers. Rural telecom Windstream Corp. in December paid $782 million for Q-Comm Corp., which owns fiber network company Kentucky Data Link. The Little Rock, Ark., carrier paid about 8.4 times Ebitda, although after savings and other benefits, the company says the multiple is closer to 6.6.

The purchase was part of an effort by Windstream to change its revenue mix. That effort also included the $310 million acquisition of data center operator Hosted Solutions Acquisition LLC from private equity firm Abry Partners and the $647 million purchase of business services provider NuVox Inc.

The core of Windstream's business, rural residential phone service, produces cash and supports Windstream's dividend. But the business is in decline. Through acquisitions, the company has tried to increase its revenue from broadband and corporate services, which have stronger growth prospects and now make up more than half of Windstream's top line.

"The dividend is so important to our investors," says Windstream CEO Jeff Gardner. In 2006, he explains, investors had a limited view of the dividend's stability and longevity. "They'd think, 'These businesses are shrinking, but we'll probably be OK for two years,'?" Gardner says.

Windstream is also filling in gaps that were created by its 2006 spinoff by Alltel Corp., which later merged with Verizon Wireless. Following the spinoff, Alltel held onto its fiber network to carry wireless traffic. The rural telecom says that Q-Comm's Kentucky Data Link fiber unit will improve the margins of its wireline operations and reduce services it must buy from other providers. Windstream is also in a better position to sell fiber capacity to other telecoms, as smartphones increase the amount of data that wireless carriers need to transport between cell towers.

Before purchasing Hosted Solutions, Windstream had a few data centers of its own. "Most of what we were selling was [server] rack space," Gardner says, which went for low prices per square foot but addressed customers' needs. Hosted Solutions has more experience with buying power and cooling for servers, and offering higher-priced services.

Managing the power demands for endless racks of servers is increasingly burdensome. This is one of the factors motiving many companies to outsource their data centers.

Robert Morse, a partner at private equity firm Oak Hill Capital Partners, says that the increase in corporate networking and the hauling of wireless data, online video and other traffic is causing power consumption to rise 5% to 10% annually. "All of the efficiencies of better chips and virtualization keep that from being higher, but aggregate power consumption is still growing," Morse says.

Oak Hill purchased Denver data center operator ViaWest Inc. from Trinity Equity Investors LLC, Goldman, Sachs & Co. and Quilvest for an undisclosed price in May. Oak Hill had previously invested in data center and hosting company Savvis Inc. and has partially exited European data center operator TelecityGroup International Ltd. ViaWest has made two acquisitions since Oak Hill's investment, buying Salt Lake City operators SingleEdge and Consonus Technologies Inc.

Energy management contributes to a long-term trend in data center outsourcing that underpins the sector's growth. "There are a lot of big corporations out there that are making that transition to outsourced data centers, but this is occurring very slowly since many of them have legacy properties," Morse says. This transition should provide "another 5% to 10% annual wind at the back" for third-party data centers like ViaWest.

There is no shortage of potential customers. Tier 1 Research, a division of 451 Group, estimates that about 15% of corporate data centers are outsourced, leaving 85% of the market untapped. "It's one of the few sectors that grew over the recession," says Tier 1's Aleetalynn Schenesky-Stronge as the economic downturn made it more attractive for corporations to outsource the housing, powering and cooling of their servers than to build their own data centers.

Much of the sector's growth comes from what Schenesky-Stronge calls "same-store sales," as existing clients buy more services. Customer defections are low. "It has all of the fundamentals that PE is looking for," she says. On the other side of the equation, data center operators need capital. "They are at full capacity. We see secondary and tertiary markets hitting capacity," Schenesky-Stronge says. "They need money. If you're not one of the big guys, debt is not available."

Tier 1 Research says that data center deals doubled in 2010. The firm tracked 20 transactions involving centers with multiple tenants in 2009, compared with 42 in 2010. Private equity is responsible for many of the transactions.

In addition to Oak Hill, Welsh, Carson, Anderson & Stowe bought a controlling stake in Charlotte, N.C., data center operator Peak 10 Inc. in October. M/C Venture Partners sold Toronto data center operator Fusepoint Managed Services Inc. to Savvis for $124.5 million in June.

In addition to Windstream, two public telecoms have also acquired data centers. Cincinnati Bell Inc. purchased data center operator CyrusOne from Abry for $525 million in June. Chicago telecom Telephone and Data Systems Inc. paid $47 million for data center operator Team Technologies LLC in December, after buying Visi Inc. of Minnesota in March.

There are also a number of real estate investment trusts targeting data centers. Chief among them is San Francisco-based Digital Realty Trust Inc., which made more than $1 billion in acquisitions in 2010. "It was a banner year, an extraordinary year," says director of investor relations Digital Realty Trust Inc. The company expects to spend $200 million to $450 million on income-producing properties in 2011.

Because of their tax benefits, ­REITs are required to derive a high percentage of their income from real estate-related revenue and pay a high percentage of taxable income through dividends. If Digital Realty acquires a business that has nonreal estate income, it could put some of it into a subsidiary that pays taxes. Over time, it would convert contracts to leases.

There are a handful of other data center REITs. DuPont Fabros Technology Inc. has been acquisitive. Carlyle Group took data center REIT CoreSite Realty Corp. public in September with a $270 million offering.

Equinix's $685 million purchase of Switch and Data in May helped focus attention on data center M&A. The deal combined two large public operators, and it signaled the M&A activity to come. But the integration also brought scrutiny. Equinix unnerved the market in October when it suggested that its revenue would soften, noting that demand might not be as robust as previously thought. As bright as the outlook seemed, the warning resonated. Equinix stock fell more than 30% on Oct. 6, and companies with similar businesses also suffered. Rackspace US Inc. fell 11.1%, Savvis dropped 10%, and Citrix Systems Inc. dropped 14.1%.

"Wall Street is very nervous about the industry," Tier 1's Schenesky-Stronge says. "They are concerned about oversupply."

Equinix's problems appear to be company-specific, she says, and arose largely from the Switch and Data purchase. The analyst says the issues do not extend throughout the data center industry, which Schenesky-Stronge says has managed its expansion. "Most buildings are presold before they even open their doors. Demand is much higher than supply," she says. New facilities are typically built to satisfy demand from existing clients. "Their customers say, 'We need capacity in X market,'?" Schenesky-Stronge says. "That's their next build."

Data centers and fiber network operators are related, literally. The more fiber networks connecting to a data center, the more valuable the data center is to customers, and vice versa. ­AboveNet's LaPerch touts his network's connection to more than 400 data centers throughout the country. "For the same reason that guys rob banks, because that's where the money is, we connect to data centers, because that's where the data is," he says.

Despite their proximity, there are differences between the two sectors, including their capital requirements and valuation ranges. And each presents varying opportunities and risks.

Gerald Granovsky of Moody's Investors Service notes that data centers have a real estate component. They have a longer lead time to market from conception to operation, and they are more capital intensive. However, the businesses have little customer churn. "People just don't leave a data center," Granovsky says. "And if they do, right now you are able to line up new customers."

He notes that data center valuations have reached 12 to 13 times Ebitda. Fiber buyouts, meanwhile, have occurred at 8.5 to 10 times Ebtida, compared with 5 to 6 times Ebitda three years ago.

On paper, at least, Granovsky says the investment case for fiber is probably a more appealing model. "Most of the time when you're digging up a street and laying a new fiber route, you already have a client," he says. Adding fiber once a route is established is not prohibitively expensive. Usually, a network operator builds an extension after signing a new customer.

There are concerns, however. "We are in a little bit of a gold rush mentality right now, with the wireless backhaul," Granovsky says. "To us, that's the biggest risk. The fundamentals are there, but we're still concerned that self-discipline may not always rule." Network operators may lean too heavily on debt to fund growth, he warns, preventing them from producing free cash flow.

An AT&T Inc. wireless manager in Indiana who has to compete with every other department within the company for capital might use a wholesale fiber network operator to carry mobile transmissions after they reach a communications tower, Granovsky notes. In a few years, when AT&T has finished juicing up its mobile network and has completed other projects, the analyst says, the manager in Indiana might get approval to build a facility.

"As you keep going down the road and you're seeing that a fiber carrier is generating a 60% Ebitda margin, that's a lot of money for Verizon or AT&T to lose," he says.

Like the data center operators, however, the fiber companies have latent opportunities. Yankee Group Research Inc. says that only about 20% of U.S. commercial buildings have fiber connections. Connection levels are much higher in, say, downtown Manhattan or Washington. Many suburban office parks throughout the country were built before modern fiber infrastructure was prevalent and house businesses that don't require advanced data services.

Salvatore Tirabassi of M/C Venture Partners says that the public markets are undergoing something of a re-­education about the fiber sector, following the overcapacity of the Internet bubble. "I don't think the capital is there and the business model is there to overbuild fiber where it already exists," Tirabassi says. There could be more fiber deals, he suggests, but they will tend to be "very strategic opportunities" given the multiples.

M/C backs Zayo Group LLC of Louisville, Colo., which bought American Fiber Systems Holding Corp. for $100 million. The Boston firm also has money in Lightower Fiber Networks, which said in December that it would acquire Open Access Inc. of Farmingdale, N.Y. Earlier in 2010, Lightower acquired Lexent Metro Connect and Veroxity Technology Partners.

M/C has made two recent exits as well. Paetec Holding Corp. purchased portfolio company Cavalier Telephone LLC, which owns some fiber assets, for $460 million in December. TelecityGroup in the U.K. paid £21.1 million ($33.5 million) for data center operator Internet Facilitators Ltd. earlier in 2010.

Ridgemont Equity Partners, spun out from Bank of America Corp. in 2010, also backs Lightower and has been active in fiber. The firm and Nautic Partners LLC sold Fibertech Networks LLC to Court Square Capital Partners for $535 million. The price exceeds 10 times Fibertech's Ebitda for the past 12 months. A week after announcing the Fibertech deal, ­Ridgemont agreed to take a majority stake in fiber infrastructure provider Unite Private Networks LLC.

Ridgemont's George Morgan says that Unite could be a platform for acquisitions, although that is not determined. Morgan says that multiples have been lower in the fiber sector than in data centers. "That's one of the things we liked about fiber," he says. "We thought it was more attractive on a relative valuation basis."

There are more data center companies of scale, which may appeal to some private equity firms. "A lot of the funds that are in the sector are pretty large and need to put large amounts of capital to work," he says.

Data centers and hosting companies may see more deal activity than fiber operators, simply because of their numbers. Tier 1 Research notes that there are more than 350 data centers in the U.S. There are thousands of hosting companies, which are typically smaller.

Oak Hill's Morse expects more data center transactions. "It's a capital-­intensive business," he says. "Companies that survived the 2000-2001 downturn have now filled up their data center facilities and need to raise money to build new capacity so they can serve their customers," Morse adds. "You can't really run a full data center without additional capacity because your customers want to grow, and they will go to competitors if your facilities cannot accommodate that growth."

One question is whether metro fiber operators and data center companies will combine. But there are reasons to keep the businesses separate. ­AboveNet formerly owned data centers but divested them in 2006. Fiber and data centers are both capital intensive, LaPerch says. Moreover, AboveNet's lack of data center assets has value in itself.

"We think it would be detrimental for us to be actively involved in the data center business because we have such a great relationships with all of the data centers," he says.

While there may not be another combination along the scale of Equinix and Switch and Data in the U.S. potential deals are out there. Telx Group Inc. filed for an initial public offering in early 2010 but has yet to go public. The GI Partners portfolio company could be an interesting match for European data center operator Interxion Holding NV, which has financing from Baker Capital and has itself filed for an IPO on the New York Stock Exchange.

Beyond M&A, the health of the public market will be crucial for both fiber networking companies and data center operators. Private equity is heavily invested in both sectors. Assuring public investors that the Internet renaissance is not a rehash of the Internet bubble, and that companies have the discipline to resist overbuilding, will be necessary to establish an IPO market for the companies and provide exits for their backers.