Windstream misses the message

Contact: Ben Kolada

As the telecom industry continues its buying spree, some firms are missing the bigger picture – hosting and datacenter services are the new growth channels for telcos. While CenturyLink and Verizon have each announced acquisitions in the growing datacenter services industry, Windstream Communications appears to be satisfied with consolidating telecom assets. The telco’s purchase of complementary competitive carrier PAETEC is its seventh telco rollup since its formation in 2006. And while PAETEC does provide a wealth of network assets, it contributes little in the way of revenue growth. For the price it’s paying for PAETEC, Windstream could have gobbled up a number of hosting properties at a fraction of the cost.

To be fair, Windstream’s PAETEC pickup does provide more than 50,000 high-revenue enterprise accounts and an expanded fiber footprint. But the target’s organic revenue has been flat in recent years, and growth this year is likely to come primarily as a result of the Cavalier Telephone buy it completed in late 2010. (We would also note that Cavalier’s revenue was in precipitous decline, due primarily to churn in its consumer division. Cavalier’s revenue dropped from $421m for full-year 2009 to an estimated $390m in trailing revenue at the time of its sale.)

Beyond fiber and enterprise accounts, Windstream is also interested in PAETEC’s datacenter services assets. And rightfully so, considering Windstream’s hosting assets could certainly use a boost. The company’s last pure M&A foray into the hosting sector was in November 2010, when it shelled out $310m for Hosted Solutions. That target only generated $51m in trailing sales, or about 1% of Windstream’s total revenue. But for the $2.2bn the telco is paying for PAETEC (including the assumption of debt), it could have easily expanded its hosting footprint in the US and abroad by acquiring both InterNap Network Services and Interxion. Applying a flat 20% equity premium to the pair would put their combined deal value at about $1.6bn on an enterprise value basis, or about three-quarters of PAETEC’s price.

InterNap’s time as a takeover target could be running out

Contact: Ben Kolada

If its past is any prediction of its future, hosting services provider InterNap Network Services could soon lose its position as the industry’s next takeover target. The Atlanta-based firm, which is set to release its second-quarter results, has seen flat sales for the past three years. This is in stark contrast to the hosting industry at large, which has historically grown in the double digits. Meanwhile, other firms are emerging as more desirable targets, pushing InterNap to the back of the buyout line.

Our colleagues at Tier1 Research have written that InterNap was a favored takeover target. However, the firm appears to have since lost its luster. Investors are becoming increasingly frustrated with its poor performance, particularly after first-quarter total revenue declined 6% year over year. And shareholders once again fear the worst – in the past month, shares of InterNap have lost more than one-tenth of their value.

As InterNap is lying stagnant, other firms are posting enviable growth rates, making them much more attractive acquisition candidates. We understand that privately held SoftLayer is gearing toward the public markets, though it could certainly be scooped up before filing its paperwork. SoftLayer surpassed InterNap’s revenue last year, and is projecting bottom-line growth of about 20% this year, to just shy of $350m. InterXion has been cited as a potential target, as well. The company is also enjoying double-digit growth rates, and would provide a large platform for any telco looking to expand its European hosting footprint.

We would note, however, that both InterXion and SoftLayer are considerably pricier properties. While InterNap currently sports a market cap of about $330m, InterXion is valued at nearly $1bn. And we estimate that SoftLayer, on its own, cost GI Partners some $450m. However, when including the other legs of the SoftLayer platform – Everyones Internet and The Planet – the full price to the buyout shop could exceed $600m. But InterXion’s and SoftLayer’s price tags won’t necessarily stand in the way of their sales. We would never have guessed that CenturyLink would have been able to afford Savvis, especially so soon after closing its $22bn Qwest purchase.

After CenturyLink-Savvis, telco consolidation will target the midmarket

Contact: Ben Kolada

CenturyLink’s Savvis acquisition, which closes today, is the largest telco-hosting deal on record, though we expect that it will be followed by a rise in smaller telco-hosting pairings. As the number of large hosting targets, which typically serve enterprises, continues to shrink, we anticipate that telcos that were unable to get their hands on prized enterprise properties will still look to enter this industry by consolidating the fragmented small and midsized hosting market.

Based on the most notable telco-hosting deals to date, Verizon’s Terremark buy and CenturyLink’s reach for Savvis, enterprises appear to be the primary market for large telcos looking to sell cloud services. However, we are noticing emerging interest from telcos looking to serve SMBs. Last month we saw Madrid-based telco Telefónica spend a reported $110m for cloud hoster acens Technologies, which serves more than 100,000 SMB customers throughout Spain. On a much smaller scale, in February local competitive carrier CornerStone Telephone announced that it was picking up consumer and SMB-focused Web hoster ActiveHost for an undisclosed amount.

We’ve written before that the greatest opportunity for telco-hoster combinations may actually be for regional and smaller telcos to buy smaller hosters. The hosting market is still fragmented, particularly among smaller providers, and many of these firms are experiencing capital constraints that are preventing expansion. Regional and local telcos will be able to take advantage of this fragmentation and acquire small complementary hosting providers without spending too much money, since smaller providers tend to garner smaller valuations, typically between 6-8 times last-quarter annualized EBITDA. However, if telco-hosting consolidation grows at this level, the acquired properties will most likely be colocation-focused, since most small hosting providers founded their business on colocation services.

US telcos feeling the squeeze

Contact: Ben Kolada

Amid double-digit revenue growth in the cloud infrastructure market, US telcos are increasingly buying their way into this industry in an effort to stem losses in their traditional wireline businesses. However, just as the hosting and colocation sectors are growing rapidly, so too are the major players being acquired. So far this year, we’ve already seen three of the largest hosters scooped up by eager telco service providers, with CenturyLink’s $2.5bn Savvis purchase being the most recent. If the remaining telcos don’t move fast enough, they could increasingly be squeezed out of the growing cloud infrastructure space. And competition for the remaining firms is expected to increase as foreign operators could look to enter the US market as well.

Atlanta-based Internap Network Services is among the short list of firms most likely to be taken out next. The company has a wide-reaching geographic footprint, with facilities spread throughout the US, Europe, Asia and Australia. The company’s large US and international presence makes it a particularly attractive target, especially for large CLECs such as tw telecom and PAETEC, or even cable MSO Comcast. However, its footprint could also attract foreign operators looking for synergies in their home markets, as well as entry into the US market. My colleague Antonio Piraino at Tier1 Research recently penned a piece reminding buyout speculators that just a few years ago Internap rebuffed a takeover offer from Indian telco Reliance Communications. He notes that Reliance may once again be a potential suitor, alongside Asian firms Pacnet and China Telecom or European provider Colt Technology Services Group.

Though opportunities for US acquisitions are diminishing, domestic telcos still have options. Given the hyper-competitive takeover market that is expected for remaining US hosters, US telcos may instead look for international deals. As seen by regional stalwart Cincinnati Bell’s CyrusOne unit expanding into London, US telcos are showing no fear of international expansion when it comes to their hosting and colocation businesses. If US telcos look abroad, we wouldn’t be surprised if they checked out Interxion. The Schiphol-Rijk, Netherlands-based firm operates 28 datacenters in 11 countries spread throughout Europe, and pulled in more than €200m in revenue in 2010, a 21% jump from the previous year.

Hosters lose another telco acquirer

Contact: Ben Kolada

In the latest billion-dollar-plus telco transaction, Level 3 Communications has announced that it is acquiring Global Crossing in an all-stock deal worth $1.9bn. (The actual price of the acquisition – the largest we’ve recorded for Level 3 – is closer to $3bn when Global Crossing’s debt is included.) And while the deal impacts the telecom industry by bringing together two well-known fiber operators, in a way it more significantly impacts the hosting and colocation markets by removing yet another potential telco buyer. (We’ll have a full report on Level 3 buying Global Crossing in tonight’s Daily 451.)

Earlier rumors in the hosting and colocation industries had Level 3 as a potential acquirer, perhaps picking up CDN vendor Limelight Networks or hosting company Internap Network Services. These rumors were made more convincing by the growing trend of telcos buying into hosting and colocation. But in their conference call discussing the transaction, executives at Level 3 and Global Crossing put those rumors to rest, saying they don’t expect to announce another acquisition anytime soon. Further distancing Level 3 from the hosting M&A game is the fact that the company doesn’t appear to be too interested in hosting or datacenter services at all, since it chose a target that generates only 5% of its total revenue from these segments.

We previously noted that CenturyLink is likely out of the market as well, following its purchase of Qwest Communications for an enterprise value of $22.4bn, which saddled the company with a mountain of debt (the deal closed April 1). Last year, CenturyLink and Qwest held an aggregate $19bn in debt; that’s nearly equal to the revenue the two companies generated over the same period. Further, that debt load is more than five times the combined company’s free cash flow. Debt repayment obligations will likely put a halt to CenturyLink’s steady M&A activity, thereby forcing the company to focus on organic growth. With CenturyLink/Qwest and now Level 3 focused on integration, we expect that acquisition speculation following the next telco-hosting deal will be somewhat tempered.

Could CenturyLink’s Qwest buy prevent a future cloud infrastructure play?

Contact: Ben Kolada

Almost exactly one year after they announced their intention to merge, CenturyLink and Qwest Communications are set to close the largest US wireline consolidation play in the past half decade. But while the deal will more than double CenturyLink’s revenue, the debt assumed could prevent it from making another significant acquisition anytime soon. And that’s a shame, since the combined company’s datacenter business could use a boost.

Even in retrospect, the Qwest purchase is still a smart deal, since CenturyLink needs Qwest to expand its own meager business services division – especially since the telecom industry’s focus between consumer and businesses is increasingly leaning toward the latter. But while the move grows CenturyLink’s revenue, in the near term the assumption of Qwest’s debt will actually prevent the company from moving into the datacenter and hosting industry, which is showing more long-term potential than wireline services.

Neither Qwest nor CenturyLink are providing aggregate financial projections for 2011, but numbers from 2010 show the combined company will be weighed down by a hefty amount of debt. Last year, CenturyLink and Qwest held an aggregate $19bn in debt; that’s nearly equal to the revenue the two companies generated over the same period. Further, that mountain of debt is more than five times the combined company’s free cash flow. Debt repayment obligations will likely put a halt to CenturyLink’s steady M&A history, thereby forcing the company to focus on organic growth.

And this comes at a time when telcos are increasingly seeking growth by buying into the cloud infrastructure industry. With Qwest’s debt, CenturyLink may be the last to the table to acquire a large hosting provider, even though the company certainly needs one. Qwest’s datacenter footprint is already fairly small when compared to the other Regional Bell Operating Companies. In its last-ever annual report, the company cited 17 hosting centers in operation – that’s the same amount as many of the medium-sized private providers. Without an inorganic boost, the company could lose out on cloud infrastructure market share. Consider this: Qwest doesn’t break out datacenter revenue, but the business division’s sub-segment that includes this service only grew 8% in 2010. For comparison, in its 2011 Global Managed Hosting Market Overview, our Tier1 Research subsidiary predicted that the managed hosting sector’s global revenue will grow 19.8% this year.