CyrusOne: Profitless Prosperity

Introduction

The markets are at an all-time high and liquidity is gushing through the system, lifting boats full of holes. Quite a contrast from the whining CEOs crying out for more government stimulus. I’ve decided to dust off my bear suit and evaluate a few “taking investors for a ride” companies. And no, I’m not talking about Uber (UBER), although I believe that’s an attractive short candidate as well. Today, I am presenting to you a company in a hot area (at least until the coronavirus vaccine news came about).

CyrusOne (CONE) is a data center REIT based in Dallas, TX that is barely profitable, has negative free cash flow, and is issuing equity to fund its operations and dividend. While the company is benefiting from the munificence of lenders and equity investors, it cannot go on like this forever. The stock has no backstop if it begins to fall and I believe it has 40% downside to fair value.

Business overview

CyrusOne develops data centers and then leases space in them to companies who want to locate their servers there. Companies pay for the space and for power. The major telecom companies like Verizon (VZ) operate such centers, as well as independent companies. The business is capital intensive and requires considerable expense to build out the space and install back-up power facilities. However, unlike a residential or commercial building, a lot of the capital expenditure does depreciate (think generators). The average lease term for the company is 4.5 years, which provides some revenue stability and I believe there is not much credit risk associated with its customers.

Financial overview

The company’s financial reporting is a hodge-podge of non-GAAP metrics that I don’t subscribe to, so I won’t mention most of the meaningless data it presents. I understand that others may find those metrics useful in their analysis.

For the quarter ending September 2020, the company reported $263 million of revenues (a 4.7% increase over the prior year) and $4.2 million of operating income (excluding $8.8 million of impairment losses). Interest expense of $13 million was more than operating income, thus resulting in a loss for the quarter. For the 9 months of the year, the situation was a little better, with interest expense only a little more than operating income. Thus, the company is barely able to service its debt.

The company is spending a lot on capex (at the rate of 2x depreciation) and burning cash in the process. It has seemingly not much to show for all this spending as net operating real estate rose 6.7% YoY, well in excess of the revenue increase. The company has funded the cash flow deficit by issuing $325 million of stock this year.

The company is paying out a dividend of $0.51 per quarter on its common stock even though it lacks profits or free cash flow. It has been modestly increasing this dividend over time, no doubt appealing to dividend investors.

The company is a beneficiary of falling interest rates. Its average interest rate on debt is an astoundingly low 2.13%, aided by some debt denominated in EUR like 1.45% notes due 2027. Even so, the interest expense on its income statement is understated as it capitalizes about $5 million of this expense every quarter.

With 119 million shares, the company has a market cap of $8.3 billion. Add on $3.1 billion of net debt and you get an enterprise value of $11.4 billion. This represents a robust 10x forward revenues. Not bad for a barely profitable company with modest growth. In fact, the company has accumulated a deficit of $900 million (i.e. its cumulative losses) since inception.

(Following the recent accounting change that requires companies to show the value of operating lease liabilities on the balance sheet, some information services include this figure in the enterprise value calculation, leading to a higher figure.)

Issuing equity to pay dividends

The company is issuing equity to raise cash in order to pay shareholders its dividend. So it is in effect raising money from investors in order to pay investors. Rather than do underwritten public issuances, the company has entered into forward sale agreements for an at-the-market equity program, where the stock is sold regularly into the market. It expects to raise more than $400 million this way over the next year.

Valuation: Fair value of $40 for the stock

I will assume that the company can over time get to a 10% operating margin, double what it is doing now. On next year’s revenue estimate of $1.1 billion, that would be $110 million of operating income. Take out $55 million of interest expense and you are left with $55 million for equity holders or $0.46 per share. A generous 40x multiple (we live in inflated times) and rounding up would get you to fair value for the shares of $20. This isn’t too far from the current $22 book value. I will treat this as the bear case. As the company sells equity at a price far above this value, it does increase the fair value a little bit.

For the base case, I will double the prior valuation and present a fair value of $40, for 40% downside from the current price. I won’t bother with a bull case as the current valuation reflects considerable bullishness.

I am unable to offer a specific catalyst that will prompt investors to revalue the stock, except that eventually they will get tired of low earnings quality, limited growth, constant equity issuances and a high multiple.

Risks are manageable

The biggest risk to a short thesis is usually an acquisition of the company. There have been rumors in the past about the company putting itself up for sale. In an era of low interest rates and companies looking to buy growth, an acquisition cannot be ruled out.

The short interest is not high at 6% of shares outstanding, but the chance of a short squeeze exists, particularly if acquisition rumors re-surface.

Finally, there is a risk that the company succeeds in dramatically increasing its revenue, margins, earnings and free cash flow. I would view the chances of this happening to be slim.

Pre-emptive disclosure

Writing a short thesis on a stock on a public forum is an invitation for blowback from holders of the stock. I welcome respectful comments from eponymous readers. Please desist from hurling insults from behind a veil of anonymity.

Disclosure: I am/we are short CONE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.