REIT Conversion and Sale Among Considerations for Data Center Unit

Cincinnati Bell was one of the first publicly-traded LECs to invest heavily in data centers, a strategy that has stabilized the telcos’ top line in recent years and granted it a high-growth business segment. Last Friday the company reported 4Q11 earnings and its colocation unit provided the highlights to an otherwise lackluster quarter in which it posted a significant operating loss. While its 4Q11 earnings disappointed, news of a potential shakeup in its data center segment gives Cincinnati Bell shareholders reason for optimism.

In 4Q11, Cincinnati Bell’s operating margins slipped and it took a $50.8m goodwill impairment charge leading to a 13% drop in annual operating income from 2010 to 2011. Overall, the company reported a quarterly loss of $30.4m for 4Q11 on revenues of $365.3m.

Despite the loss, Cincinnati Bell continued to generate more revenue from colocation services in 4Q11. It took in $49.1m in data center revenues in the quarter, a 21% increase from 4Q10. Operating income from data centers increased a more modest 10% YoY, with the gains trimmed by higher marketing and operating costs as the company attempts to attract more clients. 

For the year, Cincinnati Bell invested $118.5m in its data centers, accounting for 47% of its overall capital expenditures. Colocation revenue was $184.7m during 2011, indicating a capex margin of 64% for the segment. It increased capacity by 124k square feet in the year, ending 2011 with 763k square feet of data center space.

With this continued reinvestment into the business and on the heels of another strong quarter from its data center unit, the company announced last Friday that it is exploring options for the segment ranging from a sale of the unit, to an IPO to no change at all. At the root of any of these options: unlocking the value from what has been Cincinnati Bell’s highest growth area.

The announcement is a strong statement by management that it does not feel the true value and growth potential of its data center business is adequately reflected in the company’s market price. Looking further into Cincinnati Bell’s historical trading multiples offers some insight into why the company feels it is undervalued.

The foundation of Cincinnati Bell’s colocation business is CyrusOne, a data center operator it acquired from private equity firm ABRY Partners in June 2010 for $525m. Pre-CyrusOne acquisition, the public was trading Cincinnati Bell with an implied business enterprise value of around 2.1x revenue. Post-deal, the market has continued to trade the company in the same range of 1.9x-2.2x revenue.

Given the favorable OIBDA margins (55% vs. 41%) and higher growth profile of data centers compared to Cincinnati Bell’s traditional wireline segment, management logically expected a jump in its trading multiples after shifting its service mix towards data centers. The gain has never materialized, suggesting that the market has continued to value CyrusOne’s business in line with Cincinnati Bell’s traditional telco operations.

Recent transaction multiples indicate that a sale of the LECs data center operations may not create the value for shareholders that management seeks. For data center deals announced since the start of 2011, deal multiples have averaged 4.7x revenue and $1,118 per operating square-foot. These levels point to an estimated price tag of $850m-$875m for Cincinnati Bell’s data center business. Given that Cincinnati Bell itself paid significantly higher prices of 7.2x revenue and $3,000 per operating square foot for CyrusOne, a sale at the recently observed averages is not a particularly attractive option for shareholders.

A more intriguing plan that could create immediate value for shareholders is to convert the data center segment into a publicly-traded REIT—the same organizational structure maintained by data center developer Digital Realty Trust. Cincinnati Bell’s cfo Kurt Freyberger indicated the company is assessing a REIT conversion, adding that he believes the value of the data center business has been discounted by the public as a result of its association with the company's traditional telco operations.

Based on Digital Realty’s recent public trading levels, converting the data center segment into a REIT could pay off for Cincinnati Bell’s shareholders. The market is currently trading Digital Realty at 9.5x trailing revenue and at 17x cash flow, well above Cincinnati Bell’s current public multiples and more in line with the prices it initially paid for CyrusOne. These levels indicate a potential value of $1.8b for the data center segment—or around 60% of the company’s current implied business enterprise value.

While Cincinnati Bell maintains that all options are on the table for its data center business, it has made steps to remove barriers preventing it from forming a REIT.  By definition REITs must own the buildings and land associated with its real estate holdings, and accordingly CyrusOne has moved to purchase the properties and facilities in which it operates and now owns about half of its data centers.

Regardless of what plan of action the company takes, it indicated the evaluation process will take around 6 to 12 months. However, after an initial assessment of the options, it appears that a REIT conversion strategy is at least worth a deeper look.