One of the hottest topics over the past ten years has been the incredible growth in the internet, communications and computing. Much of this IT processing power is supplied by super-fast servers located in secure sites around the world. And one beneficiary of this trend has been this stock…
Telecity (TCY), tipped as a BUY by UBS
Telecity operates 18 data centres across seven European countries. It rents server space to companies, such as ITV and Barclays, and its fortunes have literally gone parabolic, as demand has boomed from online users coupled with a shortage of quality hosting space.
Not surprisingly, in these near-perfect conditions, Telecity’s 2007 results were impressive. Revenues were up 42% to £97.9m, giving a 112% rise in adjusted EBITDA to £23.4m, due to better occupancy levels (up from 76% to 80%) and 13% higher selling prices. The group also said that trading during the first months of 2008 has been strong, with progress made on growing the customer base. The City expects 2008 and 2009 sales of £120.6m and £142.2m respectively, delivering underlying earnings per share of 5.2p and 10.3p – albeit on a zero corporate tax rate.
But shareholders should tread with caution. Telecity would seem a sound long-term bet given that most of its turnover is contracted and recurring in nature. But there are two major storm-clouds brewing that make me nervous. First is the adoption of virtualisation software. Data centre servers are notoriously under-utilised with most not approaching peak operating capacity on any given day. According to Gartner in April 2007, during a typical 24 hour period, less than 10% of the computing power is used. Virtualisation tackles this by optimising utilisation and minimising the amount of physical assets. This means that companies adopting virtualisation need a lot less hosting space than before to run applications.
Secondly, hosting is infamously cyclical. During boom times both utilisation rates and selling prices soar. But these “super-profits” draw in new entrants, who build extra capacity to meet rampant demand. Google is currently building a series of server farms around the world, while Telecity is due to open two new facilities in London and Amsterdam this year, growing their server space by nearly 20%. This type of oversupply brought the industry to its knees after the bursting of the dotcom bubble back in 2000.
Given these major concerns, the shares are just too rich for me. Using consensus forecasts the stock trades on a lofty rating of over 20 times 2009 earnings, which looks far too expensive. And at the time of the group’s flotation at 220p back in October 2007, about 75% of the equity was held under a lock-up arrangement. This expires next month and could act as a catalyst for a sharp pullback.
Recommendation: SELL at 198.75p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments