SAVVIS, Inc. Q2 2008 Earnings Call

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SAVVIS, Inc. ( SVVS )
Q2 FY08 Earnings Call
July 29, 2008, 05:30 PM ET
Executives
Elizabeth Corse - Director of IR
Philip J. Koen - CEO, Director
Jeffrey H. Von Deylen - CFO, Director
Analysts
Colby Synesael - Merriman Curhan Ford & Co.
Simon Flannery - Morgan Stanley
Tom Watts - Cowen & Co.
Jonathan Atkin - RBC Capital Markets
Manuel Recarey - Kaufman Bros. Equity Research
Srinivas Anantha - Oppenheimer & Co.
Mark Kelleher - Canaccord Adams
Nicholas Netchvolodoff - Lehman Brothers
Jonathan Schildkraut - Jefferies & Co
Jason Armstrong - Goldman Sachs
Presentation
Operator
Good afternoon, and welcome to the SAVVIS Second Quarter InvestorConference Call and webcast. This call is being broadcast live atwww.savvis.net and recorded for replay on SAVVIS website. At thistime, all participants are in listen-only mode. After thepresentation, we will conduct an interactive question-and-answersession. Ms. Corse, please begin.
Elizabeth Corse - Director of Investor Relations
Welcome everyone and thanks for joining us. I am Elizabeth Corse,Director of Investor Relations at SAVVIS. We distributed a pressrelease this afternoon with detailed financial tables, that'savailable on our website at savvis.net. We also have slidessupporting this discussion on our website. CEO, Phil Koen, andChief Financial Officer, Jeff Von Deylen are here to talk with youtoday, after they review the quarter and the business environment,they'll take your questions.
Please be aware that today's discussion contains forward-lookingstatements as defined under federal securities laws. Actual resultscould differ materially from our projections due to various riskfactors, including but not limited to the factors disclosed inSAVVIS's Form 10-K and other filings with the U.S. Securities andExchange Commission, and we encourage you to review thosedisclosures. Our presentation, this afternoon, will includereferences to certain non-GAAP financial measures that provideadditional information for investors in compliance with the SEC'sRegulation G. Our press release distributed today, posted on ourwebsite and furnished to the SEC on Form 8-K includes both ourrational for why we believe non-GAAP information is important indescribing our operating performance and the full reconciliationwith the corresponding GAAP numbers.
Now may I introduce Phil Koen, Chief Executive Officer of SAVVIS.
Philip J. Koen - Chief Executive Officer, Director
Good afternoon everyone and thanks for joining us. We are pleasedto report solid second quarter results today. Halfway through theyear, we are executing successfully against our plan, so we arereaffirming our guidance for the year-to-date. I'm going to openwith some highlights from the quarter, then review the businessenvironment for each of our revenue lines. Jeff, will take youthrough the numbers in detail and after that I have planned toclose with some ideas about how our highly differentiated valueproposition really resonates with our enterprise customers. And, asalways, we'll take your questions before we wrap up this evening.
So let's begin. Q2's highlights are on slide four, starting withsolid revenue growth, the total revenue were up 13%, year-over-yearon a pro forma basis and 5% from Q1, driven by growth in hostingrevenue. Colo was up 25%, pro forma from a year ago and 10% fromQ1, showing the power of our new data centers. Managed hostingperformed strongly, up 27%, year-over-year and 6%quarter-over-quarter with both utility and traditional managedofferings continuing to attract new and expanded customerrelationships. As expected, network services revenue declinedslightly in the quarter.
As good as revenue was adjusted EBITDA number is our key focus, andwe are very pleased with the $44.7 million in the quarter, despitethe cost associated with data centers we're bringing into servicesthis year.
Operationally, we have some important achievements opening datacenters in Chicago and Dallas and our expanded Singapore facility,opened in July. We've extended Proximity Hosting with the help ofthe London Stock Exchange and Best in the U.K., theIntercontinental Exchange and the Chicago Mercantile Exchange inChicago and the Singapore Exchange in our Singapore center. This isa great value-added service we offer that draws enterprises withsecurities trading functions from the largest to the smallest tothese IDCs for both Colo and managed hosting services combined withthe low legacy [ph] cross connections to the training platforms inthat facility.
We launched an important customer service initiative that willenable us to attract satisfaction more closely and driveimprovement. That will help us ensure, we continue to track newcustomers and expand relationships with existing customers. Onecustomer that honored us with a significant award was the U.K.'sHome Office, a cabinet-level government department. They presentedus with their Supplier Value Award for Best TechnologyImplementation against some very heavy competition.
Now let's turn to some perspective on the current businessenvironment in which SAVVIS operates. I'll start with some color onthe colocation market. We had a strong footprint of diversifieddata centers, there is a detail look at our IDCs as an addendum totoday's slides. This provides a great base, with which to meet thevarying demands of our customers. We've broken out our footprintinto standard, high and ultra power density centers on slide five.
The two main points, I want to make here are, one, that generallydemand continues to outstrip supply for colo and two, that pricingis rational and stable, when we look it on a kilowatt equivalentbasis. About half of our sellable square footage is in standardpower density category with less than a 100 watts per square foot.These are the centers where we command about $30 to $45 per squarefoot per month. I think some people have a mistaken idea that theseIDCs are in low demand, but in fact they continue to sell at steadypace as we approach the saturation point. In fact, in Q2, 20% ofour installs were into our standard powered IDCs and these centersare about 70% utilized today. The high power IDCs comprise roughlya quarter of our sellable square feet and have seen some of thestrongest demand so they are about 80% utilized today.
These centers price at roughly $40 to $65 per square foot permonth.
Finally, at the ultra high-end all of our expansion data centersopened in 2007 and 2008 deliver at least 125 watts per square foot,facing strong demand as you bring them on to the market withpricing achieving a level of about $60 to $80 per square foot, onaverage. Even in these centers though the largest users are pricesensitive and we've willingly [ph] walked away from large footprintdeals because the customer wasn't willing to meet our priceobjectives. We won't sacrifice our return objectives for a quarteror two faster revenue growth and we are well able to sell smallerfootprints to our core target customers.
That strong demand for our centers supports our business model ofremaining selective in our sales approach. We want to work withcustomers who will make the most of our relationship with SAVVIS.This idea is the segway in for my view on Managed Hosting on slidesix, since a key element of our colo differentiation is SAVVIS'sgreat value-added offering and Managed Hosting as well as network.More that 40% of our colo customers use some element of ManagedHosting. That Managed Hosting offer includes, Traditional managedwhere we own and operate dedicated equipment for our customers, thehigh availability, utility compute platform, introduced in 2004,which provided dynamic capacity for a pay by the drink model andVirtualized Intelligent Hosting, a lower cost way to get thebenefits of virtualization without the challenges of doing ityourself. There has been absolutely no change in the fundamentaldemand for these offerings. We had a strong second quarter forManaged Hosting, both from a booking and revenue perspective, whichdemonstrates that our value proposition continues to resonate withthe enterprises.
We are seeking the same level on inspection and approval wediscussed since April with clients taking longer than haspreviously been typical to sign off on these multi-year,multi-million dollar contracts. This is understandable when youconsider the complexity of these deals. Our Managed Hostingoffering isn't turning up a lamp sack for a couple thousand dollarsa month. What we're offering at a high-end, customized solution forcomplex business needs. Our solutions almost always include aprofessional services component to enhance the computing, storageand security capabilities. Our typical customer is a large ormid-size enterprise deploying complex web-based hostingapplications. We are developing a strong reputation withbrand-based companies whose web performance is critical tomarketing success.
For many of those customers, the applications they're deploying ournetwork intensive and the SAAVIS network services are another waywe can add value. The network layers readily into both colo andManaged Hosting offerings, providing a premium over hosting onlyproviders for clients who want a truly bundled single-sourcesolution.
To break into its components on slide seven, the smallest piece ofour network revenue is unmanaged bandwidth we sell wholesale tocustomers... to carriers. This is a smart price market that hasbeen under pricing pressure to greater and less degree for aboutfour years. It's only 17% of the network revenue stream and we sellonly where we have ideal capacity and can get price points thatstill make sense for us.
The HAN is our current success story as data center clients use ourhosted area network to provide Internet access for their data. Over90% of colo customers use the HAN. It's essentially a super crossconnect that can take our clients from the SAAVIS data center toany appearing [ph] point they want. The value of this offering isclear and 16% year-over-year growth in Q2. As I said before, ourmanaged network strategy has great potential, but clearly needsmore over.
We have great solutions with our state-of-the-art applicationtransport network. Our customers tell us they want to get managednetwork and managed hosting services from a single provider.However, solid new wins in 2008 have been more than offset by churnfrom our VPN-only base of clients. We are delivering new marketingand sales programs to our team in the second half, designed tohighlight the value of the bundle approached to managed servicesand we'll keep you updated as we work to deliver on the promise ofthis competitive differentiator. I want to assure you, we arefocused intently on returning the network revenue strength to agrowth phase.
Now we'll be handed off to Jeff for the financial review.
Jeffrey H. Von Deylen - Chief Financial Officer, Director
Thanks Koen. I would like to go over slide nine, which isabbreviated P&L and it shows the quarterly comparisons, both forthis quarter, for the first quarter, for prior year quarter and ina pro forma view. We've excluded non-cash comp from both the grossprofit and the SG&A line for each period and show both pro formaand reported numbers for a year ago.
Quarter-over-quarter, as Phil mentioned, total revenue grew 5% fromthe first quarter. On a year-over-year basis, revenue was up 6% andon a pro forma basis, total revenue was up 13%, which we believe isthe most relevant year-over-year comparison.
Our gross profit improved to 43%, as the new data centers began togenerate more revenue than the cost. SG&A, while was up 3%,sequentially from the first quarter, actually declined to 22% ofrevenue during the quarter, which was down from 23% of revenue inthe first quarter. The increase in the dollars, reflect highercommissions paid on the install business that we installed duringthis quarter. That net result was a very strong adjusted EBITDAgrowth of 11% compared to the first quarter, reflecting revenuegrowth, cost control and improved performance from our new IDCs. Asa percentage of revenue, adjusted EBITDA margins expanded to 21%from 20% in the first quarter.
Now, let's talk a little bit more about the details of the revenuestreams, which we've laid out the three revenue streams, Colo,managed hosting and network services on slide ten. Colo growth wasactually ahead of our expectations and grew 10% from the firstquarter. This achievement was a result of our strong bookings inthe prior quarters and an excellent pace of installations, bothinto the legacy and to the new data centers.
Managed hosting growth of 6% from the first quarter was also at thehigh end of our expectations, as we successfully installed businesstold in previous quarters. Our total hosting revenues for both themanaged and colo together increased 8% from the first quarter andwas up 26% on a pro forma basis from the second quarter of a yearago. Our network services revenue declined about 1% in the firstquarter of 2008 and was down 4% from a year ago.
Looking forward, we are comfortable with the sequential growthranges we projected in April, and those were the colo revenuegrowth in both Q3 and again in Q4 will be between 5% and 9%. Thegrowth in managed hosting will be between 2% and 6%, on asequential basis. And on the network side, we are anticipating thatcontinued rationalization of the client base, which will drivedecline in the quarterly revenue for the second half.
Now let's talk about the expansion data centers and the progressthat we've made. You can see that on slide 11. The new data centerrevenue more than doubled to $14.2 million during the quarter. Thenew data centers rates [ph] adjusted EBITDA breakeven or just about$20,000 of positive EBITDA, as we ramp the revenue into thefixed-cost base. We continue to see an attractive fill rate on thenew data centers with about 67% of the colo space in the Phase Idata centers sold. We also opened the Singapore data center in Julyand together with the Boston, Chicago and Dallas data centers,we've sold about 32% of the colo space in those centers. Ourexpansion IDCs continued to generate colo prices averaging justunder $70 per square foot per month, while the yield per squarefoot, including managed hosting and network services is just over$80 per square foot in those centers.
In total, as we talked about on the opening, our adjusted EBITDAgrew by $4.4 million from $40.3 million to $44.7 million in thequarter. You can see on this slide the new data centers contributedabout $2.7 million of this improvement while the legacy hostingbusinesses contributed the other $1.7 million. In total, on a fullyallocated-basis, our hosting revenue includes both the managedhosting and the colo revenue, contributes approximately 26%adjusted EBITDA margins during the quarter and that was up from 25%adjusted EBITDA margin in the first quarter. On a fullyallocated-basis, our network services business has adjusted EBITDAmargins that have remained in the low teens for each quarter andcontributed approximately $8 million to $8.5 million of adjustedEBITDA each quarter.
On slide 12, we show that we are pleased with the progression we'vemade in colocation pricing. We're up 2% sequentially over the firstquarter and up 12% year-over-year, we've made steady improvementtowards our target of $50 per square foot across our entirefootprint and our overall yield remains strong in over $80 persquare foot. The overall sequential decline you see from the firstquarter on our overall revenue per square foot is a result of mixshift. As we've shared with you in the past, the colocationrevenue, especially in the new data centers will grow faster thanthe managed hosting revenues, as we feel that... as the fill rateis 18 to 24 months for the colocation and five to seven years forthe managed hosting space. However, we are clearly expecting thatthe contribution for managed services will continue to drive ourlong-term data center yield to over $100 per square foot over thenext several years.
Now let's add a bit of color on the utility rate increases that wehave seen and experienced. Just to give a little bit more color,our energy cost, as a percentage of hosting revenues have been inthe range of 11% to 14% of hosting revenues over the past fivequarters. In the third quarter, you can expect that to be at thehigh-end of the range as a result of higher cooling cost due tohigher temperatures and that seasonal impact we've seen certainlyover the last few years. We've recently seen experienced... areseen energy cost increases in our LA, DC and New York markets.Currently, our colocation client contracts allow for us to passthrough these cost increases to our customers after a 30-day noticeperiod, and after the first 12 months of their initial contract.
We expect that the dollar impact of these known increases will beapproximately $750,000 per quarter, which should largely be offsetby the increases to customer billings that are beginning in August.We clearly are monitoring all of our other markets and reactingquickly to the changes in energy cost and the changes those mayhave to us in the future. One of the strongest point of SAVVIS isour conservative balance sheet and our under leverage position aswe show on slide 14. During the quarter, we completed a $35 millionsterling long-term debt facility or a $70 million U.S. facility tofund our build out of our U.K. data center. We completed thisfinancing to better match the currency inflows and outflows for ourU.K. investment. At the end of June, we had a total ofapproximately $580 million of long-term debt and capital leases. Wewould expect that balance to grow to approximately $610 million bythe end of the year as we draw down the remaining balance on theU.K. facility as that build out is complete. We would also expectto end the year with approximately $100 million of cash.
Given our expectations for year-end debt and cash balances, ourleverage position with adjusted EBITDA for this year at a mid-pointof $182.5 million. We expect that our leverage will be about 3.3times levered on a gross debt basis and about 2.8 times levered ona net-debt basis. Our expected new annual cash interest costs areapproximately $40 million. Based on our forecasted adjusted EBITDAfor 2008, our EBITDA covers about 4.6 times our cash interest cost,giving us a strong position to fund our future businessrequirements. With our adjusted EBITDA expanding over the course ofthis year and into 2009, as we began to leverage the fixed cost ofthe new data centers, our leverage and coverage ratios shouldcontinue to improve.
As Phil mentioned, we have reaffirmed our guidance for 2008 as wehave laid out on slide 15. We continue to expect pro forma revenuegrowth in the low double-digit range with the dollar range of $840million to $870 million, for the year. We are confident inachieving adjusted EBITDA margins of 21% to 22%, and pro formaadjusted EBTIDA growth of approximately 24%. Of the $280 million to$300 million, we expect to spend for capital expenditures about$145 billion $150 billion is for previously announced data centerexpansions. Below the adjusted EBTIDA line, we anticipate about$130 million to $140 million of depreciation and amortization,about $30 million to $35 million of net interest expense and taxexpense of about $1 million to $2 million, reflecting ouranticipated AMT expense for cost.
On slide 16, we reiterate some of the metrics behind our 2008outlook. After a strong installed base in the second quarter, wehave about $60 million of annualized revenue in our backlog. As weinstall that revenue over the second half, we'll begin to recognizethat revenue. We would assume that we'll continue to grow colorevenue by about 5% to 9%, sequentially as we continue to installrevenue into the new data centers, we expect managed hosting togrow about 2% to 6%, sequentially, in each of the next quarters andas I indicated previously, we are at the high-end of both of thoseranges in the second quarter, but remain comfortable with the rangeof our sequential growth rates, given the natural fluctuations thatwe've seen from quarter-to-quarter.
On the cost side, we continue to add about $2 million per quarterrelated to new IDCs. In addition, utility costs will be higher inthe third quarter than in the second quarter by about $3 million asa result of the warmer weather required and required higher coolantcost. We've taken measures to control discretionary costs and willcontinue to manage revenue and expense ratios aggressively.
As a final wrap up to my section, I'd like to announce anorganizational change. We've made the decision to relocate theinvestor relations function from our Virginia office to ourcorporate headquarters here in St. Louis. Elizabeth has made thedecision to stay in the Washington DC area and as a result shall beleaving SAVVIS after four years with the team. We've identified anew IR Director who will start officially on August 18th.Elizabeth, will be working with us to ensure a smooth transactionthrough the end of the quarter. Both, Phil and I would like tothank Elizabeth personally for all of her hard work and leadershipof the IR function over the last four years. She was instrumentalon helping SAVVIS, create an IR presence after our acquisition ofCable & Wireless through our preferred stock conversions, asignificant secondary offering and the expansion of both ourself-stock coverage and our buy side ownership list. I know she hasdeveloped many strong relationships with many of you over thoseyears and will be talking with you directly over the course of thetransition in the weeks ahead. We wish her all the best as shemoves to next phase of her career.
With that, well I'll turn it back over to Phil.
Philip J. Koen - Chief Executive Officer, Director
Thanks Jeff. Earlier I talked about colo, managed hosting andnetwork services. One of the key points I hope I made clear is thateach of these offerings are synergistic with the others. The realvalues of SAVVIS for our customers and ultimately for our investorsis a power of bundling service elements to create IT infrastructureas a service.
Beginning on slide 18, we are taking a look at a few customerexamples to help you understand how we're adding value with thisapproach. First, an entertainment company wanted a robust reliableplatform on which to develop and deliver online games. They choseSAVVIS's Virtualized Intelligent Hosting, which was delivered inthe second quarter this year. We've evaluated the infrastructure wecreated for them as flawless. And we've already expanded theirSAVVIS installation to meet market demand. This customer plans thedouble their Virtualized Intelligent Hosting footprint in thesecond half with a potential to grow to more in 2009 as theyintroduce new online multi-player games and grow their subscriberbase. This customer has also chosen to use a number of SAVVIS'smanaged security services to provide a secure online gamingenvironment.
On slide 19, the $600 million per year work force managementcompany came to SAVVIS to provide a fully managed hosted solutionto the more than 30 million customers. Their existing operatingmodel are providing remotely managed solutions, required supportand maintenance for over 20 versions of their platform, require asignificant cost and time with the [ph] IT support group to troubleshoot and resolve the issues. The customer in SAVVIS joined ajoint... form a joint task force to design and develop a managedhosted solution that would meet the specific compliance andtechnical client-server platform as well as develop joint marketingmaterials to demonstrate to their customers the operational andfinancial improvement that they would drive as a result ofimplementing a managed environment. As a result of the moving to amanaged hosting environment, the company has realized savings atover 30% relating to the support and maintenance of their product.For SAVVIS, this account represents nearly $1.8 million inannualized revenue and we've seen a nearly ten-fold increase in theaverage monthly bookings since embracing to managed hostingplatform.
Finally, slide 20, reflects a major win for SAVVIS. This is aglobal financial services firm, one of the world leaders in theirfield. They view SAVVIS or colocation professional services formany years and one of their business divisions recently came to usfor rapid deployment of a tier-I application. SAVVIS wasinstrumental in deploying a highly complex implementation projectwith a very aggressive timeline. As a result the customersuccessfully launched their new online platform. As they work todrive more services over the web, this group developed overlappingIT platforms that created inefficiency, the lack of scalability fortheir offerings. SAVVIS provides a managed network solution over amanaged hosting platform that enabled the client to drive newservices quickly and efficiently out to their end users. SAVVIS hassolidified it's standing as a trusted device by meeting andexceeding all implementation milestones set by the customer and asa result, has opened the door for additional opportunities. Whilethis assignment is well above our typical deal, we were happy tohelp. Today, the customer is generating over $20 million ofannualized revenue as we continue to roll out new services. So Ihope that helps you visualize why customers seek SAVVIS solutionsand why we are confident at targeting customers that use multipleservices as the right approach to minimize our investmentrequirements and maximize our returns.
Now I just got back from a trip to the U.K., Singapore and Tokyo,and I want to spend a moment on our opportunities in those marketswith slide 21. We are getting very good traction outside the U.S.,and I am very pleased what we have accomplish. Even better, I amenthusiastic about what lies ahead. As I look across our globalfootprint, I am impressed with our strength in Europe. We opened anew data center there at exactly the right time. Our U.K. team isconducting an increasing number of tours there everyday. Managedhosting has always been a strong offer in the U.K. and today itsgaining greater strength.
In Asia Pacific, the economic environment is robust and again thetiming of our Singapore expansion is spot on. The fundamentalgrowth of enterprises in that market is driving strong interest,especially in our managed hosting and network services. At boththese markets, we're offering Proximity Hosting Services targetedat the financial services electronic trading community. We'vesecured strategic relationships with several key exchanges,including the London Stock Exchange, BATS, U.K., and the SingaporeExchange. These are in addition to new partners in the U.S. thatinclude, Chi-X, Intercontinental Exchange, and the ChicagoMercantile Exchange as well as others we hope to announce in thecoming week. With managed hosting, Proximity Hosting and strongmarket demand I think we've got a lot to look forward to in ournon-U.S. market.
I'll close by emphasizing again that we're managing this companyfor the long-term as laid out in slide 22 and we are very pleasedwith our prospects. Our target customers continued to do deepinspection around their decision-making, but they are enthusiasticabout our infrastructure solutions as a great approach to very realchallenges. We are executing against our plan to meet thechallenges of 2008 while building and growing for the long-term.
And Jeff and I will be happy to take your questions now.
Question and Answer
Operator
[Operator Instruction]. Our first question comes from ColbySynesael with Merriman.
Colby Synesael - Merriman Curhan Ford & Co.
Just two basic questions, one from a strategy standpoint, youmentioned that [inaudible] with your last comments, that you guysare focused on the long-term of the company, if you look theresults obviously the upside came from the pure colocation portionof the business, will it make sense for you guys to have more ofyour self focusing more on just the colocation at this point, oryou guys think that that's well balanced? My second question has todo with just market-to-market, any markets where we are seeing,strengthening or weakening [inaudible] first quarter? Thanks.
Philip J. Koen - Chief Executive Officer, Director
Colby, this is Phil. Thanks for your question. Well I'd like to saythat I think the strength came from both colo and managed... thesequential growth rates were at the high end of what we hadtelegraphed is what we think about. To answer your questiondirectly we are not a colo play. The issue there is that we don'thave the footprint and we don't deploy the amount of capital inbuilding data centers that some of the real estate and otherplayers who are focused in this. So our whole value propositionhere is use colocation as the first step point⬦ and outsourcesolution, but to move people up the value stack and we are reallyfocused about driving the highest returns we possibly can on thatdata center investment.
So it's not about can we just fill it up as fast as we can becausesimply what you have to do then is turnaround and deploy increasingthe amounts of capital to continue to run that race. We think amore prudent strategy is to continue to focus on building long-termvalue through trading people up to higher and higher levels ofmanaged services. I'd point to you that last customer example is agreat example of exactly how that strategy works.
Regarding market-to-market strength, the core markets we are inacross the U.S. continued to see good solid demand. I don't feeland I don