Hosting
Valuation-What is Happening?
By Graham Anthony
Several
centuries ago The Baron Rothschild is reported to have said,
"I invest only when I hear the sound of cannon fire and
see blood running in the streets. I sell when I hear the sound
of the violins." In all, a good strategy-if you have
risk capital to purchase in times of trouble-and the staying
power to wait out-a sometimes very long--war.
Unfortunately
not every firm has the cash or scale to prosper in turbulent
times. When the underlying dynamic of an industry changes,
such as it has over the last year in the IP space, with a
dramatic contraction of credit, over building of capacity,
and shifting demand causing many firms to fail, for many firms,
selling some or all of their assets rather than buying may
be the sensible alternative. Selling allows owners to capture
some of the value that has been built in order to have the
capital and ability to be able to play the game another day.
For others, a massive buying spree, either with their own
cash or borrowed money if they can get it, may be the best
strategy. How one should best respond to turbulent times may
largely depend on what position one is in at the time of trouble.
For those
who have experienced first hand the last twelve months in
the Hosting Industry, the Baron's quote may seem applicable
to the present, albeit the order reversed. In the fourth quarter
of 1999 and early 2000 there were dozens of buyers for hosting
companies (as well as ISPs and telecommunications equipment)-and
very few sellers. While the Industry leaders may not have
spent time listening to violins-Cobalt, Cisco and PSInet did
serenade the attendees at ISPCON with the sounds of Earth,
Wind and Fire, Journey and other big name bands. No amount
of cajoling could persuade many of the owners of hosting firms
to sell, despite sky-high valuations being offered. In fact,
the sea of buyers were perceived by many hosters as an annoyance
and distraction. For most Hosting Firm owners in 1999 and
early 2000, staying the course and building their own business
made perfect sense: there was virtually unlimited demand,
limited supply and seemingly unending pools of capital willing
to finance the Hosters growth, which often exceeded 100% per
year. Those that did sell, commanded big prices, often unrelated
to the underlying cash flows of their business.
Less than
eighteen months later, the dynamic has reversed: there are
currently very few buyers for Hosting Firms or hosting assets.
The few cash buyers that remain are able to purchase the assets
currently for sale at quite reasonable prices, generally based
on the cash flow being generated-or believed to be able to
be generated-- by those assets. Some of the assets these cash
buyers are purchasing are the same Hosting assets they lost
in bidding wars to other firms paying astronomic prices- often
the same firms now selling with the help of a bankruptcy trustee.
What
Happened?
In 1999
and early 2000 as an agent purchasing small hosting firms
with cash for a large national Hosting company, I was often
outbid by buyers paying 4, 5 and 6 times revenue. Prices at
which even the rosy projections of the cash flow of the Hosting
Firms being purchased would never come close to repaying.
(Even assuming that the Hosting business being purchased generated
100% cash flow and had no expenses, at this level of pricing,
it would take the buyer 4-6 years to recover their investment-before
interest and before investing to finance the growth of the
business, if any.) The buyers paying these lofty sums were
in general public entities for which the stock market was
valuing their firms at 8-12 times their reported revenues-valuations
their projected future profitability could never justify.
These public buyers were arbitraging the difference between
their public market valuation and the purchase price they
were paying for the Hosting firms they were buying. Sometimes
these public firms were buying with cash-more often with stock.
As a rule of thumb, these buyers were hoping to purchase hosting
revenues for half to a third of what the public market was
valuing their revenue. As long as the public markets valued
these public firms at insane multiples of revenue, the high
multiples the public firms were paying for Hosting companies
was justified.
Today,
the public market is valuing these former buyers public stock
at far lower prices-often well below the multiples at which
they sought to buy firms less than a year ago. As the public
market valuations of many of these acquiring firms has fallen,
they have been unable to continue to purchase Hosting firms,
since many of the sellers are unwilling to take these substantially
lower valuations at current levels in stock.
This leaves
only the cash buyers with a compelling currency in the Hosting
marketplace-or stock buyers from outside the Hosting Industry
whose public currency has not yet been decimated.
What
is happening today?
The need
for hosting is not going away. One could argue, as I do, that
any entity with a Yellow Pages listing will someday need a
web site. It may not happen tomorrow, but the overall reliance
on web-hosted information continues to grow dramatically.
What we are experiencing currently is a temporary wringing
from the market the over capacity in data centers and salaried
web talent brought on by firms building in advance of demand
for these services. Until 12 months ago, the investment community
shoveled money at Hosting businesses encouraging them to build
fast to be ready to grab market share as the Industry grew.
Unfortunately the Hosting Industry built capacity far in excess
of current demand. Firms that cannot afford to hold on to
their unprofitable data centers and underutilized web professional
infrastructures are being forced to close centers and lay
off talent. In certain instances, these firms are operating
so far below breakeven profitability, they are being forced
to sell key pieces or in entirety. The irony is that this
capacity that eventually will be needed.
What is
happening is a restructuring of the Hosting Industry's balance
sheet. Overextended firms that collectively spent billions
on equipment and acquiring customers are now being forced
to sell these recently acquired assets and customers at prices
as low as a tenth of what they paid for them. The cannon are
booming and blood is running in the streets and there are
very few Rothschilds around with the resources and staying
power to afford to compete for these assets.
In short,
Hosting firms are now forced to live and die by the old economy
metric of cash flow. The valuation metrics both for public
entities and for the firms they wished to buy shifted from
valuations based on revenue to valuations based on the cash
the Hosting companies are able to generate.
What
does this mean for you?
If your
hosting business is generating nice cash flow and you are
growing your business out of current cash flow, this shift
in valuation means very little. In fact, this shift in valuation
combined with the dramatic reduction in available bank financing
may work strongly to your benefit. A good number of poorly
run Hosting concerns, and some well run but over extended
Hosting firms, will be forced to exit the market. Overall
pricing of quality hosting services will move to a level to
cover the well run provider's cost of delivering the services
plus a profit and players that are not making a profit will
be squeezed from the market place. You should be able to recognize
increasing margins as these non-economic players exit the
market.
If you
are sitting on excess cash, you may be able to buy quality
data center equipment and hosting accounts at attractive prices.
If you are making money and wish to sell, you probably will
be able to get a fair multiple based on your current cash
flow.
Eventually
as the supply of assets that must be sold dwindles and the
number of buyers with cash who understand the opportunity
increases, prices will rise to an equilibrium where the cash
generated from these assets and hosting accounts equals the
cost of the investor's capital adjusted for the perceived
risk. What will that equilibrium price be? Anyone's guess,
but in old economy businesses it has traditionally been a
multiple of 2x-5x annual cash flow. Prices historically have
been on the higher end for larger businesses ($10 million
of revenue and up) and on the lower end for smaller businesses.
But don't expect that level of pricing until overall demand
for hosting has risen to a level where all the existing assets
are being utilized.
What
is a firm generating little or no cash flow worth?
Any business
is worth what a willing buyer and a willing seller can agree
upon.
If none
of the buyers with available cash can generate a profit operating
those assets or delivering services to those accounts, it
is worth nothing.
Again,
it is not that these assets are bad-indeed many of these Hosting
firms have grown their revenues and number of accounts nicely
during the period of time they were owned by their current
sellers. It is just that in the current environment, few investors
are willing to finance losses into the future.
However,
if a buyer can append those assets to their current enterprise
and make a profit operating them or delivering services to
the selling firm's customers, the selling firm's assets and
customers are worth something. Generally that price is a multiple
of the cash flow the buyer can expect to generate from those
assets. Unfortunately for the seller, it is generally not
a high multiple.
Currently
the multiples I am seeing being paid for hosting accounts
in transactions that have closed recently have been in the
following ranges:
Virtual
(Shared) Hosting 0.25x -1.0x annual revenue
Dedicated Hosting: 0.4x-1.3x annual revenue
Colocated Servers: 0.5x-1.3x annual revenue
The lower
ranges represent what I have seen large buyers offer to pay
in distressed situations. The higher multiples represent what
I have witnessed healthy businesses wishing to sell today
receive for their hosting accounts.
Very profitable
Hosting firms that are generating net cash flow in excess
of 30% of revenues are valued as a going concern-based on
their current cash flow and the perception of what that business
can produce in the future. In these situations, expect valuations
of 2.5x-3.5x current annual revenue plus the possibility of
an incentive for future growth post close.
Make no
mistake, I am not saying that such pricing is fair or just.
I am saying that currently it is what is. Ruth Roosevelt,
an expert on markets and market behavior, counsels her trading
clients that in the market, price is reality. The prices above
reflect the current reality. The good news is that markets
fluctuate and that reality can change.
Additionally,
every Hosting firm is to an extent unique with its own firm
specific value drivers, such as product mix, location, cost
structure, market positioning, etc. If you wish to know what
your Hosting firm is worth today, contact one of the brokers
or investment bankers that you know who have experience doing
transactions in the Hosting Industry.
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