U.S. Colocation Consolidation Likely Contagious

With Switch and Data announcing yet another acquisition in January, it looks like the consolidation we have seen in the North American colocation market is continuing unabated. By contrast in Europe, where there is a strong case for similar consolidation to take place amongst a multitude of regional providers, hardly anything has happened over the past few years despite some compelling economic arguments to suggest they should. But this may be about to change with pan-European provider TeleCity announcing in mid-January that an indicative proposal for the company has been made.

The new year was only a few weeks old before Switch and Data announced the acquisition of Dallas-based provider LayerOne in January, their latest move in a string of deals stretching back to their June 2000 acquisition of Extranet in 111 8th Ave., New York. This most recent purchase gives them a third site in the Dallas area and now 35 facilities across the United States and Canada in 23 individual markets. This is the company’s fifth such acquisition (see table, “Significant U.S. Colocation Deals”), but Switch and Data is not alone in looking to the acquisition route for growth, with both telx Group Inc. and Equinix Inc. closing transactions during the course of last year. It could be argued that telx’s acquisition of 56 Marietta was the most dramatic move we have seen in the market to date, with telx expanding from their traditional base in 60 Hudson, where they offer some 45,000 square feet of fitted-out space, to running the well-established 160,000- square-foot facility in Atlanta, effectively increasing the company’s footprint by five times, and, ironically, now counting Switch and Data among its newly acquired customers.

Earlier, in 2002, Equinix similarly combined three separate companies and 15 facilities across six separate countries.

With finance seemingly more easily available in the sector once again, not just because of the recovery in the capital markets but also because some of these companies, having weathered the storm, are now generating cash and even profits so leading to a virtuous circle, it would not be an especially brave call to suggest that this consolidation trend is likely to continue. However, one may like to speculate further that the heat may be turned up a little this year and that some more dramatic deals may be more easily achievable in the more boisterous climate. But according to Hunter Newby, chief strategy officer at telx, the industry’s consolidation is not just about doing deals for the sake of it, it’s about buying “the right assets for the right reasons.” In other words, these deals are being driven for reasons specific to each company. In telx’s case this means looking to acquire facilities where their interconnection models can add value; it is not interested in acquiring assets just because they may be available at an attractive price. For others, Newby speculates, the reasons may driven by financial pressures, for instance to acquire revenue, or even strategic, perhaps to deny access to a competitor.

This sounds like good news for the large number of independent operators still remaining in the U.S. market, though it’s still possible that some of them may start to look at synergies with companies overseas. Indeed, it is in markets outside the United States that things might finally be starting to happen.

ACROSS THE POND

In contrast to the North American market, the situation in Europe has been much calmer for the past few years. Yes, a number of providers such as CityReach or Digiplex disappeared when the bottom dropped out of the market back in 2001, but they were taken apart piecemeal rather than snapped up intact by opportunistic rivals. In fact, a number of the sites themselves were bought by corporate buyers at cents on the dollar. For example, CityReach’s and Digiplex’s West London sites were acquired by UBS and Deutsche Bank, respectively. Another player, IXEurope acquired both its Frankfurt and Zurich facilities by taking over local independent operators in each location in 2000 and in April 2004 purchased Telehouse’s Geneva facility. Yet the case for some more drastic consolidation in Europe is strong with as many as six operators providing some form of pan-European footprint often (usually) in the same locations.

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The irony of the situation in Europe is that because all providers did well in 2004, the odds of consolidation happening actually were increased. As everyone has grown stronger, it has reduced opportunities for the strong performers to purchase the poor ones. And, of course, for the shareholders in these companies, while the improvements in trading over last year will be welcome, the companies’ valuations are still at fractions of their original worth, so any deal that crystallizes these values still could cause some difficulties. That said, private equity and venture capital backers of most of these companies will be seeking an exit at some stage and with the six key pan-European operators offering 39 facilities across the top six markets (see table, “Carrier-Neutral Colocation Providers in Key European Markets”), the potential for cost-cutting is only too plain to see. Do we really need six separate teams of salespeople selling colocation services in Paris?

Guy Willner, CEO of IXEurope, also makes the point that there is still value in the acquisition route to expansion. “With power needs continuing to rise, the cost of building from scratch continues to escalate,” he explains. But Willner also points out one of the problems with the strategy in surplus space in Europe is in the wrong locations. For instance, markets like Frankfurt remain oversupplied whereas the London market is relatively tight. Indeed, Willner already is looking for a third site to add to IXEurope’s two existing facilities serving the London market.

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All things considered, it was quite a surprise when on Jan. 24, TeleCity, a pan-European colo operator offering nine facilities in six countries, was forced by a two-day, 20 percent surge in its share price to release a statement to the London Stock Exchange declaring that an indicative offer proposal for the company had been tabled, albeit at a discount to the then prevailing share price. The board stated the offer was being considered and that further statements would be forthcoming. At press time at the end of January, talks between the company’s management and the potential buyer are ongoing. At the current share price of 20 pence (about 38 cents) the company is valued at just under 60 million pounds (about $113 million). At present, it is hard to see how the offer is going to succeed with the stock market pricing TeleCity at a premium to the indicated offer price of 19 pence, but the board of directors believes the offer to be worthy of consideration and perhaps that they can persuade a higher offer to emerge. It is not uncommon for an indicative offer to be made with a view to meeting with the management and requesting access to detailed financial information before a formal offer to all shareholders is made.

There is no indication as to what company made the offer, so it is hard to know if it signals the beginning of consolidation in Europe or not. It is unlikely the approach has come from one of the other European operators despite the synergistic benefits that could be squeezed out from combining two companies with big geographic overlaps.

Shareholders in Redbus Interhouse plc, another pan- European provider that are similarly listed on the London Stock Exchange, also have benefited from the recent excitement and will have enjoyed the similar-sized increase in their shares over the recent trading sessions. It certainly will do Redbus shareholders no harm should TeleCity be subsumed into another group or indeed the market may speculate that should the potential suitor not be able to reach a deal with TeleCity, perhaps the spotlight will turn on Redbus themselves.

TeleCity’s customers will, of course, be most concerned that should the bid proceed, the buyer will maintain the carrierneutral status of the company’s nine facilities. This is such a key selling point for the company’s services that any possible buyer must be aware that should they alter the neutrality, a mass customer exodus would be the likely result over time. At present, the best advice for customers has to be to wait and see.

3i Group, the U.K.-based multibillion-pound venture capital investor remains TeleCity’s biggest shareholder with 45 percent, while original founder Mike Kelly still retains a 7 percent stake. TeleCity also raised an additional 8 million pounds last year by a rights issue at 9 pence a share and came to the market in June 2000.

Gamblers might cite Equinix as one possible buyer. The U.S.-based company is currently valued at $750 million, offers coverage across the United States and Pacific Rim, but has a glaring gap in Europe. A move by Equinix probably would be welcomed by TeleCity staff and management, who would be less exposed in terms of the cost benefits a European-based buyer would be seeking to exploit. Regardless of the buyer, the offer for TeleCity may at last herald the shakeup in the European colocation marketplace.