For any emerging market opportunity, it's always a case of weighing the risks that come with the opportunities. In the case of 21Vianet Group , the low ROE, reflective of the commoditized nature of the business, coupled with the accompanying risks, will make me avoid this stock.
21Vianet Group is the largest carrier-neutral Internet data center services provider in China. 21Vianet provides hosting and related services, managed network services, cloud computing infrastructure services and content delivery network services, improving the reliability, security and speed of its customers' Internet connections through 21Vianet's Internet infrastructure. 21Vianet operates in 33 cities in China, and has a base of close to 2,000 customers.
Moats that matter
According to the Provisions on Administration of Foreign Invested Telecommunications Enterprises ( FITE), foreign investors aren't allowed to own more than a 50% equity interest in any Chinese company engaging in value-added telecommunications businesses. This represents a significant barrier to entry for foreign competitors. 21Vianet, the listed vehicle on Nasdaq incorporated in the Cayman Islands, operates under a Variable Interest Entity (VIE) structure to comply with these restrictions. However, there is nothing to stop domestic independent data center companies (IDCs) from leasing bandwidth from the telecom operators and joining the fray.
Bulls on this stock will talk about 21Vianet’s scale built on its first-mover advantage and its large and loyal customer base. The argument does not hold water, however, if one examines the rise and fall of giants in the technology and telecommunications industries. Firstly, the first-mover advantage often works against the incumbent when it is slow to innovate or respond to quantum shifts. Secondly, low customer switching costs usually negate any benefits of customer loyalty.
21Vianet is riding on the increase in penetration of fixed line broadband and smartphones in China. The country represents the largest broadband Internet market globally, and is expected to register broadband subscriber growth in excess of 15% per annum going forward, based on research provided by BuddeComm, an independent telecommunications research and consultancy company.
Also, according to a February article by Forbes contributor Chuck Jones, China carriers’ smartphone 3G penetration is only at 22%, based on subscriber data provided by China Mobile, China Unicom and China Telecom. For comparison, developed countries like Singapore, Hong Kong, Australia and South Korea have smartphone penetration rates in excess of 50%.
21Vianet’s peers include Equinix and InterXion .
Equinix connects businesses with partners and customers worldwide through a global platform of data centers and operates in 38 markets across the world, including Asia-Pacific. It acquired Hong Kong-based data center provider, Asia Tone, in July 2012.
In fiscal 2012, only 24% of Equinix’s capital expenditures were dedicated to the Asia Pacific region; it currently has data centers in Singapore, Hong Kong, Sydney and plans to expand to Tokyo as well.
InterXion is a provider of carrier-neutral colocation data center services to over 1,200 customers through 28 data centers in 11 countries in Europe. It's Europe focused, with no new significant Pan-European entrant for the last decade.
All three stocks are valued similarly based on enterprise value multiples, trading at 13-to-16 times trailing twelve months EV/EBITDA. If forward P/E is used instead, 21Vianet appears to be the most undervalued at 17 times forward P/E.
Comparatively, Equinix and InterXion trade at 58 and 35 times forward P/E, respectively. A low valuation is justified only if it comes with lower returns and lower risk. Only half of this is true for 21Vianet. While Vianet has the lowest trailing twelve months ROE of the three at 3.2%, it has the strongest balance sheet with the lowest gearing of 27%. Equinix and InterXion delivered ROE's of 6.1% and 10.7%, respectively, for the last twelve months, but both have gross debt-to-equity ratios exceeding 50%. None of the three stocks pay a dividend.
The biggest risk for any company is the reality that your suppliers are also potentially your greatest competitors. Despite claims that the Chinese government is supportive of private and non-state-owned businesses in China, it is not difficult for China Telecom and China Unicom to raise broadband fees charged to enterprise users, among various ways to raise the bar for IDCs like 21Vianet to gain access to their networks. The risk becomes more serious if and when the carriers decide to devote greater efforts to their data center business.
It is natural to be excited by growth, but I always think that only a company with a sustainable moat is in a position to capitalize on growth opportunities. If a company cannot keep customers or maintain margins, growth is not meaningful. In my opinion, 21Vianet does not have a sustainable moat and is subject to high levels of uncertain regulatory risks.
This article was originally published as Risks Outweigh Emerging Market Opportunities for This Stockon Fool.com
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