Internap: Where to Now?

Last night Internap (IIP) delivered financial results that confirmed the strong turnaround at the company. From my perspective the most important part of the financial release was the increased revenue growth guidance for 2006, since the meager revenue growth projected last quarter was a factor in limiting the upside valuation for the company.

Overall, based on these results we see no near-term business risks for the company (in fact conditions should continue to improve throughout 2006 and 2007), implying that the stock has little downside risk here other than overall market risk. At the same time, though, with the stock up over 250% since my purchase five months ago and with the company now sporting a market valuation of nearly $500 million (over 20X estimated 2006 EBITDA and nearly 50X estimated free cash-flow), it is difficult to see what can move the stock higher for the remainder of 2006.

My general feeling is that the company´s costs are still out of line, based on comparisons to other more lean competitors. This fact, in addition to the company´s pristine balance sheet, makes Internap (IIP) a good acquisition candidate, but I´m not holding out hope for an acquisition particularly since the company is not a pure play in any one particular growth area of IP, making it difficult for a larger "pure-play" competitor to buy the company (i.e. what would they buy? The IP routing services part or the co-lo?).

Of course it is possible that on its own Internap (IIP) will prove successful in selling more higher margin IP services in the coming  years, and at that time expenses as a percentage of revenue will drop to more normalized levels (as seen at more lean competitors), but I´m not convinced the company has the ability to really compete successfully in upselling higher-margin services, especially given the solid lead of more experienced competitors. 

In addition, I´m pretty convinced that the management team at Internap (IIP), as is the case with most public companies, will have little willpower to contain expenses as revenues rise over the coming years. This can be seen by the nearly 20% increase in cap-ex forecasted for 2006, despite the fact that the company is still operating at way beneath 100% capacity. Money In, Money Out, is the familiar mantra for management when revenue increases and business improves.

Overall, as noted Internap (IIP) has clearly turned around and the company is in solid shape. However, the valuation already more than adequately reflects the improved prospects of the business, and I don´t see much more upside in the shares (which are over 40% above our initial price target). With that said, given my belief that you need to sell when you can and not when you have to, I am taking this high volume share day to take some money off the table at Internap, selling 50% of my position in the stock. I will continue to hold on to the remainder of my shares for the rest of the year because it is possible that the stock can become ridiculously overvalued, like other stocks in the sector, and I of course don´t want to miss out on this potential bubble, should it occur. Of course, I think it is foolish to gamble big on possible irrationality, which is why I am taking some profits here.

Please Note: I first recommended Internap (IIP) at $0.40, and still hold a position in the stock. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Comments

[symlkrborn]

brought to my attention by matador in IIP's excellent board. I really liked your objective take on IIP even tho you had a position . iam gonno go tru ur archives. strongly rec the author here.

[Guy]

Yehuda, I want to commend you again for your pick of IIP at .40 - which was was ahead of the herd, and for your objective analysis of the strengths and weaknesses of the company. On the question of high costs, have you factored in the possibility that the new FCP 10 gig boxes could really take off in terms of sales? Internap has the best route control product on the market and very little real competition at the high end. These boxes will sell for around 100k when they go on the market in June and Internap's profit margins on those boxes are around 70%. If Internap can really start to reach critical mass in terms of selling these devices, it could significantly alter the gross margins of the business. Also, given that broadband useage will go from 38 to 88 million Americans over the next 6 years or so and video is really starting to take off with Google Video, youtube.com etc. I see the demand for Internap's FCP and IP services growing significantly. Thoughts?