(The following statement was released by the rating agency) Overview
-- U.S. data center operator Peak 10 Holding Corp. plans to issue a new $300 million senior secured term loan to refinance its existing credit facility and pay a dividend of approximately $215 million to its private-equity owners.
-- We are assigning our 'B' corporate credit rating and negative outlook to Peak 10 Holding Corp.
-- We are also assigning our 'B' issue-level rating and '3' recovery rating to subsidiary Peak 10 Inc.'s $330 million senior secured credit facilities, including a $300 million term loan due 2019 and $30 million revolving credit facility due 2018.
-- The negative outlook reflects Peak 10's heightened leverage exceeding 8x pro forma for the recapitalization, and the increased likelihood for a downgrade if the company is unable to grow EBITDA by at least 20% in 2013.
Rating Action On Oct. 9, 2012, Standard & Poor's Ratings Services assigned its 'B' corporate credit rating to Charlotte, N.C.-based Peak 10 Holding Corp. The outlook is negative.
We also assigned our 'B' issue-level rating on subsidiary Peak 10 Inc.'s $330 million senior secured credit facilities. The proposed facilities consist of a $300 million term loan due 2019 and a $30 million revolving credit facility due 2018. The '3' recovery rating on this debt indicates our expectation for meaningful (50% to 70%) recovery in the event of a payment default.
The ratings reflect the company's "highly leveraged" financial profile and "weak" business risk profile under our criteria. Pro forma for the proposed recapitalization transaction, we expect our adjusted measure of leverage for the company to be above 8x at the end of 2012 under our base-case scenario, which includes the present value of operating leases in our debt calculation. However, we also expect healthy revenue growth of 15% to 20% over the next couple of years, fueled by increased utilization of existing assets, facility expansions, and a secular trend toward outsourcing IT functions with managed and cloud services, partially offsetting these risk factors.
Our assessment of the company's business risk takes into account its small scale with limited business diversity, and exposure to economically sensitive small and midsized business (SMB) customers. In our view, these risks more than offset the company's multiyear contracts, its focus on less competitive second- and third-tier markets, and a modest utilization rate that will allow for high-margin incremental growth.
Peak 10 is a data center operator that provides colocation, bandwidth, and managed services to SMB customers with operations in the southeastern U.S. Formed in 2000, the company has grown through a series of small acquisitions, greenfield market entry, and organic growth. It now operates 23 data centers in 10 markets across 7 states. The diversified customer base reflects the focus on small businesses, as its largest customer accounts for under 2% of total revenue, and the top 25 customers less than 20%.
The data center colocation business represents about 58% of revenues. We view this business segment favorably, given the predictable recurring revenue base and low customer churn. The company's utilization of existing facilities, based on power consumption, is about 47%, providing for significant potential to expand its existing base of business within the current footprint. Monthly churn for colocation tends to be under 1%, since customers may face high switching costs. Further, we view technology risk as limited since the company primarily provides physical space, power, and cooling for Internet infrastructure. However, Peak 10's focus on small customers and its relatively small facilities reduce the potential for economies of scale that influence high margins for larger providers. It also caps average revenue per customer, making high growth more difficult to achieve and maintain.
Bandwidth connectivity accounts for 20% of Peak 10's revenues. This includes delivering Internet access and private-line connections to its colocation customers. Given our expectations for growth in Internet traffic and the resulting increased need for bandwidth, we expect strong demand for both colocation space and connectivity to continue over the next few years.
The company derives the remaining 22% of revenues from managed and cloud services, which we expect will grow faster than the company's other segments. This business includes a wide range of services, but given its SMB customer base, Peak 10 specializes in backup and restoration, network management, and virtual services, which are less labor intensive than managed service applications that larger enterprise customers require. Additionally, Peak 10 can offer these services from a centralized infrastructure. The operating leverage and low overhead provide Peak 10 a high gross margin of near 75% for these services. We believe Peak 10 can benefit from selling managed services to its current customers because it already has an established relationship and houses the customers' key infrastructure. However, due to lower barriers to entry increasing competition, lower customer switching costs, and the potential for in-housing, managed and cloud services could lead to higher customer churn and are more susceptible to pricing pressure. Customers may also eliminate or bring these functions in-house to reduce costs during an economic downturn.
Under our base-case scenario, we expect revenue to grow about 20% in 2012, reflecting sales of managed services to current customers, the addition and expansion of facilities, and new colocation customer growth in its current data centers. We see revenue continuing to grow by about 15% to 20% over the next couple of years. As facility utilization increases and revenues shift to higher margin managed services, adjusted EBITDA margins, which were about 40% as of the second quarter of 2012, should modestly improve toward the mid-40% area in the near term. We assume EBITDA will increase by more than 20% in 2012, with similar EBITDA growth of around 20% in 2013. Incorporating these growth expectations and no additional debt-funded expansions, we believe that total adjusted leverage will be above 8x at the end of 2012, and just below 7x by the end of 2013. We expect the company to build and acquire new facilities, but still achieve break-even free operating cash flow (FOCF) in 2012. Given the company's increased leverage and higher cash interest expense, we expect FOCF to be modestly negative in 2013 despite strong EBITDA growth.
We consider Peak 10's liquidity "adequate" under our criteria. Sources of liquidity consist of an undrawn $30 million revolving credit facility and $12 million of cash pro forma for the recapitalization transaction, as of Sep. 30, 2012. Liquidity is critical for the company to fund its operating needs and data center expansion. While we expect FOCF to be break-even in 2012 due to elevated capital expenditures for new growth, we believe the cash and revolver are sufficient to fund a deficit that could arise in 2013. In line with our criteria, we expect sources of liquidity to exceed uses by more than 1.2x over the next year and net sources to remain positive, even with a 15% to 20% drop in EBITDA. The proposed credit facility includes a total leverage covenant that we expect will provide over 25% EBITDA headroom.
Recovery analysis For the complete recovery analysis, see the recovery report on Peak 10, to be published on RatingsDirect soon after this report.
The outlook is negative. We expect leverage to exceed 8x pro forma for the proposed recapitalization, which would not support the rating if the company does not remain on a trajectory to reduce leverage to below 7x by the end of 2013. We believe the company can achieve this leverage improvement if it can increase EBITDA by at least 20% in 2013. However, if an unfavorable shift in the supply-demand curves in its core data center markets in 2013 results in slower-than-expected EBITDA growth, leverage is likely to remain above 7x. We will closely monitor Peak 10's run-rate EBITDA versus our base-case forecast throughout the next year to determine if the company is unlikely to de-lever below 7x, which would warrant a downgrade to the rating.
Alternatively, over the next year, if the company issues additional debt for an acquisition which does not have as favorable profit characteristics as its core business, we could lower the rating if prospects for debt reduction become more limited.
Strong demand for data center colocation space should result in continued double-digit revenue growth and improvements in overall profitability, resulting in material leverage reduction from EBITDA growth over the next few years. We could revise the outlook to stable if we believe the company is on a path to sustain leverage below the mid-6x area over the next year, which could occur if EBITDA growth were to exceed 20%.
Related Criteria And Research
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New Rating; Outlook Action
Peak 10 Holding Corp. Corporate Credit Rating B/Negative/-- New Rating Peak 10 Inc. Senior Secured
US$30 mil revolver bank ln due 2018 B
Recovery Rating 3
US$300 mil term B bank ln due 2019 B
Recovery Rating 3
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