Internap Insights

Posted on May 9, 2006

Recently I received the following excellent comment from a subscriber concerning Internap (IIP):

"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?"

My thoughts:

First off all, let me say that I still hold a significant amount of shares of Internap. I think the company is in solid shape and it is difficult to be bearish on Internap considering the much improved financial results. I sold half my holdings primarily because I think that is a prudent course of action after making over 250% in less than six months. Based on past experience, continued gains of that magnitude are possible, but very unlikely. From my perspective, you are always "playing the odds" in the stock market. Anything can happen, but the question is what are the odds of it happening? What happens if your dreams don´t come true? What are the different scenarios? What are the risks in each scenario and what are the expectations? Too often, I think we as investors buy into a dream of the future, without acknowledging the risks and uncertainties.

In any case, I agree with your bullish comments. The FCP 10 gig box is exciting and solid sales of this high margin product will clearly alter the margins at Internap (IIP) giving the company better operating leverage and rendering my expense nitpicking moot. In addition, I agree with your increasing broadband argument which bodes well for Internap. This is in fact the reason why I bought the stock in the first place.

However, the question as mentioned above is always one of odds, risks, and expectations. What if IIP sells a ton of FCP 10 gig boxes? But, what happens to the stock, if they don´t? What happens if sales are slow initially?

Personally, I like to buy stocks when even if the best case scenario does not come to pass, the stock price still has little downside risk. At $0.40 this was the case with IIP, but at $1.40+ the risk premium is quite a bit higher. One only needs to look at Level Three´s (LVLT) recent acquisitions and the multiples that they paid off of expected EBITDA and Cash-Flow to get various possible valuation scenarios for Internap. Of course these valuations somewhat ignore the "option" value provided by the FCP, but they do show the level of risk to IIP´s stock price should the FCP product and other growth initiatives fail to meet market expectations.

Overall, my impression is that Internap is about fairly valued at current prices assuming different possible scenarios and using absolute EBITDA and cash-flow valuations. I should note that the stock does appear somewhat undervalued based on relative price to sales valuation metrics, but I caution that these metrics are, in my opinion, useless with respect to Internap, given its current margins and product mix. At the same time, relative valuations ignore the possible unsettling prospect that many leading Internet infrastructure companies are currently once again significantly overvalued.

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