Tech Biz: US telco CenturyLink buys Savvis for managed hosting, co-location and .... the Cloud

In case anybody missed it, Tech M&A is back with a vengeance. The first four months of 2011saw the announcement of deals valued at around $111billion.

A big piece of this, of course, was accounted for by AT&T's acquisition of T-Mobile USA from Deutsche Telekom for $39bn, primarily to get much needed wireless spectrum capacity for its data-demanding mobile customers.

Telcos were also players in smaller but still billion-dollar-plus transactions. Among the most interesting examples was Verizon's "data center deal" for Terremark, a well respected provider of data center co-location and managed services, including cloud computing. (See our research note of February 13, 2011.)

As might have been expected, the Verizon/Terremark deal immediately set off rampant industry speculation about who would be next. Hosting company Savvis was frequently cited, with telco giant AT&T seen as a likely buyer.

As it turns out, Savvis is in fact being acquired, but by a much smaller telco, the US focused CenturyLink.

With estimated 2011 revenues of around 1 billion dollars, Savvis is an important provider of managed services, colocation and network infrastructure for enterprises, and is widely considered to be a significant player in cloud computing.

CenturyLink is the third largest telecommunications company in the United States. With its previous acquisition of Qwest completed as of end 1Q11, the company is forecasting 2011 revenues of around $15 billion.

On April 27, 2011, the two companies announced an agreement under which CenturyLink will acquire Savvis for $2.5 billion in cash and stock, plus the assumption or refinancing of $700 million of net debt.

According to the two companies, the combination of CenturyLink's hosting and network assets with Savvis' solutions in colocation, managed hosting and cloud services will enable CenturyLink to "achieve global scale ... and will accelerate its ability to deliver quality managed hosting and cloud capabilities to its business customers."

CenturyLink also stated that it expects to integrate its hosting business and Savvis' managed hosting and cloud services into a single business unit, managed by the existing Savvis leadership team.

The transaction is expected to close in the second half of 2011.

Overall, Duquesne Group sees this acquisition as bold but reasonably priced, which is fortunate given CenturyLink's mountain of debt.

Growth was clearly the driving factor, as CenturyLink - like many other telcos - moves into higher growth, data center based services, in order to compensate the decline of traditional networking businesses.

As telcos continue to move into value added services and the cloud, the big question within the industry will of course once again be: who's next?

For large IT users, the potential impacts will depend on whether they are currently customers of one of the two companies, but also in large part on geography - where they are based and where they want to be over the next few years.

Within the industry, CenturyLink's agreement with Savvis came as something of a surprise, mainly because its recently completed acquisition of Qwest left it with a mountain of debt. At year end 2010 on a pro forma basis, the combined debt of CenturyLink and Qwest stood at approximately $19 billion, nearly equal to the revenue the two companies generated over the same period.

Logically enough, the company's credit ratings are weak, for example, Baa3 from Moody's which is the lowest investment grade rating, just one step above "junk". For comparison, AT&T is rated A2, five notches into investment grade, while Verizon and France Telecom are rated only slightly lower at A3.

In the context of these financial parameters, CenturyLink's acquisition of Savvis is a bold move, but (fortunately) one that appears to be reasonably priced.

Comparison with the Terremark deal is both interesting and inevitable. Both companies are well respected players in co-location and hosting services, including cloud computing. On the financial level, both have run up a string of losses (building big data centers is not cheap) and accumulated a lot of debt.

Verizon is paying a 33% premium over the market, in a transaction that values Terremark at around 4 times annual sales. In our analysis, Duquesne Group saw this earlier deal as somewhat "pricey". As the CEO of Savvis famously said shortly after the announcement, the Terremark deal reflected a “very attractive valuation”.

As it turns out, however, CenturyLink is now buying Savvis at the more modest P/S valuation multiple of 2.5, with an 11% premium over the market.

The trend now seems to be established that telcos are moving into data center based services, including cloud computing. Networks are a very big part of the picture, and that's where the telcos have a real advantage.

Assuming that the advanced economies continue to mend and that the NASDAQ continues to advance, it can probably be safely assumed that acquisitions will continue as the telcos march into the cloud.

"Build or Buy?"

"Build or Buy" is a classic management issue, but as different telcos evolve their strategies and business models the question can be posed different ways. Comparing the two recent hoster acquisitions is again useful.

In buying Savvis, CenturyLink has continued its practice of buying into new businesses, in this case data center based services. Its own much smaller activities in this domain are to be folded into the Savvis business unit. To compensate the decline in its traditional businesses, CenturyLink must grow and it hopes that it is buying growth.

The issue was quite different in Verizon's acquisition of Terremark. The telco giant already has a growing cloud services business and expects to need a lot more modern data center capacity, together with the related skills. Designing and building data centers takes time, and Verizon is in a hurry. In a nutshell, Verizon is building its own cloud business, but buying the data centers it needs to support it.

Who's next?

In the US based hosting business, Rackspace is of course the real prize. It is a market share leader in managed hosting and is widely recognised for excellent customer service. In cloud computing IaaS, the company has a strong Xen-based technology platform, reinforced by its open source collaboration with NASA ("OpenStack ").

With high growth and consistent profitability, Rackspace has a market cap of around $5.6 billion, over 7 times annual sales. Unlike Terremark and Savvis, Rackspace has (so far as we know) no particular reason to put itself up for sale. Even if it did, the deal would be very expensive, even for a big telco with deep pockets.

Opportunities for telco takeovers of US based hosting companies are clearly diminishing, although there has been some speculation about Internap, a company with facilities throughout the US, Europe, Asia and Australia.

In this context, international deals are a distinct possibility. US based telecommunications companies could well find some interesting hoster acquisition opportunities in Europe. A possible candidate might be Netherlands based Interxion, which operates 28 datacenters throughout Europe. Of course, as the action goes international, the big European telcos - and even some Asians - may well be bidders too.

The game looks far from over.

Current Savvis customers will probably not see much impact, except possibly a somewhat improved investment capability by their provider.

Current CenturyLink customers, however, will be able to take easy advantage of high quality data center services, including cloud computing, with the possible benefit of end to end control by the telco.

Outside of the current customer base, much will depend on geography, given the predominately US focus of both CenturyLink and Savvis.

For US oriented companies looking for data center based services, the Savvis business unit of CenturyLink will of course continue to be an entirely credible candidate. Even if they are looking for a package of networking and cloud services, Savvis/CenturyLink may well be an interesting "challenger" to consider in competition with the telco giants. CenturyLink is hungry for the business, and this may well translate into aggressive financial offers.

Outside of this context, Savvis/CenturyLink will probably be seen as an "outsider", to be considered in particular circumstances, for example, by non-US companies with big ambitions for the US market.