Equinix Affirms Financial Reporting Accuracy After Independent Review (NASDAQ:EQIX)

On May 8, 2024, Equinix (NASDAQ:EQIX) released Q1 24 results, and, more importantly, addressed the Hindenburg Research short seller report, that was published on March 20, 2024:

Equinix announced that the Audit Committee of the Company’s Board of Directors conducted and has substantially completed a previously announced independent investigation, with the assistance of independent third-party professional advisors.

Based on the findings of the independent investigation, the Audit Committee has concluded that Equinix’s financial reporting has been accurate, and that the application of its accounting practices has resulted in an appropriate representation of its operating performance.

As part of this assessment, the Audit Committee did not identify any accounting inconsistencies or errors requiring an adjustment to, or restatement of, previously issued financial statements or non-GAAP measures.

edited for clarity

Having followed Equinix since its IPO, chronicling its rise from near-collapse to industry leadership, we feel compelled to share our perspectives and our diligence, now that the company has addressed the accusations.

Hindenburg Research short seller report

Here is a breakdown of Hindenburg’s four main allegations formulated against EQIX:

• Equinix manipulates accounting for AFFO
• Equinix manipulates accounting for operating expenses
• Equinix is overselling power
• Equinix’s core business is being disrupted by hyperscalers.

The debate surrounding the specific accounting practices of data center REITs has likely existed since these companies began listing on stock exchanges.

A 2013 short thesis by hedge fund executive Jonathon Jacobson of Highfields Capital Management was targeting data center accounting issues.

Jacobson asserted that investors should short shares of Digital Realty Trust (DLR), saying the company relied on the capital markets to fund its dividend and highlighting data center maintenance expenses as a grey area.

As Rich Miller noted:

the issues Highfields raised about maintenance costs brought changes to industry best practices, and ultimately more transparency for data center investors.

In December 2018 Jesse Tebb issued a research report calling Equinix “The Enron of data”:

Sky Drop Research’s target price was zero, as you would expect for a company that is accused of “fabricated financial statements”.

The report, available at this link, listed seven main accusations to justify its strong sell rating:

While the Hindenburg report offered a more in-depth examination, citing conversations with alleged former Equinix employees to substantiate their claims, the core allegation of accounting manipulation remains largely consistent with the Sky Drop Research report.

Both reports also quote a CEO transition and increasing competition in support of their negative view of the company.

The main reason for resurrecting this unsuccessful short position by Sky Drop, published in 2018, is to highlight that fraud accusations weren’t exactly breaking news for investors already well-versed in EQIX situation.

In more recent times, another famous fraud detective, hedge fund manager Jim Chanos, established a short position against data center stocks in 2022.

Jim Chanos is betting against data centers

“This is our big short right now,” Chanos said in an interview with the Financial Times.

The FT quoted Chanos saying: “The real problem for data centre REITs is technical obsolescence.”

Chanos was also very critical of the accounting of data center maintenance expenses.

Chanos attack seemingly targeted the entire data center REIT sector, but Equinix and Digital Realty bore the brunt of it, being the main, if not the only, US-listed companies in this space.

While both Jesse Tebb and Jim Chanos made bearish calls on data center stocks that were ultimately dismissed by the market, Hindenburg Research, a fraud-exposing outfit, reignited investors’ worries, specifically regarding Equinix, by raising exactly the same concerns.

For the time being, let’s highlight two main data:

• Critical stances of the accounting of data center maintenance expenses have been circulating since the start of the sector – in Equinix’s case, the 2018 Sky Drop Research’s report addressed exactly the same accounting issues highlighted by Hindenburg;
• Unlike Sky Drop’s blunt zero target price, Hindenburg’s report took a more measured approach. While it provided a very detailed analysis of the alleged fraud, its conclusions mainly focus on Equinix’s future challenges: rising competition, commoditization risks, and a hefty valuation premium combined with growth prospects that, according to Hindenburg, will soon reverse course.

Equinix’s REIT conversion

Equinix didn’t start as a REIT, but as a technology company with a network neutral approach to colocation. Its emphasis has always been on its data center interconnection business.

Here are some old comments from EQIX CFO:

Keith Taylor- Equinix, Inc. – CFO

When we started the business back in 1998, we thought we didn’t want to put our capital into land and building, we wanted to build the leasehold improvements, which is [consistent] with our data center [business model].

But as long as we have economic control, that’s what really matters. [long term] leasing is really just effectively another financing tool that we have.

Equinix at Nasdaq Investor Program: November 29, 2016 – edited for clarity

The company completed its transformation into a REIT starting from January 2015.

We explored the potential impact of the company’s REIT conversion in our article: Equinix: worth more as a REIT?

Management believed that converting to a REIT structure would provide a more accurate picture of the company’s value. REITs are assessed using metrics like AFFO, which directly reflects a company’s ability to generate cash flow.

In addition, as REITs must pay 90% of their profits to investors, Equinix could become very attractive to income investors seeking a regular cash flow.

It should also be reminded that, at that time, several data center competitors like DLR , CyrusOne, etc. were structured as REITs.

On the negative side, REITs rely more heavily on debt financing, increasing their financial risk, especially if they are strongly growing the business – like EQIX.

A fraud conducted out in the open?

Hindenburg’s two main accusations are related to alleged accounting frauds:

• Equinix manipulates accounting for AFFO
• Equinix manipulates accounting for operating expenses

Among the evidence presented in Hindenburg’s 10,000-word report, one chart is particularly significant in supporting their allegations of fraud.

How could this possible?

During its June 2014 Analyst Investor Day, EQIX management openly discussed how the REIT conversion would affect some reported data, including decreasing the percentage of recurring CapEx to revenue:

In this chart, we can visualize the relationship between AFFO and the previous method of calculating CapEx:

(slides n. 39 and 40, available in Hindenburg’s report).

On March 25, 2024, soon after the Hindenburg Research short seller report came out, Erik Rasmussen, an analyst covering EQIX at Stifel, commented:

Our view is that when the company converted to a REIT (announced in 2014/effective January 1, 2015), the company as part of its conversion process, did a detailed review of all relevant REIT-oriented metrics, meeting NAREIT industry standards and other public reporting RElTs.

This review also included the revision of its GAAP CapEx definitions, which we do not believe materially differ from other REITs. The main changes we have observed are that there were changes from its old definition of maintenance CapEx such as “installation” (reconfiguration vs. custom installs) and any capital investments that resulted in incremental revenues from a customer as growth/expansion CapEx vs. being classified as maintenance/recurring. The company also expenses a portion of its maintenance spending instead of capitalizing that spend. We do not believe either of these two approaches are different than of any of its DC [data center] peers. Further we believe that management teams have the discretion on non-GAAP items and certain classifications.

A key sign of fraud is, normally, a lack of data and explanations.

Equinix’s management has been remarkably transparent. Since 2014, they’ve openly disclosed all relevant data, including the AFFO metric and recurring CapEx calculations that are now under scrutiny.

This level of transparency is unusual in fraud cases.

Is Equinix overselling power?

The third pillar of Hindenburg’s allegations is that EQIX is overselling power:

[Equinix] has quietly relied on a risky approach to growing revenue: overselling power capacity in the hope that customers won’t increase their usage up to the power they’ve contracted for.

In brief, Equinix doesn’t have enough power at some of its facilities to satisfy its current customer contracts…

Another former executive told us that power overselling could be as high as 175%:

“Most Equinix data centers are what they call over-utilized anywhere from 120% to 175% of power.”

Equinix boasts an exceptional >99.9999% reliability rack record, and has had very few outages since inception.

There seems to be a disconnect. Reconciling extreme reliability with overselling power up to 175% is a challenge.

As a smoking gun, Hindenburg, however, presents a compelling case to support their claims:

Equinix’s failure to provide sufficient power was the subject of at least one customer lawsuit. In December 2021, Blade Global alleged that it paid over $1 million to Equinix to secure space and power, but when it came time to use the space, Equinix acknowledged that its “servers would require more CFM [cubic feet per minute] of cooling than its New York facility could provide.” [Pg. 4]

The problem seems more related to cooling than power – but that’s not really the point.

We believe Hindenburg’s report may not present the whole picture. We believe there’s more to the story.

French cloud gaming startup Blade Global filed for bankruptcy in March 2021.

Equinix filed a proof of claim for $995,093.21 in the bankruptcy proceeding.

Blade Global [US] filed a separate complaint against Equinix – as Hindenburg suggests, it accused EQIX of not fulfilling its obligations.

Here is a section of docket n. 26 of the lawsuits – which also shows Equinix’s answer to the complaint (pg. 6):

Our understanding is that Equinix proposed a solution that could accommodate Global Blade’s servers (at a price point that wasn’t agreeable to Blade Global). Additionally, there are serious questions regarding Blade Global’s server fan usage practices.

Equinix and Global Blade settled their dispute out of court.

Is Equinix’s core business being disrupted by hyperscalers?

The growth and predominance of large cloud providers (“hyperscalers”) like Amazon, Google and Microsoft is an existential threat to Equinix’s two main revenue sources: 1) colocation (70.4% of revenue in 2023) and 2) interconnection (17.0% of revenue in 2023). [F-58]

We beg to differ.

Equinix offers very close proximity to almost 85% of the US population:

Jim Poole – Equinix, Inc. – VP of Business Development

But just to give you some perspective, Equinix’s facilities, the IBX is in just the United States, sit within 10 milliseconds of 80% to 85% of the U.S. population.

Equinix Inc at Credit Suisse Technology Conference – November 30, 2022.

We see hyperscalers as a threat to a different segment of the data center market, the wholesalers or data centers lacking a strong focus on verticals.

Equinix’s interconnection rich ecosystem and unparalleled proximity to end users is the key differentiator from its mid-market competitors, which may be suffering from the raise of hyperscalers.

Long ago, when he was trying to explain the company’s business model, Equinix’s founder, Jay Adelson, used the analogy of an airport:

A good analogy for an exchange point is that we function as an international airport for Internet networks and services. And our airlines are networks and our travelers are data bits and bytes.

With a stretch, we could describe hyperscalers as companies building huge and powerful airports in the desert – an interesting concept with a lot of scale, that nevertheless needs a way to be connected to that 85% of the population that is sitting within 10 milliseconds of an Equinix facility.

Hyperscalers won’t break EQIX business model and make it obsolete.

A self-fulfilling prophecy?

When Hindenburg issues a short report, the market listens.

Its track record is there to remind us that their research is accurate, and could lead to uncovering fraud, financial shenanigans and inappropriate accounting behaviors, like polishing some metrics.

A well-timed negative report from a prominent short seller like Hindenburg can also target a company’s weak points, even if the report is not entirely substantiated, potentially causing undue harm.

When Hindenburg’s short thesis on EQIX was disclosed, the company was planning to issue the offering of a €500 million nine-year euro-bond, which was cancelled.

We previously noticed that the need to rely on a continuous stream of financing, both through debt and share issuance, to sustain growth, makes a company like EQIX more at risk if doubts about accounting irregularities are risen in the market.

Since 2020, Equinix has issued six tranches of green bonds, approximating $4.9 billion.

In November 2022, EQIX established an “at the market” equity offering program in the amount of $1.5 billion. As of December 31, 2023, the company had approximately $469.7 million available for sale under the 2022 ATM Program.

A strategically timed negative report by a short seller can damage a company by hindering or disrupting its typical financing activities. This can create a domino effect, where the report itself triggers a decline in the company’s financial health, fulfilling the initial negative prediction.

The timing of the Hindenburg report couldn’t have been better. Equinix’s stock was peaking, they just had announced a CEO change, and they were tapping into the debt market.

Conclusion

If Equinix’s assertion of accurate financial reporting and fair performance portrayal is substantiated by the ongoing investigations, as we believe, concerns raised by Hindenburg Research would be alleviated.

Investors could finally return to focusing on Equinix’s strong metrics and performance, especially in its margin rich interconnection business.

We await the full investigation results and the resolution of the two subpoenas from the U.S Attorney’s Office for the Northern District of California and the S.E.C. to put all these issues and uncertainties in the rear mirror.

Now that Hindenburg has achieved the initial drop in EQIX’s share price, their future actions will be crucial. Will they maintain their short position, indicating a long-term strategic play on the company’s health? Or will they shift gears, suggesting their initial attack was primarily tactical, aiming for a quick price swing, which has actually been achieved?

Their next move would be a telling sign of their seriousness and the strength of their report.

AS Hoya Capital Research highlighted here on Seeking Alpha, “Hindenburg has a hit-and-miss track record and poor history on its REIT-specific calls, alleging in December 2022 that senior housing REIT Welltower (WELL) was a “shell game.”

Welltower has been one of the top-performing REITs since this short report.