Great Expectations

Digex (DIGX) was raised to expect the world. With wealthy and indulgent parents, and room to grow, the future seemed bright. So what went wrong?

by Manish Aurora and Shariq Khan
of rationalinvesting.com

Apologies to Charles Dickens for the title of this article. We are talking about Digex (DIGX), a provider of web site and application hosting services to businesses and organizations operating sophisticated sites and internet applications.

Big clients
It boasts an impressive list of clients including United Airlines, Dupont, Fannie Mae, DirecTV, Ford, DaimlerChrysler, Pepsi, Forbes, and others. Major competitors include AT&T, Concentric, Data Return, EDS, Exodus, Frontier/GlobalCenter, Globix, and Genuity.

Digex markets its services primarily through a direct sales force focusing on Fortune 2000 companies, mid-sized businesses, and alliance partners for its e-Link and app-Link programs. An engineering team supports all sales force efforts with technical, project management, and configuration expertise.

Big data centers
Digex has two Internet Data Centers (IDCs) with more than 200,000 square feet of space each, located in San Jose, California and Beltsville, Maryland. The company also recently opened a smaller data center (7,000 square feet) in London, U.K.

Each IDC is further subdivided into sub-farms that can hold approximately 1,100 servers each. The current IDC buildout can support around 14,000 servers. Assuming around $3,000 per server per month, the company can support more than $500 million in revenues with its current IDC buildout, and more than $700 million in revenues including the additional capacity coming online, which should keep it humming in the near term.

In spite of this, Digex's market value has been shaken, if not stirred. The full fury of Nasdaq's correction was bestowed upon DIGX, bringing the stock down from the $180's to the $60's. While the stock is probably fairly valued based upon a cash flow model, it still trades uncomfortably above replacement value. It seems likely that capacity will continue to come online at a torrid pace, and price compression will hit this business hard over time, with consequences in the equity markets.

Also, one might ask, why was DIGX the market's darling? Well, Microsoft and Compaq jointly invested $100 million, and it also had a sugar daddy in Intermedia Communications.

Family feud
After the decline, in July, Intermedia examined its options, and the sugar baby went on the block, creating some optimism. Instead, the parent sold itself to WorldCom for $39 a share, or about $3 billion, including its 54-percent stake in Digex. Worldcom's ambitions in the hosting business effectively create a poison pill on bids from Global Crossing and Exodus, capping the stock price.

Digex's board apparently hasn't blessed the transaction yet, although they waived certain rights to object to the Intermedia transaction and have, consequently, invited lawsuits in Delaware courts.

Why any firm would have any (legally defensible) control over the sale of its parent is far from clear.

WorldCom is in the middle of a campaign to spend $1 billion to develop 120 Web-hosting centers by year-end (there is a complete rat race on to create telecom hotels) and install switches that transport voice via the Internet to help customers save on access fees.It could do with Digex's experience.

Even at $60, things do not look rosy for the stock.

Here are the numbers.

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