Fitch Downgrades Global Switch to 'BBB'; Outlook Stable

(The following statement was released by the rating agency) Fitch Ratings-London-28 September 2020: Fitch Ratings has downgraded data centre owner Global Switch Holdings Ltd.'s (Global Switch) Long-Term Issuer Default Rating (IDR) and senior unsecured rating to 'BBB' from 'BBB+'. Fitch has also downgraded the senior unsecured rating of Global Switch Property (Australia) Pty Limited, reflecting a parent company guarantee, to 'BBB' from 'BBB+'. The Outlook on the Long-Term IDR is Stable. The downgrade reflects the negative impact that the default by Daily-Tech (publicly announced on 1 June 2020 in Global Switch's 2019 annual report) is having on Global Switch's EBITDA. Daily-Tech, formerly the company's largest customer, defaulted on its service agreements relating to three data centres, which led to Global Switch terminating the contracts. While corporate and bank guarantees offset some of the effects on 2019 EBITDA and a guarantee remains fully in effect for 15 mega watts (MW) for the Hong Kong contract, 2020 EBITDA will be negatively affected. Cash flow leverage has been increasing since 2017, primarily owing to new data centre developments and we had forecast net debt/EBITDA to reach 5x in 2020, slightly breaching Fitch's negative sensitivity, decreasing after as these developments' income streams come on-line. However, the loss of EBITDA from Daily-Tech will push cash flow leverage well outside those sensitivities for several years. Like other data centre businesses, the company has seen demand increase during the pandemic and has signed 37 MW of new commitments between December 2019 and July 2020. Renewals have also been strong and development activities remain largely on time and on budget. The Outlook reflects the favourable, but competitive, operating environment of data centres, which should ensure stable but low growth as new developments are completed and customers take up new capacity. Key Rating Drivers Key Customer Default: Daily-Tech, a China-based developer and operator of data centres, defaulted on payment obligations under its service agreements relating to data centres in Hong Kong, Singapore Woodlands and Frankfurt North with commitments of 15 MW, 18 MW and 6 MW, respectively. Daily-Tech generated around 18% of 2019 revenue. Although Global Switch benefited from corporate and bank guarantees totaling more than HKD500 million (GBP50.7 million), because of impairment charges relating to the Daily-Tech default, 2019's EBITDA declined. The company has signed extensive new commitments to fill the vacant space arising from the Daily-Tech contract termination, but we forecast 2020 EBITDA to decline. Mounting Cash Flow Leverage: Development spending has been increasing leverage metrics, particularly since 2018. We had forecast net debt/EBITDA to reach 5x in 2020 (slightly above our previous negative sensitivity), before steadily declining. Primarily due to the Daily-Tech default, we forecast net debt/EBITDA to reach around 6.5x in 2020. This will fall to around 5.5x in 2022 as the company lets both vacant and newly developed space. Fitch expects the EBITDA interest cover to remain healthy at around 6x. Positive Sectoral Trends: Strong growth in data and internet traffic, the spread of mobile devices, outsourcing and cloud computing are accelerating demand for data centres, a highly specialised real estate sector. The COVID-19 pandemic has accelerated demand by hyperscale cloud providers and accelerated companies' migration to the cloud, with renewed focus on data security, improved data analytics and cost savings. However, data centres have limited alternative use and the market transaction evidence is less frequent compared with most real estate sectors. Obsolescence remains a long-term risk as new technology or regulations could quickly transform how data is handled and stored. There is significant development and consolidation of data centre owners and operators globally, increasing concentration and competition in this highly capital-intensive industry. Impact of Hyperscalers: Hyperscaler cloud providers, mainly Amazon (NASDAQ:AMZN), Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOGL), are key customers for data centres as they lease significant space, often on long leases that provide stable and visible revenue. However, given their magnitude and reach, they wield significant pricing power and can suppress rental growth and compress margins. Cloud providers can also contract their own end-users in their own data centres, removing customers' need for third-party data centre services, drawing away current or potential data centre customers. We expect Global Switch's network-dense co-location data centres, which provide interconnectivity between customers, to be more resilient to these changes. Nevertheless, as hyperscalers continue to grow and tenant demand increasingly comes from a few large companies, Fitch expects Global Switch's profit margins to come under pressure. High Quality, Concentrated Portfolio: Global Switch's portfolio comprises 13 large, high-specification, carrier and cloud-neutral, multi-tenanted data centres, with almost 370 mega volt amps (MVA) of power supply capacity. The assets are in eight key communication hubs in Europe, including Frankfurt, London, Amsterdam and Paris, and Asia-Pacific, including Hong Kong, Singapore and Sydney. Global Switch's data centres are highly secure and have reliability exceeding 99.999%, a key consideration for customers. The investment property portfolio value, excluding developments, at end-2019 was GBP5.4 billion. Although geographically diverse, the portfolio is relatively concentrated. The company benefits from stable revenue through its medium-term leases, although the Daily-Tech default reduced the average lease maturity to 4.3 years from 5.4 years. Development Peaking: As data centre demand continues to grow, Global Switch continues to significantly develop its portfolio. The company plans to spend around GBP750 million of capex through 2022, with around 50% of this to be spent in 2020. Capex in 2020 will mainly relate to the completion of stage 2 (building 3, 4 and 5) of the Hong Kong data centre, which will be the largest of its type in the territory when complete. Other notable new developments include Frankfurt, and Amsterdam and, further ahead, London South, and re-developments at Paris and Madrid. To mitigate building risk, the company phases construction, obtaining connectivity and power in advance, and ensuring some level of pre-commitment from customers. The company also has a history of successfully completing projects. Committed capex is low at less than 2% compared with the portfolio value. Diverse, but Concentrated Customer Base: Global Switch has over 350 customers with companies ranging from IT, communication, finance and managed service providers. With a number of tenants being managed service providers, systems integrators or hyperscalers, the tenant base is relatively concentrated. The top 10 tenants generated around 50% of revenue at end-2019. Most large tenants are investment-grade and hold contracts across multiple locations, mitigating some credit risk. Occupancy is moderately low at around 75%, mainly reflecting the Daily-Tech default, as well as new development capacity. Occupancy rates are not comparable with other real estate sectors as the predominance of large customers, especially hyperscalers, limits the ability to lease small, discrete areas. Shareholding Continues to Develop: The Jiangsu Shagang Group, a China-based steel producer, remains the largest shareholder of Global Switch with around a 50% holding on a look-through basis and controls the board through partial ownership of other shareholding entities. Ownership changes over the past few years have not altered Global Switch's strategic direction or policies, owing to a shareholders' agreement that gives management control of company operations. Shareholders have also entered into a security control agreement that ensure that Global Switch's data centres remain secure. Global Switch is working towards an IPO (subject to market conditions), which should enhance public disclosure, transparency, and corporate governance. Derivation Summary The data centre industry varies from other real estate sectors. They are highly intensive users of power, and fees are based not only on the area leased, but also on the amount of power used or provided. In addition, data centres are highly secure and require significant mechanical and electrical infrastructure. This makes them highly capital intensive, certainly compared with retail, office and logistics real estate. Developments have a long lead time, owing to the need to acquire the necessary permits, securing sufficient power sources and a complex, typically phased building schedules. In addition, industry dynamics differ from other real estate as it is becoming globally concentrated with growth driven by demand from the hyperscale cloud providers. Given these dynamics, data centres operators tend to have conservative financial metrics with cash flow leverage similar to 'A' category rated real estate companies. Global Switch, for example, even with net debt/EBITDA expected to peak by end-2020 at around 6.5x, reflects a conservative financial profile compared with most other real estate sectors. With 13 assets across Europe and Asia, Global Switch is smaller than US-based Digital Realty (DLR; BBB/Stable), which operates around 281 data centres globally. Like Global Switch, DLR focusses on hyperscale, co-location and interconnection services and large-scale customers instead of retail services. This gives both companies a concentrated, but high-quality, tenant profile. DLR currently has a net debt/EBITDA of around 6x, but this is expected to reduce to a mid- to high-5x range. Global Switch, which has grown entirely through its own developments, has leverage levels above its historical levels, but we expect net debt/EBITDA to fall to around 5.5x in 2022 as new developments are let. CyrusOne, Inc. (CONE; BBB-/Stable) also concentrates on large-scale services, giving it a similar tenant concentration to Global Switch and has built an international presence following the acquisition of Zenium (with data centres in London and Frankfurt) in 2018. CONE has a net debt/EBITDA of 5.8x and Fitch expects it to remain in the mid to high 5x range. DLR has an average lease length of around five years, compared to around 4.5 years for CONE and 4.3 years for Global Switch. Key Assumptions - Revenue decline of around 11% in 2020, followed by mid to high-digit revenue growth - Capex of around GBP750 million from 2020 to 2022 - No acquisitions or disposals - Yield on cost for developments at 6%, with occupancy rates on new developments growing to match those on existing assets - Special dividend recapitalisation of GBP90 million in 2020 RATING SENSITIVITIES Factors that could, individually or collectively, lead to positive rating action/upgrade: Net debt/EBITDA below 4.5x on a sustained basis EBITDA net interest cover above 3.5x on a sustained basis Material increase in the occupancy rate or average lease length Factors that could, individually or collectively, lead to negative rating action/downgrade: Net debt/EBITDA above 5.5x on a sustained basis EBITDA net interest cover below 2.5x on a sustained basis Aggressive committed development capex, beyond the current pipeline, that is not pre-let or covered by existing liquidity Significant decrease in the occupancy rate or average lease length Best/Worst Case Rating Scenario International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579. Liquidity and Debt Structure Good Liquidity: At end-2019, Global Switch had cash and cash equivalents of GBP92 million and had access to the undrawn portion of GBP299 million of its GBP425 million committed revolving credit facility, which matures in April 2021 (Global Switch extension option to April 2022). Near-term maturities consist of a GBP7 million Australian dollar-denominated bond maturing in December 2020. Committed capex at end-2019 was GBP73.5 million. REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING The principal sources of information used in the analysis are described in the Applicable Criteria. ESG Considerations The highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg Global Switch Property (Australia) Pty Limited ----senior unsecured; Long Term Rating; Downgrade; BBB Global Switch Holdings Limited; Long Term Issuer Default Rating; Downgrade; BBB; Rating Outlook Stable ; Short Term Issuer Default Rating; Affirmed; F2 ----senior unsecured; Long Term Rating; Downgrade; BBB Contacts: Primary Rating Analyst Bram Cartmell, Senior Director +44 20 3530 1874 Fitch Ratings Ltd 30 North Colonnade, Canary Wharf London E14 5GN Secondary Rating Analyst Shiv Kapoor, CFA Associate Director +44 20 3530 1509 Committee Chairperson John Hatton, Managing Director +44 20 3530 1061 Media Relations: Adrian Simpson, London, Tel: +44 20 3530 1010, Email: adrian.simpson@thefitchgroup.com Additional information is available on www.fitchratings.com Applicable Criteria Corporate Rating Criteria (pub. 01 May 2020) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10120170) Corporates Notching and Recovery Ratings Criteria (pub. 14 Oct 2019) (including rating assumption sensitivity) (https://www.fitchratings.com/site/re/10090792) Sector Navigators - Addendum to the Corporate Rating Criteria (pub. 26 Jun 2020) (https://www.fitchratings.com/site/re/10125796) Short-Term Ratings Criteria (pub. 06 Mar 2020) (https://www.fitchratings.com/site/re/10112342) Applicable Model Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s). 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