Internap Needs to Figure Out What Business It's In

Internap (INAP) reported yesterday that quarterly revenues had declined 6% year-over-year to $61 million. The drop was expected as the company is trying to transform itself from a reseller of other provider's assets to a facilities-based data center provider. As part of that initiative, it has committed to a $50 million capital program.

Financially, Internap looks like the anti-Level 3 (LVLT). It shares Level 3's broad product line, but historically it has taken a hit on its income statement for reselling services at low margins, while Level 3 has taken a hit on its balance sheet by building large networks. Internap has much lower debt/revenue and much higher revenue/PP&E than Level 3 as a result. But now Level 3 is cutting capex to shore up its balance sheet, while Internap is increasing capex to improve its income statement.

Internap has never been a typical reseller. It developed a proprietary algorithm for routing traffic across multiple networks, but then extended the marketing concept behind this strategy to become a reseller of a broad range of IP and hosting services. Not unlike most resellers, it has a fairly broad product catalog. But transforming itself to more of a facilities-based provider means more than building up the capital budget, because it will not get a reasonable return on assets as without growing market share substantially.

Offering IP services, colocation, managed hosting, and CDNs. Internap is like Level 3, Equinix (EQIX), Rackspace (RAX), and Akamai (AKAM) rolled into one company, but without the market leadership in any of these services. To date, this has made it a balance sheet strong, but income statement weak distributor of other company's assets. But as it now builds on its own, it has to do more than commit capital to data centers, it has to look at where it can develop some kind of cost advantage over its competitors, and that won't happen in all four services.

Unlike its larger competitors, Internap owns proprietary routing software - MIRO (Managed Internet Route Optimizer) - that tackles many of the latency problems associated with BGP. But there is no reason to limit this technology to just its own service. If makes more sense economically to spread MIRO's development costs to other companies by selling it to them directly, not as part of a monthly IP service where the market has demonstrated it will not pay much premium for a proprietary technology.

In the collocation market, Internap has long relied on locating at existing facilities built by companies like Equinix and Switch and Data (which is now part of Equinix). But as long as its selling IP services, it will never truly be carrier neutral, which has been a key selling point for Equinix's service. Moreover, a $50 million boost in capital investment is not going to be enough to match the billions Equinix and Telx have already invested. It will likely have to compete on price, which is unpleasant if you are reselling, but deadly if you're selling access to your own assets.

Instead of competing against Akamai, Equinix, and Rackspace, Internap really should be competing against someone like privately-held Packet Design, which is selling its proprietary routing software to large carriers and enterprises alike. Routing is still an expensive, high latency, but necessary long distance network function, and Packet Design has had success solving corporate customers pain points with Cisco's proprietary EIGRP, and carriers' challenges with BGP. I know Internap is not about to shut down its network and just start selling its software, but there is a unique technology sitting within the company that is being stifled by the requirement that no one else can have access to it.