TEXT-S&P assigns CyrusOne Inc 'B' rating

Fri Nov 2, 2012 10:51am EDT

Overview
     -- U.S. data center operator CyrusOne Inc., currently a wholly-owned 
subsidiary of Cincinnati Bell Inc. (CBI), is planning to become an 
unrestricted subsidiary of CBI, and raise stand-alone debt financing and 
conduct an IPO.
     -- We are assigning our 'B' corporate credit to CyrusOne.
     -- At the same time, we are assigning ratings to operating subsidiary 
CyrusOne LP's proposed $225 million secured revolving credit facility due 2017 
and proposed $500 million senior unsecured notes due 2022.
     -- The stable rating outlook is based on our expectation that the company 
will have "adequate" liquidity to fund an aggressive growth strategy and 
substantial cash outflows over at least the next two years.

Rating Action
As we previously announced on Oct. 30, 2012, Standard & Poor's Ratings 
Services assigned its 'B' corporate credit rating to Carrollton, Texas-based 
CyrusOne Inc. The rating outlook is stable.

We are also assigning our 'BB-' issue-level rating and '1' recovery rating to 
operating subsidiary CyrusOne LP's proposed $225 million secured revolving 
credit facility due 2017. The '1' recovery rating indicates our expectation 
for very high (90% to 100%) recovery for lenders in the event of a payment 
default. In addition, we are assigning our 'B+' issue-level rating and '2' 
recovery rating to the company's proposed $500 million of senior unsecured 
notes due 2022. The '2' recovery rating indicates our expectation for 
substantial (70% to 90%) recovery for noteholders in the event of a payment 
default.

Rationale
We expect the company to use proceeds from the proposed debt financing to 
repay roughly $475 million of intercompany debt owed to CBI. Following the 
IPO, we expect CBI to own 9.8% of common shares in CyrusOne Inc., and a large 
majority of operating partnership shares in CyrusOne LP, which after a 
12-month lockout period, could be exchanged for common shares on a one-to-one 
basis. In addition, CyrusOne plans to convert into a REIT in conjunction with 
the IPO, which could occur in the fourth quarter of 2012 or early 2013. 

The ratings on CyrusOne Inc. reflect the company's "highly leveraged" 
financial profile, including our expectation for substantial cash outflows to 
fund what we consider an ambitious growth strategy. Pro forma for the proposed 
debt financing and initial $300 million IPO, liquidity will be roughly $500 
million, which we consider necessary to fund growth capital expenditures and 
shareholder distributions for roughly two years before CyrusOne will need to 
raise additional capital. Our assessment of the company's business risk as 
"weak" under our criteria takes into account our relatively favorable growth 
expectations for data center outsourcing by large business customers, but also 
recognizes the longer-term risks of aggressive expansion leading to pricing 
declines or higher customer churn.

We expect CyrusOne to record healthy revenue growth (+20%) for the next 
several years, based on the development of new colocation space and increased 
demand from new and existing customers. As a result, we currently view these 
revenue trends as supportive of CyrusOne's aggressive growth strategy. 
However, we believe its ongoing capital needs expose the company to unexpected 
shifts in supply and demand fundamentals, or to adverse credit market 
conditions if it is unable to scale back capital spending in a timely manner.  
 

CyrusOne provides physical colocation space through 23 data centers in 9 
markets, with a high degree of revenue and square footage concentration in 
Cincinnati and various Texas markets, including Dallas and Houston. The 
company targets large, enterprise customers, with no one customer(excluding 
CBI) accounting for more than 8% of annualized rent. There is a degree of 
revenue concentration in the energy industry, which accounts for 38% of 
annualized rent. However, we believe the company's enterprise customers 
currently outsource only a modest percentage of their datacenter needs, 
providing healthy growth potential in the energy sector and other verticals, 
such as online media and content companies.  

We believe the company's focus on large enterprise customers has resulted in 
lower revenue churn (3% for 2011 and 4% for the first nine months of 2012) 
compared with peers that have a greater mix of more volatile, small- to 
medium-sized customers (SMB) or Internet-based businesses. CyrusOne has been 
aggressively adding colocation space, which totaled 895,753 square feet as of 
Sept. 30, 2012, with 78,000 square feet of colocation space under development 
and 762,000 of powered shell space available for future development. To 
diversify revenue streams, CyrusOne also focuses on growing high-margin 
interconnection revenue, which currently accounts for a negligible amount of 
total revenue. We believe interconnections create network effects and will 
increase the retention of CyrusOne's existing customer base and attract new 
customers in underpenetrated verticals. However, in our view, it could take a 
number of years to meaningfully grow this revenue stream, because of the 
company's need to attract more telecom carriers or large Internet companies to 
many of its data centers. 

Under our base case scenario, we believe colocation space will continue to 
rise at current rates of about 20%, and that revenue growth per square foot 
will begin to benefit from increased interconnections over the next few years. 
We believe the utilization rate, which was 78% for the third quarter of 2012, 
could decline further in the fourth quarter and potentially remain below 80% 
in 2013 because of new colocation space added in Phoenix and Dallas. As a 
result, we expect total revenue growth in the low-20% area over the next few 
years. We believe the EBITDA margin, which was very healthy compared with the 
peer group at roughly 53% for the 12 months ended Sept. 30, 2012, could drop 
modestly to the high-40% to low-50% area over the next 12 months, because of 
the dip in utilization, but could grow to the mid-50% area in the longer term 
because of growth in high-margin interconnection revenue. We believe that 
EBITDA will increase at a mid-teen to low-20% rate in 2012 and 2013, which 
could accelerate in later years if the company is able to expand EBITDA 
margins and grow interconnection revenue. 

Pro forma debt to EBITDA (adjusted for operating leases) was high, at roughly 
5.4x for the 12 months ended Sept. 30, 2012. We expect this ratio to fall to 
the low- to mid-4x area in 2013 because of EBITDA growth. We believe that 
discretionary cash flow will be in the negative $150 million to $200 million 
range over the next few years, because of sizeable capital expenditures and 
shareholder distributions. 

Under a REIT structure, the company will be required to payout at least 90% of 
taxable income in the form of shareholder distributions. We expect taxable 
income to be modest over the next several years, and as a result, we have 
estimated potential distributions as a percentage of funds from operations 
(FFO). Our expected FFO payout ratio is based on industry peers such as DuPont 
Fabros Technology Inc. and Digital Realty Trust Inc., which had payout ratios 
of 34% and 68%, respectively, as of the second quarter of 2012. Based on these 
peer payout ratios, we have estimated annual distributions of about $40 
million to $50 million over the next few years, which will continue to 
increase with growth in EBITDA. As a result, we expect the company's total 
coverage ratio (including interest expense and distributions) to be in the 
high-1x area over the next few years. REITS such as DuPont and Digital tend to 
have total coverage ratios in the low-1x area; however, these companies have 
higher leverage, preferred dividend payments, and mandatory debt amortization. 

Liquidity
We consider CyrusOne's liquidity as "adequate," based on our criteria. Pro 
forma for the proposed financing and IPO, we expect sources of liquidity to 
include cash of roughly $275 million and full access to the proposed $225 
million revolving credit facility. We assume funds from operations will be 
about $90 million to $100 million in 2013. Uses of liquidity include modest 
working capital cash usage as the company continues to rapidly expand, and 
sizeable capital expenditures, which we estimate will be in the $200 million 
to $250 million range over the next several years. 

Under a REIT structure, the company will be required to payout at least 90% of 
taxable income in the form of shareholder distributions. Because of our 
expectation of negligible to modest taxable income over the next few years, we 
have estimated distributions based on a percentage of FFO and adjusted funds 
from operations (AFFO). To compute AFFO, we subtract from FFO certain 
recurring real estate expenses, such as maintenance capital spending and 
leasing costs. Based on peer payout ratios, we have estimated annual 
distributions of about $40 million to $50 million over the next few years, 
which will continue to increase with growth in EBITDA.

We expect the company to maintain an adequate cushion of compliance against 
all its covenants. The proposed revolving credit facility contains financial 
covenants, including an initial 2.5x senior secured leverage covenant, which 
steps down to 2x in 2015. The credit agreement also contains a 2x fixed-charge 
covenant, with no step-downs, and an initial total debt to gross asset value 
covenant of 55%, which tightens to 50% in 2015. 

Outlook
The rating outlook is stable, based on our expectation that the company will 
have adequate liquidity to fund growth initiatives and negative discretionary 
cash flow over at least the next two years. Since we expect the company to 
pursue aggressive capital spending over the foreseeable future, and continue 
to experience discretionary cash outflows, an upgrade would most likely be the 
result of a reassessment of the company's business risk profile to "fair" from 
"weak." Specifically, we could raise the rating if the company continues to 
successfully increase its scale, diversify its customer vertical base, and 
grow high-margin interconnection revenue. An upgrade scenario would also 
require our confidence that the company will remain well-capitalized, and 
maintain adequate liquidity despite capital spending and shareholder 
distributions. 

Conversely, we could lower the rating if operating performance weakens because 
of competitive pressure or over-expansion, causing utilization to tumble to 
the low-70% area and debt to EBITDA to rise to 6x or higher, with little 
prospect for improvement. A downgrade could also occur if we came to view 
liquidity as a significant risk, because of an unwillingness to scale back 
capital spending in conjunction with deterioration in operating trends coupled 
with adverse credit market conditions.

Related Criteria And Research
     -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
     -- Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
     -- Criteria Guidelines For Recovery Ratings On Global Industrials 
Issuers' Speculative-Grade Debt, Aug. 10, 2009 
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008
     -- 2008 Corporate Criteria: Rating Each Issue, April 15, 2008 
     -- 2008 Corporate Ratings Criteria: Ratios And Adjustments, April 15, 
2008 

Ratings List

New Rating

CyrusOne Inc.
 Corporate Credit Rating                B/Stable/--        

CyrusOne Finance Corp.
 $500 mil sr unsecd nts due 2022        B+                 
   Recovery Rating                      2                  

CyrusOne LP
 $225 mil revolving bank ln due 2017    BB-                
   Recovery Rating                      1                  
 $500 mil sr unsecd nts due 2022        B+                 
   Recovery Rating                      2                  
 

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