Equinix to Build More Owned Data Centers with “Nodes” for Cloud Giants

DCK Investor Edge is a weekly column about investment in the data center market, covering both publicly traded data center REITs and privately held players in the space. More about the column and its author here.

Global interconnection giant Equinix is not changing its business model. However, the line is blurring between what constitutes wholesale data center and retail colocation deployments. This is especially the case when it comes to the largest consumers of data center space, the hyper-scale cloud service and Software-as-a-Service (or SaaS) providers, social media giants, and other planet-scale tech platforms.

Winning the battle for data center customers now requires having secure, fast, and cost-effective alternatives to access multiple public cloud services and managed services vendors. Equinix is looking to get a competitive advantage by working closely with hyper-scale customers to attract highly profitable traditional enterprise customers for colocation cabinets and private cloud deployments.

Catching the Next Wave – Part II

Speaking at the Citi Internet, Media, and Telecom conference in Las Vegas earlier this week, Smith reviewed a busy 2017 and shared the company's near-term strategy, which includes "catching the next wave of cloud deployments" – something he’s been talking about frequently as of late. This was similar to the theme from last year's conference presentation, where cloud giants like Amazon Web Services, Microsoft Azure, and Google Cloud Platform were mentioned as potential anchor partners to help with international expansion by Equinix into new countries like South Korea, India, and South Africa.

Related:Equinix Wants to Do to Data Center Connectivity What AWS Did to Computing

But there was a new twist this time around. According to Smith, Equinix intends to proactively develop owned facilities that will incorporate 1MW to 2MW hyper-scale nodes -- described as "collapsed architecture" -- for the dozen largest cloud service and SaaS providers, plus Facebook and Apple.

Equinix is not looking to compete for the multi-megawatt super-wholesale deals. However, this new initiative does underscore the need for Equinix to own more of its facilities to compete for these hyper-scale customers on long-term leases (10 or more years).

Smith said Equinix expects to underwrite these hyper-scale deals at a mid-to-high teens project internal return rate (IRR). This is a much lower margin compared to the low-30s IRR underwritten for the development of Equinix data center space intended for retail cabinet deployments.

Other "next wave" initiatives discussed during the session included: Software Defined Networking and Network Function Virtualization, 5G, Big Data, new applications (use cases), major changes in the security space, and future storage trends. The focus on winning the submarine cable derby remains a corporate priority, with 28 to 29 Equinix data center locations mentioned by Smith as being "perfectly positioned" to win contracts for providing access to new cables being deployed.

Related:Google Cloud Makes Direct Connection Service Faster, Inks Equinix Deal to Expand Network

These initiatives are being spearheaded by a group of about 100 employees working as the "Next Wave" team led by former Equinix COO Charles Meyers. Essentially, this team is tasked with "future proofing" Equinix. The balance of the company’s 7,000 employees remain focused on daily operations and delivering the quarterly performance that Wall Street has come to expect from the connectivity-focused Equinix retail colocation business model.

Expect M&A to Continue

Over the last two years, Equinix acquired TelecityGroup in Europe, Bit-isle in Japan, completed and integrated the $3.6 billion Verizon data centers in the Americas last year, and finished 2017 with the announcement of a $792 million acquisition of 10 Metronode data centers in Australia, to be purchased from the Ontario Teachers Pension Fund. It had previously announced a $93 million acquisition of a Zenium data center in Istanbul, Turkey.

Equinix now has a market cap of $34 billion, making it one of the ten largest US real estate investment trusts (REITs). After the Metronode acquisition is completed, it will operate a network of 200 or so data centers in 52 markets, located in 24 countries.

Metronode Was Pricey

Notably, Smith confirmed that Equinix paid up in order to win the Metronode deal. I have heard the number of 31x EBITDA kicked around as the multiple. Smith said the deal was "in that zip code." It was by far the most expensive acquisition of 2017, in large part because of new institutional players and sovereign wealth funds looking to find a home for capital in the data center space.

The chief exec said that in addition to data center operators, Equinix had to beat out dedicated infrastructure funds, "and this new capital raised the bar." Keep in mind, Equinix trades at about 25x 2018 AFFO per share multiple, making the Metronode acquisition less of a stretch.

Additionally, Smith detailed that the Verizon Americas portfolio was fully integrated in December and confirmed that it continues to perform better than it was underwritten. Verizon Americas will be accounted for separately for two more quarters as a "carve-out," so performance can easily be tracked by analysts and investors. Verizon was a much larger acquisition, and the portfolio’s outperformance could in a sense help offset the high Metronode-deal multiple.

Investor Edge

The Republican tax bill passed in the US at the end of last year has changed the playing field for investors. There are concerns about too much of a good thing (GDP growth) and increased government borrowing to fund the deficit which is anticipated to grow significantly over the next 10 years.

The interest rate on the US 10-year Treasury Note spiked up above 2.5 percent last week. Many economists are predicting a 3 percent interest rate on the 10-year Note by the end of this year. The price of a barrel of oil has recently spiked up to highs not seen since December 2014. This is inflationary and could translate into a "shadow tax" on the consumer paid at the gasoline pump and for winter heating bills.

These macroeconomic factors have led to a sector rotation where materials, transports, manufacturing, and other sectors that benefit from the tax bill (and/or higher interest rates) are being bid higher. This has led to a solid start for the Dow 30, which continues to set new records almost daily. But dividend-focused sectors like utilities and REITs have not fared as well.

Data center REITs are no exception. They have sold off 4 to 5 percent during the first two weeks of 2018. Notably, Mr. Market is throwing out the million-dollar babies (data centers and wireless towers) with the REIT bathwater (slower-growth sectors). Data center landlords are putting new development capital to work at double-digit returns. Several, including Equinix, have guided to grow revenues and earnings (FFO/AFFO per share) at a double-digit clip as well to support exceptional dividend growth.

I believe that data center REITs are currently on sale, which I doubt will continue after the fourth-quarter and full-year 2017 results are announced in February. Therefore, this would be an excellent time to put some idle cash to work if you believe the secular drivers of cloud, Big Data, streaming video, IoT, edge computing, and data center outsourcing will continue.