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Bill Stoller
March 1, 2018
7 Min Read
NYSE trading floorSpencer Platt/Getty Images
Recognizing when public company shares are trading below their intrinsic value is one of the secrets to becoming a successful investor. Unfortunately, it’s easier said than done.
Savvy investors understand the challenge of weighing subtle variables. Those variables are difficult to identify and quantify, but they do exist, often lurking just below the surface.
A Rough Start to 2018
Over the past two years, data center REITs chalked up an impressive track record of double-digit revenue and earnings growth that resulted in relative outperformance during those years.
But that streak ended abruptly in the first two months of 2018. Why has the bloom suddenly fallen off the rose? The self-fulfilling prophecy that all REITs, regardless of sector, are roadkill in a rising-rate environment is a lazy explanation.
There may be a more fundamental reason for data center REIT underperformance beyond a first-level narrative that REITs are simply bond substitutes. Arguably, the confluence of management teams investing in future growth at a time when investors are focused on short-term rates and seeking higher returns is a double-whammy for data center stocks.
Ignoring Growth?
In a rising-rate environment, the best defense for any dividend growth stock is the ability to grow earnings much faster than inflation and rate hikes.
This is where data center stocks have an advantage over more traditional real estate asset classes which are leveraged to GDP growth, employment, consumer spending, etc. Data center investors benefit from tailwinds of exponential global data growth and related IT spend by cloud and SaaS providers, content, and streaming media, Big Data and AI, wireless data, IoT, and an enterprise shift toward hybrid IT architecture and outsourcing to third parties.
It appears concerns regarding rising interest rates have trumped the higher growth narrative, resulting in a data center stock sell-off. But there could be other factors contributing to the recent price weakness in data center REIT shares.
The Supply Enigma
The Q4 2017 results are in for all five data center REITs, and it’s crystal clear that Mr. Market is not impressed.
It appears many investors remain concerned about the supply and growing "shadow supply" lurking under the surface in top US markets.
Shadow supply can be tricky. Many projects are announced with great fanfare and then struggle to get built. There are massive campus projects announced where years can elapse prior to moving dirt, or just a small fraction of capacity is built initially.
However, difficult as it may be, tracking supply is the easiest part of the puzzle.
The Demand Dilemma
The commensurate level of demand is much harder to ascertain. Since Q4 2015, hyper-scale cloud has changed the net-absorption dynamics in the largest US data center markets.
It requires piecing together a picture with partial information gleaned from a variety of sources. Data center landlords, brokers, design consultants, and contractors operate in a world where non-disclosure agreements are common.
Supply is relatively clear compared with demand estimates, which are murky at best and almost always anecdotal. This makes it particularly challenging for analysts and investors to weigh the information they receive from management regarding sales funnels and deal pipelines.
Additionally, at a time when most incumbents in low-barrier to entry markets like Dallas, Phoenix, Atlanta, and Northern Virginia are expanding, there are fresh players popping up powered shells like mushrooms after a rain shower. Investors see the supply growing, without a clear view of the demand supporting the increased pace of development.
Keeping Score is Difficult
On one hand, a strong wholesale leasing quarter with signature hyper-scale wins is always heartening for investors. However, winning the leasing derby in a quarter is not necessarily an automatic recipe for success.
If wholesale leasing is strong in a quarter, concern immediately shifts: Is this a one-off? On the other hand, if leasing is below guidance for the quarter, investor concern immediately shifts to interpreting those tea leaves. In a sense, it is a no-win situation for wholesale-focused data center REITs, unless each quarter features solid results or an increase in guidance.
There is another troubling issue: How much of the reported demand is being double and triple counted? This underscores the very real concern facing investors: a zero-sum game where there will be only one winner. This fear is exacerbated by the inherently lumpy nature of landing super-wholesale deals, which can involve total investments of $250 to $500 million and sometimes even more.
Organic Growth and Expansion
The scale of new wholesale powered shells and price of land for data center campuses has increased dramatically during the past 18 months. Therefore, new builds require greater amounts of capital. Even when de-risked by pre-leasing, these large-scale projects will become a drag on earnings until they are substantially completed and reach stabilized occupancy.
In the short-term, buying land for new campuses or offering customers opportunities to expand in existing campuses or new metros will be dilutive. However, it is crucial to have data center halls available to lease to capture a portion of the demand in each market. Of course, there is less risk if there is a leasing backlog, an anchor tenant pre-leases space, or in developing build-to-suit projects.
Expensive M&A
Notably, the M&A environment that has become particularly expensive of late. The competition for attractive acquisition targets heated up considerably in 2017 -- a record year for data center deals.
Iron Mountain, for example, paid up handsomely to acquire IO Data Centers in a $1.3 billion deal that triggered a sell-off in IRM shares, because it was dilutive to existing shareholders. The IO deal was underwritten to break even or be slightly AFFO-positive after two years.
Iron Mountain's core document and magnetic tape storage businesses are not fast-growing businesses like data centers, which exacerbated the sell-off.
Equinix announced the $792 million Metronode acquisition at the tail end of 2017. In February, on the same day it released its Q4 earnings, the company announced acquisition of the Infomart Dallas building for $800 million. Former CEO Steve Smith confirmed in January that Metronode was purchased for about 31x EBITDA; at first blush, the Infomart deal appears to be even more pricey.
However, both deals will be accretive to AFFO after the first year, according to management. The key will be the ability to sell into existing capacity in both Dallas and Australia.
Another deal announced at the end of 2017 was CyrusOne acquiring European data center operator Zenium for $442 million. This strategic acquisition followed on the heels of a $100 million investment in Chinese carrier-neutral data center operator GDS Holdings.
Upon closing, Zenium gives CyrusOne inventory to sell in London and Frankfurt, as well as land for expansion. However, once again, this deal will initially be dilutive to earnings and not accretive until year two, according to management.
This CyrusOne slide captures the essence of the dilemma publicly traded data center REITs face:
Pricey strategic M&A is a headwind for earnings growth. Purchasing land to expand existing campuses and enter new markets is also initially dilutive. Even successful strategic investments like CyrusOne’s $100 million stake in GDS Holdings are not going to generate additional cash available for distribution. Building massive powered shells to ensure adequate capacity to serve existing hyper-scale customers is dilutive until the space is occupied and generating rent to help grow EBITDA.
Investor Edge
The rising rate environment is masking some of the dynamics at work when it comes to publicly traded data center REIT valuations. There are investors who are selling REITs, including data center REITs, in a rising rate environment. But the reasons for the lack of buyers are far more nuanced.
Confidence in management's ability to execute on a strategic business plan is crucial. However, the lack of visibility into wholesale demand when supply is growing creates uncertainty. It is incumbent upon management teams to do a better job to educate investors regarding demand for wholesale space, and why it is crucial to keep the pedal on the metal and fund growth initiatives in the face of increasing competition.
If management teams did not invest in growth initiatives to take advantage of secular growth trends, shareholders would be outraged. Paying a high premium to acquire strategic assets upsets them as well. The recent price action underscores the need to focus on block and tackle organic double-digit earnings growth.
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