Digital Realty Sees Weaker Outlook, Prompting Selloff in Data Center Stocks

111-8th-Avenue

The exterior of 111 8th Avenue, where Digital Realty extended its lease in 2010. The company just took a $10 million charge related to the lease extension.

Stocks of data center providers fell sharply today after the sector's largest company, Digital Realty Trust, lowered its revenue guidance for the coming year, saying enterprise tenants were deploying new data center space more slowly than expected. The company also took a $10 million charge tied to an accounting error in revenue from a lease renewal at 111 8th Avenue in New York.

Digital Realty's stock plunged more than 16 percent on the news, dropping $9.12 to $48.90 in midday trading. Shares of other publicly held data center providers headed lower on the news, including DuPont Fabros (down 6 percent) and CyrusOne (off 4.7 percent). Two other companies, CoreSite and Equinix, sere 3 percent lower.

Digital Realty said it would buy back up to $500 million of its own shares to support its stock price. The company said it would also focus on selling data center space to smaller "mid-market" companies that are less likely to experience delays in deploying new space.

Slower Expansion Than Expected

Executives of Digital Realty said that some of the company's largest enterprise customers were delaying data center deployments within their leased space. Data center space is built and occupied in phases to manage the high cost of construction. Enterprise tenants lease large amounts of space to lock down capacity for future growth, but landlords don't begin receiving rent until the tenant moves into the new space. Digital Realty builds space in 1.1 megawatt suites (known as "pods")

Some of these large tenants are moving into the first phase of their space, but then taking longer than expected to move into the second and third phases of their deployments. This is particularly true with tenants who are outsourcing for the first time, and have miscalculated how soon they would need additional spoce.

"In many cases, their timeframes slid more than they thought, and we haven't been conservative enough in leaving wiggle room in these timelines," said Mike Foust, the CEO of Digital Realty.

Slower Payments, Not Lower Revenue

Foust emphasized that these tenants are still responsible for the leases, but it's taking longer for Digital Realty to realize revenue from those deals.

"We are disappointed with the third quarter financial results, but the robust leasing velocity gives us confidence in the underlying health of the business as well as customer demand for Digital Realty's data center solutions," said Foust. "While lease commencements have lagged our initial expectations, the solid backlog of leases signed-but-not-yet-commenced represents contractual obligations for future rental revenue, and sets the stage for healthy growth in cash flows over the intermediate term."

Given the delayed commencements, Digital Realty has trimmed its revenue guidance, lowring its projected funds from operations (FFO) to a range of $4.60 to $4.62 per share, down from the previous range of $4.73 to $4.82.

"We believe our revised outlook is a realistic assessment," said Foust. "

$10 Million Charge Tied to Lease at 111 8th Avenue

The third quarter results include a $10 million non-cash rent expense adjustment related to the company's lease at 111 8th Avenue in New York. In September 2010, Digital Realty signed a 10-year extension of its lease, pushing the expiration of its lease from June 2014 to June 2024. This appears to have occurred just prior to the building's sale to Google, which is reportedly inclined to let data center leases in the building expire so it can claim that space for its growing New York business offices (see Internap to Move Out of Major Manhattan Data Hub).

The lease extension allowed Digital Realty to lock down extremely valuable space in a key building, but the company failed to adjust the straight-line rent expense when the lease was modified in September 2010. The $10 million adjustment for this quarter reflects a "catch-up" of rent that should have been recorded.

The drop in Digital Realty's stock price may summon memories of a headline-making May presentation in which hedge fund Highfields Capital Management asserted that investors should short shares of Digital Realty Trust, saying the huge data center developer was understating the future investment in facilities that would be required to support its enterprise customers. Digital Realty said Highfields was “mischaracterizing its disclosures, but subsequently adjusted its accounting for capital expenditures for data center maintenance.

But Foust emphasized that leasing remains strong, and insited that indistry fundamentals were sound.

"We signed new leases totaling $47 million of annualized GAAP rental revenue during the third quarter, including nearly $28 million since the second quarter earnings call in late July," he said. "This represents the third-highest quarter in the company's history, and the dollar volume of leases signed year-to-date has already exceeded the full-year activity in 2012."