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Benefit from Data Centers with These REITs

May 29, 2014 | About:
Vinay Singh

Vinay Singh

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When the Federal Reserve recently hinted that a reduction in their monthly bond-buying program is likely, it shook the entire stock market. Assumed interest rate sensitive areas like the real estate investment trust (REIT) sector were especially hard hit. For example, the iShares DJ US Real Estate ETF, one of the largest in the REIT category, dropped about 16% over the last few months.

As REITs took their hits, the data center subsector became very interesting. The industry's fundamentals looked good, its future seemed promising and valuations appeared attractive. The evidence supported taking a position, but a nagging question remained. Would it be a short-term play or could the sector be relied on for larger longer-term gains? Here's a quick summary on the group’s status.

The What and Why of Data Centers

Data centers are buildings that house a large number of computer servers and include the key infrastructure needed for their optimal operation. In the past, most companies kept their data center requirements in-house. However, a combination of globalization, bandwidth intensive applications, and cloud computing access, plus tight corporate budgets, made the use of data centers increasingly sagacious.

The industry has grown significantly thanks to the favorable conditions. In general, revenues for the sector have more than doubled since 2008 and analysts believe there’s continued growth of around 10% a year for at least the next four years. Since data center REITs are just as profitable as other real estate peers, but with a much lower debt profile, this conducive environment looks to offer room for meaningful advancement.

There are some concerns, however. A major worry is the concentrated customer base these REITs seem to have. Digital Realty Trust (DLR), a leading global provider, had 20 of its largest tenants generating 47% of annualized rent with the top three tenants generating 17% in 2012. DuPont Fabros Technology (DFT), a smaller player, reported that three of its largest renters accounted for 48% of revenues. The risk to operations from a single defecting large client seems a real one.

Some Notable Data Center REITs

Given the pros and cons, the sector looks worthy of further investigation. Here are some key companies:

Digital Realty Trust, having 127 properties with 23.7 million square feet worldwide, is a major player. It reported revenues of $363.5 million in the latest quarter, up 19.7% from the prior year. Booked funds from operations (FFO) came in at $167.8 million, up 5.2%, with adjusted FFO rising 11.2%. FFO is an alternative financial measure used by the real estate industry to measure operating performance. FFO basically represents normally derived net income excluding items like impairment charges, gains and losses on real estate sales, and depreciation/amortization expenses.

An aggressive expansionary company, Digital Realty shares look interesting. Using a cash earnings times a capitalization multiplier valuation, fair value looks around $63 a share at a 22 times multiple, discounted from the REIT current average 28 times multiple. Fair value is based on revenues of around $1.5 billion, cash earnings of $370 million, and a cash profit margin of around 24.7%.

DuPont Fabros Technology is a smaller operator. It has 10 data centers located in four major U.S. markets with a total of 2.5 million square feet. For its latest quarter, the company reported FFO of $37.9 million, a 22.7% jump from 2012. Revenues increased 11% to $91.6 million.

While the company is currently focusing on maximizing occupancy, they are also developing a new location. The property, called ACC7, will be the first built using the company's new efficient power usage design which should result in reduced energy costs for customers and lower operating costs. DuPont Fabros also has a common stock repurchase plan in place, a rarity in the REIT world. The program is for up to $80 million and has repurchased $37.8 million or 1.63 million shares so far.

The company’s shares seem to be attractively priced with a reasonable business value around $27 per share at a 22 times multiple, given it can maintain revenues of around $370 million, cash earnings of $80 million, and a cash profit margin of around 21.6%.

Equinix Inc. (EQIX), which connects more than 4,000 companies inside the world’s most networked data centers, is a little different than the REITs previously mentioned. It is not currently a REIT but is pursuing conversion and plans to make an election for REIT status for the taxable year beginning Jan. 1, 2015.

The company is also more of a hands-on data center operator, offering additional services such as technical support, remote services and network monitoring more freely than other providers do. Its focus on having a wide ranging neutral interconnection communication hub for cloud service providers, large financial companies, network service operators and other large enterprises gives it a key competitive advantage. The company’s scope also means that it has a more diverse customer base. No single client accounts for 10% or more of sales.

Equinix revenues were $525.7 million for its latest period, a 15% increase over the same quarter last year. Income from continuing operations was $112.2 million, a 10% increase, and a FFO equivalent was $163 million, or near 8% higher than in 2012.

Equinix stock looks slightly rich presently with reasonable fair value around $158 a share at a modestly discounted 20 times multiple. The calculation is based on revenues of around $2.3 billion, cash earnings of $386 million, and a cash profit margin of around 16.8%.

Conclusion

Data center REITs certainly look intriguing. Their story seems solid and valuations appear mostly inviting but the sector hasn’t been as time-tested as most of its REIT brethren. It’s not quite clear how data center REITs will fare over the long-term in a less favorable and more competitive environment. Nonetheless, at least at this time, they seem a valid investment consideration.


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