Data warehousing stocks are beginning to surmount the rough patch that many REITs experienced last year, when some companies' shares dropped more the 10% on concerns about rising interest rates. Yet the sector as a whole is rebounding and looks to post further advances. Shares of some of the bigger players in the data center business are up more than 15% this year. Although chip hardware manufacturers have all posted revenue decreases due to a temporary lull in capital spending by large cloud providers, that doesn’t change the fact that data center traffic is projected to increase at a brisk 25% rate through 2021.
Data centers provide hubs for corporate customers to store data, access the internet and connect to external cloud providers such as Amazon. Although the need for tertiary hardware/chip components may be slowing down currently, companies will continue to migrate their IT needs to the cloud because of the flexibility and cost savings. Data centers will be needed regardless of demand for processors and video graphics components. In other words, data warehousing centers are not as sensitive to the level of existing capital spending by cloud providers as companies such as Intel (INTC, Financial), Nvidia (NVDA) and Samsung, all of which saw revenue declines due to weaker demand.
Overall, stocks in the data center sector are selling at enticing valuations. Data warehousing stocks trade at 94% of their net asset values, versus 100% for the overall REIT market. They sell at 18 times estimated adjusted funds from operations (AFFO), an index that measures a REIT’s operating cash flow, compared with 20 times for the entire REIT sector. According to Nate Crossett, an analyst with Berenberg Capital Markets, data centers are projected to grow at an AFFO rate of 10% versus 6% for all REITs from 2019 through 2020.
Two stocks are well situated to participate in this expansion: Equinix (EQIX, Financial) and CoreSite Realty (COR, Financial). Both companies concentrate on the retail data warehousing sector. There are two types of data centers that address the diverse IT and cloud computing needs of corporations. One is retail warehousing sites, where companies use extensive networks to exchange information and to access external cloud service providers such as Microsoft (MSFT, Financial) and Amazon (AMZN, Financial). The leasing rates for retail centers are generally more profitable than leasing rates for wholesale centers, which specialize in providing networking systems for large companies.
Equinix is the largest REIT in the data center sector by revenue. The company runs 200 data centers in 52 urban regions worldwide. Equinix focuses its business on dense networking centers that pack hundreds or more customers into network-intensive digital systems. Equinix’s customers prefer the dense locations as the proximity helps reduce latency (data lagging).
The company expects sales to increase 9% through 2022. Although this is a drop from its heyday of 18.2% growth, its bottom line is still expanding at a 10% AFFO rate. The current yield is only 2.3%, but with free cash flows increasing, shareholders can expect an increase in the payout.
CoreSite (COR, Financial), with a market capitalization of $3.6 billion, targets the same retail warehousing market as Equinix, but on a smaller scale. It has the second highest footprint in the Virginia/Washington, D.C., corridor as a percentage of its client roster. While Equinix may have more centers, CoreSite’s locations, such as the data-intensive Washington, D.C., area, are considered prime. It is second only to Equinix in number of cloud on-ramps, representing 6.5% of the data center sector total.
The company recently reported that recurring monthly revenue increased more than 6%. In those metro areas where Equinix’s centers are full or it has no presence, CoreSite can sign up customers who may have otherwise signed on with Equinix. CoreSite’s operating costs are relatively low, as it uses third-party vendors to manage its software networking needs.
The downside for the company is that its existing centers are nearly running at capacity, which could crimp future growth. Analysts expect that AFFO will increase only 3.5% in 2019 for $5.01 per share. Unlike some other data center firms, CoreSite has never issued stock to fund a deal or a warehousing development. The stock is currently yielding 4.3%, which is at the high end for the industry, and the good news is that it has grown at a rate of 29% per year for the past five years.
The risks facing data center companies are not insignificant. Although the REIT sector benefits from the Fed’s current 2019 policy of not increasing rates, this posture is not written in stone. Another risk is that big cloud services providers like Amazon will build their own data centers instead of contracting out to third-party warehousing vendors. Although they are projected to grow, leasing levels are coming off the record levels of 2018. And, although price competition among data center providers is heating up, this is occurring more in the wholesale end of the business, though it may impact the retail centers in the future.
Since most corporations will inevitably move to cloud computing, enterprising investors who can stomach short-term downturns in the sector may consider a purchase at current valuations a good addition to their portfolios.
Disclosure: I have no position in any of the securities referenced.