Digital Realty Trust Signals Problems in the Data Centres

One week after datacenter services company Equinix (NASDAQ: EQIX  ) disappointed the market with a lackluster set of results, it was datacenter REIT Digital Realty Trust's (NYSE: DLR  ) turn to indicate that industry conditions are getting tougher. But is this a short-term growth hiccup or a longer-term problem? And with behemoths like Google (NASDAQ: GOOG  ) and Amazon's Web Services, or AWS, rolling out their own datacenters, are Equinix and Digital Realty headed for more difficulty?

Digital Realty reality
Digital Realty reported funds from operations, or FFO, of just $1.10 in the third quarter compared to analyst consensus of $1.20. FFO is just a metric that REITs use to equate to EPS. Although $0.07 of the "miss" is due to a rent expense adjustment, its core FFO still only came in at $1.16.

Moreover, its guidance for 2014 was disappointing. Quoting from its conference call:

We are revising our 2013 FFO per share guidance to $4.60 to $4.62, down from $4.73 to $4.82 previously, and revising guidance for 2013 core FFO per share to $4.65 to $4.67, down from the prior range of $4.74 to $4.83

This adjustment is a reduction of 3.5% or $0.17 of EPS at the mid-point of guidance, but to be fair to Digital Realty, $0.07 is due to the aforementioned rent adjustment and $0.03 is due to a joint venture with Prudential.

However, the worrying bit is the $0.06 that is due to "delayed lease commitments." In other words, customers are not utilizing the datacenter space—that they signed up for—as quickly as Digital Realty had anticipated. This is a sign of a maturing industry, or at least, one in which the customers have the upper hand with regard to pricing negotiations. Moreover, in its earnings release, Digital Realty gave preliminary guidance for 2014, and informed investors that rental rates on renewal leases are expected to be roughly flat on a cash basis, along with operating margins "approximately 25-75 basis points lower than the historical run rate."

In other words, Digital Realty is finding it harder push through price increases. Another sign of a maturing industry.

Equinix deals with reality
These industry trends are confirmed when looking at Equinix's recent results. There is a more detailed analysis of them linked here.

Equinix had lowered earnings guidance already this year, and its third quarter results also contained some negative nuances. Its deal sizes are getting smaller, while its sales cycles are lengthening. However, Equinix's management argued that it was primarily a consequence of delays caused by enterprises planning more complex hybrid cloud deployments:

I don't believe they are really just driven per se by macroeconomic uncertainty or a broader enterprise anxiety or anything like that... ...just driven by the fact that the decisions of CIOs to move to sort of hybrid cloud infrastructures

Partially in response to these developments, Equinix strengthened its relationships with Microsoft's (NASDAQ: MSFT  ) cloud platform, Azure/and also with AWS. The idea being that Equinix's customers will find it easier to build out their hybrid clouds from within its [Equinix] infrastructure. In fact, Equinix sees the development of cloud services from the likes of Google, Amazon and Microsoft as a net positive in the long-term.

The bottom line
Essentially, the evidence is that the datacenter market is maturing and pricing power appears to be moving away from the datacenter providers and toward the buyers. Meanwhile, its incumbents are still investing in new capacity. Investors in datacenter providers InterXion, Telecity and DuPont Fabros should take note.

Whether the issue is going to be prove relatively short term (as is implied by Equinix's arguments over the hybrid cloud deployment issue), or if it's simply a function of oversupply, the near-term outcome is likely to be similar. The industry is facing some pressures and cautious investors should wait until there are signs of pricing power returning.

Is Equinix in a Bubble About to Burst?

Those of you old enough to be investing before the year 2000 will recall that there there was another recession in the last decade or so. Many investors have forgotten about the technology boom and bust that occurred at the start of the last decade. However, in certain sectors like telecommunications and Internet infrastructure, the scars still run deep. Indeed, stock prices of data center providers like Equinix (NASDAQ: EQIX  ) , InterXion (NYSE: INXN  ) , and the U.K.'s Telecity are all down in 2013, largely because of fears of the sort of overcapacity that plagued the economy after the tech bust. Are the concerns justified? Is now a time to buy?

As is always the case in investing, the answer is yes, and also no.

Why it's a "no"

Economics 101 will tell you that most industries follow a pretty familiar path. High profits in an industry tend to encourage new entrants (or in this case, encourage existing providers to invest in new data centers), and capacity increases as everyone enjoys profits. After the initial profit euphoria, history tells us that firms tend to over-invest, only to then see profitability fall as too much supply is on tap. Indeed, all the leading players have been aggressively expanding data center capacity in recent years.

Of course, the problem for investors comes when profitability starts to fall in anticipation of tougher conditions. Analysts start downgrading their price targets, and suddenly the roof caves in on your stock. Everyone then realizes that end-demand was vastly overestimated. All of this happened in 2000 with Internet infrastructure darlings like Cisco Systems (NASDAQ: CSCO  )  and Alcatel-Lucent. The fallout was painful.

CSCO data by YCharts

Fast-forward to today and there are signs that the data-center providers may be facing overcapacity issues. The single best indicator is probably gross margin. Decline is an indication of a drop in pricing power, while an increase represents the contrary.

INXN Gross Profit Margin Quarterly data by YCharts

Gross margins look like they are moderating for InterXion and Equinix. Furthermore, Telecity saw its gross margin decline in the first half from 57.3% last year to 56.9% this year. Telecity's revenue per occupied square meter increased only 2.1%, which suggests that future revenue increases will come from capacity expansion rather than pricing.

Turning to Equinix, it reduced its forecast for second-half revenue growth, partly because it saw softer conditions in Germany, longer sales cycles within its enterprise markets, and its average deal size appears to be getting smaller. All three are signs of slower growth. 

InterXion gave results in August, stating:

Customers continue to have extended decision-making time frames, but demand remains healthy and the pricing environment is consistent with previous quarters, as is the sales pipeline.

Again, when sales cycles get longer, it is usually a sign of a slowing market. If pricing is consistent, it implies the industry players are finding it harder to increase them.

Why it's a "yes"

This isn't the late 90s. It really is different this time around because long-term demand looks much better-placed.

Internet-enabled devices -- smartphones, tablets, etc. -- simply weren't available back then in order to drive demand for all the network capacity that had been built up. It's a different story now. AT&T and Verizon are both seeing strong smartphone subscriber growth, and Intel has had to take substantive action to change its business, thanks to the shift to mobile devices.

It's a similar story with corporate demand for cloud computing, and software as a service (SaaS) applications. All of which is leading to demand for data centers to store information and applications for corporation. Moreover, financial services firms are not displaying any slowdown in their desire to use increasingly complex trading systems.

Data center demand remains high as evidenced by Cisco's revenues.

source: company accounts

Where next for Equinix?

In conclusion, end demand does appear to be slowing, and analysts/investors are starting to downgrade expectations. However, this is arguably reflected in Equinix's  share prices right now. The key valuation metric -- as defined by Equinix -- is the 'adjusted discretionary free cash-flow.' Roughly speaking, this is the free cash flow generated if you strip out the expansionary CapEx. In its last update, Equinix forecast this figure to be around $620 million to $640 million for 2013, which represents around 5.2% of its current enterprise value. 

 

The valuation looks fair, but the stock carries the normal risks inherent in industries that are facing short term risk. If you are a cautiously minded investor, you might wait for a better entry point to compensate for the risk that margins start to fall. Alternatively, you could monitor gross margins, and industry pricing power in order to gauge when the demand has caught up with capacity.