4 stocks to play the data-center boom

  • By Daren Fonda,
  • Barron's
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Data-center stocks may finally be getting over a rough patch. As real estate investment trusts, many fell more than 10% last year, hit by concerns about rising interest rates. A slowdown in the industry’s growth also weighed on sentiment.

Yet the stocks are staging a comeback and look poised for further advances. Shares of big names, such as Equinix (EQIX) are up more than 15% this year, beating the broader market. Rising rates may pose less of a threat, with the Federal Reserve striking a more dovish tone. The stocks have been revalued lower and now look cheaper than the broader REIT sector. And long-term growth drivers remain intact: Data-center traffic will increase at a 25% rate through 2021, predicts Cisco Systems (CSCO). And the number of giant “hyperscale” centers, built for firms such as Amazon.com (AMZN), is expected to increase by 50% through 2021, as companies increasingly shift to cloud-based services.

“The big macro trend is digital transformation,” says Charles Meyers, CEO of Equinix, one of the largest data-center REITs, in an interview with Barron’s. “Companies are evolving into a cloud-first world, and that is a major driver of our business.”

Data centers are the hubs and spokes of the internet for corporate customers. Companies lease space, based on their power needs, to exchange and store data, connect to cloud providers, and access the internet. The industry’s first wave of growth centered on telecom service providers that wanted neutral data-exchange sites as they built out the internet; outsourcing of corporate data centers came next as the internet gained traction.

The industry is now riding new waves of innovation. Companies are increasingly using multicloud architectures—relying on public cloud providers like Amazon Web Services for some applications while using private cloud infrastructures for others. Another big growth driver, says Meyers, is the marriage of artificial intelligence and big data. Retailers and insurance companies, for instance, are using AI, or machine-learning, techniques to analyze vast quantities of data to price goods and services more effectively. “Companies are placing large amounts of data at Equinix facilities and they’re using AI to develop business insights,” he says. Longer-term, he sees demand from blockchain applications and “edge” networks that will support autonomous driving and the internet of things.

Barron’s found four leading companies whose stocks look compelling: Equinix, CoreSite Realty (COR), Iron Mountain (IRM), and Dutch firm InterXion Holding (INXN), whose common stock doesn’t pay a dividend.

Equinix, CoreSite, and InterXion focus on “retail” data centers: network-dense campuses where companies exchange information and access cloud providers like Amazon, which also runs its own data centers. Leasing rates for retail look more favorable than those for “wholesale” centers, which focus on storage and networking for large companies and cater to hyperscale customers, according to Nate Crossett, an analyst with Berenberg Capital Markets.

Iron Mountain is primarily a document-storage REIT, but it’s leveraging its corporate relationships to move into data centers. The company is also a compelling yield play: The stock yields 6.9%, well above REITs’ average of 3.8%.

Data centers do face challenges. One concern is that the big cloud providers build more of their own data centers, relying less on third-party sites. There’s also a growing trend toward “software-defined” networks that stitch together servers without the need for physical cables in a data center.

Moreover, the industry is at the mercy of tech spending trends. Semiconductor manufacturers Intel (INTC), Nvidia (NVDA), and Samsung Electronics (SSNLF) recently reported weaker demand for chips used in data centers. Amazon.com, Facebook (FB), Alphabet (GOOG), and Microsoft (MSFT) have signaled that 2019 capital expenditures will be strong, but signs of a slowdown would probably depress data-center stocks.

Leasing volumes for the centers, meanwhile, are coming off record levels in 2018. And price competition is heating up, especially in the wholesale and hyperscale arenas, where private capital has flooded in and funded start-ups.

Indeed, while hyperscale is a big growth area, companies are reporting development yields on new projects below 10%, down from the midteens a few years ago. Yields of 9% on new projects are still good, compared with those in the broader real estate world, but the question is: How low will they go?

One other caveat: the industry perpetually issues equity and raises debt to fund growth. Digital Realty Trust (DLR) has been particularly acquisitive, buying a Latin American data center, Ascenty, last year for $1.8 billion, and issuing 8.5 million shares of common stock. Other data-center outfits are making acquisitions that could pressure returns on capital and profits.

Nonetheless, this is still a growth industry, with relatively good valuations. Data centers trade at 94% of net asset value, versus 100% for REITs overall. They go for 18 times estimated 2019 adjusted funds from operations, or AFFO, a REIT measure of operating cash flow, versus 20 times for REITs in general. Data centers are forecast to grow AFFO at a 10% rate, versus 6% for all REITs, from 2019 to 2020, according to Crossett. “They’re trading at some of the best levels since late 2015,” he says.

Equinix, the largest REIT in the sector by revenues and enterprise value ($43.1 billion), runs 200 data centers in 52 metro areas worldwide. It focuses on interconnect: networking hundreds or thousands of customers into dense digital ecosystems. The more customers packed into a data center, the more valuable the location. Clients want proximity to one another to exchange data and reduce latency (the delay in data transmission), and they want to be in the metropolitan areas where data traffic is growing fastest.

Equinix has made several acquisitions to expand its global scale. The firm is now digesting a large portfolio of Verizon assets, along with data centers in Australia and Dallas. These deals should help win customers: If companies such as Amazon locate servers in an Equinix facility, businesses will follow for connections to their cloud services. Equinix already has the most cloud on-ramps of any data center—52% of the total, according to Crossett.

Granted, Equinix expects sales to increase 9% a year through 2022, less than half its 18.2% rate over the past five years. Meyers says it’s tougher to grow that fast off a larger revenue base. But the bottom line is still climbing at a healthy 10% rate, based on AFFO. The shares yield only 2.3%, but with cash flows rising, Equinix is likely to steadily grow its payout. The company “should consistently deliver the strongest organic growth among data-center REITs,” says Jefferies analyst Jonathan Petersen. He has an Outperform rating on the stock and recently raised his price target to $500.

CoreSite is a smaller version of Equinix, with a market cap of $3.6 billion. It has the second-largest exposure to the thriving northern Virginia/Washington, D.C., market, as a percent of its portfolio. The firm’s locations are considered prime. It has the most cloud on-ramps after Equinix, with 6.5% of the industry total. The company recently reported that occupancy at its facilities increased by 0.4%, to 92.8%, and monthly recurring revenue rose more than 6%, a good sign for pricing, according to Crossett.

CoreSite can pick off customers in U.S. metro areas where Equinix’s data centers are either full or the company doesn’t compete. Its operating costs are relatively low, partly because it uses external vendors to manage software networking.

CoreSite’s biggest problem is its data centers are nearly full, limiting growth. Analysts expect AFFO to rise just 3.5% in 2019, hitting $5.01 per share. But its pipeline as a percentage of rental square footage is, at 47%, one of the highest in the industry. That should help lift AFFO 7.9%, to $5.41 a share, in 2020, according to consensus estimates. CoreSite has never issued equity to fund a deal or development. The stock’s 4.3% dividend yield is on the high end for the industry, and it has grown it at a 29% annualized rate over the past five years.

Investors view Iron Mountain’s document-storage business as a melting ice cube; who needs to store boxes of paper in an increasingly digital world? But the company’s paper volumes largely have held steady, fueled by sales in Europe and emerging markets, regulatory requirements for document retention, and outsourcing of storage by the U.S. and other governments. The company is also shifting to more digital services, such as document coding and analytics in a partnership with Google.

Iron Mountain looks appealing as an emerging play on data centers. The firm bought data centers from Credit Suisse that it’s now leasing back to the firm. “They got the deal because of their relationship with Credit Suisse,” says Evercore ISI analyst Sheila McGrath. “They’re aware of the changing landscape of information, and they’re making investments to keep up.”

Data centers account for just 5% of revenue, but they are highly profitable. Iron Mountain expects the business to account for 10% of total earnings before interest, taxes, depreciation, and amortization, or Ebitda, by 2020. Analysts expect adjusted funds from operations to increase $3.6% in 2019, to $3.13 a share. That’s anemic by data-center standards, but it’s reflected in the valuation: The shares trade at 12 times estimated 2019 AFFO. As data centers become a bigger part of the business, investors may push up the stock’s multiple. At 15 times AFFO Iron Mountain would still trade at a 17% discount to the group, but fetch $47 a share.

One of the largest European data-center companies, InterXion, has built a strong beachhead in the interconnect business, operating in key metro areas like Frankfurt, London, and Paris. It’s now leveraging that base to sell hyperscale capacity to large customers. “The hyperscale customers want to be on those interconnect platforms,” says Cowen analyst Colby Synesael. “That’s a unique advantage to win those deals.”

InterXion has announced record expansion plans for 2019. The company is expanding its data center in Marseille, France, a key transit point for international data traffic over undersea cables InterXion also runs. “Marseille is a huge home run for them,” says Synesael, adding that it should help the firm win more hyperscale deals.

InterXion trades at 17 times enterprise value to Ebitda, on the higher end for the industry. But it has one of the fastest growth rates, expected to boost Ebitda 16% in 2019, and it’s increasing revenue at a 15% clip, versus the industry’s 11% median. “We like the simplicity of the story,” says Synesael. The European market isn’t as penetrated as the U.S., he adds, creating more opportunity for InterXion to grow.

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