Why Digital Realty Made The Right Move – Seeking Alpha

The data center landscape has changed so much in the last two years alone that industry insiders and management teams are scrambling to keep up.

Image: Benzinga

Many SA readers were aware I have had a Strong Buy on DuPont Fabros Technology (NYSE: DFT) which was the only 100% wholesale publicly traded data center REIT.

During the past 52 weeks, DuPont Fabros has traded in a range of $37.54-63.46, hitting all-time highs during today’s trading.

Many REITs 4 Alpha members own shares and were pleased to see the ~10% pop Friday morning when global data center Goliath Digital Realty (NYSE: DLR) announced the merger. My view of Digital Realty going forward is now far more constructive in light of this deal.

If you aren’t familiar with data center REITs, here are links to three recent SA free articles:

Digital Realty is by far the largest landlord measured by square footage, with 24 million square feet of data centers, plus development and future expansion space.

Wholesale refers to larger deployments, which are usually measured by both power requirements (megawatts) and square footage. Power densities in wholesale data centers have been increasing, which means the critical IT load will often be the limiting factor, rather than space.

So, why is buying a much smaller rival such a big deal? In my view, Digital Realty really had little choice. It would have become increasingly difficult to make the numbers each quarter without a few 10MW-plus US leasing wins.

DLR/DFT Merger – Quick Overview

Digital flexed its financial muscle in 2015 to purchase former tenant Telx, a provider of connectivity-focused retail colocation solutions. Notably, this $1.86-billion acquisition allowed Digital to offer a full range of offering to clients. It was a bold move.

Back in January, I covered Digital’s Citi (C) presentation for Data Center Knowledge, where the focus was on organic growth and development in US markets. A major acquisition didn’t appear to be in the cards.

Digital Realty approached the DFT board regarding a deal about three months ago, and for the past month these two REIT management teams worked exclusively to hammer out the terms. CEO Bill Stein once more has quickly reassessed industry trends and made a strategic move to bolster customer offerings.

On Friday, Digital announced an all-stock merger with DuPont Fabros valued at $7.8 billion, including assumed debt, and ~$200 million if DFT preferred shares. Another bold move.

Source: Digital Realty – DFT merger presentation (all slides)

DuPont Fabros’ shareholders received a fixed ratio of 0.545 DLR shares, initially valued at just over a 15% premium, based upon a $118.02 price for Digital common shares.

During the past two years, the demand for larger deployments of 10MW+ appears to have morphed more quickly than Digital was able to adapt. Notably, Digital has continued to have success with its measured approach of phased wholesale development, geared to smaller wholesale customers. These block-and-tackle deals are typically in the 500kW-5MW range.

The size of some of the recent DuPont Fabros leases is mind-boggling, with a single customer recently inking a pair of 14.4MW leases for Ashburn, Virginia, and metro Chicago.

Source: JLL, photo Allen Tucker – January 2017

This success with the hyper-scale vertical is a tailwind helping DuPont Fabros to eclipse its own record-breaking signings during 2015 and 2016.

The massive ACC 9 data center shown above is now 100% leased. A few stats:

  • 326,000 sf (~7.5 acres under roof) with 28.8MW of critical power.
  • HVAC (9) 1,398 ton chillers (N+2) with 200,000 gallons of chilled water storage.
  • Diesel generators (20) 2,250 kW (N+2) with four 50,000-gallon underground diesel storage tanks.

DFT’s Ashburn campus comprises of 2.138 million gross square feet, built on 159.7 acres with a total critical load of 207.9 megawatts, according to the company website.

What Has Changed? Hyper-scale.

The most significant change has been the attitude of the rapidly growing planet-scale cloud service providers, including: Amazon Web Services (NASDAQ:AMZN), Microsoft Azure/Office 365 (NASDAQ:MSFT), Google Cloud Platform (NASDAQ:GOOG) (NASDAQ:GOOGL), IBM/Softlayer (NYSE:IBM), and Oracle Cloud (NYSE:ORCL). The investment grade credit rating of the largest cloud providers on a long-term lease of 10-12 years makes this asset class even more attractive for data center landlords.

Successful data center operators become part of the planning process with these customers, adjusting designs, up-sizing powered shells, and purchasing adjacent land for expansion of campuses in Northern Virginia, Chicago and Dallas.

The exponential growth of public cloud computing and software solutions delivered from the cloud makes it difficult for these “hyperscale” cloud giants to forecast their own growth. While companies like Apple (NASDAQ:AAPL) and Facebook have plenty of cash, they are not trading at lofty P/E multiples because they are experts at building data centers. Investors care about the core businesses, not the data center real estate.

Speed-to-Market Advantage

On the other hand, data center REITs have been busy designing and building a “better mousetrap,” while co-creating increasingly efficient supply chains with vendors. These design/build teams are utilizing prefabricated components built off-site (often in low-cost locales) and then trucked in “just-in-time.”

This also creates a leg up on speed-to-market, which gives cloud giants choices that didn’t exist even 18-24 months ago. Large data halls can be outfitted in 12-16 weeks in existing powered shells – essentially the lead time to procure and deploy servers and other necessary tenant-supplied equipment.

These public cloud service providers are sophisticated customers that utilize multiple locations for redundancy. Cloud providers don’t need to pay for a “Cadillac solution” at every location. Alternatively, some apps are mission critical and require N+1, N+2, and 2N concurrently maintainable designs. Distributed IT architecture allows for a wide range of solutions. The ability to provide multiple locations in the same region allows flexibility to handle a wide range of customer deployments.

The slide above points out the massive size of DFT data center phases compared with Digital’s more traditional data center fleet.

DuPont Fabros SV-1 data center was built out in three phases totaling 360,000 sf with 36.6MW of critical IT load. Digital has 15 data centers in the same market with draw of 47MW of power.

In Northern Virginia, DuPont Fabros’ nine data centers contain the same square footage as Digital’s 17 data centers. DuPont Fabros customers are drawing over two times the amount of power of Digital’s 17 data centers containing similar square footage in that market. Notably, these DFT mega-scale facilities are packed with more customer servers. The flexibility to accommodate high-density deployments is a factor in winning hyper-scale customers.

Right off the bat, an obvious synergy could develop quickly in Northern Virginia, the largest data center market on the planet. DuPont Fabros has a huge footprint in Ashburn, but is running out of land. Digital Realty had the foresight to lock down land for an expansion campus.

Data center demand has created an increasingly pricey market for land. A prime parcel recently sold for $1 million per acre. This trend has made two-story data center designs more practical.

Traditional Enterprise

Enterprise adoption of hybrid cloud and distributed IT architecture is still in the early innings. Hybrid refers to a mix of legacy corporate data centers, servers colocated off-premises in leased space (dedicated infrastructure), and public cloud (shared infrastructure) solutions.

This has positively impacted all aspects of the data center landlord business. Retail colocation generally refers to many small deployments in a multi-tenant data center. Meanwhile, the growth of wireless data, internet gaming, social networks, and streaming content requires moving these “high-performance” applications closer to the eyeballs of the end users. This is often referred to as the “edge” of the network.

Legacy corporate data centers are still where the majority of proprietary and mission-critical applications, and “crown jewels” (intellectual property) reside. However, those traditional budgets are shrinking as the majority of new IT spend is going to cloud solutions, according to numerous industry studies and reports by Gartner, IDC, 451 Research and others.

Digital excels at offering a wide range of solutions for large enterprise customers in multiple markets.

Combined Top 20 Customers

In addition to leasing to financial services, social media, network, and cloud providers, Digital has been making a good living the past couple of years partnering with IBM, AT&T (NYSE:T), CenturyLink (NYSE:CTL), Verizon (NYSE:VZ), and others. These customers have much larger sales forces calling on enterprise.

Cloud, network and IT services companies can become customer magnets and form valuable industry ecosystems over time.

Digital wins by leasing them more space as their customers expand within DLR campus locations. Essentially, these tenant/partners sell “up the IT stack,” direct to enterprise customers. Digital provides “foundational” space, power and physical security.

Digital Realty offers the only true global footprint with “one throat to choke” from a single-cabinet or cage, to traditional wholesale deployments for large enterprise customers.

Digital has also had recent success selling to cloud customers outside of the US, where there is often less competition and better ROIC.

Source: Data Center Frontier

Digital now has over 2,300 global customers while DuPont Fabros has about three dozen customers. This represents a huge potential opportunity for the combined company. Additionally, the close relationships that DFT has with its largest customers, including Microsoft and Apple, may prove to be invaluable going forward.

Bottom Line

In a Data Center Knowledge article published on Monday, I wrote:

According to Digital management on Friday’s conference call, ‘The transaction is expected to be roughly 2 percent accretive to core FFO per share in 2018, and roughly 4 percent accretive to 2018 AFFO per share.’ Basically, ~1 percent AFFO from $18 million in expense synergies, ~2 percent estimated from replacing DuPont high-yield debt with Digital investment-grade debt, and one percent from the higher DLR share multiple.”

However, some feel that this is conservative and that there could be more upside in the near term.

Earlier this week, Cowen & Co. analyst Colby Synesael upgraded Digital Realty to outperform from market perform, bumping up his target price to $126 from $106. He noted the DuPont deal improves revenue/FFO growth outlook as well as DLR’s strategic value to customers. Management forecasts for 2% FFO/4% AFFO accretion in 2018 are conservative.

Baird analyst David Rodgers wrote in a note the DFT/DLR deal was positive for the entire data center REIT sector. Rodgers raised interconnection-focused CoreSite Realty‘s (NYSE: COR) price target to $124 from $109, DLR to $116 from $110, and DFT to $63 from $53, while downgrading DFT to neutral from outperform following deal announcement.

Investor Takeaway

In a nutshell, this is a REIT sector to overweight. However, finding the “fair value” entry target prices can be the tricky part. This is where my SA Marketplace REITs 4 Alpha members have an advantage. If you have not been following my research closely on Seeking Alpha, my recent Marketplace Roundtable interview with SA Pro Editor Daniel Shvartsman details why we are overweight data centers and focus on technology at REITs 4 Alpha.

I recently launched REITs 4 Alpha: High-Yield | DGI | Technology on SA’s Marketplace. Readers get my buy and sell alerts, watch lists, portfolios, and deep industry-level analysis, especially for data centers and tower REITs. We also have a vibrant community of REIT investors sharing ideas throughout the market day. Please consider joining the group or getting in touch with me through my SA account if you have questions.

I relentlessly hunt for diamonds in the rough and rising stars in addition to closely following data centers, covering REIT blue-chips and breaking news. Please consider following me as a Seeking Alpha author if you would like to be notified when my future articles are published.


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