Jim Chanos Takes Aim at Data Centers and Their High Valuations

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Noted maverick Jim Chanos has a mixed background. Although his prediction of Enron’s downfall brought renown, his bet against Tesla Inc. proved painful. When it comes to data centers, the gigantic hangars that house racks of computer servers for large corporations, it’s posing a credible challenge.

The case of the bear is not immediately obvious. We are creating more and more data. And since private equity funds have been bidding richly for these assets, listed players are at risk of “cutting” (selling borrowed shares in the hope of buying them back cheaper). Only industry giants are viable targets: Equinix Inc., with a capitalization of $57 billion, and Digital Realty Trust Inc., with a market value of $35 billion. Most of the major Wall Street brokerages rate them as “buyers” or “neutrals.”

But investors are rightly dubious. Stocks were already underperforming the US real estate mutual fund sector this year before the Financial Times revealed Chanos’s negative opinion in June. Morgan Stanley analysts summed up the concerns: demand and price prospects, poor returns on capital, competition, cost inflation, higher financing costs and the risk of “obsolescence.”

That fits with Chanos’ informed thinking. Major cloud companies — Amazon.com Inc., Alphabet Inc.’s Google and Microsoft Corp. — are the industry’s biggest customers, but they’re also building their own facilities. Chanos thinks that means they are actually competitors. In other words, cloud providers will get future growth at the expense of data centers.

Without a doubt, REITs have a future. Many corporations will want to maintain their own servers in data centers, rather than relying solely on the cloud. Installations in cities close to end users provide fast connection speeds, which in many cases are essential. Cloud companies will continue to lease data centers as they enter new markets. Equinix boss Charles Meyers says he is not in a “zero-sum game” with the big cloud companies.

The downside is that none of this guarantees that REITs are destined to grow as fast as their stock valuations imply.

The harsh reality is that the long-term trend has been intense competition putting deflationary pressure on rents. Things may be looking up today, but this could be a problem. The disruption of the pandemic hampered new developments as demand accelerated. Vacancy rates in major US markets have dropped to 4%, from 10% in 2019, according to analysts at UBS Group AG. In the second quarter, Digital Realty returned to leasing sites at 3% above existing rents and Equinix posted record bookings.

It is difficult to be sure that this marks a decisive break with history. Additionally, construction, maintenance, and energy costs are rising; higher rent renewals may not compensate. Cloud giants could slow investments next year as they move from expansion to “digestion,” according to analysts at Morgan Stanley.

Many investors value these companies at multiples of funds from operations (FFO, a real estate measure of the cash flow generated by the business) after deducting so-called capital expenditures. This capex is the expense that companies say is required to maintain revenue rather than win business (accounting standard setters don’t make that distinction, making it an opaque metric). The concern is that this charge will have to increase.

Sustaining capex at Equinix has been low as a percentage of revenue, providing a tailwind that may not last, according to research from Barclays Plc. According to forecasts compiled by Bloomberg, Equinix’s adjusted FFO is expected to increase by approximately 9% compounded annually from 2021 to 2024. That’s roughly in line with what Morgan Stanley expects for the REIT sector as a whole. For Digital Realty, the comparable figure is just 6%.

Meanwhile, the financial environment is getting worse. REITs pay most of their taxable income in dividends to qualify for tax breaks. To finance expansion, data center companies raise debt and sell shares. Even setting aside the absurdity of a business model that pays out massive dividends and then requires shareholders to provide cash, debt and equity are getting more expensive. That increases reliance on asset sales to finance growth.

Despite all these uncertainties, valuations look high. Digital Realty is trading at 16.3 times expected FFO per share in 2023, and Equinix is ​​trading at 27.6 times, versus its peers at just under 16 times, Bloomberg data shows. Looking at corporate values ​​relative to expected earnings before interest, taxes, depreciation and amortization next year, the multiples are also above the REIT average despite the stock’s decline.

Signs of a slowdown in cloud investments, or a hit to costs and capex, would likely accelerate the sector’s ongoing downgrade by undermining the narrative that the industry is in a positive cycle. The challenge remains: Why do these stocks deserve premium valuations given mounting cost pressure and intense competition?

More from Bloomberg’s opinion:

• Real estate is the crisis risk to watch now: John Authers

• Microsoft’s roller coaster exposes the risks of the cloud: Conor Sen

• Alibaba shows how hard it is to kick a habit: Tim Culpan

This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

Chris Hughes is a columnist for Bloomberg Opinion who covers deals. Previously, he worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.

More stories like this are available at bloomberg.com/opinion

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