Trouble In The Datacenters?

Trouble In The Datacenters?

One week after datacenter services company Equinix disappointed the market with a lackluster set of results, it was datacenter REIT Digital Realty Trust's 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 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 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.

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Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends, Equinix, and Google. The Motley Fool owns shares of, Google, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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