Digital Realty Gains on Data-Center Frenzy

As technology providers rush to build data centers that deliver computing over the Internet, Digital Realty's shares have more than tripled since 2008

Digital Realty Trust (DLR), the largest provider of data-center real estate, has almost tripled on the New York Stock Exchange since late 2008, amid a server-farm demand surge that the company says may intensify this year.

The proportion of companies that plan to expand data centers rose four percentage points, to 85 percent, this year, San Francisco-based Digital Realty said yesterday in a statement, citing a survey it commissioned from Campos Research & Analysis.

Digital Realty's outlook for demand prompted the company to boost its full-year forecast for funds from operations (FFO), a measure of cash flow in the real estate industry, on Apr. 28. Digital Realty's customers include Facebook, Yahoo! (YHOO), Google (GOOG), and Microsoft (MSFT), which are among the biggest users of the servers and buildings needed to deliver storage and computing over the Internet via the so-called cloud.

"We see cloud computing as the huge driving force behind companies such as Digital Realty," says Sonny Lin, a senior portfolio manager for Pillar Pacific Capital Management in Daly City, Calif. "We are still positive on the stock and we see no reason why we would exit at this point." Pillar holds 22,360 shares of Digital Realty Trust and manages about $500 million in investments, he said.

Digital Realty has climbed 186 percent since Nov. 20, 2008. It outpaced the 157 percent gain in an index of real estate investment trusts with a market value of at least $15 million in the same period.

Of companies that plan data-center expansion this year, 60 percent said they will lease space from a provider rather than build their own, Digital Realty said, citing the survey of 300 information technology executives. Digital Realty benefits because it leases data-center space, commanding 22 percent of the wholesale market, according to Tier 1 Research, owned by New York-based 451 Group.

An Upgrade in FFO Forecast

Funds from operations may rise to a range of $3.95 to $4.05 a share this year, Digital Realty said on Apr. 28. That's up from a previous forecast of $3.80 to $3.95 a share. FFO, a cash-flow measure used by real estate investment trusts, excludes depreciation and other items and doesn't conform to generally accepted accounting principles.

Digital Realty's stock ascent slowed last year amid concerns of oversupply in data-center real estate. Its shares tumbled 22 percent from Oct. 5 to Dec. 17 after Equinix, its second-largest customer, cut its quarterly and full-year sales forecasts. "We felt blindsided," says Jordan Sadler, real estate equity research analyst at KeyBanc Capital Markets in New York.

Forecasting data center demand can be difficult because it can take as long as two years to build one, while the technology industry's needs can shift more quickly. A space glut ensued after the dot-com bust of 2001, according to Gartner. Yet use of data centers has increased in recent years with the advent of social networking and mobile applications delivered via the Internet. Businesses are also snapping up storage, software, and further computing tasks through the cloud.

Global demand for data centers is likely to increase 14 percent this year, up from 13 percent in 2010, according to Jeff Paschke, a senior analyst at Tier 1 Research. "We're seeing a broad-based demand for data-center facilities," Digital Realty Chief Executive Officer Michael Foust says in an interview. "The supply concerns have been overstated. We see supply and demand at worst in a solid equilibrium and more often, demand is well in excess of supply."

Rapid Building Conversions

To stay on top of demand, Digital Realty frequently buys relatively small buildings and converts them to data centers, rather than build giant data centers from the ground up. The company also staggers the construction of individual data centers in each building. Digital Realty converted a former furniture warehouse into multiple data centers in Santa Clara, Calif., one of the largest markets. After some initial preparation of the building shell, it took 26 weeks to get each data center up and running, says Jim Smith, Digital Realty's chief technology officer. Smith says he's working on ways to reduce that time to 12 weeks.

Facebook, one of Digital Realty's largest customers, opened its own home-built data center in Prineville, Ore., last month. The social networking company may lease less space in the future from third-party providers, says Larry Yu, a Facebook spokesman. "We had Facebook as a client with just 40 racks of servers," Smith says. "Some companies will grow past us."

Of 19 analysts tracked by Bloomberg, three have "sell" ratings on Digital Realty. One of those is Michael Bowen, of Guggenheim Securities, who said in a recent research note that the company may come under pressure as some companies switch to their own data centers.

As existing users move on, Digital Realty is counting on fresh customers to pick up the slack. "Five years ago, everybody wanted to have their own data center," says Jim Kerrigan, executive vice-president of the national data center practice at Grubb & Ellis. "But today there's much more interest in companies going to a third party to build it."

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