Summary
- As the largest data center REIT, Equinix does much more than just lease space and cabinets.
- For this purpose, using its scale together with the fact that it hosts hyperscalers, it has evolved into the "home of the hybrid multicloud".
- However, there are uncertainties especially with a stronger dollar, the trajectory of recurring revenues, and also the growth strategy, especially in the current macroeconomic environment.
- In these circumstances, aware of its potential while waiting for conditions to become clearer, it makes sense to adopt the ETF strategy to have some exposure to the stock.
Equinix ( EQIX ) is a $59.87 billion data center REIT whose share price is more than $200 down from its September 2021 highs despite its FFO (fund from operations) having reached a record in the second quarter of 2022 (Q2) as shown by the orange chart below.
The market seems to be pricing more risks than rewards in a rising interest rate environment where high inflation persists. Also, the strong dollar could be causing headwinds.
Therefore, my aim with this thesis is to assess whether investors’ concerns are justified. For this purpose, I will go beyond Equinix's role as a lessor of data center space and cabinets to one where it is adding value to its business through the "home of the hybrid multicloud" and "Everything-as-a-Service" themes.
Everything-as-a-Service for Hybrid Multicloud
As part of digital transformation, more companies are migrating their IT workloads to the cloud. This has given rise to the concept of multi-clouds whereby one company can be subscribed to the clouds of Microsoft’s (NASDAQ: MSFT ) Azure, Amazon’s (NASDAQ: AMZN ) AWS, Google’s (NASDAQ: GOOG ) (GOOGL) GCP, or others. Now, these are public clouds (or hyperscalers because of their large scale) and also due to the fact that they span across most of the world’s geographies. These constituted 35% of Equinix’s revenues in the second quarter of 2022 as shown in the pie chart below and labeled as “Cloud & IT”.
Cloud v/s Enterprise Revenue percentages (www.seekingalpha.com)
Interestingly Enterprise customers or large corporations which typically lease one to hundreds of cabinets also made up 35% of recurring revenues.
As for hybrid cloud, it occurs when a company uses both the public cloud I talked about earlier as well as its own private cloud to house its databases and IT applications. This can be located within its own corporate data center, but more organizations are choosing to host servers within Equinix's or competitor Digital Realty Trust's ( DLR ) premises in the form of colocation.
Moreover, as the world's largest data center operator after a string of M&As, Equinix has started to play a determinant role in hybrid cloud and calls itself the “ home of the hybrid multicloud”. It deserves this position with its mix of hyperscaler (cloud and IT) and enterprise customers, which confers to it the opportunity to create cloud-on-ramps. These are used to connect enterprise customers to the public clouds through the data center facility itself instead of using expensive fiber connections in case the two parties are in different locations. The REIT has over 200 on ramps which play a key role in attracting more enterprise customers who want to establish fast links to hyperscalers.
This also beefs up Equinix's connectivity business which has increased by 13% in Q2 on a year-over-year basis, or faster than the broader business which grew by 9.6% . For this purpose, the company has a service called Equinix Fabric which, as an SDS (software-defined service) allows enterprise customers to connect rapidly to over 9500 potential partners in an Everything-as-a-Service fashion.
There is also the Digital-Advantage-as-a-Service operating model, completely different from the traditional data center server hosting process which can be very cumbersome as customers have to buy their own hardware and bring it all the way to the data center. Here, by partnering with Dell ( DELL ), the data center operator allows customers to directly order the servers through a wholesale agreement. Hence, the customer is less impacted by supply chain woes. Other partners include Fortinet (NASDAQ: FTNT ), Pure Storage ( PSTG ), Cisco (NASDAQ: CSCO ), and many others.
The fact that these are partner-driven means no marketing costs for Equinix which has increased its operating profit margin from 15.7% to 17%. However, with the inflation rates still at high levels in the third quarter of 2022, risk factors also have to be considered.
Risk Factors
Just as for the wider economic sector, the company has been impacted by wage inflation, but more by higher energy costs as data centers consume a lot of electricity. Also, as a large consumer of electronics items that are embedded into cabinets, power systems, and air conditioning units, Equinix has been impacted by supply chain issues since Covid with conditions being exacerbated with lockdowns in China.
Moreover, with 60% of revenues coming from abroad, the company is particularly susceptible to the strong dollar when the foreign currency revenues it receives are transferred to the U.S.
On a positive note, I found that the company does have a number of ways to mitigate risks.
First, as for inflation, it can charge higher as lease contracts already make provision for rising electricity bills or other costs. Now, operating in a highly competitive landscape, there are risks that this may prompt customers to move their equipment after bargaining with rivals. However, in practice, it is not so simple for enterprise customers who already have multi-year contracts and there is also the connectivity aspect to contend with as I elaborated earlier.
However, things may be more complicated for cloud customers who constitute a sizeable 35% of the customer base as they are aware of their roles as anchor tenants in attracting colocation business to a data center. They also have the capital needed to set up their own facilities in case they are pushed too hard. Moreover, despite a sophisticated hedging mechanism to dampen the effects of an appreciating greenback, there could be pains if there are meaningful devaluation of local currencies in some of the 31 countries where Equinix operates, especially in Latin America where the company recently acquired four data centers from Entel.
Therefore, the REIT can be impacted by deteriorating macroeconomic conditions but it has low customer concentration risks, with no single client contributing more than 2.6% of monthly recurring revenues in Q2 as shown in the table below. Additionally, to mitigate supply chain issues, it has built a vast inventory amounting to $300 million which contains spare parts for critical systems. Therefore, Equinix can navigate through market volatility.
Customer Count and Churn (www.seekingalpha.com)
On the other hand, while churn remained constant as shown in the table above, the number of customer additions shrank both on a year-on-year and sequential basis in Q2, as shown in the table above. Also, non-recurring revenues rose faster than recurrent ones.
The company still managed to grow (by 9.6%) thanks to acquisitions, but this growth strategy implies more debt, which stands at $16.3 billion . This translates to a debt-to-equity ratio of over 150% which is way higher than peers.
Valuations and Key Takeaways
Therefore, it is a mixed picture, with positives, one being Equinix's key role in the hybrid cloud market valued at $85 billion in 2021 and expected to reach $262 billion by 2027 after growing at 20.6% CAGR.
Furthermore, the record FFO which has been achieved on the back of a period of high inflation seems to show that the business model which relies on differentiated service offerings is not suffering. In this respect, as per the executives, they even managed to increase net bookings during the last eight quarters in a row. However, it is important to see how this translates to recurring revenues. Along the same lines, I will be on the watch out for whether the executives are able to raise prices as they mentioned during the earnings call on July 27.
Moreover, with the Fed hiking rates being favorable to both a stronger dollar and tighter liquidity conditions amid higher borrowing costs, it is better to be prudent in the way to invest in Equinix, unless you already hold the stock. To this end, even after the above 20% downside, this is not an opportunity to buy the dip, as valuations still remain unfavorable . The reason is that in current macroeconomic conditions, the value strategy which is about low P/E stocks is likely to prevail.
Hence, I have opted for the ETF option, namely in the form of Schwab U.S. REIT ETF ( SCHH ) which charges 0.07% and dedicates about 4.55% of its assets to Equinix and other specialized REITs. This is a low figure in terms of the percentage of assets held but a look at the charts below shows that the ETF (in orange) has suffered much less downside than Equinix itself. Another ETF that holds more, or 16.26% of the data center REIT, is the Pacer Benchmark Data & Infrastructure SCTR ETF ( SRVR ). It charges 0.6%.
For comparison purposes, the charts show total returns which include dividends in case these are reinvested. SCHH appears a better choice and pays a dividend yield (30-Day SEC Yield) of 2.66%.
Finally, against an unfavorable monetary policy backdrop, the market is right in pricing more risks than rewards for Equinix, but in view of the REIT's ability to have developed its data center ecosystem beyond much more than just leasing space and cabinets, the stock cannot be ignored. For this purpose, I chose the ETF option to have some exposure while it attracts more enterprise customers to its hybrid multicloud and is able to pass on additional costs to the hyperscalers.
For further details see:
Equinix: Home Of The Hybrid Multicloud But Uncertainties Remain