June 12, 2017

Still a box

by Breakingviews

Think of it as real property used for virtual purposes. Digital Realty Trust, a builder and owner of data centers, is buying rival DuPont Fabros Technology in a deal worth $7.6 billion. The race by Amazon, Alphabet and other tech firms to dominate cloud computing has resulted in huge demand for server farms. The $18 billion Digital Realty’s move is a response to that and may be a good use of its overvalued stock – but it’s still paying too much.

Data-center real-estate investment trusts straddle two worlds. Consumers’ desire for selfies, video and other online content creates seemingly insatiable demand for server space. Firms like Digital Realty can rent out most of a new building’s capacity before it’s finished. Such tech-style characteristics have sent stocks in the sector on a Google-like tear. Digital Realty’s shares have risen fivefold in 10 years. Yet to qualify as REITs, these companies pay out nearly all their cash. That provides a handy dividend yield, and investors like that too.

Expectations may be too high, however. Digital Realty is valued at about 19 times estimated EBITDA over the next 12 months. Punters are betting on hefty growth in dividends, not relying on a static 3.3 percent current yield. There are, however, risks. The likes of Amazon, Google, Facebook and Oracle could build and run server farms in-house. Or demand growth could slow, leaving the REITs with overcapacity.

It makes strategic sense for Digital Realty to snap up its rival. Increased size boosts its negotiating power. And if times turn tougher, scale will help. Financially, however, the deal is harder to justify. The expected cost savings of $18 million a year and gains from refinancing DuPont Fabros’ debt are nice, but they aren’t worth nearly enough to cover the more than $700 million premium Digital Realty is paying.

One redeeming feature is that the purchase will be paid for in the acquirer’s inflated shares. Even allowing for the premium, Digital Realty is paying a smaller multiple of DuPont Fabros’ EBITDA than is built into its own worth. That partially hedges the lofty price – but the buyer’s share price still looks disconnected from reality. With tech stocks like Amazon, Apple and Microsoft sliding since Friday, the danger of a reconnection is looming a little larger.

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