Write a Storybook Ending -- Or Lose Your Shirt

Brendan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Some investors are avoiding data center REITs like the plague. This makes sense given rising competition, but such REITs are not yet extinct. In fact, due to a massive sell-off, some are trading at low prices. This provided a great opportunity for income-seeking investors.

Altered playing field

Prior to the rise of Amazon (NASDAQ: AMZN) and Google (NASDAQ: GOOG), data centers were a hub of activity. Now, Amazon, Google and other tech firms are leaving some center owners wondering how they will respond to the market.

Amazon Web Services enables users to run virtually any application in the cloud, including data center capabilities. Forrester Research estimates that Amazon claims about 70% of the market for renting computing capacity and data. Additionally, Amazon continues to re-position itself to sell its services to large companies which historically own their hardware or used data centers.

Google is in the heat of the battle, too. In 2006 Google invested over $600 million to establish a state of the art, energy efficient data center that could potentially serve as the hub for the firm’s war against Amazon. Google’s centers paved industry standards in environmental protection, energy efficiency, and security. Further, the search engine giant offers Google Compute Engine, an application which enables organizations to “run large scale computing workloads…hosted on Google’s infrastructure.”

Data center REITs that have to compete with these giants are at a disadvantage.

Inside scoop

Jonathon Jacobson, founder of Highfields Capital Management, frames the situation well:

Analysts are concerned about rising capital expenses and declining rent at data center REITs. They also worry that technology companies such as Amazon and Google are increasingly building their own data centers rather than renting space from REITs. That is decreasing demand for space in the REITs’ centers and is further troubling because the big technology companies potentially could compete with REITs by leasing out space to smaller businesses.

Digital Realty Trust (NYSE: DLR) and DuPont Fabros Technology (NYSE: DFT) are the largest publicly-traded data center REITs. Just in the past month, Digital Realty Trust’s stock price has plummeted over 12%. As of the most recent quarter, it has operating cash flows just over $89 million and over $355 million cash outflows from investing activities. Even with a negative cash flow, Digital Realty Trust continues to increase its bottom line. Investors should also note that its dividend yield far exceeds its competitors’ yields. Currently, its long term investments seem to be working.

DLR Free Cash Flow data by YCharts

DuPont Fabros Tech is sitting in a better cash position, and it has a current ratio of 1.98. Competitor CoreSite Realty’s (NYSE: COR) current ratio is only 0.67 and Digital Realty Trust’s is only 0.73. In the awful case of liquidation -- which is far from the current state -- you want to own DuPont Fabros Tech. Furthermore, it boasts an extremely low beta, and earnings for the first quarter were up $0.04 from 2012.

The firm exercised a stock repurchase option during the first quarter. It acquired 1,623,673 shares at $23.12 per share. Given that DuPont Fabros Tech is trading just above $24, that leads me to think it is a definite buy.

 BetaDividend YieldForward P/E
Digital Realty Trust 0.74 5% 11.37
DuPont Fabros Technologies 0.37 3.10% 21.86
CoreSite Realty Corp 1.25 3.20% 14.7

CoreSite Realty is focused on growth. The firm has increased its dividend payment almost 108% since the company was founded in 2012. Management said they will continue to increase dividends until it reaches the point “required by REIT status and to retain excess cash flow for investment into development opportunities.”

Core Site Realty’s trailing P/E ratio is 112. Its forward P/E is only 14.7. This is further proof of the firm’s strategy. Even with a price decline and higher market risk, its lower forward P/E makes it a much more attractive investment. Expect more earnings per share with this REIT.

Strategy

The massive May sell-off led to under-priced data center REITs. Further, the effects of Amazon and Google’s data centers impacted these firms’ stock price during May.

With the exception of the wake from traders leaving the market, it seems that a big enough pie exists for data center REITs to exist alongside industry mammoths. If you’re looking for income, receiving dividends while we watch this game from the sidelines may be a good play.

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Brendan Marasco has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Google. The Motley Fool owns shares of Amazon.com and Google. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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