There's considerable investor interest in data center companies and for good reason. In this clip from "Real Talk" on Motley Fool Live, recorded on March 25, Motley Fool contributors Matthew DiLallo, Matt Frankel, and Tyler Crowe discuss the top data center stocks and why scaling is so important in the industry.
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Matthew DiLallo: I actually was looking into them, how the valuations change because we've obviously seen stock prices drop. The National Association of Real Estate Investment Trust, they put out this great data set every month from everything to what their earnings estimates are, and then what price-to-earnings are, and REITs FFO, and what the projections are for the next few years. You can get tons and tons of information on this. I thought it was interesting to go back a few months to look at data center. I looked at September's data, and back in September, the data centers at the time, I think there were four publicly traded ones. They were selling for 25.5 times FFO, which really, that's higher than a lot of other REITs, but for an industry that's growing fast, that wasn't too bad. Then, if you look a year ahead, it was 23.8 times. They're a little bit more cheap as they were growing, but then you fast forward a couple of months to last month and data centers were down to 22.5 times current year estimates, and then 21 times the next year's estimate. They've gotten considerably cheaper over that time. Digital Realty (DLR -1.63%), for example, is down 20%, so you have a company stock price that has dropped significantly and they're growing their earnings, and that's made them much more attractive. If they weren't so big, I would think that this would get private equity even more excited about buying some of these. But really, private equity bought at the peak, and that was even driven because they see so much growth ahead, like Blackstone (BX -0.11%) with their buying QTS Realty (QTS). It's all about the future. They paid a big premium for that company because there's so much data infrastructure that needs to be built, and they're looking at this as we can still make a lot of money because they are taking that thematic approach as so many companies are transitioning to putting their businesses online and just going all in on digitization. Blackstone's like, yeah, we can make money on that. That's why they're still out there looking to buy as many data centers that they can because scale is another big thing. We talked about how big Equinix (EQIX -0.44%) is and how big Digital Realty is. That scale gives them advantages of where they can buy things in bulk to build data centers. That's where a lot of these smaller players, like Tyler was talking about Switch (SWCH), they don't have that scale to go out there and buy stuff in bulk, and so to go to a private equity firm and be in that ecosystem of their scale, that's attractive to them for their cost of capital. That's another factor that's driving this, just the overall investor interest. So many investors that have money to put into the market, they're looking at this trend, and the best way that they're seeing it is through these private equity companies. There's a lot of things driving this valuation kick.
Matt Frankel: Tyler, what do you think? Do you think in a year there are going to be no data center stocks left for us to invest in because everyone's bought them all?
Tyler Crowe: I doubt it simply because of the science of Digital Realty Trust and Equinix. They seem to be big enough to fend off any really large private capital, but it's attractive for a lot of private money, institutional money to go after these. It's actually another discussion Matt and I were having previously is that publicly traded real estate these days have much more conservative balance sheets than what you're seeing on the private side of the market. If you look at the balance sheets of these companies, they have very good leverage metrics. Their debt-to-capital is considerably lower than what you might see in the apartment market. If I'm a private operator that says, I can lever this up and I can squeeze much more cash flow out of these companies, it's a very attractive option right now. With the public markets and public REITs still being like a little snakebit from debt during the great financial crisis to the fact that tech stocks are down therefore data centers are down. That one, I don't know. It seems like a real messaging perception misnomer here. Sure, Meta (META -2.77%) is down, but they're not collecting fewer data points because their stock is down. Data collection is still growing, 5G is getting deployed, and we're going to start seeing things like automated vehicles, greater deploying of the metaverse AI, all of these things. Data is just still going to grow exponentially from where we are from here. To think that, just because tech stocks are down that they're not going to be creating more data that require storage, seems a little short-sighted.