Bill Stoller on February 5, 2016

Shares of wholesale data center provider DuPont Fabros Technology shares spiked 6 percent following its fourth-quarter 2016 earnings report Thursday, closing up 4 percent. Analysts clearly liked what they heard from DFT CEO Chris Eldredge and CFO Jeff Foster.

The company’s re-commitment to its wholesale data center focus, announced in November, did not take long to pay off for investors.

DFT reported a record 47MW in signed leases for 2015, including 12 leases for a combined 32MW in the fourth quarter. The results exceeded its previous annual leasing record by more than 5MW.

Notably, it was able to achieve a return on investment of 13 percent on its latest leasing activity, a full 100 basis points above its target return.

A Rosy Outlook

Data center leasing by web-scale operators, the likes of Facebook and Microsoft, is on the rise, and wholesale data center providers like DFT are reaping the benefits.

“Microsoft’s Azure announced their premium services grew nearly 3x year-over-year, with compute usage nearly doubling year-over-year and SQL database usage increasing more than 5x year-over-year,” Eldredge said. “The growth in this space is staggering and reinforces our view of a future with tremendous upside.”

Notably, DFT derives 60 percent of its revenue from its top four customers: Microsoft, Facebook, Rackspace, and Yahoo. Its tenant concentration may now be viewed more positively by investors, as the hyperscale cloud providers accelerate CapEx spending.

According to a recent market report by the commercial real estate firm North American Data Centers, Apple, Microsoft, and Salesforce signed substantial leases with DFT. Overall, hyperscale companies drove more data center leasing in 2015 than usual, Jim Kerrigan, managing principal at North American Data Centers, told us.

No Room at the Inn

Eldredge said Northern Virginia and Chicago showed the strongest demand from large-scale tenants. DFT had to pass on a 10MW requirement recently because of a lack of available space.

Currently, the company only has 1.5MW of available capacity, with another 30MW expected to be placed in service during 2016.

Measured Growth

It appears that DFT’s future growth will be constrained by conservative management of the balance sheet, rather than by customer demand.

Foster explained that maintaining net-debt-to-EBITDA at 5x or less was a key metric for management. However, there will be no new equity issuance planned for 2016.

The company intends to fund its growth in 2016 from cash, cash flow, and existing debt facilities, but pace of development could be accelerated by proceeds from the sale of its New Jersey data center.

DFT intends to recycle this capital to fund its development pipeline, including a planned expansion into Toronto in late 2017 or early 2018. Other expansion plans include Hillsboro, Oregon (outside Portland), and potentially Phoenix.

DFT booked an impairment of $122 million, or $1.52 per share in Q4, to reflect the actual market value of the NJ1 (Piscataway) facility. During 2015, only 2MW of wholesale deals were signed in that market. However, management reported strong demand for NJ1 from retail data center REITs, private equity, and technology companies.

Market Updates

Chicago: CH2 Phase II (5.7MW), scheduled for April, is 25 percent pre-leased, with CH2 Phase III (12.5 MW) following in July 2016.

Northern Virginia: ACC7 Phase III (11.9 MW) will be available June 2016. Additionally, DFT just closed on 44 acres of land in Ashburn, Virginia, which will support future development of ACC9 and ACC10, as well as a 10MW powered base shell or build-to-suit.

Santa Clara: On DFT’s previous data centers, SC1 and SC2, the ROI was just 9.25 percent. This is a land-constrained market, but pricing is still competitive. The company is looking to “de-risk” development of SC3 by waiting for a pre-lease of 10 MW or more prior to breaking ground. While DFT might not get a 12 percent ROI in this market, management is not willing to break ground until they have a proverbial bird in hand.

ACC9 Phase I and CH2 Phase III are both in the capital plan for development in 2016.

Investor Takeaway

DFT appears to be firing on all cylinders, while its core group of wholesale customers is beefing up capital spending. However, the current conservative balance sheet approach risks taking the foot off the gas pedal.

Notably, a delay in the closing of the NJ1 data center sale could lead to a slowdown in funding for new development deliveries in 2017.

Given the apparent strong demand from hyperscale cloud providers, it might make sense for DFT to enter into a joint venture arrangement on some data centers to free up more capital to meet customer demand. Its Santa Clara data centers might be ideal candidates. The lower unlevered ROI from SC1 and SC2 is less than plan but would still be very attractive to a pension fund or an insurance company as a JV partner.

In addition to hastening earnings growth, this would also help DFT to accelerate its diversification geographically. As it stands right now, entry into the Portland and Phoenix markets appears to be off in the distance, likely not until 2019.