Equinix REIT: An Absolute Beast, But Not A Bargain (NASDAQ:EQIX)
2023 and 2024 have been great times to invest in REITs in my opinion. The thesis has largely yet to play out, however prices in the sector have been quite depressed since the Federal Reserve swiftly raised interest rates in an attempt to quell historically high inflation rates.
The Federal Reserve hiking cycle began on 17 March 2022. Since then, the Vanguard Real Estate ETF (VNQ), a widely used proxy for the REIT market as a whole, is still down 15%, moderately up since the bottom reached in the second half of 2023. During the same time frame, the S&P 500 has appreciated over 23%.
The massive under performance can be explained by the overreliance on financing by the real estate sector, which makes it hard to fund growth when the cost of capital is high. Nevertheless, inflation is very clearly heading towards the 2% target, albeit more slowly than anybody would hope. A Fed pivot towards an easing cycle would unlock quite a bit of value coming simply from a repricing higher of the sector.
Not every REIT has suffered, however. Equinix, Inc. (EQIX) during the same timeframe is actually up 7% on a stock price point of view (excluding dividend), much better than the real estate market. Equinix over the last decade has been a fantastic compounder, and it now enjoys an incredible scale across the globe. The data center provider has become an integral part of the internet infrastructure, and the market has clearly rewarded this enviable position. Unfortunately, this also means that the stock is currently trading at a very high valuation. I argue that there are better options in the market at the moment purely due to unattractive valuation.
The infrastructure of the digital world
EQIX is the biggest pure-play data center REIT available in the United States market.
This is undoubtedly one of the sexiest corners of the market, as data centers have become over the decades the fundamental infrastructure of the digital world. Although the name of the game has changed from time to time, from the birth of the Web to the AI craze of our days, data centers are what allows our world to be interconnected at incredibly high speed.
Equinix was founded in 1998 as an agnostic data center platform offering third-party networks the opportunity to share data traffic. The company has reinvented itself as a real estate investment trust relatively recently in January 2015. Over the decades EQIX has scaled an impressive operation across 33 different countries, reaching over 10,000 customers, 2,000 networks while boasting an impressive 99.99% reliability.
Today, Equinix is a $73 billion behemoth with an annual revenue of almost $8 billion, still growing at impressive rates. Over the last four fiscal years, the company has grown revenue at an average rate of 10.7% which is quite fast for REITs in general, and very fast for REITs of this size. The result of such an efficient, ambitious and critically fundamental infrastructure company is one of consistent growth of both top and bottom line over the course of a decade.
Customer concentration is not an issue, as the top 10 customers only represent a cumulative 17.1% of revenue, while the top 50 customers represent about 37% of revenue. By being one of the biggest data center providers in the world, naturally, EQIX can list the biggest companies in the world as their customer. About 69% of the company’s customers are indeed businesses with an annual turnover of at least $1 billion, while an additional 13% of customers have an annual turnover between $100 million and $1 billion. By not directly dealing with small and medium size businesses, customer churn does not represent a big problem for Equinix as traditionally this metric came in at about 2%, usually offset by the onboarding of new customers.
Interestingly, only 67% of recurring revenue comes from properties that are fully owned by Equinix, while the remaining revenue comes from properties that for many different reasons are leased, usually with very long contracts. Some properties, for example, are located in jurisdictions that do not allow full foreign ownership of such types of assets, or other properties might be the result of joint ventures between EQIX and partner companies. Given its scale and reach, EQIX can be quite flexible in the structure of their assets ownership, and that can be a real advantage as it allows the company to keep growing without necessarily needing to put up huge quantities of cash for each potential investment.
Excellent debt management
As every REIT, Equinix relies quite heavily on financing to operate. Investing in real estate requires a lot of cash, which usually is for the most part financed. One of the biggest advantages of REITs of huge sizes is that they have easier access to capital, generally at a cheaper rate, which allows them to more easily fund new endeavours.
This rule of thumb is in full play at Equinix. The company’s Net Leverage Ratio currently stands at a reasonable 3.6x while the Debt Ratio is at 20%, one of the best across the biggest REITs according to Statista.
EQIX currently has $13.4 billion of gross debt, well laddered each year across the next decade or so. The mix of debt is also very interesting as some debt was issued in USD Senior Notes, some as Green Notes (which should be theoretically cheaper), and some was actually in different currencies which can be potentially very beneficial (EUR, GBP or JPY in this case).
As an example of how Equinix has the tools to allow them easier access to cheaper financing, on May 23, the company has announced the offering of $750 million of EUR Senior Notes due in 2034, which are expected to have an effective interest rate of around 3.9% after taking into consideration currency hedging. This kind of rate is very competitive considering that the current Federal Funds Rate in the US is set at 5.25% to 5.50%
As far as REITs go, Equinix appears to be in a great place from a debt management point of view, which is always crucial when assessing potential investments in the space.
Equinix 1, Hindenburg Research 0
Back in March of this year, the famous short seller Hindenburg Research published a report denouncing accounting malpractices at Equinix, among other considerations on the future of their business. In particular, the short seller accused the management of manipulating the AFFO calculations by misrepresenting maintenance CapEx as investments in growth, giving the appearance that the business spends a much smaller percentage of Revenue just to keep their machines running.
Following the accusations, management has announced that they would conduct an internal investigation aided by an independent third-party professional firm. The results of the investigations have been made public by Equinix during the latest earnings report on May 11: the audit found no malpractice and provided no guidance on necessary changes to the internal accounting rules.
Despite the positive outcome from the internal investigation, the matter is that the company has still received two subpoenas on this particular issue from both the Securities and Exchange Commission, and the US Attorney’s Office from the Northern District of California. As of now, there are no updates on the investigation.
After reading both the Hindenburg Research short report and various commentaries around it, I came away with the impression that foul play here is unlikely. The report is mostly based on available data regularly published by the company, and the way they account for AFFO does not seem to be a secret. As a general rule of thumb, I don’t like when companies rely too much on adjusted financial metrics, as deviating too much from standard accounting practices leaves too much room for misrepresentations and opacity.
My personal take on the matter is to treat the short report as a red flag to monitor, but not necessarily something to act upon, as probably it will not end up being material for either EQIX’s business or their share price.
The market expressed relief when the company disclosed that the internal investigation concerning the Hindenburg Research allegation came back clean, and the stock is now trading roughly at the same price as when the short seller report was published. It appears the market is not discounting anything concerning the outstanding investigations and relevant subpoenas. I tend to agree, as the short seller allegations do not seem to indicate fraudulent behaviour and as such I don’t expect anything material to come from the investigations.
Q2 2024 preview and full-year guidance
The company will report the second quarter 2024 results on 7 August 2024. EQIX seldom surprises investors, as the business is largely quite predictable. Guidance issued the last time around is for Revenue of $2.15 billion at the midpoint, which would represent top-line growth of about 19.6%. Adjusted EBITDA margin will come in stable between 47% and 48% like clockwork.
For the full fiscal year, the company is instead forecasting revenue of $8.74 billion at the midpoint, which would represent a growth from the previous year of 12%, which indicates that EQIX will see a seasonal slowdown in the latter part of the fiscal year.
I fully expect the company to hit their target, as they rarely miss their own guidance.
Current dividend policy and valuation
One of the most important aspects of investing in REITs is the dividend. As every investor knows, REITs must disburse 90% of their taxable income to shareholders, which makes them a fairly reliable generator of passive income.
Equinix stock has appreciated remarkably well over the past decade (up about 250%), which leads to a current dividend yield far from exciting at just 2.2%, very much below other peers. However, over the last eight years the company has compounded their quarterly dividend from $1.75 per quarter to $4.26 per quarter for a CAGR growth rate of about 11.6%. The growth rate seems to have accelerated even as of late, considering that between 2022 and 2024 the dividend grew between 17% and 18% per year.
As exciting as these dividend growth rates are, I must say that when paired with the stock’s current valuation, they overall don’t constitute the most enticing investment. Sure, the dividend will grow, but the base of 2.2% of yield is rather low and will require many years to grow into a yield on cost of about 4% or 5%, which today can be easily found among high-quality REITs.
Moreover, the stock’s current valuation is as steep as it gets, which makes big gains in price appreciation not that likely.
From a forward Price to AFFO point of view, the company is trading at an elevated multiple of 22.08x, 36% more expensive than the sector median. As we learned from the short seller report, however, there’s a chance that the company is unfairly discounting their maintenance CapEx when adjusting their Funds From Operations. In order to play it safe, we could probably more reasonably look at Price to FFO, which, however, is extremely expensive at a whopping 31.73x, about 129% more than the REIT sector median according to Seeking Alpha.
Conclusion
I think it makes sense why EQIX trades at a premium: it operates in a sector that enjoys a clear and seemingly inextinguishable generational tailwind, it has an incredible track record, it offers a service that has become essential for the existence of the digital world. If Equinix continues to operate as it did in the past, there’s a world where today’s price is actually attractive.
However, I also would not be surprised if EQIX ends up trading sideways for years to come, which indeed already happened as the stock is trading today at the same level as four years ago, with quite a lot of volatility in between. Personally, I would not feel comfortable opening a position when the stock trades at such a steep valuation because I would be betting that the company will execute perfectly: that might very well be the case, but at the moment there are still good REITs trading at much cheaper valuation offering yield of over 5%. For the moment, I am happy to stay on the sideline and take advantage of possible bumps along the way.