On May 8, 2013 Jonathan Jacobs of Highfields Capital Management presented at the Ira Sohn Conference 2013 and questioned Digital Realty Trust (DLR) accounting for maintenance cap-ex and suggested shorting the stock.
The immediate effect from this event was a 9% drop in DLR stock. Moreover, it highlighted the issue of a potential wave of maintenance cap-ex that could adversely impact financials for not just DLR, but competitors as well.
The fact is that maintenance cap-ex has been elusive for quite some time, and investors have never been particularly happy with the transparency companies provide in this regard. Maintenance cap-ex has been speculated to be between 3% and 7% of revenue, although the data center companies generally put it at the lower end of the range. The maintenance cap-ex subject is more complex than pinning a simple number on it like we might with a consistent expense like property taxes.
At issue is the potential financial impact of end-of-life equipment needing to be replaced or the necessity of investing capital to simply keep a facility in operation to support existing tenants. Investors want to be sure capital is being invested prudently, which includes careful cap-ex spend planning and not having to replace equipment prematurely.
While “maintenance” is an important subject for all concerned, maintenance cap-ex is particularly interesting to the investment community. From the investment community standpoint, any funds spent that do not contribute to the growth of the business are some form of maintenance of the business, and they tend to lump it together when analyzing the company. If the cap-ex is not growing the business, it is maintaining the business.
Data Centers Speaking Up
Nobody wants a 9% stock drop over the speculation of a single investor who brings into question accounting practices. The upshot has been some preemptive damage control on the part of public data center companies.
CyrusOne addressed the maintenance cap-ex subject during a June presentation at the 2013 NAREIT Conference. Gary Wojtaszek, President & CEO of CyrusOne, commented that he specifically included a slide in his presentation highlighting their Mason Data Center, which is now about 22 years old.
Source: CyrusOne NAREIT 2013 presentation. www.cyrusone.com
Wojtaszek commented that the reason he included it in the presentation is that there has been a lot of recent press in the industry directed at one of their competitors in regards to a “wall” of maintenance capital that’s going to be coming up. Wojtaszek indicated that he believes that some of the information being disseminated is incorrect, and for the building he was talking about he indicated they have been investing 0% to 3% maintenance capital over the last 10 years since they’ve occupied that building and expect the same for the next few years.
In addition to ongoing maintenance capital they also spend 2 – 3% a year on ongoing preventative maintenance. Wojtaszek said they don’t have any major expenses coming due on the property and are currently making about a 13% return on $6 million annual rent for a building that “if you listen to some of the information in the market would be worthless today.” Combining maintenance capital expenditures (0-3% of revenues) and preventative capital expenditures (2-3% of revenues), it is fair to assume that CyrusOne’s combined non development cap-ex is in the 1-6% of revenue range. Keep in mind that these were comments from Wojtaszek’s presentation, and not necessarily audited accounting numbers.
On CyrusOne’s 2Q 2013 earnings call and presentation their data reflected a 1% recurring cap-ex for the quarter, but did not specifically addresses maintenance cap-ex. The NAREIT presentation included the following historical cap-ex data.
Source: CyrusOne NAREIT 2013 presentation. 4. Development Cap-ex includes development of real estate, acquisition of real estate and other non?real estate cap-ex. www.cyrusone.com
At Digital Realty Trust they have made adjustments to their quarterly reporting that includes more specific definitions to differentiate between recurring and non-recurring capital expenditures in their Historical Capital Expenditures data, as depicted below (page 29, Q2 2013, 10-Q). In addition, they also broke out repair and maintenance line items from rental property operating expenses in other sections of the 10-Q, but were careful to point out that those adjustments were in addition to recurring cap-ex to maintain properties.
Source: Digital Realty Trust Q2 2013 earnings call presentation. www.digitalrealty.com
Although this seems like progress, footnote (2) specifically says “Non-recurring capital expenditures are primarily for development of space and land not including acquisitions costs. In addition, these expenditures include certain infrequent expenditures for capitalized replacements, upgrades, or other projects which enhance the operating portfolio,” To wit, true maintenance cap-ex is buried in these numbers. That said, there is more transparency there than has been in the past. Recurring cap-ex for DLR ran in the 3-4% of revenue range over the past four quarters.
Equinix also beefed up their coverage of capital expenditure detail for their Q2 2013 earnings call and presentation. The slide below includes a description and breakout of these expenses. Equinix came up with a pretty straight forward 2% of revenue for true maintenance cap-ex and an additional 2% of revenue for replacement cap-ex, resulting in 4% of revenues used to maintain and extend the useful life of its data centers, as shown in the presentation chart below.
During the CFO’s presentation he said “Ongoing capital expenditures were $40.2 million, which included less than $10 million in maintenance and efficiency enhancements and single points of failure capital.” The CFO also commented that 2% is within their expectations and there should be no meaningful reinvestment requirement in their IBXs.
Source: Equinix Q2 2013 earnings call presentation. www.digitalrealty.com
Equinix needs to stay out in front of this subject considering the volume of capital investments supporting their sites, and the fact that some sites are maturing.
Over at DuPont Fabros, Hossein Fateh, President and Chief Executive Officer, said “let’s turn to a topic of major interest in our industry, cap-ex” within just a few minutes of his opening remarks, further saying “I’d like to walk you through our lease structure and how cap-ex and other items are recovered from our tenants.” DuPont, as a strict ground up developer has not acquired any properties with existing leases, so they have written all their own leases. The DuPont lease structure is triple net and structured to recover most cap-ex. Maintenance cap-ex is recovered through tenants on a straight-line basis over the useful life of the asset. Overall, maintenance cap-ex recapture ranges between 80-90%.
The argument against this approach is that requiring customers to participate in these expenses would put DuPont at a competitive disadvantage. Fateh explains, however, that the sales pitch to clients is that they themselves are assuring infrastructure excellence which is paramount to their success. Furthermore, this up front transparency assures that DuPont has no motivation to cut any financial corners regarding maintenance cap-ex. Fetah explains “Our customers do not want us to be financially incentivized to cut corners on maintenance.” The bottom line for clients is that no matter where they lease, the provider will recover those costs in some way through the tenants.
Representatives from each of the companies addressing the maintenance cap-ex subject are quick to point out, and often more than once, that the assets at the core of their business are very long term with life spans of 15-30 years or more. They also point out, as seen in the Equinix slide above, that enhancing the life of those long-term assets is a high priority.
Accounting for cap-ex equipment is not always straight forward, and where there is ambiguity it makes sense to account for it in the most advantageous way. Although it’s not likely this event will bring forth an exact accounting without ambiguity, it has certainly increased transparency and will not likely be ignored in the future.
This report is for informational purposes only and should not be construed as investment advice. Seek an appropriate professional for investment advice. . For questions about this report contact Alan Howard at ahoward (at) wiredre.com or 602-885-5311.