By Christopher Gannatti, CFA
People, businesses, and even governments have transformed the way they relate to data.
Now you can access almost entire discographies with just an internet connection through services like Spotify (SPOT). That The idea of lugging all your data around with you no longer makes sense.
Data centers and a smooth, efficient internet connection are responsible for this change.
Cloud providers vs. data centers
Cloud computing has attracted enormous attention as a megatrend in its own right. Global sales are forecast to exceed $495 billion in 2022, which could reach more than $1 trillion by 2030. Around 30% of enterprise workloads have moved to the cloud.1
When we think of “the cloud,” some of the largest companies in the world spring to mind. Amazon’s (AMZN) Amazon Web Services (AWS) Leads; Together with Microsoft (MSFT) and Google (GOOG) (GOOGL), the three companies account for 65% of the combined share of global cloud services spend.2
But when we say “the cloud,” what does it look like in the physical world? We can assume that the software will always be present on our smartphones, tablets and computers, but this all depends on a specific, purpose-built infrastructure.
Figure 1 is from Equinix (EQIX) Q2 2022 Investor Presentation. Equinix is a leading provider of data center infrastructure, operating on six continents in 31 countries with 248 data centers.3 Here they take four of the big “hyperscalers” — the companies that power the cloud platforms that enable much of the world’s digital needs to be met.
Even though we know the names of the hyperscalers — these are typically some of the largest market cap companies in the world — we might not be familiar with the name “Equinix” right away. Still, it’s clear that Equinix is central to the functioning of today’s digital world.
Figure 1: Equinix provides a physical foundation for the cloud hyperscalers
Slicing the cake of economic profits
Today, Equinix gets about 35% of its total rental from the largest cloud providers. Would you like to sit on the other side of the negotiating table with the world’s largest corporations? Factoring in the impact of energy costs, large tech companies pay about half the rent of a small business or government tenant.5
Asking whether data center providers will ever supplant the world’s largest companies in terms of their ability to extract economic value from the cloud ecosystem is probably the wrong question. Instead, it may make sense to think about the relationship between current price and projected future supply/demand balances. Data center infrastructure is a commodity in the broadest sense, provided vendors can provide essentially the same capabilities to cloud computing companies.
The world’s increasing focus on climate and the environment is making it harder to build more data centers that use lots of water (cooling) and lots of electricity. In the first six months of 2022, asking rents for data centers in major US locations increased by 5.9% compared to the same period in 2021. If this trend continues, it’s possible that 2022 will be the first year of positive data center rental growth since 2017.6
Will the hyperscalers “go their own way”?
The largest companies in the world are able to think strategically over long periods of time because of their enormous resources. People outside of Apple (AAPL), for example, may have realized too late that the perceived commitment to Intel’s (INTC) chips was not permanent and that Apple – with the appropriate commitment and investment – could develop its own chips based on the experience of its customers better. With companies generating tens of billions of dollars in annual cash flows, these resources combined with long-term thinking could erase perceived limitations.
In fact, hedge fund manager Jim Chanos is betting against data center infrastructure providers like Equinix and Digital Realty Trust (DLR). These hyperscalers can and do build some of their own facilities — a Microsoft data center in Chicago spans 700,000 square feet, the size of about 52 Olympic-size swimming pools.7 Why shouldn’t they start building all of their facilities themselves, thereby reducing the cost of data center infrastructure providers?
While nothing is ever “impossible”, when thinking of strategic value properties like this one, location is important. If Equinix or Digital Realty Trust have their infrastructure in the more ideal locations, connected to the major networks with the right infrastructure, it’s not possible to build something new in the same location. If today’s hyperscalers were to start from scratch, they would probably build a lot themselves. Given that these companies are trying to leverage existing infrastructure wherever they can to serve their customers — assuming companies like Equinix and Digital Realty Trust own those properties — they’ll likely continue to have their place in the ecosystem. The convenience of plugging into existing setups can replace the cost savings of manufacturing in-house.
It’s also that the customer base is likely to evolve. Just as the hyperscalers may be thinking about ways to get more economic value and take away the expense items paid to technology infrastructure providers, other companies are seeing large expenses being paid to Microsoft, Amazon, Google Cloud, etc. It’s possible that the diverse businesses undergoing their specific “cloud migrations” will seek direct relationships with infrastructure providers in the future.
This idea has been debated for almost as long as hyperscalers have been in the cloud computing business, and so far data center infrastructure providers like Equinix and Digital Realty Trust are still at it.
Conclusion: Digital transformations need physical infrastructure
We spend a lot of time thinking about different megatrends like cloud computing, artificial intelligence, 5G, the internet of things… the list goes on.
Figure 2 shows that data transmission standards – things we know as 2G, 3G, 4G, 5G – have a lifespan of about 20 years.8th The move to 5G tells us that more and more data is being generated and processed and we need data center infrastructure to support it.
Figure 2: Developments in connectivity standards in the United States
If investors are thinking of another way to get involved in megatrends – in their underlying infrastructure rather than the more direct players – the concept of “new economy” real estate could offer something unique that offers a different risk and return profile than that could show stronger growth -oriented technology stocks. Learn more about our specific strategy: the WisdomTree New Economy Real Estate Fund (WTRE).
1 Source: “The Cloud Computing Giants Vie to Protect Fat Profits” economist08/29/22.
2 Source: Aaron Tilley, “Cloud company outlook cools as customers tighten spending,” Wall Street Journal8/25/22.
3 Source: Equinix Investor Presentation, Q2 2022.
4 Source: Carol Ryan, “Data centers are unpopular. All the better for their shares.” Wall Street Journal30.8.22.
5 Source: Ryan, 08/30/22.
6 Source: Ryan, 08/30/22.
7 Source: Anna Gross, “Will the Cloud Kill the Data Center? Jim Chanos thinks so.” financial times08/29/22.
8th Source: “Introduction to the Tower Industry and American Tower”, American towerStatus 12/31/21.
As of September 9, 2022, WTRE held 4.70% and 5.03% of its weight in Equinix and Digital Realty Trust, respectively. Click here for a full list of fund holdings.
Important risks associated with this article
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Christopher Gannatti, CFA, Global Research Director
Christopher Gannatti joined WisdomTree in December 2010 as a Research Analyst, working directly with Jeremy Schwartz, CFA®, Director of Research. In January 2014, he was promoted to Associate Director of Research, where he was responsible for leading various groups of analysts and strategists within WisdomTree’s broader research team. In February 2018, Christopher was promoted to Head of Research Europe, where he will be responsible for all of WisdomTree’s research efforts in the European market, based out of WisdomTree’s London office, as well as providing global support for the UCITs platform. Christopher joined WisdomTree from Lord Abbett, where he worked as a Regional Consultant for four and a half years. He received his MBA in Quantitative Finance, Accounting and Economics from NYU’s Stern School of Business in 2010 and his bachelor’s degree in economics from Colgate University in 2006. Christopher holds the Chartered Financial Analyst designation.
Editor’s note: The summary bullet points for this article were selected by Seeking Alpha editors.