Will cloud giants really drive colos off a financial cliff?

The dude who predicted the Enron collapse bets they will

Analysis Jim Chanos, the infamous short-seller who predicted Enron's downfall, has said he plans to short datacenter real-estate investment trusts (REIT).

"This is our big short right now," Chanos told the Financial Times. "The story is that, although the cloud is growing, the cloud is their enemy, not their business. Value is accrued to the cloud companies, not the bricks-and-mortar legacy datacenters."

However, Chanos's premise that these datacenter REITs are overvalued and at risk of being eaten alive by their biggest customers appears to overlook several important factors. For one, we're coming out of a pandemic-fueled supply chain crisis in which customers were willing to pay just about anything to get the gear they needed, even if it meant waiting six months to a year to get it.

The pandemic created a massive backlog for datacenter infrastructure ranging from servers and switches to racks and power supplies. With the supply chain showing signs of recovery, analysts are predicting robust growth in the datacenter market, which of course includes legacy datacenters.

When folks eventually receive their orders they're going to have to put them somewhere, and for many that's still going to be at colocation providers. In anticipation of this, many colos have accelerated their expansion plans to ensure they can meet this demand when it arrives.

More than a server farm

What's more, Chanos's depiction of datacenter REITs as little more than a place to park a couple of servers or racks — and admittedly a lot of them still are — isn't exactly an accurate depiction of the larger providers.

Many colos are quickly becoming full-fledged infrastructure-as-a-service providers as they embrace new consumption-based models and place a stronger emphasis on networking and edge connectivity.

"As you look at the colocation services, the networking services have become a pretty big deal to differentiate them from just being a simple chunk of real estate to plop your servers," Forrester analyst Glenn O'Donnell previously told The Register.

Equinix, for example, offers a full suite of edge networking, bare-metal compute, and datacenter interconnect services to its customers in addition to leasing space in its facilities.

Are cloud providers really coming for the colos' lunch?

Chanos also asserts that these legacy datacenter operators should be wary of their cloud customers, which he argues will be their undoing.

"The real problem for data center REITs is technical obsolescence," he said. "Their three biggest customers are becoming their biggest competitors. And when your biggest competitors are three of the most vicious competitors in the world, then you have a problem."

Chanos is, of course, talking about the big three cloud providers: Amazon Web Services, Microsoft Azure, and Google Cloud Platform.

To Chanos's credit, an IDC report out this week found that many datacenter and colocation customers were accelerating their cloud migrations as a means to circumnavigate ongoing supply chain disruptions and inflationary pricing pressures.

"The last few years have demonstrated that, in challenging times, businesses increasingly rely on cloud services to modernize their operations and deliver more value to customers," Dave McCarthy, research VP of cloud and edge infrastructure services at IDC, said in a statement. "This trend is expected to continue as public cloud providers offer more ways to extend cloud services to on-premises datacenters and locations. These options reduce the barriers to migration and will facilitate the next wave of cloud adoption."

In other words, offerings like AWS Outposts, Microsoft Azure Stack, or Google Distributed Cloud may help cloud providers coax customers out of their private datacenters and colocation leases into the cloud.

Speaking on CNBC this week, Digital Realty CEO Bill Stein rebuffed Chanos's arguments.

"I think Jim maybe isn't aware that demand has never been stronger in our space," he told the financial news network. "He refers to our cloud service providers as our competitors, but we view them as our partners, and they view us as partners. We enable their growth around the world."

He also highlighted the company's expansion plans in Africa, Europe, and existing markets, like Virginia, where Digital Realty plans to add 1.5 gigawatts of new capacity.

Stein isn't wrong to point out the colocation provider's geographic reach, which remains one of colocation providers' biggest advantages over their cloud counterparts. The major cloud providers operate a relatively small number of large datacenters, predominantly clustered in key metros around the world. By comparison, Equinix and Digital Reality, two of the largest colos, operate hundreds of sites globally, many in far-flung locations where the cloud providers have little to no coverage.

To further bolster their numbers, many large datacenter REITs have turned to cannibalism. In the first half of this year alone, we've tracked roughly a dozen colocation mergers and acquisitions as large colos expanded their reach to new markets.

That's not to say the cloud providers aren't expanding too. Dell'Oro Group reports that the major hyperscale and cloud providers will open upwards of 30 new regions this year, despite challenging economic and supply chain conditions.

A short-sighted bet?

It's exactly these kinds of economic headwinds that Chanos says will unravel REITs.

"The whole cross section of REITs just seems absurd to us," he said on Bloomberg's Odd Lots podcast earlier this week. "We've gotten so used to feasting on these ultra-low interest rates that I don't think people realize where equities will trade in a resetting market where risk-free rates are 4-5 percent."

Executives at Equinix, Digital Realty, and Iron Mountain previously dismissed rising interest rates during their respective earnings calls this spring. "We have no meaningful near-term exposure to rising interest rates," Equinix CFO Keith Taylor claimed on the company's Q1 earnings call.

Speaking to CNBC this week, Stein hammered this point, arguing that the company was largely isolated from rising interest rates for similar reasons.

"We've been pushing rates this year and will continue to push rates. And our escalators are now being indexed to CPI, so we're hedged against inflation," he told CNBC, adding that he believes that residual values will be "further protected by the current inflationary environment."

Despite these claims, datacenter REITs, and the broader tech space in general, have seen their valuations decline precipitously since the start of the year.

Equinix and Digital Reality are prime examples. Equinix, which has seen its stock price slide more than 20 percent this year to date, recently landed on a Wells Fargo short-list, while Jefferies flagged datacenter REITs as a "stagflation risk." Meanwhile, Digital Realty has fared even worse, with its stock price sliding more than 25 percent from the start of the year.

However, if stock prices are any indicator, the cloud providers – their parent companies anyway — have seen their stock prices decline by similar or even worse margins. Amazon has seen its stock price tumble more than 36.6 percent since January.

Chanos's next big short depends on these trends continuing, but with supply chains steadily improving, and demand for datacenter infrastructure at a record high, that's anything but a sure bet. ®

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