Demand for Digital Real Estate Is Greater Than Just the Cloud

Wednesday, October 11, 2017

Despite tremendous growth in the wholesale and retail data center industries over the past five years, internet infrastructure and communications services analyst Jim Breen believes the industry is still in the early innings of a profound shift. Similar to cellular tower providers being among the biggest beneficiaries of the development of advanced mobile technology from 2G to 4G LTE, he believes that colocation providers will be among the biggest beneficiaries of cloud computing as cloud providers look to cost-effectively expand infrastructure to the edge of the network.

The global colocation market is fragmented and highly competitive, with many small colocation service providers competing with global telecommunications carriers and carrier-neutral service providers for a share of the fast-growing market. Over 30 colocation providers have emerged to contend in the highly successful data center outsourcing market.

Over the past decade, the market has evolved rapidly as enterprises seek to optimize IT resources by outsourcing with colocation or public cloud providers. Colocation involves some capital cost (servers, software, and possibly racks) for enterprises, but it does not involve costs and operation of all the equipment required to make a data center functional. According to Breen, "As enterprises have become increasingly comfortable with outsourcing more core IT, we believe the next wave of public cloud and colocation growth will be long-tailed. As such, the movement of IT resources such as applications, compute, and storage away from on-premises facilities and into data centers is still in its early stages." Colocation service providers continue to benefit from a massive shift of applications moving to the more-efficient public cloud deployment model.

In 2016, hyperscale cloud providers dominated global data center lease activity. Although this demand has moderated in the first half of 2017, cloud providers continue to represent greater than 25% of revenue for all of the top six publicly traded data center providers, and revenue from this vertical has kept pace with consolidated industry growth. Since top cloud providers lease data center capacity from all of the top providers, Breen believes that continued growth of the public cloud should continue to serve as a catalyst for wholesale and retail providers.

However, data center demand is more than just cloud-driven; adoption is taking place in a broad swath of industries. Breen estimates "that telecom network providers represent 25% of global industry data center leasing and financial services are 20%. Data centers form the main internet peering points for the delivery of financial data today, and we expect healthcare and enterprise to drive the next stage of industry demand."

With large internet content providers, financial services firms, and telecom services providers deploying servers in wholesale colocation, retail colocation, on-premises, and public cloud configurations, data center providers are increasingly trying to expand the scope of their offerings. Wholesale colocation providers deal with large spaces, 10,000-square-foot data centers that are essentially empty space or a shell, except for the power and cooling infrastructure. The customer installs the servers and racks, and connects and configures the IT gear. Retail colocation generally offers services that wholesale colocation does not, such as maintenance of servers. The wholesale approach has typically been of interest to companies seeking larger data center footprints with greater power needs as the economics of wholesale space have historically been most attractive to companies requiring at least 1 megawatt of power capacity for their data center. Digital Realty has historically focused on larger wholesale deals, offering finished "turnkey" spaces at less expensive per unit rates than retail colocation. Although in recent years, it—along with other wholesale data center providers—has been pursuing smaller deals in an effort to maximize the value of their data center space, bringing them into direct competition with retail colocation providers that often lease their space, such as Equinix.

Over the long term, Breen believes the deployment of internet applications (SaaS, OTT) will be evenly split between colocation and the public cloud. A portion of colocation demand has arisen from service providers/enterprises that outgrow the public cloud. However, many large internet content providers remain in the public cloud, which continues to gain new features. Public cloud providers will continue to be both customers and competitors to colocation providers over the long term.

Industry consolidation should continue at a robust pace as the leading providers pursue scale, scope, and prime real estate assets. The first half of 2017 featured several multibillion-dollar M&A transactions. Consolidation has enabled the continuation of stable pricing. We expect M&A to remain prolific as regional providers seek to enter new markets and larger players seek to eliminate tough competitors.

This report initiated coverage of Digital Realty Trust, CoreSite, and CyrusOne. For more information on these or other companies from Jim Breen’s coverage list, please contact your William Blair sales representative.

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