DuPont Fabros Technology, Inc. (DFT) owns, develops, operates, and manages wholesale data centers in the United States.  Its data centers are used by customers to house, power, and cool the computer servers that support their critical business processes. As of September 2008, it had five stabilized operating properties in northern Virginia, as well as development properties in Chicago, Illinois; Piscataway, New Jersey; and Santa Clara, California.

Recent concerns about DFT access to liquidity and the risk to its development pipeline has driven the stock down by 65% in the past week.

Business Model

DFT has a very simple business model and a nice niche in the real estate world.  It develops properties that have no alternative uses except for data centers.  There is less competition relative to other types of properties such as office, retail, and apartments etc because developing data centers require specific know-how that is outside the “comfort zone” of most real estate developers.

All properties are under triple-net leases and contain annual rent increases.  Tenants are responsible to pay all direct operating expenses, and pro rata share of indirect expenses.  Therefore cash flow is very stable and you can view the common share as a bond-like instrument.  

Moat: Extremely high switching cost

• Disruption of service.  This would be a disaster for the tenants (internet companies and financial institutions).
• Potential loss of data.
• In layman’s terms, moving a data center is 10 times harder than relocating a Walmart store from NYC to LA with zero inventory missing while keeping the store open.  Let’s just say tenants will not move unless they HAVE TO.

Moat: strong, consistent demand

·        The “size” of data is growing exponentially with technological advancement.  Digital camera used to be 1MB.  Now 10MB is the norm.  New blue-ray formats has tripled the data that an old DVD movie contains.  There are more examples.

·        Emails, youtube videos, our bank account usage history etc.  Our everyday lives are generating “data” continuously, and that drives demand for data centers.

Major Competition

·        Mainly from users building their own centers.  The credit crisis actually helps DFT because firms are more likely to “outsource” rather than using capital.

Properties

Short-term liquidity

Source: 3Q08- 10Q, earnings call, Bloomberg

Risks

• The major risk is the credit of the tenants.  As of Oct 1, 2008, Microsoft and Yahoo accounted for 69% of annualized rent. 
• DFT has debt maturity in Dec 2009 and Aug 2010.  It will cause problems if credit remains frozen for the next few years.

Why did the stock go down?

• In order to bring ACC5 and NJ1 online (CH1 is finished) and payoff amounts owing related to SC1, DFT needs approximately $312 m.
• Concern about DFT access to capital.  Management indicated they would raise $300 - $400 m of debt on ACC4, but were only able to get $100m.
• In negotiation with an unnamed pension fund for mezzanine financing for $150m.  Market fears what if the deal collapse?
• Disappointing leasing results in CH1.
• Dividend cut.

I believe the market has overreacted to the above issues.

Bankruptcy Risk

Even if the credit market stays frozen and DFT is not able to get the financing they need, they will still have the stabilized assets and CH1.  The total price of “walking away” would be roughly $200 m ($68m of payables, $70m for SC1, $62m for NJ1 and ACC5: the rest is labor cost that will not have to be paid).  DFT has $175m and generates about $15 – 20 m cash flow per quarter.  Additionally, ACC5 and NJ1 is debt free.  So the bankruptcy risk is close to zero.

Valuation

Using a discount rate of 15% and assuming no growth, DFT is worth $8.5/share. 

In a normal environment, I assume 12% discount rate, 3% growth ( rent increase is included in the lease contracts, it is cost of living or 3%, whichever is greater), the share would be $14/share.

This excludes CH1 and the pipeline of NJ1 and ACC5.  In other words, you get a free call option on the pipeline, for which will be online in Q1 and Q3 of 2009.

Catalyst