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Morningstar | An Outlook Affected by Capacity Constraints Overshadows Strong Quarter for CoreSite

CoreSite reported a strong third quarter that exceeded consensus estimates for revenue, EBITDA, and funds from operations and left the firm tracking slightly ahead of our full-year expectations. However, capacity constraints resulted in lower new lease signings and a diminished pipeline that will likely cause 2019 results to fall below our projections and require a higher level of capital spending than we forecast. We plan to reduce our $110 fair value estimate by $3-$5 to account for that outlook, but we continue to like CoreSite's strategy. We think its emphasis on network connections and history of resisting the temptation to chase undifferentiated data centers strongly support its narrow moat. While we recommend a wider margin of safety given near-term headwinds, we see this as an interesting name on a bigger pullback.

For the quarter, operating revenue and adjusted EBITDA each grew 13% over last year, leaving the firm on pace to exceed our projections of 12% revenue and EBITDA growth. Revenue rental growth of 11.5% matched our forecast and is identical to what we project for the year. However, interconnection revenue growth decelerated, falling below double-digit year-over-year growth for the first time in recent memory at 9%. While the drop is noteworthy, we expect a portion of it was due to the churn of a single customer, and while it may see similar levels over the next couple quarters, we expect its long-term trajectory to remain in the low-double digits annually.

The biggest adjustment to our model is likely to be a revised capital expenditure level in 2019. We expected it would increase significantly over 2019 and be over 50% of sales, as we knew several data centers would be under construction. However, in discussing its initial outlook, management said it expects spending to be $400 million-$450 million, $60 million-$110 million more than we had forecast, even though we were not surprised with the amount of space that will be under construction.

We are not concerned with the higher construction cost. Data center construction costs don't evenly align with the productivity they bring on line, meaning that most costs are up-front, and they can then scale the data centers to accommodate more tenants with a fraction of the spending requirement. The near-term outlay will weigh on our fair value estimate, but we don't expect it to affect our long-term spending projections.