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Morningstar | CoreSite Meets Muted Expectations to Close a Year of Disappointing Execution; Maintaining $105 FVE

After CoreSite's disappointing results last quarter, we were conditioned to expect less than stellar results over the next several quarters, as the company deals with insufficient supply to meet demand and higher build costs while it increases capacity. Fourth-quarter results and 2019 guidance the company offered were consistent with that outlook. Although we'd classify the self-imposed headwinds as execution missteps, we won't disparage management for being consistent with the firm's culture, which we think is its virtue. We've liked CoreSite because it has refused to recklessly chase a hot market, instead staying focused on its small footprint of existing markets, where we believe it has a competitive advantage due to the network effect that is behind our narrow moat rating. We believe it may lag competitors' performances while the environment stays hot, but we think CoreSite has better ability to weather colder times. We have some concern that management will overreact to the current constraint, but given the firm is staying in existing markets and simply enhancing its current footprint with the increased near-term building, we are maintaining our view of the firm and our $105 fair value estimate.

Revenue growth in the quarter was 11% year over year but flat sequentially. The 13% revenue growth for the full year was a significant deceleration from 2017's 20%. We expect revenue growth in 2019 to be around 7% before temporarily spiking to the mid-teens in 2020 as it takes advantage of new capacity. Adjusted EBITDA margins--53.6% in the quarter and 54.4% for the year--compressed slightly, down 100 basis points and 20 basis points, respectively. Property operating and maintenance costs and rent were a bit higher than the prior period, and management noted cost inflation in its build costs, which affects the firm as it undertakes more aggressive expansion. We model continuing operating and maintenance inflation over our forecast, averaging about 2% through 2028.

At the end of 2018, CoreSite had 271,000 square feet under construction, and we expect the bulk of that to come on line in 2019, including new space in Santa Clara and Virginia, two of the hottest markets and places where CoreSite is especially constrained. The firm expects about $370 million in additional build costs for the square footage under construction, which will contribute to all-time high capital expenditures for CoreSite--we project about $400 million total capital spending in 2019. As we noted, we have some concern with this level, which we expect to be about 65% of sales and, more importantly, will require leverage to go above four times EBITDA, which is higher than the firm's typical range. However, CoreSite has seen capital spending spikes before, most notably in 2013 and 2016, and each time the spending retreated to more normalized levels afterward. As long as this does not become a trend, our view of the company remains the same.