Has a leading data center firm finally seen the stock stall after a strong year of gains? Equinix Inc (NASDAQ:EQIX) now trades at a phenomenal 67x forward earnings yet investors apparently can’t get enough of the stock with it up 120% since the start of 2012.

While the stock surged to a multi-year high last week, the data center firm continues to spend more on capital expenditures than operations can generate. The company is in the process of transitioning to a REIT further suggesting market excitement has probably reached a high point. After all, the company basically only rents space and power to technology clients. It isn’t the technology expert normally envisioned by the market.

Even as a CPA and former analyst at a telecom, I must admit that reading the financials of these data center firms is a struggle. A company such as Equinix now has moved beyond free cash flow to discretionary free cash flow and adjusted discretionary free cash flow. While excluding certain one-time charges have some validity, investors need to be alert.

Adjusted Discretionary Free Cash Flow

The biggest issue with this sector remains that the companies continue to build data centers and networks for the future that will never be the future networks. The minute a competing data center is built, the business customers will flock to the updated services provided by the new data center.

The big issue with valuing a telecom play versus a real estate play is the depreciation expenses. For the traditional real estate concept, the building doesn’t actually depreciate at the rate required for accounting purposes. Wonder how many customers still use the Equinix facilities from 2000 especially if no major capital updates were completed?

The below chart from the Q3 earnings presentation highlights the major issue with the sector as a whole. The company classifies capital expenditures as ongoing versus expansion. While the discretionary free cash flow number appears impressive with the expansion capital and depreciation charges excluded, at no point does the company actually generate more cash from operations than it turns around and spends on new capital other than a random quarter prior to major expansion growth.

The question remains whether the company is building to add customers or replace aging facilities. The recent transaction to selloff 16 data centers highlights that issue further. Not to mention, in Q3 2012 the company spent nearly $100M more on capital expenditures than the adjusted discretionary free cash flow.

REIT Transformation

The planned transition to a REIT on January 1^st, 2015 makes a ton of sense considering the company rents real estate space. Sure the space is customized for a hot, growing sector with apparently insatiable demand, but it still doesn’t change the fact that competition is fierce and growing.

The company already faces competition as a REIT with Digital Realty Trust, Inc. (NYSE:DLR) , DuPont Fabros Technology, Inc. (NYSE:DFT) , CoreSite Realty Corp (NYSE:COR) , and recent IPO CyrusOne. The average yield in the sector is already below 4% showing a potential over excitement in REITs that benefit from the growth in demand for data center space.

Digital Realty will provide the most useful comparison when Equinix transforms to a REIT. The company has a market cap of $8.7B and a revenue base of $1.27B. Both numbers slightly smaller than Equinix. The stock trades with a 4.1% yield.

Dupont Fabros and CoreSite are considerably smaller companies but have similar multiples as Equinix. These two stocks yield less than 3.5% suggesting Equinix has already benefited from gains related to transforming to a REIT.

Further competition also exists with most of the major telecoms that also rent space in data centers to clients.

Stock Performance

The stock performance over the last year has been absolutely phenomenal as the plans to transition to a REIT no doubt caught the attention of investors looking for yield. The 52-week high of $222.55 is roughly 120% higher than the start of 2012 around $100. Interesting the other REITs have mostly struggled during that time period with only CoreSite having gains even close to half of Equinix.

Chart – Data Center REIT Comparison

EQIX Total Return Price data by YCharts

Conclusion

As an investor fundamentally opposed to the valuation of Equinix as 2012 started, the huge gains make the view of the stock even more negative. One of the biggest issues in the collapse of the telecom stocks in the 2000s was the consistent inability to generate cash even as the sector was booming due to exploding spending on capital expenditures.

At some point, the great wealth creating companies generate cash beyond the amount needed to expand or update services. If business demand was at a premium, why don’t these companies increase prices on existing locations to generate the cash needed for new facilities? Constantly building to satisfy customer requirements for cheap rental space doesn’t justify sky-high stock valuations. Ultimately generating free cash flow creates wealth.

The article Investors Ignore Data Center Firms Spending Problems originally appeared on Fool.com and is written by Mark Holder.

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