- Making overly optimistic projections about the estimated useful lives of computer equipment can be used to inflate profits.
- Data center stocks with a very high cost of capital should be avoided.
Declining balance versus straight line depreciation
The declining balance method of depreciation closely mimics the market value of computer equipment. Using the declining balance method at a rate of 30% closely follows the trend of computers prices falling by half every 2 years.
For whatever reason, many data center stocks use the straight line method for depreciating computer equipment. Suppose the straight line method is used with an expected life of 5 years. In the first few years, the straight line method will produce (slightly) higher reported accounting profits than the declining-balance method. At year 4/5 and onwards, the straight line method will produce lower accounting profits. If a company is rapidly growing, then the straight line method will produce higher accounting profits.
In my opinion, publicly-traded companies should use the declining balance method. The depreciation rates of computer equipment is fairly well understood. Choosing the declining balance method will get rid of unnecessary accounting distortions.
Amazon uses straight line deprecation with a 3 year expected useful life. In my opinion, this is overly conservative and deflates Amazon’s reported profits. (In general, Amazon could do a better job at investor transparency. I could not figure out how much money it loses on early-stage ventures and how much it makes on mature businesses.)
Abusing expected useful life
There are certain data center stocks out there that continually issue stock. In my opinion, many of them have a Ponzi scheme element to them where the incoming shareholders are giving money to the old shareholders. One of the ways that these companies can inflate their accounting profits is to use the straight line method and to assume unreasonably long useful lives for their assets.
- It is possible to misclassify rapidly deprecating computer hardware as something else that depreciates at a lower rate. One red flag is if computer hardware makes up a suspiciously low percentage of overall assets. A data center may have very little computer equipment and networking equipment if customers bring their own servers and switches and routers. However, almost all data centers will offer Internet exchange services which requires the data center to own switches and routers (networking equipment). Small colocation customers with a few servers will generally purchase Internet connectivity from the data center (so the data center must own networking equipment for these customers). It is also likely that the data center has in-house IT needs.
- If computer hardware is lumped into a very generic category, then the accounting is more of a black box.
- It is a red flag if a company continually extends the expected useful lives of its equipment. One way to spot this is to compare 10-Ks across time.
Capitalizing expenses can potentially inflate accounting profits. Capitalizing interest costs and software development costs is on the aggressive side; not capitalizing them is conservative. I do not believe that these areas cause major accounting distortions for data center stocks. However, it is worth looking at to give you a sense of whether or not management is trying to be aggressive or conservative in their accounting.
Cost of capital
It is definitely worth looking at the interest rates that a company is paying on its debt and leases. It is generally a red flag if a company is paying more than 10% interest.
It also does not make sense for companies to borrow at interest rates higher than what their assets yield. I would definitely stay away from companies that borrow money so that they can lose it faster.