Digital Realty hitting the hard reality
“The true art of memory is the art of attention.” (Samuel Johnson)
Remember datacenters? In 2000, many of these operators crashed with the tech bust, but like the phoenix they made have made a comeback again with the real estate bubble.
One of them in particullar, Digital Realty Trust (DLR), is still flying high.
At about $31 per share, it is about 40% down from its all time high of $50 and has rebounded from its November 21 low at $18. It currently trades at:
-142 times TTM earnings
- 15.1 times EBITDA (or a cap rate of about 7%)
-2.7 P/B
-8.1 X TTM Revenue
At these lofty prices the stock is, in my opinion, priced for perfection and bound to disappoint. Below are the four reasons why I think this stock is bound for a correction:
Primo: Sub-market cash returns on declining asset values. It generates a value destroying, miniscule, return on book equity of about 1%, and is paying a dividend yield of 4%. It’s like getting paid 4% on a bullet that will return less than the principal. For this type of return you’d be better off buying 10 year bonds and getting close to 3%.
Secundo: increasing costs of capital. It’s a capital intensive business (structured as a REIT) which requires constant tapping into the capital markets for debt and equity. Investment banks and their analysts love it, but investors are much less receptive now and with no appetite recovery in sight. Debt refinancing is much more expensive and equity issuances are more dilutive. This means less growth and lower earnings per share in the futures.
Tertio: Vulnerable client portfolio. Looking at their client portfolio, the largest client responsible for 10% or so of rental revenue is Savvis a $300 million market cap tech company providing “cloud” applications. Not a rock solid company by any means, but it does not seem to be in immediate survival danger either. The second largest customer is Qwest (Q), the telecom company formerly lead by Joe Naccio; the third, Equinix (EQIX), is another tech company, with a respectable $2 billion market cap, offering products which are rather similar to DLR: connectivity and collocation, etc. The fourth largest customer, called Telx Group is a company also offering fairly similar collocations services controlled by private equity firm GI partners. DLR is a portfolio company of GI partners and the CEO of GI partners is the Chairman of DLR, (interesting…). About 15% of the business comes from Silicon Valley.
Bankruptcies, consolidations and business relocations are likely to impact the portfolio, as does the fact that many of their clients have businesses that are remarkably close to DLR, and in many cases in addition to leasing from DLR, they own their own datacenter facilities, so they can always build and operate their own centers if they get cheap enough.
Quatro: inflation risk. The average life left in the leases is about 7 years. According to their filings “many of the leases provide for fixed rate increases”- many does not mean most, and a fixed rate increase means many that are not indexed to inflation.
Conclusion: In my view this Phoenix will soon turn into…an Icarus.
(The phoenix from the Aberdeen Bestiary.)
Disclosure: short DLR.
