Digital Realty (NYSE:DLR) has been in the news a lot. The San Francisco-based Data Sector REIT has been the target of a short play that began on May 8th when Highfields Capital made a case that the $9 billion REIT was worth two-thirds less than Mr. Market was claiming. Since that time, Digital shares have traded down by around 15.5% with a recent close of $56.28.
Recently I caught up with Green Street Advisor's Senior Analyst, John Stewart. He is a leading industrial and technology analyst as he has covered the data sector at Green Street and other notable firms including Credit Suisse, Citigroup and Merrill Lynch. Stewart is a member of the CFA Institute and the New York Society of Securities Analysts. He earned his B.S. in Accounting from Oklahoma State University and is a Chartered Financial Analyst (CFA) charterholder.
Thomas: John, thanks for your time today. In a recent Seeking Alpha article I explained that the IRS has formed a "working group" to determine whether Iron Mountain's (NYSE:IRM) record-warehousing model is defined as "real estate" as the agency is examining the business more closely to determine whether or not its "interest in real property" - primarily storage racks - are included (as "real estate"). My first question is related to the racking and specifically, how can Digital's racking system be considered real estate when Iron Mountain's racking systems are being questioned?
Stewart: The biggest distinctions in my mind are that Digital owns the dirt under its buildings, and leases space out to tenants - that's the definition of commercial real estate, as far as I'm concerned. I don't cover Iron Mountain, but it's in the document storage business. It leases, rather than owns, most of the real estate it controls, and it charges customers by the box, rather than the square foot.
Thomas: My second question has to do with Iron Mountain's business model. It seems that the company's "economic moat" is shrinking as the data sector REITs are growing. In other words, what is the future in document storage as the "paper" market share seems to be shrinking while the paperless (or cloud) space appears to be expanding?
Stewart: Again, I don't cover Iron Mountain, and I'm sure there will always be a need to store some important physical documents. On the other hand, there is definitely a trend towards "going paperless" where possible, and we're storing a lot of documents in Evernote these days instead of old-fashioned filing cabinets. It's also fascinating that Iron Mountain is getting into the data center business itself, notably with a large underground facility in a former limestone mine outside of Pittsburgh.
Thomas: Speaking of the cloud, Digital Realty has been under the microscope lately as the hedge fund, Highfields Capital Management, has recently shorted the largest data sector REIT maintaining that the shares should be trading at around $20 per share. Now I have publicly recommended Digital and my target price of $65.50 was justified by the 12.8x P/FFO multiple and consistent and growing dividends paid. What are your thoughts on Digital's current share price of $61.21?
Stewart: We have a published HOLD recommendation on shares of Digital Realty Trust. However, I would point out that Digital maintains a conservative balance sheet, and management has created significant value for shareholders over the company's tenure in the public markets. Buy-and-hold investors certainly have a much more attractive entry point here, than they did before Highfields started rattling cages back in early May, when the stock was trading at over $70/share.
Thomas: Green Street is one of the most outspoken REIT proponents for NAV-based valuations. Can you explain your NAV-based model for Digital Realty and what cap rate are you using and do you feel as there are sufficient comps to support your valuation of Digital?
Stewart: Sure. We essentially apply a "cap rate" to their rental income stream to arrive at our estimate of the value of the real estate they own, which is really no different than applying a multiple to a cash flow stream to arrive at the value of any other business. We currently use a 7.0% cap rate to value Digital's portfolio, and yes, I do believe there are sufficient comps to support our valuation. I think there was a time, early in the sector's life cycle, when data center cap rates were much more art than science, but the sector has really become a mainstream asset class over the past several years, and we do see enough data center comps to feel reasonably comfortable with the cap rate we use to value Digital's portfolio.
Thomas: One of Highfields' arguments has to do with the sustainability of the data sector model. It seems that the data sector REITs are in the infant stages of becoming a dominating REIT sector and with Equinix (NASDAQ:EQIX) likely to list REIT shares in 2015, then the sector will be larger than the self-storage or triple-net sectors. How can the "cloud" be shrinking?
Stewart: Well, I don't think the cloud is shrinking. I think what Highfields was trying to say is that competition is increasing, and large tech companies like Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN) are beginning to offer cloud services which will compete with Digital's data center business. I don't think there's any doubt that competition in this business has increased - Digital enjoyed first-mover status, had the field essentially to themselves for the first couple of years, and generated tremendous returns. Those outsized returns did attract competition, however, and several new entrants have moved into the space. On the other hand, I think the cloud services that Google and Amazon provide is a fundamentally different business than Digital's dedicated data center model. I also think demand is strong enough to support both business models.
Thomas: Another Highfields' argument has to do with declining lease rates and negative releasing spreads. Is that a valid argument?
Stewart: It is. Like I said, competition has definitely increased, and that has put downward pressure on rents. As a result, rents that may have been signed at the peak of the market are rolling down today. So, yes, rental rates have declined due to increased competition, and re-leasing spreads on expiring rents have been negative lately. On the other hand - despite the very recent backup in interest rates - it's still a low-return world, and return requirements on all asset classes have come down over the past several years. Consequently, even at today's lower rents, Digital is still able to generate a very healthy (several hundred basis point) spread relative to its cost of capital.
Thomas: It seems that one of the biggest issues that Highfields has questioned (regarding Digital) has to do with the financial accounting and specifically the cap-ex that is being (or not being) reported. Is this more of a transparency issue or an ethical issue? What is it that Highfields is contending?
Stewart: Well, I don't think Highfields necessarily got any of their facts wrong, but I do think they were on a mission to find a "smoking gun" that just wasn't there. Digital's disclosure is highly transparent (take a look at the quarterly Supplemental disclosure package on their website), and I have a high degree of confidence in management's integrity. I think Highfields was insinuating that Digital is cooking the books to defraud investors, and I just don't think that's the case.
Thomas: Digital appears to have a well-supported dividend that increased to $3.12 per share or 6.8% over 2012. The company has produced 15.3% compounded annual dividend growth since 2005 and its dividend policy (pay out a minimum of 100% of taxable income and <90% payout ratio) is sound. The first quarter (Q1-13) payout ratio was 84.1%. In your opinion, is Digital's dividend record sustainable?
Stewart: Yes. We believe Digital's dividend is well-covered and sustainable.
Thomas: Finally, I have spoken with Michael Foust and I have listened to several earnings calls. He appears to be a very experienced CEO and his leadership strategies seem to be well-aligned with shareholders and investors. It is interesting, however, that some investors have questioned his slow response to the Highfields short. I don't think Foust made a public statement regarding the Highfields' attack until I met you at the NAREIT REIT Week conference. Do you think he should have responded earlier?
Stewart: I'm not really sure what else he could have done. Keep in mind that Highfields has never published their presentation, they just made their remarks to a closed investor conference, so there was never any direct challenge to refute. You also can't control what other market participants are going to do. Some people are going to buy your stock, and some are going to sell. The best course of action, in my view, is to let actions speak louder than words, and prove the naysayers wrong by consistent execution. I think Digital is off to a great start on that front, as evidenced by the immediate stock price reaction following the well-received property tour and investor presentation at NAREIT.
Thomas: John, thank you for your time. Greatly appreciated.
Green Street Advisors, which started in 1985, is the leading independent research firm specializing in REITs, covering 83 North American real-estate companies and 29 in Europe. The firm employs more than 30 dedicated research professionals in the US and Europe, much more than other sell-side shops. Green Street's hallmark is its independence. The firm does not engage in investment banking or consulting projects for companies in its coverage universe. Of particular note is its excellent track record: the firm's Buy recommendations have returned 25% annually since 1993, versus 12% for all companies it covers and 0% for its Sells.