Digital Realty: A High-Quality REIT Paying Safe, Growing Dividends

| About: Digital Realty (DLR)

Summary

DLR has increased its dividend for 11 consecutive years and offers a safe 4% yield.

The company is benefiting from the surge in data usage and enjoys strong occupancy rates.

Is the stock a buy for dividend growth investors?

Digital Realty Trust (NYSE:DLR) is a fast-growing real estate investment trust (REIT) that has raised its dividend every year since going public in 2004.

While the company is far from having a long enough dividend growth history to quality as a member of the dividend aristocrats list, it has numerous attractive qualities.

Digital Realty is a direct beneficiary of the rapidly growing usage of data by businesses and consumers alike. It powered through the financial crisis and also scores well for dividend safety and growth.

Digital Realty's stock has been one of the best-performing holdings in our Top 20 Dividend Stocks and Conservative Retirees portfolios, and we remain optimistic about the company's dividend growth trajectory.

Business Overview

Digital Realty is a REIT that supports the data center needs of more than 1,600 customers across industries such as financial services, information technology, manufacturing, and more. The company is the largest data center REIT in the world and has a portfolio of 139 operating properties.

Data centers provide secure, continuously available environments for companies to store and process important electronic information such as transactions and digital communications. Data centers can also serve as hubs for internet communications in major metropolitan areas.

The key components of a data center can be seen below and include servers, network equipment, cooling systems, electrical power systems, and more. Data centers consume a lot of power to keep the servers running and the room's temperature under control.

Click to enlarge

Source: Digital Realty Fact Sheet

Approximately 61% of Digital Realty's rent is from turn-key services, in which it provides everything but the servers. Some customers choose to provide the power components used in the data center (e.g., HVAC, battery, generator, electrical) and design it all themselves. This mix accounts for another 20% of the company's rent.

Digital Realty generates about 80% of its rent in North America with the rest from Europe (14%) and Asia (6%). The company's largest tenants are IBM (7.5% of rent), CenturyLink (6.1%), Equinix (4.0%), Facebook (2.3%), and AT&T (2.1%), LinkedIn (2.0%), and Oracle (2.0%).

Digital Realty is also well diversified by customer type. Approximately 33% of Digital Realty's annualized rent is from IT Services, 24% from Telecom Network Providers, 19% from Other Corporate Enterprises, 15% from Financial Services, and 9% from Internet Enterprises.

Business Analysis

Playing in a growing industry is almost always better than competing in a shrinking market. In Digital Realty's case, its data center operations are exposed to several long-term secular demand drivers.

Simply put, data use is exploding and driving more demand for servers and data centers. Growth of internet traffic, over-the-top-video, cloud, and mobile data traffic is expected to range from 21% to 45% per year over the next several years, according to an investor presentation by Digital Realty.

As a result, Markets and Markets expects the global data center solutions market to grow at a compound annual growth rate of 11.7% from 2015 through 2020 to nearly double in total value. As the largest data center operator in the world, Digital Realty is well positioned to ride this tailwind.

Data center REITs are also attractive businesses because their services are non-discretionary expenses for companies -- the data being stored and processed in data centers is needed to run their operations. As a result, Digital Realty enjoys high utilization rates in most economic environments.

As seen below, Digital Realty's total portfolio occupancy has remained about 90% in each of the last seven years, including 95% in 2009. The company also notes that its tenant retention ratio has been strong at about 72% of net rentable square footage.

Click to enlarge

Source: Digital Realty Company Overview

Occupancy and retention rates are also high because it is costly for customers to switch data center facilities. Digital Realty cites that it costs customers anywhere from $10 million-$20 million to migrate to a new facility. A new data center deployment also costs customers $15 million-$30 million, further reducing the incentive to switch landlords. The following chart shows how much higher tenant retention rates have been for data center operators compared to other types of landlords.

Click to enlarge

Source: Digital Realty Company Overview

Digital Realty's average remaining lease term with customers is 5.8 years, and fewer than 15% of its total leases are set to expire in any of the next five years. Most of the company's leases also contain 2%-3% annual rental rate increases. As long as customers stay financially healthy to pay their rent obligations, Digital Realty has solid cash flow visibility.

The company is also uniquely positioned to meet the needs of major businesses because of its scale, reputation, and favorable real estate locations in major metropolitan areas. Having customers such as IBM, Facebook, LinkedIn, and Oracle speak to the quality of Digital Realty's properties.

We also like the company's diversification by customer (top 20 tenants are 44% of annualized rent) and industry, which helps smooth out earnings. Digital Realty's mix of data centers is also improving.

In October 2015, the company acquired Telx Holdings for about $1.9 billion. Telx is a leading national provider of data center colocation solutions and doubled Digital Realty's high-margin colocation business, which allows companies to rent partial spaces within a data center.

Telx also introduced Digital Realty to over 1,000 new companies it can target for its existing data centers. This is important because over 80% of the company's traditional large footprint leasing activity over the last two years has been repeat business with existing customers.

Overall, Digital Realty operates in an industry with favorable growth trends and gains benefits from its scale, cost-efficient real estate locations, non-discretionary services, and strong customer relationships.

Digital Realty's Key Risks

We generally avoid investing in technology companies because industry trends can unexpectedly and quickly take a turn for the worse. In Digital Realty's case, we think the biggest risk is that data centers are overbuilt in anticipation of strong data usage trends.

After all, Digital Realty cannot control the capital allocation of its competitors. As long as cheap financing is widely available and industry margins are high, more supply will enter the market. If an excess supply of data centers occurs, Digital Realty could experience unfavorable lease renewal rates (13% of its square footage under lease expires through 2017), weaker profitability, and lower growth.

As seen below, new construction is set to double data center supply in some of the cities Digital Realty operates in. Time will tell if this new capacity loosens the market's favorable fundamentals, but it's important to remember that Digital Realty is somewhat protected due to its scale, reputation, cost-efficiency performance, and financial stability.

Click to enlarge

Source: Digital Realty Fact Sheet

As technology evolves, it's also possible that companies learn to store and manage data much more efficiently. This could reduce demand for physical data center space. However, there would have to be major advancements to offset the 20%+ annual growth in data usage across Digital Realty's major markets.

Beyond risks unique to the data center market, Digital Realty faces risk from the health of capital markets. REITs are required to pay out 90% of their taxable income as a dividend to keep their REIT classification and the favorable tax treatment it comes with.

Since REITs pay out such a high amount of their earnings, they have less capital on hand to grow their businesses. As a result, they typically issue shares and debt. As seen below, Digital Realty's capital structure was over 50% debt last year, and the company's diluted shares outstanding have risen from 24 million shares in 2005 to a whopping 139 million shares last year.

Digital Realty Dividend

Source: Simply Safe Dividends

Digital Realty Dividend

Source: Simply Safe Dividends

REITs can run into trouble if credit markets tighten up and/or their share prices sink, raising their cost of capital and potentially causing a liquidity squeeze.

Digital Realty currently maintains investment grade credit ratings from the major agencies, although it sits at the bottom tier of what is considered "investment grade." The company has just $75 million in cash on hand compared to $5.9 billion of debt, but it has a relatively conservative debt maturity schedule with nothing major coming due until 2020 (see below).

However, all REIT investors should be aware of capital market risk -- companies will cut the dividend before they miss interest payments during times of financial stress.

Click to enlarge

Source: Digital Realty Fact Sheet

Dividend Analysis: Digital Realty

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Digital Realty's Dividend Safety Score of 77 indicates that its current dividend payment appears to be very safe today. The company's adjusted funds from operations (AFFO) payout ratio in 2015 was a reasonable 78%, and Digital Realty targets an AFFO payout ratio below 90%.

While this would be a relatively high payout ratio for many types of businesses, Digital Realty has generated very stable earnings and growth since it went public.

Digital Realty Dividend

Source: Simply Safe Dividends

Demand for data centers is also somewhat resistant to economic cycles. The company's sales grew over 20% in 2009 as businesses continued outsourcing their mission-critical data center needs. DLR's stock also outperformed the S&P 500 by 29% in 2008.

Digital Realty Dividend

Source: Simply Safe Dividends

While sales growth has decelerated over the last five years, Digital Realty has continued to earn a reasonable return on equity in the high-single digits. The company's return is limited by its capital intensity and competitive nature of rental rates, but its profitability should be consistent.

Digital Realty Dividend

Source: Simply Safe Dividends

As long as industry fundamentals remain positive and capital markets remain friendly, we believe Digital Realty's dividend is in good shape from a safety perspective.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

DLR has raised its dividend every year since its IPO in 2004 and grown its dividend by about 13% per year over the last 10 years. However, as seen below, dividend growth has decelerated. The company most recently raised its 2016 annualized common dividend by 3.5%, marking its 11th consecutive increase. Going forward, we expect dividend growth in the low- to mid-single digits.

Digital Realty Dividend

Source: Simply Safe Dividends

Valuation

DLR's stock has a dividend yield of 4%, which is below its five-year average dividend yield of 4.9%. The stock also trades at 18 times FFO per share. We think the company can continue generating mid-single digit income growth, which would imply annual total return potential of 8%-10% per year.

We have enjoyed a total return of more than 40% since initiating our position in the stock last summer, and it's hard to make a strong valuation case for the company today.

Conclusion

At the end of the day, Digital Realty seems a bit overpriced today and we are not interested in adding to our position. However, data center fundamentals look strong, and we like the themes the company is benefiting from.

As long as Digital Realty is keeping its data centers occupied at favorable rental rates and capital markets remain healthy, we are content to keep collecting our quarterly dividend payments. We plan to hold Digital Realty and some of our favorite blue-chip dividend stocks for the long haul.

Disclosure: I am/we are long DLR.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.