WikiLeaks Is A Powerful Catalyst For This Data Center REIT

| About: QTS Realty (QTS)

Summary

Thanks in large part to wikileaks, managing data for the federal government now requires the implementation of stringent security protocols.

Federal agencies and the government contractors face a number of unique challenges that go hand in hand with bureaucratic operations.

Due to the nature of the data the government stores, they are a valuable target for hackers.

Clearly, cyber-security will be an important mandate for the new Trump Team and we believe that QTS is poised to profit.

In the December edition of the Forbes Real Estate Investor (published today), we provide insight into a few sectors that we believe will benefit from the new President Trump administration.

One sector that we believe holds the most potential is the Industrial sector, and a few days ago, President-Elect Trump went to work earlier than expected by persuading United Technologies (NYSE:UTX) to keep around 1,000 factory jobs at the Carrier plant in Indianapolis, instead of moving them to Mexico. According to a tweet, Trump explained

It appears that the economic drivers are in place for the U.S. Industrial sector to outperform in 2017 and we weigh-in our favorite picks in the newsletter.

Another sector that we believe is geared to outperform in 2017 and beyond is the Data Center category. As explained in a white paper from QTS Realty (NYSE:QTS):

As the number and frequency of data breaches increased and subsequently gained more media attention, people have become more aware and concerned about the security of their data.

As businesses and agencies face increasingly complex security requirements, stringent compliance restrictions and the growing demand for immediate access to data, it makes less and less sense for these organizations to invest resources in the operation and management of their own data centers.

Enterprises are leaving the data center business, opting instead to seek a partner for their data center, colocation and cloud needs.

According to QTS, "in 2005, there were a total of 157 data breaches, according to the Identity Theft Resource Center. In 2014, that number rose almost 400% to 783 breaches - an average of 15 breaches a week. The healthcare industry experienced the most substantial jump, recording an almost 2,000% increase (16 in 2005 to 333 in 2014)."

Furthermore, healthcare organizations tasked with storing patients' healthcare and other personal data must comply with ever-evolving Health Insurance Portability and Accountability Act (HIPAA) compliance standards.

Financial services companies must comply with Sarbanes-Oxley (or SOX) regulations when handling their customers' data. And because Federal government agencies contract with outside agencies to manage their data services, those contractors must ensure they meet the requirements of the Federal Information Security Modernization Act (or FISMA).

As we all know, thanks in large part to wikileaks, managing data for the federal government requires the implementation of stringent security protocols. Failing to provide a high level of security can result in the compromised data of millions of Americans.

Accordingly, Federal agencies and the government contractors that work with them face a number of unique challenges that go hand in hand with bureaucratic operations. From security issues to compliance requirements to working with big data, navigating the federal data services maze can be a tall order.

In June 2015, the U.S. Office of Personnel Management (or OPM) announced that the personal records of roughly 4.2 million people had been compromised in a cyber-breach. A few weeks later, it was revealed that the number of people affected by the hack was actually closer to 21.5 million.

Data compromised in the breach included Social Security numbers, names, dates and places of birth, as well as addresses and other information related to security clearances. Also included in the breach were 5.6 million sets of fingerprints. OPM officials later estimated the breach would cost the government $133 million, mostly for credit monitoring services for victims of the breach.

Due to the nature of the data the government stores, they are valuable target for hackers. With attacks on data systems becoming increasingly more and more sophisticated, opportunities are expanding for government contractors. As such, there is a large sum of money budgeted by the government for cybersecurity contracts with private sector businesses.

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Enter QTS Realty

QTS delivers an integrated platform of colocation, cloud and managed hosting solutions designed to simplify strategies for its customers by delivering increased IT efficiency and reduced capital expenses.

QTS's international footprint of data centers provides a redundant, robust and dependable infrastructure, ideal for workloads that demand high-performance, high transaction volumes and low latency, while processing vast amounts of data, reliably, securely and cost-effectively.

QTS operates 24 data centers on four continents, and the company is poised to deliver world-class infrastructure and value-added technology services to more than 1,000 customers in North America, Europe, Asia and Australia.

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QTS is a leading national provider of data center solutions and fully managed services and a leader in security and compliance. The company offers a complete, unique portfolio of core data center products, including custom data center, colocation and cloud and managed services, providing the flexibility, scale and security needed to support the rapidly evolving hybrid infrastructure demands of web and IT applications.

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As the nation's only provider of a fully integrated technology services platform: C1 - Custom Data Centers, C2 - Colocation, and C3 - Cloud and Managed Services, overlaid with industry-leading security and compliance, QTS is truly differentiated in the market.

Focusing on Quality, Not Quantity

QTS continues to be driven by its core business model of delivering a unique integrated services platform, on top of world-class real estate assets, with exceptional customer service to achieve industry-leading return on invested capital (or ROIC).

QTS has significant growth opportunities within its current portfolio - 1.0M sq. ft. additional capacity in existing properties and around 250 acres of land adjacent to existing properties.

QTS has flexibility to optimize product offerings in response to demand. QTS has the ability to nearly double capacity in existing properties and more than double facility sizes with adjacent, owned land at every mega facility.

Here's a snapshot of QTS's "Best-In-Class "Mega" Data Centers":

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Growing Platform

QTS's platform provides broad geographic and revenue diversification. As you can see below, QTS has a balanced revenue mix across 3C products - around 50+% of revenue derived from customers using more than one "C" product.

QTS has a high credit quality tenant base with over 1,000 customers. The top 10 tenants as a percentage of annualized MRR are approximately 34.7% and the largest tenant accounts for ~11.4% of annualized MRR; no other customer represents > 4% of annualized MRR.

QTS has industry-leading security and compliance, and is positioned to bring highly compliant solutions to sophisticated enterprise customers, specializing in the healthcare, finance, high tech and government sectors. There is a significant opportunity for QTS to grow its new and existing customer partnerships by focusing on security and compliance needs.

Cyber security risks and concerns among enterprise IT departments will unlock the next wave of enterprise outsourcing to third-party data center providers. QTS's market-leading breadth of compliance certifications & security capabilities present a unique opportunity, given the increasing focus on data security & compliance by customers.

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The Improved Balance Sheet

QTS is the smallest Data Center REIT as illustrated below:

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Source: S&P Global Market Intelligence

As you can see below, QTS's adjusted EBITDA margin continues to demonstrate the operating leverage inherent in the model. For the third quarter, the company generated an adjusted EBITDA margin of 45.7%. On a year-over-year basis, the adjusted EBITDA margin increased 170 basis points.

On a sequential basis, QTS's Adjusted EBITDA margin declined 50 basis points, driven by a lower seasonal NOI margin and also the full quarter impact of the company's recently acquired lower-utilization Piscataway facility. Also, the NOI margin tends to drop in Q3, driven primarily by seasonally higher utility costs and then ramp back up in Q4.

As of Q3-16, QTS's total debt outstanding, including capital leases was $874 million. The company's Q3-16 net debt to annualized adjusted EBITDA, was approximately 4.6x. QTS expects leverage will increase in the coming quarters as it delivers on its development pipeline.

QTS has significant liquidity capacity in the balance sheet. At the end of the quarter, the company had a total of approximately $380 million in liquidity, made up of availability under the credit facility and cash on hand.

As you can see below, QTS has no near-term debt maturities, minimal secured debt and significant available liquidity.

In August, S&P Global Ratings upgraded QTS's corporate credit rating to BB- from B+ and removed all ratings from CreditWatch with positive implications.

The rating agency also lifted its issue-level rating on QTS Realty's unsecured credit facility and senior unsecured notes to BB from BB-, while maintaining its recovery rating at 2. S&P attributes the upgrade to its increased confidence in the cash flow stability of the REIT's business, thanks in part to strong data center services demand and multiyear contracts.

The outlook is stable, reflecting S&P's view that QTS Realty's continued investment in data center capacity will give it sufficient liquidity to finance growth efforts and negative discretionary cash flow until at least the close of 2017.

Here's Why Average Joe Likes QTS

As we explained in the Forbes Real Estate Investor, we decided to take a position in QTS as a holding in our Average Joe Portfolio. We decided to initiate a position based on the attractive growth prospects, and of course valuation.

As you can see below, for full year 2016, QTS continues to expect core organic revenue growth in the mid-teens and has lowered the annual churn expectation to a range of 5% to 7% from 5% to 8%, factoring in better-than-initially projected year-to-date performance.

In Q3016, QTS raised the bottom end of its adjusted EBITDA guidance by $2 million to a range of $180 million to $187 million. The company also raised the OFFO guidance range to $139 million to $143 million.

As a result, QTS raised its OFFO per share guidance to a range of $2.57 per share to $2.65 per share. The 2016 OFFO guidance includes an estimated non-cash tax benefit of approximately $7 million. As you can see below, QTS has delivered robust growth across all metrics:

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Why Does Average Joe Like This REIT?

Time will tell if President-Elect Trump will make American Great Again, but Average Joe can't wait to make his REIT portfolio great again. As referenced above, we decided to include QTS in our Average Joe Portfolio based on the company's attractive growth levers, but also on valuation.

Take a look at QTS's dividend yield:

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Source: S&P Global Market Intelligence

OK. I get it, Average Joe is not excited about a 3.1% dividend yield; however, he does like the growth prospects, and especially the payout ratio:

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Source: S&P Global Market Intelligence

In addition to QTS's built in cushion (low payout ratio), the dividend history has been strong (double-digit) and we are forecasting continued growth in 2017:

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Source: S&P Global Market Intelligence

On a current valuation basis, QTS appears to be in-line with the peers:

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Source: S&P Global Market Intelligence

However, we see that shares have underperformed the peers over the last 12 months:

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Source: S&P Global Market Intelligence

Also, QTS has underperformed over the last 90 days:

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Source: S&P Global Market Intelligence

In closing, we believe that QTS is well-positioned to outperform in 2017. Clearly, cyber-security will be an important mandate for the new Trump Team and we believe that QTS is poised to profit from the growth across all of the company's revenue channels. QTS has a strong leasing development platform that should add value in Chicago as well as existing markets of Richmond, Atlanta, and Dallas.

QTS has more varied product offering than the peers and the company is able to address demand for data center space as well as managed hosting and cloud computing. Also we believe that QTS will become larger as the sector consolidates offering economies of scale across its varied platforms.

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Here's our conservative price target of $64.00 (2018) that forecasts annualized Total Returns of 17%:

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Author Note: Brad Thomas is a Wall Street writer and that means that he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos and be assured that he will do his best to correct any errors, if they are overlooked.

Finally, this article is free and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

REITs mentioned: (NYSE:COR), (NASDAQ:CONE), (NYSE:DFT), and (NYSE:DLR).

Sources: F.A.S.T. Graphs, S&P Global Market Intelligence and QTS Filings.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am/we are long O, DLR, VTR, HTA , STAG, GPT, ROIC, HCN, OHI, LXP, KIM, WPC, DOC, EXR, MYCC, TCO, SKT, UBA, STWD, CONE, BRX, CLDT, HST, APTS, FPI, CORR, NHI, CCP, CTRE, WPG, KRG, SNR, LADR, PEB, BXMT, IRM, CIO, LTC, DEA, NSA, HASI, VER, QTS.

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