4 Reasons Dividend Lovers Should Be Cheering This Data Center Mega-Deal

Summary

• Digital Realty Trust has become the gold standard of data center REITs, and for good reason.
• This industry blue-chip has a proven management team and has made countless investors very rich over the years.
• However, its large size means that going forward, maintaining its historically strong growth rate is getting harder.
• Buying DuPont Fabros is a great way to move the needle and ensure stronger and more secure dividend growth going forward.
• DuPont investors meanwhile will benefit from larger economies of scale and greater access to cheaper capital going forward.

Real Estate Investment Trusts, or REITs, are generally known more for their generous and slow-growing dividends.

However, data center REITs are one exception, thanks to exponential growth of cloud computing, a mega-trend that is likely to dominate the 21st century.

Digital Realty Trust (NYSE:DLR), the second largest blue-chip in the field, is the gold standard of the industry, and a REIT I'm proud to own myself.

That being said, its large size means that going forward, maintaining the strong growth rates that investors have come to expect will be harder to come by. That's why I was excited to hear that Digital Realty was buying rival DuPont Fabros (NYSE:DFT) in an all-stock deal.

Let's take a closer look at this deal to see why investors in both data center REITs are likely to benefit from this deal.

As importantly, find out if now is a good time to buy Digital Realty, or if you should wait for a better price before adding it to your diversified dividend growth portfolio.

Digital Realty: A Fast Growing Blue-Chip Data

Digital Realty Trust is America's second largest data center REIT (behind Equinix (EQIX)) and has an excellent track record of some of the REIT sector's best growth rates since its IPO in 2005.

Source: Digital Realty Trust Investor Presentation

This fast growth is due to three key factors.

The first is the explosion in big data, courtesy of things like mobile computing, cloud storage, and video on demand.

This has resulted in demand for cloud computing and data centers that continue to far exceed the fast rate of new center expansion in the industry.

That in turn allows DLR to enjoy high occupancy rates while locking down recurring cash flows under long-term rental agreements with strong annual escalators that have outpaced the rate of inflation.

It also allows for expanding the REIT's property base at some of the REIT industry's most attractive cap rates (10% to 12%), both in terms of acquiring third-party data properties or building its own through its organic growth pipeline.

Combined with a highly diversified and high-quality tenant base, DLR enjoys highly secure and predictable cash flow with which to sustainably fund its growing payout.

That being said, as the second largest data center REIT, it does get harder for DLR to maintain its historically excellent growth rates.

Metric	Q1 2016	Q1 2017	YoY Change
Revenue	$504.2 million	$550.6 million	9.2%
Core FFO	$212.6 million	$247.9 million	16.6%
Shares Outstanding	149.9 million	162.6 million	8.5%
Core FFO/Share	$1.42	$1.52	7.0%
Forward Dividend	$0.88	$0.93	5.7%
Dividend Payout Ratio	62.0%	61.2%	-1.3%

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Source: Digital Realty Trust Earnings Release

For example, in the most recent quarter, core FFO/share and dividend growth was pretty good (as far as REITs go), but hardly the kind of growth rate that is likely to make investors happy given the relatively low 3.4% dividend yield.

Which brings us to the biggest source of growth for DLR, its strong track record of well-executed acquisitions.

Digital Realty has done a great job in terms of previous needle-moving purchases that have resulted in a highly geographically diversified property base in many of the world's fastest growing markets.

And that trend now continues, with DLR announcing on June 9th that it was buying rival DuPont Fabros.

At First Glance The Deal Seems To Not Make Sense...

REIT	Shares	2017 Core FFO Guidance	Core FFO/Share
Digital Realty Trust	162.6 million	$940.5 million	$6.03
DuPont Fabros	90.3 million	$277.2 million	$3.07
DLR + DFT	213.3 million	$1.28 billion	$5.98

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Sources: Earnings Releases, Earnings Presentation, Management Guidance

At first glance, DLR's acquisition of DFT doesn't seem to make sense, given that the increased share count means that pro-forma core FFO/share will actually decrease slightly, because of the low cash yield (marginal FFO/equity cost) of just 5.1%.

However, we have to remember that the investment thesis behind DLR, and all data center REITs, is focused on the explosive long-term growth of big data.

And when we take a look at things from that perspective, then the logic behind acquiring DuPont Fabros becomes clear.

...Until You Consider The Big Picture

After the merger, Digital Realty will not only have a larger, strengthened position in its key markets, but will also benefit from an opportunity to branch out into fast growing areas of the country like Oregon, where new startups are increasingly migrating to, as well as break into the Toronto market.

More importantly, DFT's high-quality tenant base will further strengthen DLR's market share in cloud computing, which is potentially the largest megatrend of the coming century.

In addition, the deal will further increase Digital Realty's scale, resulting in not just $18 million in synergistic cost savings but also greatly boost the REIT's profitability, as seen by one of the industry's lowest general and administrative cost margins.

This brings me to the biggest reason that investors in both Digital Realty and DuPont Fabros will benefit from this deal.

REITs as an industry are highly commoditized, because rental properties, even in fast-growing sub-sectors such as data centers, don't have much pricing power.

That means that being able to achieve large economies of scale and gain access to cheap growth capital that is the lifeblood of the industry is paramount to achieving sustainable long-term dividend growth, especially in a rising rate environment.

And from that perspective, DuPont Fabros investors will benefit from DLR's strong balance sheet, including one of the few investment grade credit ratings in the industry.

That in turn will mean easier growth financing going forward, which bodes well for DLR's future payout growth prospects.

Deal Gives Digital Realty A Dividend Growth Boost

REIT	2027 Projected Core FFO (Adjusted For Share Dilution)	Projected 2027 Core FFO/Share
Digital Realty Trust	$1.806 billion	$11.11
DuPont Fabros	$787.1 million	$8.72
DLR+DFT	$2.611 billion	$12.24

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Sources: Earnings Releases, Management Guidance, Investor Presentation, Fast Graphs

While this merger won't be immediately accretive to Digital Realty investors, when you take a longer-term, 10-year outlook, you can see that it does result in about 10% FFO/share growth than DLR could likely achieve on its own.

That translates to about a 0.5% faster annual dividend growth rate over the coming decade.

REIT	Yield	Forward Payout Ratio	10 Year Dividend Growth Projection	10 Year Potential Annual Total Return
Digital Realty	3.4%	61.7%	7.4%	10.8%
DuPont Fabros	3.6%	65.1%	9.8%	13.4%
DLR+DFT	3.4%	62.6%	7.9%	11.3%
S&P 500	1.9%	39.5%	5.7%	9.1%

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Sources: GuruFocus, Management Guidance, Fast Graphs

Which in turn should allow DLR to continue generating strong, market-beating total returns even if the Federal Reserve makes good on its plan to raise rates by 2% through the end of 2019.

Source: Hoya Capital Real Estate

That's because, data center REITs are highly interest rate sensitive, with their dividend yield rising pretty much in lockstep with 10-year Treasuries. However, Digital Realty as a gold standard industry blue-chip enjoys significantly lower costs of capital, both now and in a higher rate environment.

Digital Realty Trust Cost Of Capital

Source Of Capital	TTM Capital Weighting	Cost Of Capital	Cost Of Capital (Interest Rates +2%)
Retained Cash Flow	37.8%	0%	0%
Debt	34.2%	3.50%	5.50%
Equity	28.0%	5.28%	8.71%
Weighted Average Cost Of Capital	100%	2.67%	4.32%
Cap Rates	NA	10%-12%	12-14%

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Sources: Fast Graphs, Simply Safe Dividends, Management Guidance, GuruFocus

DuPont Fabros Cost Of Capital

Source Of Capital	TTM Capital Weighting	Cost Of Capital	Cost Of Capital (Interest Rates +2%)
Retained Cash Flow	34.4%	0%	0%
Debt	28.2%	4.34%	6.34%
Equity	37.4%	5.42%	9.54%
Weighted Average Cost Of Capital	100%	3.25%	5.36%
Cap Rates (Post Merger)	NA	10%-12%	12-14%

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Sources: Fast Graphs, Simply Safe Dividends, Management Guidance, GuruFocus

Specifically that means that even if interest rates increase by 2%, DLR is likely to enjoy a weighted average cost of capital that's about three times less than the cash yield on new investments.

Which means that long-term dividend growth investors need not worry about DLR's ability to continue growing profitably even if rates keep rising steadily.

Valuation: Is DLR Still A Buy Now?

DLR Total Return Price data by YCharts

While rising interest rates have resulted in REITs greatly underperforming the broader market this year, data center REITs such as Digital Realty have still managed to beat the S&P 500.

Of course that brings up the question of whether or not DLR is worth buying today even given the beneficial effects of the DFT deal.

REIT	P/AFFO	Historical P/AFFO	Yield	Historical Yield
Digital Realty	20.4	17.4	3.4%	3.8%
Industry Median	25.0	NA	2.5%	NA

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Source: GuruFocus, DLR investor presentation

From a short-term perspective, one could argue that DLR is slightly overvalued, both because the current price/AFFO is higher than its historical median value while the dividend yield is similarly below its historic norm.

Forward Post Merger Core FFO/Share	10 Year Projected Core FFO/Share Growth	Fair Value Estimate	Growth Baked Into Current Share Price	Margin Of Safety
$5.98	7.9%	$110.49	7.9%	0%

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Source: Fast Graphs, Management Guidance, GuruFocus

Things look a little bit better if we take a longer-term (20-year) outlook via a discounted cash flow, or DCF, analysis.

That shows that DLR's likely growth rate is indeed priced into the current share price, resulting in margin of safety of zero.

Or to put another way, DLR is fairly valued, not overvalued.

Kind Of Investor	Target Yield	Buy Now?
New Investor	3.4%	Yes
Existing Investor	4.0%	Wait Until $94

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Source: GuruFocus

So if you, like me and Warren Buffett, believe that it's reasonable to open an initial position of a best-in-breed industry leader at fair value, then adding DLR to your portfolio today makes sense, assuming you have a long enough time horizon and willing to tolerate a potentially strong short-term downturn.

However, if you already own the REIT (as I do), then you probably want to wait for a 15% pullback, which would mean a yield of 4.0%, slightly above its historical norm, and result in a much better margin of safety.

Given the high interest rate sensitivity of the stock, this is a realistic scenario that might occur within the next three to six months, especially if the broader market experiences its long overdue (eight months and counting) correction.

Bottom Line: Digital Realty's Increased Size Will Cement Its Status As The Ultimate Data Center SWAN And Result In Stronger Dividend Growth For Years To Come

Digital Realty's decision to acquire DuPont Fabros in an all-stock deal is likely to result in a more profitable REIT going forward.

More importantly, its future dividend growth prospects are greater, thanks to its greater economies of scale, stronger balance sheet, and likely larger access to low cost capital in the years to come.

That being said, with shares currently fairly valued, only new investors with a high risk-tolerance and long time horizon should buy at these prices.

Analyst’s 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.