Investing for Dividend Growth
Investing in dividend stocks is a great way to conservatively preserve wealth while stripping out consistent income. Unlike investing in bonds, dividend investors own a piece of a business that has the potential to grow in value over time. Owning equity is more risky than bonds for those with a short time horizon, but investors who only own bonds are more likely to lose their purchasing power if the economy experiences high inflation.
Owning dividend stocks for the dual purpose of preserving purchasing power and stripping out yield is a great concept, but I have often found that some high yielding stocks are value traps. These value traps may offer high yields but have no growth prospects or may even be in declining markets. What is the point in owning a high yielding stock if the value of the equity deteriorates?
It is often better to take a lower dividend yield with the promise for greater dividend growth. The compounded growth of the dividend payments will likely result in a greater total amount of dividends received over the life of a long-term investment. Also, the underlying business is more likely to appreciate in value.
In this article, I will highlight two dividend stocks with strong long-term growth potential. Both stocks benefit from the explosive growth in digital data consumption, but the two companies are very different and benefit from data growth tailwinds in different ways.
The first stock is Digital Realty Trust (DLR) which owns data centers facilitating cloud computing. The second stock is Crown Castle International (CCI) which owns telecommunications towers used by wireless carriers. Both companies offer attractive current dividend yields but more importantly have the ability to grow dividend per share payments at a high annual rate for many years to come.
Digital Realty Trust
Digital Reality Trust (DLR) is a REIT focused on leasing data centers. The company manages 198 data centers in 32 cities around the world. This is a highly regarded real estate manager with blue chip customers that include IBM, Facebook, AT&T, and Uber. Although real estate focused on data centers sounds niche and focused, DLR is highly diversified with over 2,000 customers across different technology verticals (cloud, financial, media, communications, etc.).
Source: DLR November 2018 Investor Presentation.
As a data center landlord, DLR has strong organic growth potential. Due to a proliferation in devices and information generated by those devices, data is growing at an exponential rate. All that data needs to be processed and stored somewhere and DLR leases the physical space for that to happen.
Furthermore, computing is increasingly happening off premises in the cloud. A wave of big data and cloud computing techniques including the internet of things, machine learning, and artificial intelligence are helping to accelerate the shift to the cloud. This is driving a capex boom in the data center. As a preeminent landlord to data centers, DLR has partnered with many of the largest tech companies and is directly benefitting from the ramp in cloud capex spend.
Source: DLR November 2018 Investor Presentation.
The above table shows DLR’s financial performance over the past 8 years. The company has compounded top and bottom line earnings consistently at a double digit rate. This has been accomplished through organic and inorganic means. On the inorganic side, DLR completed a $6.2 billion all-stock merger with competitor DuPont Fabros Technology in 2017 which significantly expanded the company’s scale. Organically, not only does DLR benefit from the increasing demand for data center space, but DLR passes on annual rent increases to its customers of 2% to 4%.
As a tax-efficient REIT, DLR passes on most of its cash flow and earnings back to shareholders in dividends. FFO is a decent proxy for DLR’s cash flow and the company has an FFO dividend payout ratio of 63%. The low payout ratio along with the significant FFO growth over time implies that the dividends paid per share should also continue rising at a healthy clip. From 2005 to 2018, the dividend per share payment has grown at a 12% annual rate.
Bottom line: Digital Realty Trust is a solid dividend growth stock. The current dividend yield of 3.8% is competitive with a yield investors can get from corporate bonds, but the real end-game is that the dividend payments will likely continue rising at a double digit rate for years to come.
Crown Castle International
Crown Castle International (CCI) is a REIT focused on telecommunications infrastructure. The company owns 40,000 towers and 60,000 miles of fiber cables supporting small cell networks. The company leases space to cell phone companies which use CCI’s sites as the foundation of their network infrastructure.
CCI runs an extremely high quality business with stable recurring cash flows from blue chip customers. Customer contracts are between 5 and 15 years long and have a 97.5% renewal rate. Furthermore, once CCI leases out space on its towers, customers install their own equipment, limiting the amount of capital CCI must invest and reducing business complexity.
There are strong long term growth tailwinds driving CCI’s high-single digit organic growth. Mobile devices of various sorts (phones, tablets, and now machines like connected cars) are driving increased usage on mobile networks. Not only is devices per capita increasing but data usage per device is increasing as well. This has driven wireless carriers to invest in more equipment to densify their networks. The more equipment each carrier adds to towers, the more space they need to rent from tower companies like CCI.
Source: CCI Q3 2018 Investor Presentation.
Wireless carriers are investing significant capital to get 5G networks up and running. Expected to launch nationwide by early 2020, 5G will be a significant boost to wireless speeds but will require more equipment to run. This “densification” of cell networks results in a need for more towers, especially small cell sites in urban locations.
Source: 2018 10K.
CCI has reported that 69% of its towers have fewer than 3 tenants. Over time the company will see increased rents from towers due to more tenants per tower, more customer equipment to manage heavier traffic, and contractual annual rent increases.
The table above shows CCI’s financial performance over the past 8 years. CCI has shown very steady revenue growth that has significantly outpaced economic growth. The company earns a very high EBITDA margin exceeding 50%. This high margin supports the significant leverage taken on to finance the purchase and investment of additional towers as well as the company’s healthy dividend yield.
Dividend payments were introduced in 2014 when CCI converted into a REIT and have since grown at a high single digit rate (a similar rate to revenue growth). The company is targeting long-term annual growth in dividends per share of 7-8%. Because the company already pays out a high share of its cash flow in dividends, dividend per share growth will mostly come from earnings growth. Thankfully, the outlook for earnings growth is strong.
With a 4.2% dividend yield, CCI already has an attractive yield. The continued growth in dividend per share payments is a good draw for investors.
DLR and CCI are both interesting businesses with attractive yields and solid long-term fundamentals. DLR has a slightly lower yield but is growing its business and dividends per share at a faster rate. CCI is a slower grower but is more stable. In the event of an economic downturn, DLR may see some customer vacancies if the tech sector curtails its capex budget. On the other hand, CCI will likely experience little impact from a recession because phone plans are not cut in a downturn and wireless companies will continue to upgrade their capacity and service their existing equipment. This is all to say that I believe CCI is the more defensive pick while DLR is more growth oriented.
A major downside to both DLR and CCI is the high valuation multiples on their underlying businesses. The headline valuation multiples are slightly mis-leading because they are structured as tax-efficient REITs. REITs trade at higher multiples because earnings are favorably taxed. That being said, the multiples are high even for REITs.
For comparison, the MSCI REIT index has a 4.6% dividend yield and a 37x forward P/E multiple. CCI yields 4.2% and has a forward P/E multiple of 68x. DLR yields 3.8% and has a forward P/E multiple of 83x. Investors are paying up for growth and these are two very high quality companies.
If you are a dividend investor, I would focus more on the yield and potential for the dividend payments to grow. Over time, the valuation multiples will compress as earnings grow. The high valuation multiples are a potential red flag that the businesses could be over-valued. However, the high dividend yields will keep the stock prices elevated. Unless the dividend payments are cut, I do not see the stock prices of DLR or CCI falling very much before their yields become too attractive to pass up.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.