Seeking Alpha

Wall Street Makes Bad Choices, So We Bought Digital Realty

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About: Digital Realty Trust, Inc. (DLR), Includes: INXN
by: Colorado Wealth Management Fund
Summary

Digital Realty announced the acquisition of InterXion. DLR will give INXN shareholders 0.7067 shares of DLR per share of INXN.

DLR's management has emphasized their desire to focus on assets outside the United States, especially when they can develop the asset themselves. INXN owns the ideal assets.

By purchasing INXN, DLR unlocks an enormous portfolio of assets ripe for developing. DLR prepared an exceptional balance sheet so they would be ready to develop the assets.

Those development opportunities won't produce revenue until they are actually built and leased, so the deal will be slightly dilutive to FFO per share in 2020.

Third quarter results looked pretty good, leasing volume was exceptional. Guidance for 2019 was reduced slightly due to the timing of some asset sales.

Do you want a good investment?

The market has created a great opportunity by not understanding long-term growth.

Digital Realty

Digital Realty (DLR) has delivered exceptional returns since its IPO. Management has demonstrated a keen eye for real estate transactions which enhance shareholder value. DLR is buying InterXion Holding N.V. (INXN) to unlock the best portfolio for future development across Europe. Future developments don't pay rent. Construction in progress doesn't pay rent. Each time a development is completed, the new revenue should lead to growth in DLR's earnings (using normalized FFO or analyst AFFO). Since that revenue doesn't occur until properties are developed and leased, it has a temporary negative impact on earnings. We don't mind the temporary negative impact, because we are evaluating DLR on a long-term basis. Fortunately for shareholders, management also is focused on the long-term creation of shareholder wealth.

Digital Realty Update

Digital Realty is the second-largest data center REIT. They carry a risk rating of 2, which reflects management's risk-averse strategy for building the REIT with low leverage. The balance sheet is firmly investment grade. Despite a solid balance sheet, some volatility still exists in the share price. Investors have seen a recent dip as money moved away from the cyclical sectors. That's not a problem. We picked DLR as a long-term choice and we're going to focus on long-term analysis. We want to view the most recent developments within the context of long-term investing.

Management's Decision Making

Management's decisions have driven substantial shareholder value over the last 15 years. Since their IPO, 15 years ago, DLR has thoroughly smashed any index. Whether it's compared to REITs or to technology stocks, DLR has been a winner:

Since their IPO, DLR has won consistently. There's a great deal to like about the REIT. They deliver a solid dividend yield while maintaining exceptionally fast growth. At times, their growth techniques can bother some analysts. Management has routinely prioritized long-term growth over short-term earnings growth. That's a sign of good real estate management.

We're going to go out on a limb and make a statement that may bother some analysts: "DLR's management is more talented at evaluating data-center opportunities than analysts." Their latest acquisition is a perfect example.

Merging with INXN

DLR is merging with InterXion Holding. This is easily the most exciting announcement. While there was a negative knee-jerk reaction in the market, we believe this deal will turn out very well for shareholders in both companies.

Shareholders of INXN will get .7067 shares of DLR for each share of INXN they own.

For instance, someone who owns 10,000 shares of INXN would get 7,067 shares of DLR in the merger.

Customers Are The Real Focus

This deal is driven by the benefits it creates in serving customers. The customers want to deal with REITs who can handle their global traffic flows. Technology companies already have gone global. They want data centers to support their global presence. Bill Stein discussed the importance of a global presence near the start of the call:

Source: Seeking Alpha transcript

This global infrastructure gives DLR a superior position for selling services to other global technology companies. However, it also provides an incredible opportunity for DLR to invest internally.

Best Opportunities are Abroad

During a recent presentation (this summer), DLR's management indicated that they favored investing internationally. They believed international assets had a superior growth profile. Remember that DLR's management has an exceptional track record of deciding which assets to develop and which assets to own. When they say international assets have a superior growth profile, we're comfortable taking them at their word. So DLR intends to expand internationally, but do they intend to buy portfolios or develop new assets?

Development

A year or two ago I heard DLR's management speaking about data centers at another event. They took a question on whether they favored buying data centers or developing them internally. They said they could buy around a 6% cap rate or develop data centers near a double-digit cap rate. Did the investor really wonder whether they would prefer a 6% yield or a low double-digit yield?

Given the higher yields available on development, it should be no surprise that DLR likes to develop their own assets.

How Development and INXN Go Together

So why did DLR choose to buy INXN? Because INXN owns a substantial amount of land. Specifically, INXN owns land that's ideally positioned for building data centers. DLR arranged to buy INXN in an all-stock transaction which keeps their balance sheet in impeccable condition. When the deal goes through, they have easy access to cheap debt financing which can be used to fund development on the land they acquired through INXN.

Even though DLR is the larger company and will represent about 80% of the combined enterprise, INXN had far more land ready to develop. INXN had the land and DLR had the financial position:

Source: DLR

DLR was preparing for this transaction in advance. They sold an enormous portfolio of assets to drop their debt ratios. Their "Net Debt to Adjusted EBITDA" is declining from 6.1x to 5.0x because they are selling the Mapletree portfolio. That's a portfolio of assets management decided they didn't need in the company for the long term.

They could've used the lower leverage for a debt-financed buyout of INXN. They could've, but that would've weakened the balance sheet. Instead, they are using their own stock as the currency for the buyout. Consequently, DLR should be in a perfect position to finance development.

While we see the development opportunities driving substantial value for shareholders, we see benefits from reducing expenses as well.

Cost Synergies Exist

The DLR earnings call included management from both companies. The merger provides some significant cost synergies from eliminating duplicate costs, such as those incurred by being a public company. It also provides cost synergies by leading to a lower cost of debt. DLR has access to materially better (lower interest rate) financing than INXN. Those factors alone can create a more efficient company. Consider the expected size and EBITDA margins:

Source: DLR

Putting it Together

Let's combine the lessons we've covered:

  1. DLR wants to be huge because it creates a more compelling pitch for customers.
  2. DLR wants to focus on growing internationally because of a superior growth profile.
  3. DLR likes developing assets because of the attractive yield for shareholders.
  4. DLR strengthened their balance sheet by disposing of a large portfolio of non-core assets.
  5. DLR is buying INXN and getting access to an enormous pipeline of development opportunities.
  6. DLR has better debt financing than INXN, so the combined entity has a lower cost of debt.
  7. The merger reduces duplicative costs, driving stronger EBITDA margins.

Given those facts, how can analysts not be excited?

An Analyst Who Did Not Sound Happy

We'll take a quote from an analyst on the earnings call who sounded less excited. He can phrase the question:

Yes. First question, just strategically, you guys have been extraordinarily active at building out the global platform. And different from your original M&A deals early on, the last few have been dilutive in the near-term, part driven by development, part driven by deleveraging and asset sales, but they'll eventually be accretive. But it just feels as though whether it was Ascenty, the Macquarie deal, this Interxion deal, you sort of pushed the growth to eventually coming.

What gives investors confidence that you won't do (another deal) next year that then impacts 2021 growth and we're just on the sort of flat cycle until you eventually get to a more positive growth outlook?

Think about that for a bit. The analyst is concerned about a series of hypothetical deals to enhance the future growth profile. They reduce near-term FFO per share, but they lead to much better growth opportunities over the next decade. I want management to take those opportunities every time that they think they should. Let's look at how management responded to that question. I've added our notes on the right side and color-coded them:

Source: Seeking Alpha transcript

That's an excellent response. It touches on the key points perfectly.

The deal should be :

  1. Dilutive to FFO per share in 2020 by 1% to 2%
  2. Slightly accretive in 2021
  3. Significantly accretive starting in 2022 and lasting forever

With the exciting acquisition covered, we'll move on to briefly touch on earnings for Q3 2019.

Q3 Results

The third quarter results weren't bad. Some investors seeing the recent decline may assume that earnings were an issue. DLR lowered guidance slightly for the year, but the reduction was to reflect the timing of asset sales and joint ventures. They're selling assets a little sooner than expected, so those assets will only be contributing earnings during part of the fourth quarter.

  • Old Guidance for Core FFO per share: $6.60 to $6.70
  • New Guidance for Core FFO per share: $6.55 to $6.65

One of the major metrics to look at for data centers is their ability to lease space. Leasing space is how REITs drive revenue. Leasing space reflects the demand for the assets the REIT owns. Was DLR effective at driving a high volume of renewal leases?

Source: DLR

They were exceptionally effective. So we have a solid quarter. The company lowered guidance due to the timing of a transaction, not due to weak demand. Meanwhile, they announced a major acquisition where the combined company should be in a position to drive even stronger growth for shareholders.

Still Needs Shareholder Approval

The deal still has customary procedures to go through such as getting shareholder approval. Both boards were unanimous in approving the deal. Both CEOs favor the deal. We expect the merger to go through.

Conclusion

DLR is buying INXN to unlock the best portfolio for future development across Europe. Future developments don't pay rent. Construction in progress doesn't pay rent. Each time a development is completed, the new revenue should lead to growth in DLR's earnings (using normalized FFO or analyst AFFO). Since that revenue doesn't occur until properties are developed and leased, it has a temporary negative impact on earnings. We don't mind the temporary negative impact, because we are evaluating DLR on a long-term basis. Fortunately for shareholders, management also is focused on the long-term creation of shareholder wealth.

  • Current Rating: Buy
  • Current Buy Under Target: $139
  • Current Share Price: $118.24 - 11/25/19
  • Risk Rating: 2
  • Suitable for most buy-and-hold investors
  • Dividend Yield: 3.65% with high long-term growth expectations
  • Position: Long DLR for 2.2% of our portfolio

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.