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Digital Realty: An Intelligent REIT By Design

About: Digital Realty Trust, Inc. (DLR)
by: Brad Thomas
Brad Thomas
Dividend growth investing, REITs, newsletter provider, value

Year-to-date, Digital has returned 17%. That includes a pullback from a record high of $135 in late October 2019.

Today, I decided to take a closer look at Digital to determine whether the latest pullback of 10% warrants a Buy.

While there are risks, we consider the business combination with INXN to be highly complementary, increasing our confidence in owning shares.

We've been covering Digital Realty (DLR) since February 2013, explaining in that first research article how:

Digital is indeed the 'big dog' of the data enter space, with a proven track record for paying and maintaining dividends. And with considerable demand for high-quality data storage, the big dog has plenty of room to run."

Source: FAST Graphs

As you can see above, since we began coverage, shares have returned an average of 12.2% per year. However, we didn't begin accumulating shares until there was an adequate margin of safety.

That was good considering how, in May 2013 - just a few months after our first research article - shares plunged after Highfields Capital Management announced at the 18th Ira Sohn Investment Conference that it was shorting Digital Realty. The hedge fund stated that:

Pricing is going lower. Competition is increasing. And the company is tapping into capital markets as aggressively as they can… Do you want to pay three times book value for this?"

Highfields believed that DLR was worth $20 per share, which seemed harsh, to say the least. It was clear to me that, like many hedge funds, there was a disconnect in regards to understanding real estate investment trust valuations.

Here's how…

Understanding REITs in General and DLR in Particular

Here's the nice way to explain it: In REIT-dom, book value (and related price-to-book ratios) are often dubious with regard to general equity analysis.

Here's the blunt way to explain it: They're virtually useless for REITs.

A more common metric is net asset value (NAV) since it's a much better estimate of market value. And an in-the-know investor utilizes price to funds from operations or P/FFO. That's probably the most common calculation.

For the record, at the time of the short announcement, DLR's P/FFO was around 15x.

Then, to make matters worse, DLR and most other REITs became victims of the "taper tantrum." That was when Ben Bernanke announced the Fed was rolling out a stimulus package to reduce the amount of money it was injecting into the economy.

By November of that year, I felt the need to write:

After a short (by Highfields), a market sell-off (Bernanke), and two botched earnings calls, investors have been running for the fences. As most of you know, I stayed in the game and, more recently, I have continued to dollar-cost average shares. This concept of making equal purchases spread out over a longer period should prevent me from overpaying and help bring my investment to actual market levels."

Source: FAST Graphs

As you can see above, shares have returned an average of 20% since then. So I've been perfectly justified in maintaining at least 5% exposure.

Today, DLR is a core holding in the Durable Income Portfolio, which has delivered exceptional results. With about 14% exposure to data center REITs, it's produced average annualized returns of 20.8% since August 2013.

Source: Sharesight

Year-to-date, Digital has returned 17%. And that includes the pullback from its record high of $135 in late October 2019.

Shares currently trade at $120.95.

Source: Yahoo Finance

The Business Model

Today, I decided to take a closer look at Digital to determine whether the latest pullback - which took it down 10% in price - warrants a Buy. I'll examine the fundamentals in detail and then provide a granular look at valuation.

As Ben Graham reminds us:

An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return. Operations not meeting these requirements are speculative."

Photo Source

Most data centers today fall into a few categories. For instance, there are retail co-locations, such as wholesale (large-scale enterprise deployments) and hyperscale operations (massive ventures both owned and leased by global giants).

By those, I mean AWS, Microsoft Azure, Google Cloud, IBM Cloud, and Oracle Cloud. In which case, we're talking about facilities filled with thousands of servers and related networking gear.

There also are hybrid data centers and/or data center campuses that support multiple types of IT deployments. And many legacy applications are still being run in on-premise corporate data centers owned and operated by Fortune 1000 companies.

Source: DLR Investor Presentation

Regardless, data centers are designed to house servers and network equipment. They provide highly reliable, secure environments with redundant mechanical cooling electrical power systems and network communication connections.

And, as illustrated below, DLR is the second-largest REIT in this space:

Source: iREIT

DLR also is one of the oldest data center REITs in the world, having gone public in 2004. As of Q3-19, it owned 211 data centers in 35 cities across 14 countries.

Source: DLR Investor Presentation

We can break down its global exposure to these rounded figures:

  • 77% exposure in North America
  • 13% in Europe
  • 7% in Asia Pacific
  • 3% in Latin America.

Source: DLR Investor Presentation

As we'll go on to show, DLR's got places to be… and money to make.

More About This Money-Making Machine

DLR's primary business model is focused on hybrid cloud offerings. Specifically, it deals with co-location, meaning that its facilities are a mix of private (in-house) and public storage solutions.

Each facility has numerous small data racks and servers, which customers provide themselves.

Source: DLR Investor Presentation

These are popular with small- and medium-sized firms that don't want to spend the money for large in-house IT departments. Hybrid cloud capabilities allow clients to connect their systems to each other.

Hyperscale providers, on the other hand - like Amazon (AMZN), Microsoft (MSFT), and Alphabet (GOOG) (NASDAQ:GOOGL) - get both control over their data and the ability to benefit from AI-driven analytics and improved cybersecurity systems.

Here's a snapshot of DLR's top 20 customers:

Source: DLR Investor Presentation

Hyperscale giants like Amazon, Microsoft and Google are growing their cloud businesses at 20%-60% annually, funneling massive amounts of money into those efforts. Being platform neutral, however, Digital Realty is merely a landlord for data center servers that work with anyone's cloud system.

Source: DLR Investor Presentation

Cloud storage isn't just about companies saving money by outsourcing their IT data needs. AI-driven analytics represent a game-changing way for them to become more efficient and therefore more profitable.

By 2020, the Internet of Things (IoT) will connect more than 20 billion global devices to the internet. Increasingly, that will be on 5G networks. That trend will then gather real-time operational data, allowing companies to automate and optimize every stage of their manufacturing/distribution/logistics chains.

Source: DLR Investor Presentation

Combine that with tens of millions of driverless cars, delivery trucks, and robo taxis? Expect to see an explosion of data that will drive decades of growth for cloud computing providers and data center REITs.

And DLR is one of the best-situated companies to profit in that quickly and vastly changing game.

The Interxion Deal

Digital Realty recently announced an agreement to combine with InterXion Holding (INXN), a Netherlands-based information technology services company.

This highly strategic and complementary $8.4 billion transaction will create a leading global provider of cloud and carrier-neutral data center solutions, complete with an enhanced presence in high-growth major European metro areas.

DLR Investor Presentation

Interxion's connectivity capabilities are a primary source of competitive advantage. Its model offers highly connected locations for content providers - and the cloud platform providers seeking to provide services to them.

As Vice Chairman, President, and CEO David Ruberg explained on DLR's recent earnings call:

The combination of Interxion's connectivity capabilities with Digital's hyperscale and enterprise expertise put the combined company in a unique position to take advantage and capitalize on the emerging global digitalization trends and to offer our customers an efficient and cost-effective way to address their requirements."

DLR Investor Presentation

The transaction is being structured as a stock-for-stock combination. Interxion shareholders will receive a fixed exchange ratio of 0.7067 DLR share per Interxion share they hold.

In all, they'll own approximately 20% of the combined company, and DLR shareholders will own the remaining 80%.

DLR Investor Presentation

Overall, the businesses are complementary and should provide Digital Realty with significant scale advantages. So even though earnings growth could be challenging over the next few quarters as the integration progresses, DLR should be in a stronger position to capitalize on favorable growth trends across Europe.

And that's a big deal.

The Fortress Balance Sheet

The combined company will have an equity market cap of over $35 billion and a total enterprise value of more than $50 billion. That will put it a lot closer to being the largest data center REIT out there.

DLR Investor Presentation

Again, the balance sheet's impact will be leveraged neutral. But one of the key benefits of the transaction is the opportunity for Interxion shareholders to benefit from DLR's borrowing costs and improved ability to fund growth.

Also, its CEO, Bill Stein, pointed out on the previously referenced earnings call that:

… we do see some opportunity for cost savings, primarily redundant public company costs and interest savings on refinancing Interxion's higher cost debt at Digital Realty's lower borrowing cost in the European debt capital markets. We expect to achieve up to $20 million of annualized synergies, and we expect to realize roughly three quarters of our target in 2021, with the full run rate realized in 2022.

Assuming a second quarter close, given the (timeline) for realizing synergies, we expect the transaction will be approximately 1% to 2% dilutive in 2020 and a bit better than breakeven in 2021, and significantly accretive to the combined companies' long-term growth profile."

Keep in mind, Digital maintains an investment grade-rated balance sheet (BBB with S&P). It also has a solid record of integration, as viewed below:

DLR Investor Presentation

Short-Term Dilution, Long-Term Value

On its earnings call, DLR said it "expects the quarterly run rate to dip down in the fourth quarter." That's primarily due to a joint venture transaction it's agreed to with Singapore-based Mapletree, which should close in early November.

As a result, it's revised its 2019 core FFO per share guidance by $0.05 to reflect that dilution and its two capital raise in October.

DLR Investor Presentation

The Interxion deal should close next year. Given its expected dilutive impacts, we're modeling 2020 FFO per share at $6.92 per share. Therefore, we consider the latest pullback an opportunity to buy into this digital juggernaut…

... which could return 12%-15% over the next 12 months.

Source: FAST Graphs

DLR pays a quarterly dividend of $1.08 per share or $4.32 annually. And as viewed below, the company has an impressive record of dividend growth, raising it every year since 2005.

DLR Investor Presentation

Earnings growth has been even more impressive:

DLR Investor Presentation

And let's compare it with its peers, while we're at it, starting with dividend yield:

Here are their payout ratios:

And, last but not least, their P/FFO multiples:

Do you like what you see? I know I do…

We're Maintaining a Buy

In closing, we're maintaining a Buy after that latest pullback, recognizing that Digital is expanding its economic moat through calculated scale advantages.

As we've already stated, the integration does present risks. But we consider it to be ultimately very complimentary, increasing our confidence in owning shares.

DLR is now 6x the price that Highfields Capital Management was suggesting in 2013. (Remember, it said shares could drop to $20). Instead of "tapping into capital markets aggressively," as alleged, DLR has become a disciplined risk manager… thoughtfully generating scale and cost of capital advantages that have delivered superior returns for investors.

Authors Heather Brilliant and Elizabeth Collins wrote in Why Moats Matter, "Finding great businesses at great prices is the holy grail of investing. Yet surprisingly few investors focus on uncovering businesses with the potential to compound over time."

At the risk of being repetitive, I'm glad I did just that with Digital Realty Trust. How about you?

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

Disclosure: I am/we are long DLR, CONE, 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.