This article was coproduced with Nicholas Ward.
Lately, tech has been all the rage. Take Apple (AAPL), which recently crossed above the $2 trillion market-cap level and continues its strong rally, seemingly proving the law of large numbers a fallacy.
Tesla (TSLA) announced a stock split since its shares have rallied to all-time highs. It’s now one of the world’s largest companies by market cap.
Amazon (AMZN) is up more than 77% year-to-date. Nvidia (NVDA) nearly 200% over the last year.
The list continues from there.
Frankly put, it's amazing the market is fawning over these names considering their elevated valuations. Sure, they've shown resiliency during the shutdowns and continue to benefit from secular tailwinds.
But valuation always matters.
Knowing that, we’re looking at one of today’s most popular technology-based REITs: Digital Realty Trust (NYSE:DLR). It might not have the same sort of short-term growth results as the previously-mentioned companies. But it’s up significantly all the same.
DLR showed tremendous resiliency during the selloff in March and April. And its 29.08% year-to-date returns are certainly nothing to ignore.
We're deeply focused on attractive value, so we largely avoid high-flying REITs. But could DLR be an exception?
It's in one of the primary areas of the real estate world where investors have been finding solace. So let’s revisit it.
(Source)
Digital Realty: A High-Quality Blue Chip
Digital Realty shares have performed tremendously well throughout 2020. That’s in large part due to the belief that demand for digital storage isn’t tied to things like job growth or even GDP growth.
Management did note that its services have proven to be fairly well-isolated from the economic volatility we saw last quarter. Furthermore, the data center industry’s short-term growth prospects remain healthy, with strong expected demand from enterprise clients who require both storage and connectivity.
(Source: DLR Q2 ER presentation)
Only 3% or so of DLR's customer have approached it looking for rent relief so far. As such, its collection figures remain in-line with pre-pandemic periods.
A welcome relief in a REIT, to be sure.
Then again, Digital Realty has long been one of our favorite REIT stocks. It has one of the highest RINO scores – now known as iREIT IQ – in our coverage spectrum due to quality and, more importantly, dividend safety.
(Source: iREIT)
As you can see, the REIT IQ algorithm we've created is broken down into three primary segments:
- Scale advantage
- Cost advantage
- Management quality.
DLR is the largest data center REIT, with 280 hubs in 45 metro centers in 21 countries across six continents.
(Source: DLR Q2 ER presentation)
The company strives to maintain its hold with a fairly aggressive merger and acquisition (M&A) strategy. And it also invests heavily in major metro hubs across the world.
Since DLR focuses on both storage and interconnectivity, its building locations are of paramount importance. And it continues to build out its footprint to take further advantage of the digital space’s secular trends.
(Source: DLR Q2 ER presentation)
The stock’s recent rally pushed its market cap up to $41.7 billion. This makes it the fifth-largest publicly traded REIT overall in the U.S.
Digital Realty’s Got a Lot Going for It
What's more, DLR’s strong balance sheet has allowed it to benefit from a low cost of capital. It had strong liquidity of more than $4 billion as of June 30.
The company’s average debt maturity is six years, which is a bit shorter than many other REITs we track. However, its average weighted coupon rate is just 3%. And during last quarter, it raised roughly 500 million of 10.5-year debt in euros at just 1.25%.
At the end of Q2, DLR's net debt to adjusted earnings before interest, depreciation, taxes, and amortization (EBIDTA) ratio came in at 5.2x. Its fixed-charge coverage ratio, meanwhile, was 4.9x.
(Source: DLR Q2 ER presentation)
During the company's most recent conference call, CFO Andy Power noted that roughly 60% of its debt is non-dollar denominated. This then serves as a natural hedge for its foreign investments.
In addition, 95% of its debt is fixed rate, providing protection from a potential rising-rate environment. Power also said that 98% of debt is unsecured, providing the greatest flexibility in terms of capital recycling.
All in all, we continue to like DLR's financial position. Combined with its operational success, that’s resulted in high dividend safety scores.
Now, revenue and EBIDTA are increasing nicely, up respectively 24% and 17% year-over-year during Q2. But core funds from operations (FFO) did admittedly struggle a bit.
While it beat expectations by $0.07 per share, it was still down 6% year-over-year. That’s largely due to equity raises associated with balance sheet management and acquisitions.
Even so, we see strong booking demand in 2020. And while management did note that short term, Q2 may end up being the "high-water mark" in terms of bookings.
DLR’s positive long-term trend should continue into the foreseeable future.
(Source: DLR Q2 ER presentation)
It’s not known for providing full-year core FFO guidance on a quarterly basis. However, management did so this past time to reflect its confidence.
As such, we know that its full-year core FFO outlook is now $6-6.10 from $5.90-$6.10.
This will still represent a high single-digit drop year-over-year. Yet those previously-mentioned other metrics continue to grow nicely. And this does nothing to hurt its $4.48/share dividend safety whatsoever. Its current forward FFO payout ratio sits at 74%.
Besides, DLR should bounce back nicely in the coming years, returning to high single-digit growth.
Concerning Valuation
The real issue with Digital Realty is its valuation.
(Source: FAST Graphs)
As you can see above, shares trade at their highest premium in more than a decade. Right now, the stock's blended p/FFO multiple is 24.6x, which is well above its long-term average of roughly 16x.
Investors are clearly willing to pay a premium for what they see as a safe dividend yield here. However, their enthusiasm has pushed their dividend yield down below the 3% threshold.
That alone makes it somewhat unattractive for many REIT investors.
Additionally, when you look at the company's historical performance, the about 7% consensus growth rates analysts see for 2021 and 2022 are essentially what we’ve seen in bottom-line growth performance for the past five years or so.
That’s why we believe there’s a disconnect between DLR’s performance and valuation.
Furthermore, the expected high single-digit growth rates for 2021-2023 are well below what DLR used to generate. From 2005-2011, DLR was known for double-digit performance on an annual basis. Yet the stock rarely traded with a p/FFO multiple greater than 20x.
In short, we find today’s prices somewhat irrational.
More About Digital Realty Multiples
(Source: FAST Graphs)
Digital Realty’s five-year average p/FFO multiple is 17.1x, which is slightly higher than its long-term average premium. But it’s still far below the 24.6x shares carry today.
Even though analysts expect to see DLR's FFO grow by 7% in 2021, 7% in 2022, and 8% in 2023, the lack of margin of safety is problematic.
If we see mean reversion back to 17.1x – even after the predicted three years of strong growth – that’s roughly $128/share. Including dividends of roughly $16.50/share collected between now and Dec. 31, 2023, investors buying today at $154 would still be looking at a -2.05% annualized rate of return.
(Source: FAST Graphs)
And if the multiple were to revert back to the 16x range, they’d make -3.75% annualized total returns.
Granted, the low interest-rate environment probably won’t allow that to happen. Our fair-value estimate currently sits at $120/share. This represents about 20x on 2020 core FFO expectations and about 18.5x for 2021.
That last number still represents a generous premium relative to historical norms due to DLR's:
- Continued growth prospects
- Strong balance sheet
- Impressive dividend safety metrics
Yet it also implies an approximate 22% downside from the current price.
Even if DLR maintains a 20x multiple – the upper end of our fair-value range moving forward and about a 25% premium to its long-term historical average – investors buying today would have to wait until the end of 2023 to profit.
It would take that long for the underlying fundamentals to catch up to the current elevated premium.
(Source: FAST Graphs)
All this should show the importance of analyzing quality and valuation. Margin of safety plays a significant role in any investment’s future return capabilities.
While short-term sentiment can create irrational valuations, long-term, stock prices are fundamentals based, which isn’t good for incoming DLR shareholders.
In Conclusion…
It’s clear we don't agree with Mr. Market’s high premium on Digital Realty. But we also acknowledge it can stay irrational for very long periods of time.
So we're content to maintain our current DLR shares because of the safe dividend yield they offer. We maintain a Hold rating here due to the impressive quality it offers.
Not only does DLR offer a relatively safe about 3% yield, the stock also has mid to high single-digit dividend growth prospects moving forward. And over time, the compounding associated with such annual dividend growth has the potential to create significant wealth.
When it comes to blue-chip holdings like DLR, we believe that shares are best owned, not traded. DLR has been a big winner for us in the past. And we suspect that will continue to be the case long term.
This is certainly a stock we love to add to – when attractive opportunities arise.
As you can see below, DLR has returned 23.8% annually since our initial investment in the Durable Income Portfolio. (All portfolios can be viewed at iREIT on Alpha.)
(Source: Sharesight)
And DLR has been its sixth-best performer since the portfolio first commenced on August 2013.
(Source: Sharesight)
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.
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