- Digital Realty has continued its aggressive growth and capex plans.
- We break down the bear case and tell you why we are not attracted to this even at 52-week lows.
- If you get a bounce, run like hell.
- I do much more than just articles at Conservative Income Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
It is no fun to take the opposite of a popular trade. You generally get cat calls from the crowd and almost inevitably you never pick the exact top of the trend. Take for example the bearish and ultimately accurate call on Digital Realty Trust, Inc. (NYSE:DLR).
While the stock is down since then, it did actually move up as high as $178 before reversing. We thought this would be a good time to revisit the company as the stock has actually fallen a lot of the 52-week highs and one could argue it might have discounted the bad news.
The Company & The Long Case
DLR is a large publicly-traded REIT that has built significant scale in the Data Center platform.
Explosion in data is an easily ascertainable fact and the trend shows no signs of even slowing down, let alone stopping. It is easy to fall in love with concepts like this and this is more true when the company in question has actually delivered good results.
You won't get arguments from us with the facts or the performance since the IPO. Of course, you are not reading this to build a time machine and buy it 17 years back. What we want to focus on is what is happening today, and there, things look less pretty.
The Core Bear Thesis
From the bear cave, the key issue here is that there is a gigantic difference between perception of demand and actual demand for the company's assets. Portfolio occupancy actually rose last quarter to 83% from 82.8%, but there is no denying that 83% portfolio occupancy does not remotely suggest that things are in high demand.
In fact since 2015, occupancy has tried to emulate the boy band "One Direction".
Now investors might wonder what has happened to the funds from operations (FFO) since then. Back then DLR guided for $5.70 in FFO. 2022 guidance is around $7.00 for constant currency FFO. So we are looking at a 3% compounded growth over 6 years. While not exactly riveting, it does defy the 11.3% occupancy drop. What's happening then?
The short response is that the cost of capital has been insanely low for DLR. In March 2016, the weighted average debt cost was 3.60%.
Today, we are at 2.124%.
This happened as DLR dialed up leverage from 5.3X debt to EBITDA to 6.2X. DLR was also able to issue stock at 25X FFO. This pretty much explains a lot of the growth from DLR. What is unexplained by interest rates can be explained by capex. Back in 2016, we were at a $600 million run rate.
Now we are doing $2.0 billion.
If you think about it, putting up new data centers at that rate would only make sense if the company had tenants lined up. You would expect every new building to have huge long-term leases and a near 100% occupancy. If you run with that idea, it makes the drop in occupancy from 94.3% to 83% all the more alarming.
Jim Chanos obviously does not like this one and his thesis can be summed up as written below.
He argues that the move towards the cloud, predominantly driven by Big Tech groups such as Microsoft Corporation (MSFT), Amazon.Com Inc. (AMZN) and Google (GOOG), is the “enemy” of bricks-and-mortar real estate investment trusts such as Equinix and Digital Realty.
Chanos, who has also been hurt by a longstanding bet against Tesla, believes the tech behemoths, which he says account for around two-thirds of data centre demand, will increasingly move towards building and running their own real estate. He argues they will do this because the technology used by legacy groups is becoming old and redundant and because cash-rich Big Tech groups can build more cheaply. This will render the independent real estate investment trusts redundant.
Source: Financial Times
While we think he is absolutely correct, our concern is more with what happens when the market stops ignoring the capex and the falling occupancy. In other words, even the trend of the past 7 years is bad enough on its own to create problems. In 2022, the company will spend close to $2.0 billion in total capex, while FFO will be under $2.0 billion. DLR is also paying out a chunky dividend that consumes three quarters of its FFO. So DLR will have to finance $1.3-$1.5 billion of capex. This works as long as both the debt and equity markets remain comatose to the risks. When they wake up, there is hell to pay.
We saw this with Safehold Inc. (SAFE) where the bulls were celebrating a growth story built on buying 3.5% cash yields with issuance of 2.8% debt. Sadly, reality intervened and those bonds are now yielding close to 5.75%, Buying 3.5% cash yields with 5.75% issued debt does not work, apparently. Who knew that math could be so coldhearted? Earnings estimates for 2023 have fallen from $2.33 in early 2021 down to $1.83. DLR though is financing bulk of its debt in Europe and has been spared the interest rate reckoning till now. When it comes, expect some intense fireworks. In the meantime, cost of equity has risen meaningfully and that should start hurting the perpetual capex.
If you like DLR, and enjoy the income, we would suggest considering the preferred shares as a safer play. DLR.PJ Digital Realty Trust, Inc. 5.250% PFD SER J (DLR.PJ) is callable currently and has a 5.80% stripped yield. If we are wrong about the interest rate issue impacting DLR, then this will likely get called down the line and you would get a 5.8% yield plus capital appreciation to par.
Digital Realty Trust, Inc. 5.850 PFD SR K (DLR.PK) is another one to consider. This one has a higher coupon and is trading near par, so capital appreciation won't be on the agenda if rates drop and this redeemed.
On the common equity side, things are heavily oversold. A bounce is of course probable and we just cannot issue a "sell" rating here. We are sticking with a "hold/neutral". However, if we get a bounce to the 200-day moving average, which is sitting at near $140, we might consider going short.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
This article was written by
Trapping Value is a team of analysts with over 40 years of combined experience generating options income while also focusing on capital preservation. They run the investing group Conservative Income Portfolio in partnership with Preferred Stock Trader. The investing group features two income-generating portfolios and a bond ladder.
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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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