Digital Realty: Swap Out Of Preferred Shares Into Rexford
Summary
- We have had a negative view on Digital Realty's business for some time.
- In lieu of the common shares, we felt the preferred shares would offer a better risk adjusted return.
- They have delivered by outperforming significantly.
- At this point a swap into another set makes sense.
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This is a market to be nimble. While buy and hold opportunities do come along, we get far more trading opportunities. Sometimes these set up better return profiles. Sometimes they set up identical or almost identical return profiles with lower risk. We go over one for Digital Realty Inc. (NYSE:DLR.PK) today and follow up on our earlier thesis.
The Story Before
With DLR's Q4-2022 results still pending, investors will have to wait a bit to hear from the company as to how things are evolving on their data centers. Our quick update on the story line to date is as follows.
1) DLR has poor client retention.
2) Occupancy has fallen almost every single quarter for 7 years.
3) Capex needs are huge.
4) Since the bulk of its funds from operations (FFO) is paid out as dividends, capex needs to be funded with debt and equity issuance.
5) All of this worked in an era of very low interest rates.
6) All of this worked in an era of high stock multiples.
7) We don't have either of those today.
Our call in September was crystal clear.
Seeking Alpha
The preferred shares we had suggested were Digital Realty Trust, Inc. 5.250% PFD SER J (NYSE:DLR.PJ) and Digital Realty Trust, Inc. 5.850 PFD SR K (NYSE:DLR.PK).
That worked out beautifully. Despite DLR (light blue) having had a tough 2022 till that point, they moved even lower by over 12%. DLR.PK (purple) and DLR.PJ (yellow) did much better.
Yahoo Finance
Both preferred shares also delivered positive total returns when you take into account the two dividends received.
How To Move Things Now
Analyst community is slow in acknowledging just how wrong they were, but they are at least moving in the right direction. FFO estimates are coming down slowly for 2023 and beyond.
Seeking Alpha
They still appear incredibly high relative to the challenges DLR has today. Our take is that by the time 2024 is over, we will see that FFO for 2024 will come in lower than what we will get for 2022. Of course by that time estimates will have been lowered so much that we will all get dizzy with the fact that the company "beat estimates".
In our view, the fundamentals are now getting worse. We are finally seeing the technology layoffs announced and acknowledgement that the growth story is done for now.
The announcement of Google (GOOG) laying off employees came shortly after tech company Microsoft (MSFT) announced that it will be laying off 10,000 employees this year. Before Microsoft, Mark Zuckerberg-owned Meta (META) also announced that it will fire 10,000 employees soon.
Source: MSN
To but this in context, DLR's occupancy was 94.3% in 2015.
DLR Q1-2016 Supplementary
Last quarter after 7 years of "growth" we were at 83.4%.
DLR Q3-2022 Supplementary
It is hard to envision this moving up during a recession and during a time when technology companies are tightening their purse strings. Credit Suisse research helps summarize this for investors.
Credit Suisse
That is a long sentence, but about as accurate as it gets.
The risk here is a severe structural weakness in a recession that spreads from beyond the common shares into the preferred shares.
The Trade
This may be an early call and freely acknowledge it. It is also unlikely that the risks go beyond the common share multiple compression. But it is definitely a possibility. If you look at the history of mall REITs that went under, you will notice that all of them had higher occupancy levels prior to filing, than where DLR stands today. Hence at this point, we think it is prudent to switch.
The switch we think should be done is to move from the Digital Realty Preferred shares into those of a far stronger company, Rexford Industrial Realty Inc. (NYSE:REXR). Counter to DLR, REXR is excelling in all areas. We will briefly go over the differences between the two.
1) Occupancy levels remain incredibly strong for REXR.
REXR Q3-2022 Presentation
2) REXR is achieving incredible leasing spreads.
REXR Q3-2022 Presentation
3) Debt to EBITDA is just 4.1X.
REXR Q3-2022 Presentation
This number is about 2.5X multiples lower than DLR.
DLR Q3-2022 Presentation
4) REXR preferred shares are a great deal today. Rexford Industrial Realty, Inc. 5.625 CUM PFD C (NYSE:REXR.PC) has underperformed the two DLR preferred shares since our September article.
Yahoo Finance
Rexford Industrial Realty, Inc. 5.875% PFD SER B (NYSE:REXR.PB) also currently trades at a lower price than DLR.PK with an almost identical coupon (5.85%). The switch makes sense.
Verdict
While the preferred shares for DLR delivered quality alpha over the common shares, we think it is time for a big upgrade. Ditching DLR preferred shares for REXR is moving up multiple notches in quality while getting a slightly better yield. Do note that the idea is for the preferred shares alone as we think REXR common shares are still very expensive.
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.
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Disclosure: I/we have a beneficial short position in the shares of QQQ either through stock ownership, options, or other derivatives. 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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