Digital Realty: A Safe Dividend Growth Stock, But At A Steep Price (NYSE:DLR)

Digital Realty: A Safe Dividend Growth Stock, But At A Steep Price (NYSE:DLR)

In late March, we had covered Digital Realty (DLR), explaining why its shares provide a COVID-19-proof investment case, especially attractive for dividend growth investors. Since then, the company’s shares have returned around 9%, after indeed maintaining a robust performance during the peak months of the pandemic. During this time, we have also covered a number of data center and cell tower REITs, as these two sub-sectors have been featuring some of the safest cash flows, suffering minimal impact, compared to the other sub-sectors. If anything, the demand for data centers has remained strong, as COVID-19 accelerated the growth of e-commerce and the need for digital services and infrastructure.

In this article, we would like to revisit the stock and assess the company based on its updated financials and prospects, to try and more accurately assess investors’ expected returns.

More specifically, we will:

  • Go over Digital Realty’s latest financials and expansion prospects
  • Assess the stock’s valuation, dividend growth, and potential investor returns.
  • Conclude why shares could provide dividend growth investors with an investable opportunity, though the stock’s total return potential lags.

Financials and expansion

Over the past decade, Digital Realty has been snowballing, consistently growing its revenues due to capitalizing on the ever-increasing demand for more data centers, as the tech industry’s processing and storage needs have been growing larger and larger.

As a result of multiple acquisitions and a robust development pipeline, Digital Realty currently operates more than 280 data centers globally, having grown to a market cap of just under $40B, making it currently the 7th largest U.S. REIT. The company’s latest quarterly results were particularly exciting, as the REIT’s revenues increased by around 22% YoY, aided by the InterXion (NYSE:INXN) acquisition, fading any previous fears of a slowdown.

Together, Digital Realty and the leading European provider of carrier and cloud-neutral colocation data center solutions, InterXion, should be able to grow at a much faster rate. The merged company can leverage its geographical expertise and financial resources more efficiently. For example, during Q2, they acquired a 3.6-acre land parcel in Madrid, Spain, for approximately $37 million. The land parcel is less than one kilometer from InterXion’s existing campus in Madrid. InterXion’s familiarity and experience with the local market allow Digital Realty to gain exposure to the particular European market, which could have lagged in doing so before. At the same time, Digital Realty’s cheap and easily accessible financing is able to make these sorts of acquisitions smooth, which InterXion would not have been able to execute at such speed and low costs.

By cheap financing, we are referring to Digital Realty’s ability to leverage its sound financials and borrow at incredibly cheap rates, as it expands its own and InterXion’s operations further. In mid-June, for example, the company closed an offering of €500 million, or approximately $565 million, of 1.250% euro-denominated notes due 2031. This borrowing rate is lower than the rates some of the world’s most financially healthy companies like Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), and Microsoft (NASDAQ:MSFT) are able to borrow in the U.S. Because European rates have entered negative territory, Digital Realty should be able to utilize such cheap debt along with InterXion’s know-how in the European market to accelerate the company’s growth and unlock operational synergies. The company’s backlog is another metric that points towards increased rental revenues, having doubled QoQ, amid Digital Realty’s robust development pipeline. Source: Investor Presentation

Valuation, dividend growth, and investor returns

As a result of favorable financial performance and potential value-unlocking synergies, management slightly raised its guidance from FFO/Share of $5.90-6.10 to $6.00-6.10 for FY2020. However, is this outlook enough to compensate for the stock’s current valuation?

Below we have listed the current valuations of the major U.S. data center REITs. With the exception of Equinix (NASDAQ:EQIX), the rest of them are trading at nearly 19-23 times their underlying FFOs. Keep in mind that this multiple is way higher than the sector’s average of around 14.5, as data centers provide growing and relatively highly secured cash flows, hence the premium.

Source: Author

Analysts estimate that Digital Realty will grow its FFO/Share at around a high single-digit, to a low double-digit rate in the medium term. Over the past decade, the company has grown its FFO/Share by a CAGR (compound annual growth rate) of around 7.8%. We are going to use this rate instead, in order to be prudent.

Source: Seeking Alpha

Further, we estimate a medium-term CAGR of around 5.5%, which is in line with the company’s past five-year average, and which should be well-covered by FFOs. Let me remind you that Digital Realty has been consistently rewarding its shareholders with dividend increases for 15 consecutive years.

As a result of prudent dividend increases, the company’s distributions remain incredibly safe, with a payout ratio of around 74%. Plugging our FFO/Share and DPS growth estimates, we get the following figures. Source: Author

Now, to estimate the stock’s potential returns, we need to plug in our expected growth rates, Digital Realty’s current price ($147.7), and various future valuation scenarios. As you can see, if shares retain their current valuation (forward P/FFO/Share of 24.2), investors are quite likely to enjoy double-digit annualized returns.

We have used reserved growth estimates, which the company is likely to beat and outperform, being closer to analyst estimates, as its expansion plans materialize. However, even with more humble assumptions, Digital Realty offers adequate returns, with a considerable margin of safety.

Source: Author

It is quite likely that a compression towards a more reasonable multiple will limit the stock’s total return potential. However, we believe that as long as data centers display some of the safest rental revenues in the market, they will retain their current premium going forward. Finally, unlike other types of investments, Digital Realty offers tangible returns, through a growing dividend, which should keep investors interested in holding their shares while they are developing their income. Its current yield of around 3.11% makes for a decent dividend growth entry point.

Conclusion and risks

Digital Realty is one of the fastest-growing REITs, capitalizing on the ever-increasing demand for data centers across the globe. While the stock offers a decent return potential that could touch the double-digit return threshold, it’s important to note that at its current valuation, the stock’s extraordinary return surplus has already been largely captured. Digital Realty is unlikely to see its past, explosive returns, as the prolonged investor demand for its shares has pushed shares at a relatively high valuation, limiting a more exciting future return potential.

Still, Digital Realty offers an investable case for dividend growth investors, as its current yield of around 3.1% offers a modest income stream, which, assuming growth of around 5%, should develop in a tangible source of future returns.

However, as with every investment, Digital Realty holds some risks worth considering. In our view, the most significant is its debt to equity relationship. REITs use both debt and equity financing to grow, as they distribute the majority of their cash flows back to investors. A healthy ratio between the two is vital. In our previous article, the company’s debt/equity ratio was standing at nearly 100%, indicating balance. However, post the acquisition, from which InterXion shareholders ended up owning around 20% of Digital Realty current float, the ratio has fallen dramatically due to the extra units created.

Equity is more expensive in terms of funding future projects, as Digital Realty has to pay extra dividends for every additional share. The company’s future DPS growth, therefore, will struggle for a while before cheap debt issuances (like the one mentioned earlier) provide a more equitable balance sheet.

In our case, we will stay on the sidelines for now, as the stock’s expected return profile is not enough to excite us. We could potentially reconsider buying, though, amid a potential correction.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any 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.

Originally published on Seeking Alpha

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