money Why Digital Realty Trust Still Has Room to the Upside
Finding stocks that have traded higher this year in the current environment is difficult. Even after the best week for markets since the 1930s, the S&P 500 is still down nearly 19% year-to-date.
One company that has actually traded higher this year is Digital Realty Trust (NYSE:DLR). Digital Realty has seen its share price climb 12% so far in 2020, beating both the market index and the iShares U.S. Real Estate ETF (IYR), which has lost almost 25% so far this year.
In fact, Digital Realty has outperformed both indexes over the past five years, returning 101% over this period of time. The S&P 500 has gained almost 28% while the Real Estate ETF has lost 11% over the last five years.
Even with the current market volatility, I believe it is very likely that Digital Realty will continue to reward shareholders, both in terms of share price appreciation and dividend growth. Let's look at why.
Company background and growth prospects
Digital Realty is a real estate investment trust, or REIT, that focus on the purchase and development of properties for technological use.
Digital Realty is truly a global company, owning interests in 225 proprieties across 13 different countries. The trust's properites includes date centers for the storage and processing of information, technological manufacturing sites and internet gateways that allow for the transmission of data in major metropolitan areas.
As a technology REIT, Digital Realty sits in a sweet spot as the demand for cloud storage has exploded in recent years.
Source: Marketsandmarkets.com
It is estimated that the total global market size for cloud computing could reach more than $623 billion by 2023. This would represent a compound annual growth rate, or CAGR, of 18% from 2018 levels. Digital Realty estimates that global data center traffic will grow with a CAGR of 25% and that global cloud IP traffic will increase with a CAGR of 27% through at least 2021.
This is a high rate of growth that isn't expected to dissipate any time soon. This bodes well for the future of Digital Realty, as it is a global leader among the technology focused REITs. The trust is able to use this size to help continue to grow.
Digital Realty was founded in 2004 with just 23 properties consisting of 5.6 million square feet. As of Dec. 31, 2019, the trust had a total of 34.5 million square feet. Nearly all of this growth has been acquired, mostly through the issuing of shares, debt or both. This isn't surprising, given that REITs often resort to these measures to grow as at least 90% of income has to be returned to shareholders in the form of dividends.
What is surprising is how successful the trust has been at growing funds-from-operation, or FFO, while also increasing the numbers of shares outstanding. Digital Realty's share count has increased annual by more than 9% since 2010. Even with a higher share count, Digital Realty has still managed to increase FFO at a rate of nearly 7% per year over the last decade. The trust has actually increased FFO every year for the last 11 years, including a 12% increase in 2009. This shows that Digital Realty's secondary offerings have been put to good use to acquire properties that add to the bottom-line.
Digital Realty has proven its strategic chops over the years. Case in point, the trust agreed in 2017 to pay $7.4 billion to purchase DuPoint Fabros Technology, a technology REIT, that had contracts with some of the largest tech companies in the world, such as Microsoft (MSFT) and Facebook (FB). Partnering with the some of the top names in the cloud space also resulted in more than 50% of Digital Realty's top 20 clients having an investment grade credit rating.
Source: March 2020 Investor Presentation, slide, slide 23
More recently, Digital Realty completed its $8.4 billion purchase of InterXion. InterXion operates 53 properties in 11 countries in Europe. The company had operations in the six largest data center markets in Europe, including Dublin, London, Frankfurt, Paris, Amsterdam and Madrid, as well as an Internet Gateway in Marseille. While the deal is massive, it will help Digital Realty, which already had properties in London and Dublin, increase its presence in Europe. Shareholders of InterXion received 0.7067 shares of Digital Realty for every share of InterXion they held.
Digital Realty does have a sizeable amount of debt on its balance sheet ($10.1 billion versus a market capitalization of $34.4 billion), but by my assessment, this isn't as dire as it may seem.
Source: Digital Realty's Fourth Quarter Earnings Presentation, slide 16
The trust has no debt due until 2022 at the earliest. After that, debt is spread out through the end of the decade, with a weighted average maturity of 6.5 years. The vast majority (93%) is locked in at fixed rates, and the weighted average coupon is very low. Investors will need the monitor Digital Realty for additional debt, but the repayment schedule looks reasonable at the moment.
Because of its size and scale, Digital Realty is also in a prime position to capitalize on additional drivers within the cloud.
Source: March 2020 Investor Presentation, slide 20
As you can see, the markets for additional cloud capabilities beyond just storage and transmission are expected to grow at a robust rate over the next few years. Cloud is an area of business that is just getting started, and Digital Realty is in an optimal position as a leader in this space.
While future prospects look strong, Digital Realty's current business is also performing well. FFO for 2019 grew just $0.05 to $6.65, but 6.6% when adjusting for a higher share count. Revenue grew 5.3% for the year.
Digital Realty signed renewal leases representing $510 of annual rental revenue during the year, a successful endeavor given that slightly less than a quarter of all annual rents were due to expire in 2019. The trust also had solid growth in terms of new bookings during the year.
Source: Digital Realty's Fourth Quarter Earnings Presentation, slide 19
Including interconnection, Digital Realty signed bookings expected to produce more than $69 million in annual revenues during the fourth quarter. Only a handful of other quarters in the trust's history have been more successful. For the year, Digital Realty signed bookings expected to generate more than $250 million in annual revenues, the second-best year on record for the trust.
Dividend analysis
The trust's current business results and prospects for growth likely means that Digital Realty will continue to pay a dividend.
After increasing its dividend by 3.7% for the upcoming March 31, 2020 payment, Digital Realty has now paid and raised the dividend for 16 consecutive years.
The trust has raised its dividend with a CAGR of:
5.1% over the past three years
4.9% over the past five years
7.9% over the past 10 years
The most recent raise was lower than the listed rates, but the ballooning in share count due to the InterXion purchase is likely the primary culprit. Shares yield 3.4% as of the March 27, 2020 close, below the stock's five-year average payout ratio of 3.9% but above the 2.3% average yield for the S&P 500. This is on the lower end for a REIT, but current shareholders probably will accept this yield in exchange for the year-to-date performance of the stock.
Digital Realty is scheduled to pay out $4.48 of dividends while analysts estimate that the trust will earn $6.47 of FFO in 2020. This which would represent a FFO payout ratio of 69%. This is an extremely low payout ratio for a stock in the REIT sector, but slightly above Digital Realty's five-year average payout ratio of 63%.
Last year, Digital Realty paid $997 million of dividends to shareholders while producing $1.5 billion of free cash flow for a payout ratio of 66%. This is essentially in-line with the 68% free cash flow payout ratio that the trust averaged for the three years prior to 2019.
Both payout ratios are evidence that Digital Realty is a well-managed REIT that offers a safe and growing dividend, in my view.
Final thoughts
Shares of Digital Realty aren't cheap. The stock trades at 20.5 times FFO estimates for 2020, higher than the five-year average price-to-FFO ratio of 16.4. But the trust has several catalysts for growth, including the explosion in demand for cloud services, strategic acquisitions and an increase in bookings. Shares also offer a generous yield.
All of these factors lead to my belief that Digital Realty remains a buy even in a challenged market.
Disclosure: The author is long Microsoft.
Read more here:
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.
