Digital Realty DividendDigital Realty Trust (DLR) is a fast-growing real estate investment trust (REIT) that has raised its dividend every year since going public in 2004.

 

While the company is still far from having a long enough dividend growth history to qualify as a member of the dividend aristocrats list, it has numerous attractive qualities for investors seeking income and growth.

 

Digital Realty is a direct beneficiary of the rapidly growing use of data by businesses and consumers alike. As the data center business continues booming, the company is positioned to continue rewarding investors with rising dividends.

 

Let’s take a closer look at Digital Realty to see if this quality REIT can keep pace with the evolving technology landscape and whether or not its stock looks attractive today.

 

Business Overview

Digital Realty is a REIT that supports the data center needs of more than 2,300 customers across industries such as financial services, information technology, manufacturing, and more.

 

The company is one of the largest REITs in the world and has a portfolio of 157 operating properties located across 33 metro areas.

 

Data centers provide secure, continuously available environments for companies to store and process important electronic information such as transactions and digital communications. Data centers can also serve as hubs for internet communications in major metropolitan areas.

 

The key components of a data center can be seen below and include servers, network equipment, cooling systems, electrical power systems, and more. Data centers consume a lot of power to keep the servers running and the room’s temperature under control.

 

 

Digital Realty’s total rent is comprised of both rent from turn-key services, in which it provides everything but the servers, as well as a powered base building where customers choose to provide the power components used in the data center (e.g. HVAC, battery, generator, electrical) and design it all themselves.

 

For the year 2016, rents on renewed space increased by over 10% for turn-key flex space and 23% on powered base building space.

 

Digital Realty generates about 76% of its rent in North America with the rest from Europe (17%) and Asia (7%).

 

The company’s largest tenants are IBM (6.2% of rent), Facebook (5.9%), CenturyLink (4.6%), Rackspace (2.7%), Equinix (2.7%), Oracle (2.6%), LinkedIn (2.0%), and AT&T (2.0%). Approximately half of its customers have an investment grade or equivalent credit rating.

 

Digital Realty is also well diversified by customer type. Approximately 26% of Digital Realty’s annualized rent is from cloud players, 21% from IT services companies, 16% from content providers, 14% from network providers, 13% from financial services organizations, and 10% from other enterprises.

 

Business Analysis

Playing in a growing industry is almost always better than competing in a shrinking market. In Digital Realty’s case, its data center operations are exposed to several long-term secular demand drivers.

 

Simply put, data use is exploding and driving more demand for servers and data centers. Growth of internet traffic, over-the-top-video, cloud, and mobile data traffic is expected to range from 21% to 45% per year over the next several years, according to Digital Realty.

 

While e-commerce is hurting the long-term prospects for many retail REITs, it actually benefits Digital Realty because it further adds to overall data traffic growth and the need for more data centers.

 

The “Internet of Things” (IoT) is yet another growth catalyst, with more than 24 billion IoT devices expected to exist worldwide by 2020, generating up to 44 trillion gigabytes of data, according to Digital Realty. All of that information will require more data center capacity.

 

As a result, Markets and Markets expects the global data center solutions market to grow at a compound annual growth rate of 11.7% from 2015 through 2020 to nearly double in total value. As a leading data center operator in the world, Digital Realty is well positioned to ride this tailwind.

 

In fact, nearly 80% of Digital Realty’s 2014-2016 leasing activity is supported by growth in the global digital economy.

 

Digital Realty Dividend
 

Data center REITs are also attractive businesses because their services are non-discretionary expenses for companies – the data being stored and processed in data centers is needed to run their operations. As a result, Digital Realty enjoys high utilization rates in most economic environments.

 

As seen below, Digital Realty’s total portfolio occupancy has remained about 90% in each of the last seven years, including 95% in 2009 during the last recession. At the end of December 2016, the occupancy rate was over 89%. The company also notes that its tenant retention ratio has been strong at about 72% of net rentable square footage.

 
Digital Realty Dividend

 

Occupancy and retention rates are also high because it is costly for customers to switch data center facilities. Digital Realty cites that it costs customers anywhere from $10 million to $20 million to migrate to a new facility.

 

A new data center deployment also costs customers $15 million to $30 million, further reducing the incentive to switch landlords. The following chart shows how high tenant retention rates have been for data center operators.

 

Digital Realty Dividend

 

Digital Realty’s average remaining lease term with customers is 5 years, and fewer than 17% of its total leases are set to expire in any of the next five years. Beyond that, lease expirations are in the single-digit range over the next seven years through 2026.

 

Most of the company’s leases also contain 2% to 4% annual rental rate increases. As long as customers stay financially healthy enough to pay their rent obligations, Digital Realty has very solid cash flow visibility.

 

The company is also uniquely positioned to meet the needs of major businesses because of its scale, reputation, and favorable real estate locations in major metropolitan areas. Having customers such as IBM, Facebook, LinkedIn, and Oracle speak to the quality of Digital Realty’s properties.

 

The company’s diversification by customer (top 20 tenants are 44% of annualized rent) and industry further helps smooth out earnings, and Digital Realty’s mix of data centers is also improving.

 

Digital Realty is now aligning its go-to market strategy more closely with its customers’ needs and buying patterns by categorizing its services into three offerings – global, enterprise and network solutions.

 

Acquisitions have also played an important role in evolving Digital Realty’s business mix to better serve its customers.

 

The company acquired Telx Holdings for about $1.9 billion in October 2015. Telx is a leading national provider of data center colocation solutions and doubled Digital Realty’s high-margin colocation business, which allows companies to rent partial spaces within a data center.

 

Telx also introduced Digital Realty to over 1,000 new companies it can target for its existing data centers. This is important because over 80% of the company’s traditional large footprint leasing activity over the last two years has been repeat business with existing customers.

 

In July 2016, Digital Realty completed the European Portfolio acquisition consisting of eight high-quality, carrier-neutral data centers in Europe from Equinix for $818.9 million. This resulted in the acquisition of premium assets in Amsterdam, Frankfurt, and London which enhanced the company’s interconnection growth and colocation potential globally.

 

In order to enhance its presence in strategic U.S. data center metros, Digital Realty announced a $7.6 billion merger with DuPont Fabros in June 2017. The transaction is expected to be approximately 2% accretive to core FFO per share in 2018, but its strategic important is more important.

 

Not only are the two companies’ portfolios highly complementary, but the combination is also expected to enhance the overall balance sheet strength and result in the creation of the the second-largest data center REIT after Equinix.

 
In fact, the combined company is expected to have the most efficient cost structure and the highest EBITDA margin of any publicly-traded data center REIT in the U.S.

 

Simply put, the merger will enable Digital Realty to grow in size and generate economies of scale, helping the company better retain customers in the age of data center commoditization and increasing competition.

 

DuPont Fabros will especially enhance Digital Realty’s portfolio in Virginia, Chicago, and Silicon Valley, three important growth markets.

 

Besides this merger, Digital Realty has taken a number of other steps to fortify its balance sheet in order to maintain  financial flexibility for the future. High-interest preferred shares were replaced with lower coupon bonds and mortgage debt, for example.

 

Digital Realty Dividend

 

Overall, Digital Realty operates in an industry with favorable growth trends and gains benefits from its scale, cost-efficient real estate locations, non-discretionary services, and strong customer relationships.

 

Digital Realty’s Key Risks

I generally avoid investing in most technology companies because industry trends can unexpectedly and quickly take a turn for the worse. In Digital Realty’s case, the biggest risk is arguably that data centers are overbuilt in anticipation of strong data usage trends.

 

After all, Digital Realty cannot control the capital allocation of its competitors. As long as cheap financing is widely available and industry margins are high, more supply will enter the market.

 

If an excess supply of data centers occurs, Digital Realty could experience unfavorable lease renewal rates (16.4% of its leases expire through 2018 on an annualized base rent basis), weaker profitability, pricing pressure, and lower growth.

 

As seen below, new construction is set to double data center supply in some of the cities Digital Realty operates in. Time will tell if this new capacity loosens the market’s favorable fundamentals, but it’s important to remember that Digital Realty is somewhat protected due to its scale, reputation, cost-efficient performance, blue chip customer base, long-term contracts, and financial stability.

 
Digital realty Dividend

 

As technology evolves, it’s also possible that companies learn to store and manage data much more efficiently. This could reduce demand for physical data center space. However, there would have to be major advancements to offset the 20%+ annual growth in data usage across Digital Realty’s major markets.

 

Beyond risks unique to the data center market, Digital Realty faces risk from the health of capital markets. REITs are required to distribute 90% of their taxable income as a dividend to keep their REIT classification and the favorable tax treatment it comes with.

 

Since REITs pay out such a high amount of their earnings, they have less capital on hand to grow their businesses. As a result, they typically issue shares and debt.

 

As seen below, Digital Realty’s capital structure was over 50% long-term debt last year, and the company’s diluted shares outstanding have risen from 24 million shares in 2005 to a whopping 151 million shares last year to help fund growth.

 

Digital Realty Dividend

Source: Simply Safe Dividends


 

Digital Realty Dividend

 

REITs can run into trouble if credit markets tighten up and/or their share prices sink, raising their cost of capital and potentially causing a liquidity squeeze.

 

Digital Realty fortunately maintains investment-grade credit ratings from the major agencies, although it sits at the bottom tier of what is considered “investment grade.”

 

While the company only has $41 million in cash on hand compared to $6.4 billion of debt and annual dividend payments in excess of $500 million, it maintains a relatively conservative debt maturity schedule with nothing major coming due until 2020 (see below).

 

However, all REIT investors should remain aware of capital market risk – companies will cut the dividend before they miss interest payments during times of significant financial stress.

 
Digital Realty Dividend

 

Digital Realty Dividend Safety 

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
 
Digital Realty Dividend

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Digital Realty’s Dividend Safety Score of 86 indicates that its current dividend payment appears to be very safe compared to other stocks in the market.

 

The company’s adjusted funds from operations (AFFO) payout ratio in 2016 was a reasonable sub- 70%, providing flexibility and enough room for further dividend growth, and Digital Realty has historically targeted an AFFO payout ratio below 90% to help protect its dividend.

 

While this would be a relatively high payout ratio for many types of businesses, Digital Realty has generated very stable earnings and growth since it went public.

 

Digital Realty Dividend

 

Demand for data centers is also somewhat resistant to economic cycles. The company’s sales grew over 20% in 2009 as businesses continued outsourcing their mission-critical data center needs and Digital Realty continued expanding its reach, helping its stock outperform the S&P 500 by 29% in 2008.

 

Digital Realty Dividend

 

As long as industry fundamentals remain positive and capital markets remain friendly, Digital Realty’s dividend is in good shape from a safety perspective.

 

Digital Realty Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Digital Realty has raised its dividend every year since its IPO in 2004 and grown its dividend by about 13% per year over the last 10 years.

 

However, as seen below, dividend growth has decelerated over the last decade. The company most recently raised its 2017 annualized common dividend by 5.7%, marking its 12th consecutive increase.

 

Digital Realty Dividend
 

Going forward, Digital Realty’s dividend growth will likely continue at a mid-single-digit pace, which is about in line with expected growth in AFFO per share.

 

Valuation

DLR’s stock has a dividend yield of 3.1%, which is well below its five-year average dividend yield of 4.6%. The stock also trades at a forward price-to-AFFO ratio of 20, which is above the S&P 500’s forward P/E ratio of 17.5 and the REIT industry’s average multiple of 18.3.

 

The management has guided to increase the FFO per share by approximately 5% in 2017.

 

Digital Realty seems likely to continue generating mid-single-digit income growth, which is in line with management’s guidance to increase FFO per share by 5% in 2017.

 

You can also see below that Digital Realty has a strong track record of consistently delivering healthy FFO per share growth, adding confidence to this growth projection.

 
Digital Realty Dividend
 

Assuming Digital Realty’s mid-single-digit cash flow growth holds over the long-term, it would imply annual total return potential of about 7.1% to 9.1% per year (3.1% dividend yield plus 4% to 6% annual FFO growth).

 

While that’s not a bad total return projection for a high quality business, DLR’s current valuation multiples give me pause. The stock’s dividend yield has only been lower than it is today around 10% of the time since the company went public, for example. There isn’t much margin for error.

 

Conclusion

Data center fundamentals continue to look strong, and it’s hard not to like the themes the company is benefiting from, especially as many other REITs deal with mature markets and pressure from e-commerce.

 

As long as Digital Realty can keep its data centers occupied at favorable rental rates, industry supply and demand stays balanced, and capital markets remain healthy, the future is bright.

 

At the end of the day, however, Digital Realty’s valuation seems a bit rich. Given the number of moving parts at the company (e.g. recent merger activity and expected synergies) and the fast-changing nature of the technology sector (especially cloud computing development), a 15%+ pullback would make Digital Realty more interesting.

 

The stock’s dividend yield near 3% isn’t all that much for folks in need of current income. Other REITs, including the ones on our high dividend stocks list here, could be better income options to consider.

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