Digital Realty: buy at 52-week low despite competitive risk

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Digital Real Estate Trust (NYSE: DLR) is one of the world’s largest REITs focused on data centers and digital infrastructure. DLR stock performed exceptionally well into 2020 as it was seen to have strong tailwinds and above-average growth prospects relative to other REITs.

I warned of Digital Realty’s overly rosy sentiment in March 2020, warning that investors [Were] Overpaying for perceived security. Since then, the outlook has deteriorated. Digital Realty and other data center related games significantly underperformed the market. That being the case, it’s worth taking a fresh look at stock DLR. And, from where we’re sitting today, the odds look much more favorable for Digital Realty in the future.

Why This Former Bear Is Turning Bullish

There are two main reasons I went from Digital Realty skeptic to potential shareholder. The first is that DLR stock has significantly underperformed the S&P 500 since my previous article:

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DLR Total Return Price Data by YCharts

Including dividends, Digital Realty has produced a total return of -6% since March 2020, while the S&P has produced a total return of 58% and the iShares U.S. Real Estate ETF (IYR) provided 40%.

Thus, on a relative valuation basis, Digital Realty has become considerably more attractive relative to both its immediate real estate peers and also the broader S&P 500. Given the overall market appreciation since March 2020, I find stocks trading below their March 2020 low to be particularly interesting today.

However, there is more than just relative valuation to strengthen the case for DLR stocks here. Additionally, the company has grown funds from “FFO” operations from around $8.50 per share in 2020 to over $10 per share today. This is part of a bumpy but generally quite favorable long-term trajectory for Digital Realty’s FFO:

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DLR FFO Data Per Share (TTM) by YCharts

So, while Digital Realty’s share price hasn’t budged in the past two years and considering, actual FFO – which in turn should boost the dividend – is up 20%. And while Digital Realty’s valuation ratio has increased significantly, its peers in the REIT market and the S&P 500 as a whole have significantly appreciated in value. Thus, there is both an absolute and relative valuation argument for Digital Realty to be a much more attractive investment today.

Dividend yield increased

Over the past five years, Digital Realty has offered a dividend yield of between 2.6% and 4.0%:

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DLR Dividend Yield Data by YCharts

Prior to the pandemic, stocks were generally at the upper end of this range, with around 3.6% being the typical bid for Digital Realty stocks.

However, after the onset of the pandemic, the average return edged closer to 3.0% as people paid for Digital Realty’s apparent safety and growth prospects amid an accelerating transition to digital products and services. At the start of 2022, the yield on DLR stock fell to a low of just 2.6%.

Now, however, with the strong sell-off of Digital Realty, shares are back to yielding 3.9%, more than 100 basis points higher than at the start of the year. That’s a big difference for income investors. Given the risks I’ll talk about in a minute, it’s possible that DLR stock could drop to new lows, which would push the yield above 4%. Still, on a historical basis, it’s a pretty attractive entry point into Digital Realty today.

Dividend yield is also not a static number. Digital Realty has built a solid reputation as a consistent dividend producer; he increased his annual payment 17 years in a row. The five-year compound growth rate of 5.6% is not spectacular, but it is certainly sufficient when the current starting return is close to 4%.

Why short sellers harass Digital Realty

It’s not all positive news for Digital Realty. As you would expect with this level of dramatic underperformance relative to the market, there are skeptics trying to poke holes in the business model. Notorious short seller Jim Chanos has launched a high-profile campaign against data center REITs such as Digital Realty and equinix (EQIX). Here is the summary of this argument:

“That’s our big shorts right now,” Chanos said in an interview with the Financial Times. “The story is that although the cloud is growing, the cloud is their enemy, not their business. The value goes to cloud companies, not old traditional data centers.”

Elaborating on this point, there are potentially a few issues with the data center model. First, the fastest growing part of the universe is in cloud data hosts such as Amazon (AMZN) Web Services and alphabetical (GOOGL) (GOOG) Google Cloud. The tremendous growth rates of these companies stem, in part, from a deceleration in more traditional data centers.

On the other hand, Chanos has concerns about the accounting of data center REITs. It is possible that these companies use an overly generous definition of maintenance capital expenditure to show a profitability higher than the economic reality. Digital Realty’s free cash flow per share hasn’t grown much over the past decade, while Equinix has often struggled to generate much more positive free cash flow. A bear can argue that a portion of reported FFOs that are used to support the dividend may not be covered by a recurring base income.

Rising interest rates and the cost of capital for REITs will only add to the potential pressure with respect to dividend coverage in the future.

Conclusion of DLR Stock

I see the bearish case as having some merit. The long-term evolution of data from on-premises server farms to cloud hosting poses a serious challenge for companies like Digital Realty. They don’t take the competition down, and that’s not something that will make them obsolete overnight.

However, investors should probably start viewing companies like Digital Realty and Equinix as more mature, slow-growing companies rather than the fast-moving disruptors they were five or ten years ago. In other words, expect significantly higher starting dividend yields, but slower dividend increases from this sector going forward.

I consider the stocks to be at least fairly valued here, if not a bit cheap, and so if you like the company, that seems like a good place to consider buying. Personally, I look for a lower entry point because stocks often have a way of overreacting when there’s a strong and compelling bearish thesis, like what Chanos presented on Digital Realty and Equinix. That being said, stocks have a decent risk/reward profile at today’s price.

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