Summary
- I was bearish on Digital Realty in 2020, but I'm flipping toward the bullish side today.
- The company faces real risks and arguably is not as attractive a business as it was five years ago.
- However, this is reflected in the price today, and shares are offering a more compelling starting yield now.
Digital Realty Trust ( DLR ) is one of the world's largest REITs focused on the data center and digital infrastructure space. DLR stock performed exceptionally strongly up until 2020 as it was perceived to have strong tailwinds and above-average growth prospects compared to other REITs.
I cautioned about Digital Realty's overly rosy sentiment in March 2020, warning that Investors [Were] Overpaying For Perceived Safety . Since that point, the outlook has weakened. Digital Realty and other data center-related plays have significantly underperformed the market. With that being the case, it's worth taking a fresh look at DLR stock. And, from where we sit today, the odds appear much more favorable for Digital Realty going forward.
Why This Former Bear Is Turning Bullish
There are two primary reasons why I've gone from being a Digital Realty skeptic to a potential shareholder. The first is that DLR stock has underperformed the S&P 500 dramatically since my prior article:
Including dividends, Digital Realty has generated a total return of -6% since March 2020, whereas the S&P has produced a 58% total return and the iShares U.S. Real Estate ETF ( IYR ) has delivered 40%.
So, on a relative valuation basis, Digital Realty has become dramatically more attractive compared to both its immediate real estate peers and also the broader S&P 500. Given how much the market has appreciated overall since March 2020, I find stocks trading below their March 2020 lows to be particularly interesting today.
There's more than just relative valuation to bolster the argument for DLR stock here, however. In addition, the company has grown funds from operations "FFO" from around $8.50 per share in 2020 to more than $10 per share today. This is part of a bumpy but generally quite favorable long-term trajectory for Digital Realty's FFO:
So, while Digital Realty's stock price hasn't gone anywhere over the past two years and counting, the actual FFO - which in turn should drive the dividend - is up 20%. And while Digital Realty's valuation ratio has come in significantly, its peers in the REIT market and the S&P 500 as a whole have appreciated considerably in value. Thus, there's both an absolute and relative valuation argument for Digital Realty being a much more attractive investment today.
Dividend Yield Has Moved Up
Over the past five years, Digital Realty has offered a dividend yield ranging between 2.6% and 4.0%:
Prior to the pandemic, shares were generally in the higher end of that range, with around 3.6% being the typical offering from Digital Realty's stock.
Following the onset of the pandemic, however, the average yield moved closer to 3.0% as people paid up for Digital Realty's seeming safety and growth prospects amid an accelerating transition to digital products and services. At the start of 2022, DLR stock's yield slid to a low of just 2.6%.
Now, however, with Digital Realty's sharp sell-off, shares are back to yielding 3.9%, which is more than 100 basis points higher than where it started the year. That's a big difference for income investors. Given the risks I'll discuss in a minute, it's possible DLR stock will drop to new lows, which would push the yield above 4%. Still, on a historical basis, this is a pretty attractive entry point in Digital Realty today.
The dividend yield isn't a static figure, either. Digital Realty has established a solid reputation as a consistent dividend grower; it has increased its annual payment 17 years in a row. The five-year compounded growth rate of 5.6% isn't spectacular, but it's certainly fine enough when the starting current yield is almost 4%.
Why Short Sellers Are Hounding Digital Realty
It's not all positive news for Digital Realty. As you might expect with this level of dramatic underperformance versus the market, there are skeptics trying to poke holes in the business model. Famous short seller Jim Chanos has launched a well-publicized campaign against the data center REITs such as Digital Realty and Equinix ( EQIX ). Here is the summary of that argument:
“This is our big short 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. Value is accruing to the cloud companies, not the bricks-and-mortar legacy data centers.”
Elaborating on that point, there are potentially a few concerns with the data center model. One, the faster-growing part of the universe is in the cloud data hosts such as Amazon ( AMZN ) Web Services and Alphabet's ( GOOGL ) (GOOG) Google Cloud. Those companies' tremendous growth rates are coming, in part, from a deceleration in more traditional data centers.
For another, Chanos has concerns around accounting at the data center REITs. It's possible that these companies are using too generous a definition of maintenance capital expenditures to show more profitability than might actually be the economic reality. Digital Realty's free cash flow per share has not grown much over the past decade, while Equinix has often struggled to generate much positive free cash flow at all. A bear can argue that some of the reported FFO that is used to support the dividend may not be covered by recurring core income.
The increase in interest rates and cost of capital for REITs will only add to the potential pressure as far as covering the dividend goes in the future.
DLR Stock's Bottom Line
I see the bearish case as having some merit. The long-term evolution of data from on-premise server farms to cloud hosting poses a serious challenge to firms like Digital Realty. They aren't taking the competition lying down, and it's hardly something that will cause them to become obsolete overnight.
However, investors should probably start thinking of companies like Digital Realty and Equinix as more mature slower-growth enterprises rather than the fast-moving disruptors that they were five or ten years ago. Put another way, expect significantly higher starting dividend yields but slower dividend increases from this sector going forward.
I see shares as at least fairly valued here if not a touch cheap, and thus if you like the business, this seems like a fine point to consider buying. I personally am waiting for a lower entry point since stocks often have a way of overreacting when there's a loud and compelling bearish thesis out there, such as what Chanos has presented on Digital Realty and Equinix. That being said, shares have a decent risk/reward profile at today's price.
For further details see:
Digital Realty Is A Buy At 52-Week Lows Despite Significant Competitive Risk