2023-08-28 15:23:27 ET
Summary
- DigitalBridge stock has gained 45.5% since December and is now trading at around $16.25.
- The company's portfolio of digital infrastructures is well positioned to benefit from generative AI and the growing demand for data center capacity.
- DigitalBridge's P/S ratio of 1.6x is lower compared to the real estate sector, indicating the potential for higher valuations.
- The $22.3 target is fair in view of the opportunities and uncertainties.
Since I covered DigitalBridge (NYSE: DBRG ) in December 2022 where I rated it a Buy, the stock has gained 45.5% and is now trading at around $16.25. In the meantime, macroeconomic conditions have changed significantly with higher borrowing costs and the Fed may still hike rates to meet its targeted inflation rate of 2% as per the Jackson Hole meeting.
For this thesis, I again have a buy position and will provide an update on how the company's capital-light strategy is enabling it to get funding in order to invest and take advantage of growth opportunities realizable with Generative AI, a technology that the management covered at length during the second quarter 2023 (Q2) earnings call on August 4, with one of the presentation slides shown below.
Company Presentation (ir.digitalbridge.com)
I will also assess whether, at a price-to-sales multiple of 1.6x , it makes sense to invest, but, far from rubber-stamping the words of DigitalBridge's executives, my aim will be to realistically assess to what extent this real estate company's portfolio which stretches across digital infrastructures comprising towers, fiber networks, and data centers is well positioned to benefit from higher artificial intelligence utilization.
Generative AI-led Opportunities
First, as seen with the phenomenal rate at which OpenAI's ChatGPT has been attracting millions of users since the launch of its stable GPT-4 version back in March this year, this innovative technology has indeed become mainstream. Thus, far from being confined in the lab where only experts trained in complex machine learning programs can handle it, Generative AI which drives ChatGPT, can be accessed by almost anyone, including the common internet surfer.
In addition to its ease of use, this new artificial intelligence flavor is also different from previous ones like Recommendation AI which are used by marketers to promote engagement with their customer bases, like being recommended a new movie on Netflix ( NFLX ) based on past preferences. Thus, applications driven by Generative AI are used to generate text, images with Dall-E , and videos, resulting in the creation of more multimedia content which not only requires more computing power in data centers but also higher networking bandwidth.
Now, to get an idea of the requirements, ChatGPT's users grew by 9,900% in just 60 days after launch which implies a rate of adoption that is four times faster than video sharing platform TikTok and 15 times faster than Instagram to reach the same number of users. Now, the software algorithms that support OpenAI’s large language models or LLMs are hosted in data centers with the infrastructures being deployed mostly by large cloud service providers representing about two-thirds of the market.
Detailing further, Generative AI workloads are much more compute-intensive, estimated at around 2.9 times more than normal IT workloads based on the difference between the power utilizations. An example is Nvidia's (NASDAQ: NVDA ) power-hungry H100 GPUs (graphics processing units) requiring not only higher power density racks compared to normal CPUs (computing processor units) but also more of them in order to support AI algorithms using LLMs to be trained on large data sets.
Company presentation (ir.digitalbridge.com)
Now, as per DigitalBridge's CEO, the company is already seeing " unprecedented demand for data center capacity from technology companies looking to deploy LLMs" with the related pipeline up by 84% in Q2 on a YoY basis.
Valuing in View of Opportunities and Uncertainties
This means that the company deserves better valuations, and given that its P/S of 1.6x is lower compared to the real estate sector by -62.93% , I have a target of $22.34 assuming a 37.5% upside based on the current share price of $16.25. I could have valued the company higher, or $31.25 through a 60% upside, but this target represents a fair value as the data center portfolio represented only 35% to 40% of the assets under management in Q2 whose midpoint averages 37.5%.
The rest of the portfolio is made up of fiber, towers, small cells, and edge computing as shown below and some can argue that there are also opportunities in fiber and edge computing as in addition to high-speed GPUs, widespread consumption of AI services may require higher networking capacity far from the central metro locations, but, it is preferable to first monitor how the consumption pattern evolves.
Company presentation (ir.digitalbridge.com)
Furthermore, the $22.34 target is fair in view of the competition and macroeconomic risks being faced by DataBridge.
First, valuing the business higher would not have considered the competitors in the data center space with one of them being Equinix ( EQIX ) which has a relatively higher portion of large public cloud providers or hyperscalers as its clients compared to enterprises. Now, the high demand seen by Nvidia's GPUs is currently being driven by hyperscalers like Microsoft (NASDAQ: MSFT ) and Amazon (NASDAQ: AMZN ) and given the large numbers of server racks they lease, these tech giants are likely to bid for the lowest leasing costs. This in turn implies that while bookings are up by 84%, the actual sales figures may not increase by the same amount.
Second, as for enterprises, most normally plan their cloud migration and digital transformation projects years in advance, and may not allocate large funds to AI in the face of global economic uncertainty . In these circumstances, it is more probable that there may be a reallocation of corporate budgets toward intelligent algorithms which implies that net data center occupancy rates may not necessarily rise as anticipated, with this less rosy outlook confirmed by an article in Software Stack and Investing.
Third, there could be a pullback in capital expenses related to 5G by U.S. mobile services providers from 2024 according to analysts at KeyBanc. Now since a significant part of fifth-generation wireless network investments pertain to radio antennae which are mounted atop towers, this in turn curtails growth prospects for DigitalBridge's tower portfolio.
Now, in order to invest for growth, especially when you are not cash-rich like the big techs, there is a need to fund capital expenditure using external funding, and, in view of the tighter prevailing monetary policy, this has not proved easy for businesses in general including data center REITs.
Highlighting the Capitalization Strategy
However, things have been different for DigitalBridge which has managed to raise $3.4 billion since the beginning of 2023, through its DBP series fund which is focused on value-added digital infrastructure. This is relatively a large amount and is being spent mostly (at 75%) on data centers.
Moreover, looking at the capital structure, an amount of $200 million of convertible notes has been repaid back, with about $45 million planned to be raised through the deconsolidation of the operating segment (the Databank business), and expected to be completed this year. Despite reducing debts by the $200 million mentioned above, the cash balance remains at above $400 million as pictured in the balance sheet below.
seekingalpha.com
Tellingly, the balance sheet also shows the reliance on high levels of non-recourse debt to fund investments where lenders tend to impose higher credit standards and repayment is tied to the proceeds generated from the project being funded. Now, to explain lenders' continuous enthusiasm to fund DigitalBridge in this way despite the availability of risk-free alternatives like higher treasury yields, it is basically the company's ability to generate returns of investments above 20% CAGR.
DigitalBridge Remains a Buy
Thus, this business model where the company carries a low debt level and does not possess much cash, but still manages to finance billions of dollars worth of projects through external funding is part of the company's capital-light strategy. It has been working for DigitalBridge and has proved viable as of the end of June, assets exceeded liabilities by more than $3 billion.
Furthermore, after scaling rapidly in 2021 with revenues surging by 862% YoY as tabled below, led by the digital transformation secular trend when everything from data center colocation space, fiber capacity, and tower leasing witnessed high demand, its annual revenue growth has now moderated, but is still at double digits.
Income Statement - Annual Basis (www.seekingalpha.com)
Now, the management is banking on the next wave of data center growth this time driven by AI with around $300 billion of opportunities being estimated and these could also reverberate across the fiber and edge computing portfolios. Finally, with a history of execution, investors are entrusting DigitalBrige with more funding, which should sustain the capital-light strategy, and, as such, it deserves a higher valuation, but, still, I have adopted a dose of moderation in view of certain uncertainties.
For further details see:
DigitalBridge: AI Opportunities Through The Data Center Portfolio