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Digital Realty Trust (DLR)

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 more than 180 operating properties located across over 30 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.
Source: Digital Realty Investor Presentation
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.

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 nicely 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 24% to 46% annually over the next several years, according to Digital Realty.
Source: Digital Realty Investor Presentation

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.
Source: Digital Realty Investor Presentation
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. Jonathan Meisel, Managing Director and Data Center Solutions Market Director for JLL, believes major cloud providers will need to triple their infrastructure by 2020 to keep pace with skyrocketing data consumption. As a leading data center operator in the world, Digital Realty is well positioned to ride this tailwind.
 
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.

In fact, Digital Realty’s total portfolio occupancy has remained close to 90% of higher in each of the last seven years, including 95% in 2009 during the last recession. The company also notes that its tenant retention ratio has been strong at more than 70% of net rentable square footage.

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.

Furthermore, a new data center deployment typically 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’s average remaining lease term with customers is about 5 years, and fewer than 20% 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 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, Verizon, and Oracle speak to the quality of Digital Realty’s properties.

The company’s diversification by customer (top 20 tenants are less than 50% of annualized rent) and industry further helps smooth out earnings, and Digital Realty’s mix of data centers is also improving.

Specifically, 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 in recent years has been repeat business with existing customers.

In July 2016, Digital Realty acquired eight high-quality, carrier-neutral data centers in Europe from Equinix for about $820 million. This deal enhanced the company’s interconnection growth and colocation potential globally.

In order to further strengthen its presence in strategic U.S. data center metros, Digital Realty announced a $7.6 billion merger with DuPont Fabros in June 2017. Not only are the two companies’ portfolios highly complementary, but the combination is also expected to enhance Digital Realty's overall balance sheet strength and result in the creation of the the second-largest data center REIT after Equinix. In fact, the combined company has 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 with DuPont Fabros enables 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 cloud portfolio in Virginia, Chicago, and Silicon Valley, three important growth markets.

Overall, Digital Realty operates in an industry with favorable secular growth trends and gains benefits from its scale, cost-efficient real estate locations, non-discretionary services, and strong customer relationships. As a result, the company's dividend is on very solid ground, and management expects Digital Realty to deliver mid-to-high single digit cash flow growth going forward to help drive double-digit total shareholder returns.
Source: DIgital Realty Investor Presentation

Key Risks

Conservative investors are often best off avoiding 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 become 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, 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.

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.

Digital Realty’s diluted shares outstanding have risen from 24 million shares in 2005 to more than 170 million shares today to help fund growth, for example. 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 and has a relatively conservative debt maturity schedule with nothing major coming due until 2020. However, all REIT investors should remain aware of capital market risk given the unique structure of these companies.

Closing Thoughts on Digital Realty

Data center fundamentals continue to look strong, and it’s hard not to like the themes Digital Realty is benefiting from, especially as many other REITs deal with mature markets and low growth rates. The company should have no trouble continuing to raise its payout going forward, something it has done each year since going public in 2004. 

As long as Digital Realty can keep its data centers occupied at favorable rental rates, industry supply and demand stay balanced, and capital markets remain healthy, the company's future appears to remain bright.

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