Tag Archive for: Digital Realty Trust

No Show

Many years ago, when I was in high school, my Dad gave me some scholarly advice that paid dividends in subsequent years. He said that if I was stumped on an essay question, then the best thing to do was to “show what I know”. I may not have all the facts about the Battle of Antietam, but I might be able to muster some pretty decent paragrpahs about why Abraham Lincoln demoted General George McClellan. “Show what you know” snatched mediocrity from the flames of academic despair on several occasions.

That’s where I’m at this week. I don’t have any new conclusions, but I can tell you a few of my thoughts and observations. Here’s to showing what (little) I know…

Peakstone Realty Trust (PKST)

Oh Peakstone, you broke my heart. Last fall, I thought I found the ideal REIT trading at an enormous discount. Peakstone was priced in the $14 range and had a market cap of $480 million. The office and industrial REIT owns some prime property like the Freeport McMoRan tower in downtown Phoenix, Amazon distribution centers, and the McKesson office complex in Scottsdale.

I threw a ludicrous cap rate at the office space and figured the real estate was still worth about $1.7 billion. After subtracting net debt of $936 million, I thought the stock was worth $18. Plus it had a 6% yield.

We’re now 40% lower, and that stings. A lot. All management really had to do was buy back stock, sell assets and pay down debt. When your dividend is yielding 6%, it’s a no-brainer. Instead, deal junkies do what deal junkies gotta do. Deals, y’all. In November, they went out and re-levered the balance sheet in to buy a $490 million portfolio of outdoor storage real estate at a cap rate of… 5.2%.

I did not have buying B industrial assets with negative leverage on my bingo card, but there you go. The website photos on Peakstone’s portfolio page now look like the opening credits from Sopranos.

Barry-Callebaut (BRRLY)

The Zurich-based refiner and seller of chocolate has taken an absolute beating as the price of cocoa has skyrocketed. Shares are down 50% over the past year. I’ve never seen anything quite like the price chart for cocoa. Parabolic is an understatement. It’s actually mind-boggling.

Crop failures in Ivory Coast and Ghana have led to a shortage. But is it really that bad? There’s got to be an opportunity here somewhere. Surely futures markets are way over their skis?

Barry-Callebaut is one of the leading suppliers to confectioners, and they have a dynamic new CEO who has begun an efficiency drive. The problem is that Barry-Callebaut had to purchase inventories of cocoa at massive discounts to the contracted sales prices to their customers.

Working capital looks like an absolute trainwreck. The company spent over 2.6 billion CHF on cococa inventory over the past year. In order to cover the loss, BRRLY turned to the debt markets and raised about 3 billion CHF. Eventually, the cocoa market’s gotta rebalance, right?

Digital Realty Trust (DLR)

The sector is so hot right now. An Australian fund manager, Nate Koppikar, is shorting data centers in the belief that supply of will outstrip demand as this whole AI-thing bursts its bubble. I have looked at Digital Realty in some depth. I don’t have much of a smoking gun here, but I do agree that the market is way ahead of itself.

Digital Realty trades at 24 times projected funds from operations and carries an enterprise value of $70.4 billion. I produced a cocktail napkin set of numbers and my conclusion is that the stock trades at a 40% premium to its intrinsic value.

I took the most recent unlevered free cash flow of $1.9 billion and applied a cap rate of 5.5%. This results in an asset value of $35 billion. I subtracted debt, redeemable noncontrolling interests, preferred stock and added joint venture investments at 2 times book value. Next, I ran a very basic discounted cash flow on a future investment pipeline that essentially doubles the company’s real estate footprint in five years. I assumed 25% leverage for the new properties. The present value of future development amounts to $17.4 billion. The sum of these pieces is an estimate of net asset value of $39.7 billion.

Obviously, this is a work in progress, but here are my general observations thus far: REITs must distribute 90% of their taxable income. Therefore, it is very difficult to achieve growth through the reinvestment of profits. DLR pays a dividend yield near 3%, and this leaves virtually zero cash to deploy into new data centers. DLR must, therefore, raise external capital in order to grow. I assumed that they continue to borrow 25% of their future investment requirements. The rest needs to come from the issuance of new stock. Indeed, during the first three quarters of 2024, Digital Realty raised $2.7 billion by issuing new shares.

Raising cash through the sale of stock to deploy into profitable real estate developments works just fine as long as the return on capital exceeds the cost of capital. In this regard, DLR’s recent track record has been unexceptional. Returns on capital have hovered near 6.5%. In my future development scenario, I assumed returns of 10%. This is what their major competitor Equinix has been able to achieve. DLR has been able to produce shareholder value despite unremarkable asset performance because they loaded up with debt at the absolute bottom of the COVID-era interest rate bonanza. The weighted average cost of the $17.1 billion of loans outstanding is a puny 2.9%. Unfortunately, the incremental debt for the development program will have an interest rate in the 5% range.

At this point, I don’t have a strong conviction about the value of Digital Realty. My projections are too simplistic to be relied upon. But I do believe that the stock reflects a future development pipeline that must be executed flawlessly and at returns much higher than the company has a achieved in recent years. REITs that can issue stock, and deploy the cash at returns in excess of the cost of capital work very well. When they don’t deliver those returns, they become shareholder dilution machines. I’m going to leave it here for now.

Until next time.

DISCLAIMER

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.

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Data Center REITs Look Like A “Big Short” To Jim Chanos, But What Do The Numbers Say?

Jim Chanos, the famous Wall Street cynic, has cast a wary gaze upon real estate investment trusts that own large data centers. “This is our big short right now,” Chanos told the Financial Times. He has no doubts that cloud computing will continue to grow, but he believes that companies like Digital Realty Trust (DLR), Equinix (EQIX), and CyrusOne (CONE), are destined for trouble. His thesis: Amazon Web Services, Microsoft Azure, and Google Cloud will increasingly bypass the REITs to scale their operations by building data centers of their own. “The real problem for data center REITs is technical obsolescence,” said Chanos. “Their three biggest customers are becoming their biggest competitors. And when your biggest competitors are three of the most vicious competitors in the world then you have a problem.”

Chanos has a long record of success betting against overvalued businesses, but his assessment of the industry contrasts with Blackstone which recently purchased QTS Realty Trust for $10 billion. Meanwhile, Bill Stein, the CEO of Digital Realty Trust, quickly countered Chanos’ comments by pointing out his firm’s record bookings for the first two quarters of 2022. Yet the changing dynamics of the industry were on display Tuesday when FedEx announced that it will save $400 million annually by closing all of its data centers to move completely to the public cloud.

My rudimentary analysis of Data Realty Trust (DLR) indicates that the stock is overvalued by 10-15% relative to its underlying real estate. This kind of premium is uncomfortably high, but I’m not exactly grabbing my drumsticks for a round of Pantera. After all, the company has grown net operating income (or funds from operations, in REIT parlance) by 15% annually.

Despite the growth, there isn’t much appealing about a stock with a 3.8% dividend yield when you can earn 3% from 2-Year and 5-Year Treasury Notes. A business staring at such formidable competition should require a spread better than 80 basis points. A 25% drop in the price of the stock would be needed to produce a 5% yield.

Statistics for Digital Realty Trust are presented below. The table demonstrates a valuation of its real estate assets by capitalizing 2021 funds from operations (FFO). I add development in progress at cost and subtract debt to arrive at a net asset value of $111.89 per share, which is about 13% below the price on July 7, 2022. One could argue that I should employ forward estimates of FFO for my computation, and this would be fair. However, I am using a very low capitalization rate of 4.31%. This reflects the company’s low borrowing costs (2.22%). The FFO yield was used as a proxy for the cost of equity.

The second table shows results for the past 12 years. It indicates the rapid growth in net income for DLR, but it also shows that returns on total invested assets have been declining for years to levels below 7%. The low interest rate environment of the recent past juiced returns on equity, but even these results have become less impressive in recent periods. DLR has debt of about $13 billion on roughly $30-32 billion of assets, so the business is not exactly shy about using leverage. However, cheap debt acquired during the pandemic provided ample FFO debt coverage at 6.25x interest during 2021.

I don’t see a compelling reason to invest in DLR with the stock price trading above net asset values. And even though Jim Chanos may be hyperbolically talking his book, the threat posed by Amazon, Microsoft and Google is very real. Meanwhile, the dividends aren’t sufficient when the comparable safety of 3% Treasury yields beckons.

Note: This article contains the opinions and observations of the author. No investment recommendations are being provided and no representations are made to the accuracy of the content presented.

Bert Hancock, Author. July 7, 2022.

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