Digital Realty Secures Its Market Leadership With Fast-Growing Acquisition

This past month, I had to pay extra fees for using more data than my plan allows. Turns out that when Apple iTunes updates the software on the iPhone, it counts as 1.2 gigabytes of data use. If you happen to be roaming around at the time of the update and not connected to a Wifi network, that data counts against the monthly allotment. At first I thought, how could I have possibly exceeded my data limit? Upset at the fact that I had to pay extra, I started to have thoughts of getting rid of my phone. Or at least go back to the old Star Trek-style flip-phones with no internet access.

Who am I kidding? That thought didn’t linger very long. Not a day goes by that I don’t look up something of interest on Google or Safari. Who won Super Bowl 27? Sorry, I meant Super Bowl XXVII. For those of you wondering, I’ll save you the trouble; it was the Dallas Cowboys, who beat down the Buffalo Bills 52-17. What would I have done during a heated discussion about the Super Bowl winner of over 20 years ago had I not had access to the internet on my phone? Nothing. And the dinner conversation would have come to an abrupt stop with no clear winner. But thanks to my iPhone and data plan… I won! Therefore, I keep my iPhone with all the bells and whistles. At least as a weapon for future “debates,” if not the occasional phone call.

This thirst for data and interconnection has become pervasive in our society. People are always on their phones, and when I say “always,” I also mean “constantly.” They (we) are even texting as they drive, despite it now being illegal in many states without much of a concern, it seems, for their own safety or that of their passengers. I stopped using my phone while driving once I had children, but I still wonder, what could possibly be so important that it can’t wait until you reach your destination?

One year ago, I wrote an article about Digital Realty Trust (NYSE:DLR) and how it was well positioned to take advantage of our insatiable demand for data (Digital Realty Keeps On Cruising). The use of mobile data traffic based on a presentation by Crown Castle (NYSE:CCI), was expected to triple by 2017 compared to the traffic used in 2014. Since the article last year, DLR has returned a little over 5% to investors, underperforming the S&P 500 as well as its peers, CoreSite Realty Corp. (NYSE:COR) and DuPont Fabros Technology (NYSE:DFT), which had 58.63% and 17.58% returns, respectively. CoreSite approached the market differently from DLR by focusing more on technology companies and interconnectedness, and was rewarded handsomely. That being said, it is easier for smaller companies like COR and DFT to grow when compared to the behemoth of DLR. But success with colocation and interconnections by COR forced DLR to take note, and last month, it announced the acquisition of TelX, known as none other than “the interconnection & data center company.”

Why Colocation?

Over the last year, the environment for data centers and networking has changed considerably. It was not only important for companies to have the flexibility to place their data hardware in a variety of geographic locations, it became increasingly important for data centers to be interconnected and scalable. As more and more data flows through the ecosystem of what we still call the “Internet” (but has become much more than that), data speeds and response times can be adversely affected. According to a TelX white paper, a half-second difference in response time led to a 20% reduction in traffic and revenue. Consumers have increasingly short attention spans and higher expectations for speed, so any delay in the delivery of the information they are looking for is an uptick in the probability of losing that sale. One of the factors affecting speed is network latency (defined as the time interval between stimulation and response), which includes factors such as route selection, packet loss, and congestion. Using an interconnected and colocation model dramatically improves performance. According to the white paper, latencies are reduced by 50% in an interconnection and colocation facility compared to an enterprise data center, primarily because the number of connections is minimized.

Combine the flexibility of scaling with the lower latency, and many small to mid-sized businesses have opted to lease than buy their own data centers. Technology needs are changing so rapidly that by the time a company plans, invests, builds, and deploys a new data center, its needs may have already exceeded its capacity. To prevent this, one option would be to build a bigger data center at the risk of over-building. Another would be to lease enough space for current needs with the option to add capacity as it’s needed. This optionality with so much uncertainty and such high capital costs is an attractive benefit for many growing businesses.

TelX Acquisition

The TelX acquisition increases DLR’s revenues in colocation from 7% to 14%, while interconnection revenues will consist of 9% of total revenues per recent pro forma data. With colocation growing at a 35% rate, it is a much-needed shot in the arm, and more importantly, an indication to investors that DLR is evolving.

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The combined entity will have an enterprise value of almost $17 billion, and more importantly for DLR, a footprint in the faster-growing colocation segment.

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The acquisition presents immediate potential that goes beyond the addition of colocation and interconnection services. TelX is currently operating at just 68% utilization rate, which presents a significant upside opportunity. According to DLR, bringing those facilities up by 10%-12% utilization will result in potential revenue increase of $65 million. At a back of the envelope FFO margin of 40%, that translates into an additional FFO per share of $0.19.

TelX also has 1250 customers and 52K interconnections, which creates a further diversified customer base when combined with DLR’s existing clients.

With momentum seemingly positive after the latest earning release, DLR is positioning itself well for 2016 and beyond.

Peers

As I mentioned earlier, CoreSite had a 58% shareholder return over the last year, with over 10% of that coming in the last month. It now looks a bit overbought with a price/FFO of over 20 and a dividend yield of 3.2%, according to Morningstar.

Digital Realty, on the other hand, is trading at a reasonable 12.7 times FFO, which is comparable to the much smaller DuPont Fabros. After a year of underperformance, however, DLR is looking much more attractive to me. It is likely that DFT could experience higher growth than DLR over the short term, but in an increasingly volatile market, DLR looks like a bargain. With a dividend yield of 5.2%, it compares well against the 5.7% yield for DFT.

Risks

There are risks to any investment thesis, and this one is no different. (Just in case you were wondering.) Expanding into colocation and interconnected services is a positive strategic move for DLR, but like any other acquisition, integration challenges remain. Although I think the integration risk is mitigated somewhat by the fact that DLR owns 29% of TelX’s square footage. Within some of these facilities, the switch over process should be easy, if not seamless.

DLR also raised approximately $700 million for the acquisition, but not only will it need to issue more debt to fund the difference, it may also have to rely on more debt in the future to drive additional revenue growth. It has a strong balance sheet and it should be able to cover the additional interest expense, but on a going-forward basis, it is certainly something to monitor.

Before moving on from the forward sale of equity, however, I’d like to clarify what others have erroneously written in other recent articles about DLR. DLR has not raised the funds yet. They have entered into a forward agreement to settle and receive proceeds at any time they desire up to March 2016. Obviously, it will need to draw those funds to close the deal. There will be additional shares issued to Bank of America ML, Morgan Stanley, and Citigroup. These underwriters, in turn, have hedged the transaction by borrowing the shares and selling them (in essence, protecting themselves against a dramatic decline in the price). To cover their short position, the underwriters can then purchase shares in the open market. There will be additional shares issued, just not to the public, and the borrowing mentioned by other articles has nothing to do with DLR, but rather, the underwriters hedging themselves against adverse movements in the price of the stock before settlement. See below.

Getting back to additional risks, competition for colocation space is extremely competitive, and new entrants or combinations of entrants could pose a challenge for DLR to gain additional market share. Perhaps a COR/DFT merger or companies like EMC (NYSE:EMC) expanding into real estate are both possibilities despite the low probability of that occurring.

Conclusion

DLR’s strategic move to acquire TelX sent a strong message to the market that data center growth is coming from colocation and interconnection services. In my opinion, it will be the difference between DLR continuing to grow and evolve versus becoming the industry dinosaur that despite its stability provides little growth and therefore limited upside for investors. DLR is a core position in any portfolio containing REITs and may eventually become the anchor of a well-diversified portfolio. But in the meantime, investors would appreciate a little more growth to go along with that 5% dividend.

Sources: PM101, Digital Realty website, Morningstar

Digital Realty Keeps Cruising

DLR Keeps Cruising

On March 15th, I published an article about Digital Realty (NYSE:DLR) on Seeking Alpha (Read Article) that highlighted how its international interconnected network of data centers will help distance it from the competition. At the time the stock was at $51.51 and has since climbed to $64.77 as of July 30th. Throw in a $0.83 dividend and returns haven’t been too shabby.

At the time I suggested the stock could potentially reach $80 within a year. Do I still feel that way?

How Networking Helps Digital Realty Distance Itself From The Competition

Digital Realty Trust

One of the most powerful phenomenons of the internet age has been the network effect that increases the value of a product or service exponentially the more people own or use it. Facebook (FB) is a perfect example. (See The Facebook Effect: The Inside Story of the Company That is Connecting the World by David Kirkpatrick) Had my best friend and I been the only two people with access to Facebook, it probably would not have been able to go public and make Mark Zuckerberg a multi-billionaire. In fact, if there were 1 billion users on Facebook each with access only to his or her own pages, the value of Facebook will have been much less than it currently is. I’m sure it still would have been a great tool to post pictures on and to play Farmville by myself, but it certainly would not have been as much fun, and as valuable, without being able to share my life with others. Oftentimes even without really wanting to.