Digital real estate (New York Stock Exchange:DLR) is a Real Estate Investment Trust [REIT] which owns more than 300 data centers around the world. The company has an elite list of over 4,000 clients that includes IBM, JPMorgan, Meta, Oracle, and many more. Digital Realty is in a privileged position to benefit from secular growth trends through the Digital Transformation of companies. The cloud computing market is forecast to grow at a rapid CAGR of 15.8%. Among 2022 and 2028, reaching over $1 trillion by 2028.
Digital Realty has seen its share price drop 42% from its all-time high in December 2021, primarily due to the rising interest rate environment and FX headwinds. Despite this, the company reported strong results for the third quarter of 2022 as it beat analysts’ expectations for revenue. In this post, I’m going to break down their third quarter earnings report in detail and then reveal the valuation, let’s dive deeper.
Third Quarter Breakdown
Digital Realty generated strong results for the third quarter of 2022. Revenue was $1.19 billion, up ~5.2% year-over-year and beating analyst expectations by $5.23 million. At constant exchange rates, revenue (blue bar below) increased a substantial 11.2% year over year.
Its strong growth was fueled by strong new customer growth with 103 new registered customers during the third quarter of 2022. Notable gains include:
- A Global Fortune 2000 luxury goods manufacturer, which has adopted a data exchange on PlatformDIGITAL.
- A Global 2000 technology manufacturer also expanded its hybrid IT setup in two regions globally.
- A Global 2000 retailer that rationalized its data centers as part of a hybrid IT setup.
- A US Energy Provider Global 2000 (Hybrid Cloud Transformation)
- A Global 1000 insurance company that has moved to PlatformDIGITAL for easy access to 2 leading cloud providers.
- A leading Global 100 insurance company is streamlining its data centers and migrating to PlatformDIGITAL to gain strong access to 2 leading cloud service providers.
Digital Realty has reported tremendous traction in those businesses that want to operate in a “hybrid cloud” environment. In general, organizations have a few options when moving to the cloud. First, they can keep all of their IT on-premises, which is the traditional structure. Second, they can move all of their IT applications to a major cloud service provider like Amazon Web Services. [AWS], Microsoft Azure, or Google Cloud. Third, they can take a hybrid approach that allows companies to use multiple cloud providers and even keep some IT services “on-premises.”
according to one to study, 89% of companies are taking a multicloud approach and 80% are taking a hybrid cloud approach. Now it should be noted that the sample size was quite small for this survey (753 people), but it’s still an interesting data point and a tailwind for Digital Realty. The hybrid cloud approach may be a bit more complex, but it gives companies a greater advantage over cloud providers and allows them to benefit from the strong features of each provider.
The company signed record bookings of $176 million in the quarter. This growth was driven mainly throughout the North American region with major deals in the Portland and Dallas areas. Strong growth in San Palo led the Latin America region and Osaka led APAC growth. This large number of deals fueled a strong development pipeline of over 400 megawatts, with 60% of its developments already pre-leased to customers. This offers strong consistency and lower risk for investors, which is a positive sign. In my previous post on Digital Realty, I discussed their business model in more detail, for those interested.
Digital Realty has a beautiful rental system for their data centers where they incorporate CPI based escalators for their new leases. The Consumer Price Index [CPI] is a popular measure of inflation and this means that the company is naturally protected against the effects of inflation. Approximately 95% of their portfolio includes some type of rent escalation clause, which is positive.
Across Digital Realty’s 304 data centers and 316 buildings, the company has a strong occupancy rate of 84.7%, which recovered 80 basis points quarter over quarter. This growth has occurred despite the company rapidly expanding its global placement. Inventory which will be a slight headwind to occupancy rates in the short term. The remaining weighted average term of the lease is 4.7 years, which helps give investors an idea of the cash flow and security situation.
Digital Realty has a strong backlog of signed but not yet started leases that equate to $466 million. The time period between when a lease is “signed” and commencement is approximately 17 months, for their large multi-site enterprise customers with customer requirements. However, excluding recent business deals, the time from signing to commencement is less than 8 months, which is in line with its historical average.
FFO and NOI metrics
Two common metrics used to analyze REITs are NOI (net operating income) and FFO (funds from operations). NOI is the “net income” after all operating expenses have been misused for the properties. In this case, NOI growth of the same cash capital fell by 7.3%, which was mainly due to an exchange rate headwind of 480 basis points.
A strong dollar relative to most other global currencies has been a hurdle for many organizations, especially those with heavy exposure to foreign currencies through international revenue. In the case of Digital Realty, 56% of its third quarter operating income is in US dollars. This is followed by 21% in euros, 6% in Singapore dollars, 5% in pounds sterling and 2% in Japanese yen.
The good news is that the company invests its profits in foreign currency locally and therefore does not actually lose with unfavorable exchange rates. The company also has a hedging strategy that executes a variety of “swaps” to mitigate FX volatility and headwinds.
The company generated basic FFO (funds from operations) per share of $1.67, up 1% year over year. However, this decreased 3% sequentially due to negative currency exposure. Going forward, management forecasts that FFO per share will remain under pressure from strong FX headwinds.
Acquisitions and Expansion
Digital Realty has accelerated the expansion of its operations through a series of acquisitions. During the third quarter of 2022, the company purchased a majority stake in Teraco, a leading carrier- and cloud-agnostic data center provider in South Africa. This company has 7 data centers, 22,000 cross-connects and 7 submarine cables, giving Digital Realty strong exposure in the region. Teraco also complements the company’s existing operations through iColo in East Africa and Medallion in West Africa.
Digital Realty has also acquired land on the beautiful Greek island of Crete, a popular holiday destination but also a strategic hub for connectivity. The company is also developing hubs in Barcelona and Israel.
The company reported a leverage ratio of 6.7x, which is slightly above its historical average. However, the company has increased its liquidity position to ~$3 billion, so the company is in a strong position.
Its weighted average debt maturity is ~5.5 years with approximately three-quarters of its debt in non-US currencies, so it will benefit from foreign currency devaluation. 80% of Digital Realty’s net debt is also fixed rate, which helps mitigate major issues with rising interest rates.
To value Digital Realty, I will compare price to funds from operations at some data center REITs in the industry. Digital Realty (DLR) is the cheapest data center REIT of the peer I have seen with a P/FFO [fwd] = 13.99. By comparison, Equinix (EQIX) has a P/FFO [fwd] = 27.2 and CyrusOne (CONE) (previously acquired by KKR) had a P/FFO [fwd] = 20.1. As an additional data point, American Tower (AMT), which is more focused on the telecom tower industry, has an FFO price of 16.5, which is also more expensive than Digital Realty.
As additional information, Digital Realty trades at an average valuation (C+) in relation to the real estate sector. Note, however, that this includes all types of real estate, including commercial offices that are trading below the historical average, due to uncertainty about future use cases. Data centers have much more growth and certainty, so they tend to trade at a higher multiple.
Digital Realty is a great company that is poised to benefit from the tailwinds of digital transformation and hybrid cloud. The company has generated solid financial results in the third quarter, despite currency difficulties. Management is proactive and implements a number of strategies, from investing international revenues locally to executing a series of acquisitions. The stock is undervalued relative to historical metrics and industry peers, so the company could be a great long-term investment.