Author: Gen Alpha

Investing in megatrends can be profitable if done at the right time and valuation. Such may no longer be the case with hot names in the AI space such as Nvidia (NVDA) and C3.ai (AI) as their trains have left the station.

Moreover, many of the leading tech stocks in the AI space pay either a very low dividend yield or none at all. This means that an investor would need to sell shares in order to realize any tangible benefit from capital gains.

This brings me to Digital Realty (NYSE:DLR), whose global presence in data centers may fuel the AI revolution, all while paying investors a meaningful yield. I last covered DLR here in March, highlighting its tailwinds.

As shown below, DLR still trades well off its 52-week high of $140 despite the recent rally in price. In this article, I discuss recent developments and why the stock presents solid value for income investors seeking to capitalize on the growing AI trend.

Why DLR?

Digital Realty is a leading data center REIT that provides collocation and interconnection solutions to 5,000 customers that are both big and small, including Microsoft (MSFT) and Meta Platforms (META). It has an international presence that spans across 28 countries on six continents, consisting of over 300 facilities.

DLR is seeing strong demand, as it signed 122 new logos, with strong 0-1 MW bookings and record interconnection bookings during the first quarter. As shown below, DLR’s bookings has remained at an elevated level compared to pre-2020.

At the same time, it’s seeing meaningful re-leasing spreads, with rents increasing by 4.5% on renewal leases on a cash basis. This contributed in healthy same-store cash NOI growth of 3.4% YoY (5.2% growth on a constant currency basis) during the first quarter.

Looking ahead, DLR should benefit from its continued increase in global presence since its acquisition of Telx back in 2015. Today, its data center footprint ranks in second place in North America, Europe, and LATAM, and in first place in the Middle East and Africa. This makes DLR one of the go-to data center providers for customers in need of colocation for their cross-border connects.

Notably, AI represents an important frontier for DLR, as it’s still in its nascent stage. Management highlighted the incremental growth opportunity in this space during the recent conference call:

The bigger picture around AI is that this is an incremental major wave of long-term demand that will certainly need to have proximity to the major data that sits today. And the first two waves of demand of moving from on-prem locations to hybrid locations and the second wave of multi-cloud haven’t even hit the shore yet, while this next wave of demand is falling behind it.

AI is cloud adjacent because of a lot of the applications, it’s empowering and the way the customers are bringing it to market. It’s something we’ve been watching for many, many years. And I would reiterate also that there are pockets of AI that we’re able to support rather efficiently.

Risks to DLR include a somewhat higher leverage ratio, with its net debt to Adjusted EBITDA currently sitting at an elevated at 7.1x. However, this could be due more to timing of when new bookings come online.

Moreover, DLR’s balance sheet strength is supported by a reasonable debt-plus-preferred-to-total enterprise value of 39% and a strong fixed charge coverage ratio of 4.4x. DLR carries a low weighted average coupon rate of 2.8% of its debt. Over 80% of its net debt is fixed rate, and 82% of its debt is non-U.S. dollar denominated, which means that it has the capacity to tap global markets such as those in Europe for lower interest rates.

Importantly, DLR has a valuable asset base, which it can tap to recycle capital and pay down debt should the need arise. This is reflected by a recent transaction in a joint venture deal in Osaka, Japan, in which the sale price represented a substantial premium to its development cost.

Turning to the dividend, DLR currently yields an attractive 4.9%. The dividend is covered by a 73% payout ratio, based on the midpoint of management’s 2023 Core FFO/share guidance of $6.70.

DLR also represents good value at the current price of $98.89 with a forward P/FFO of 14.8, sitting below its normal P/FFO of 16.7. Sell side analysts who follow the company expect respectable 7% annual FFO/share growth in 2024-2025, and have a consensus Buy rating with an average price target of $117.37. This represents a potential 24% total return over the next 12 months.

Even with no return to a normal valuation, DLR could match the total long-term return of the S&P 500 (SPY) with a 5% yield and a low-bar 4% to 5% annual FFO/share growth.

Investor Takeaway

Overall, Digital Realty is a solid income-oriented play in the long-term data center story with an AI kicker. Its global presence makes it a key player in this space and provides a strong base for continued growth. As such, income investors seeking to capitalize on key trends in the data center and AI space may want to give DLR a hard look for its yield and capital appreciation potential.

The recent tech-fueled rally is reminiscent of the FOMO-mentality a couple of years ago, when everyone was trying to get in on the action around meme stocks. This time is different, however, as it’s on a much grander scale due to the sheer size of the companies such as Nvidia (NVDA), which has led to whole indices such as the S&P 500 (SPY) and Nasdaq being pulled up.

At the same time, many value stocks have been left in the dust, creating opportunities for bargain seekers who prize income over capital gains. While it may be nice to see unrealized gains on paper, one would have to sell the stock to realize it, and that can lead to more FOMO if said stock continues to shoot higher in the short term.

That’s why some investors may prefer to buy and hold quality value stocks that throw off decent income, and which they don’t have to worry about selling at the right time. This brings me to Kinder Morgan (NYSE:KMI), which, as shown below, is now trading just shy of its 52-week low, while throwing off a 7% yield at the same time.

I last covered the stock here back in March, noting its excess cash flows that gives it financial flexibility. This article highlights recent updates and why KMI is a high income bargain at present.

Why KMI?

Kinder Morgan is one of the largest North American energy midstream companies. Its natural gas pipeline network spans 70,000 miles and moves around 40% of U.S. natural gas production. It also has 700 billion cubic feet of natural gas storage, which comprises 15% of the total natural gas storage capacity in the U.S.

Most investors in this industry know that regulatory hurdles have made it more difficult to build fossil fuel infrastructure, including pipelines, in the U.S. That actually makes KMI’s existing pipelines more valuable due to reduced competition, and puts the company in a favorable position when customer contracts are up for renewal.

Plus, natural gas will be needed for a very long time, especially considering the recent push by the EPA, which could result in two-thirds of car and light-truck sales to be battery-powered vehicles by the year 2032. With the current electric grid in certain parts of the country that perennially show strain during peak summer weather, relying solely on renewable energy to “plug” the gap simply won’t be enough.

As such, natural gas should be ever more important as a means to fulfill ambitious EV ambitions by the current U.S. administration. This is also supported by recent the recent IEA World Energy Outlook, which predicts that fossil fuels will supply 62% of the world’s energy demand in 2050, and the U.S. Assistant Secretary of Energy recently stated last month that “the world absolutely needs new gas investment.”

Moreover, KMI is also hedging its bets, as 86% of its project backlog is devoted to lower-carbon energy services. This includes RNG (renewable natural gas) and renewable diesel projects, including a new renewable feedstock storage and logistics hub at KMI’s Louisiana facility.

Notably, KMI’s entire project backlog equates to $3.7 billion, of which $3.3 billion carries an attractive project cost to EBITDA multiple of 3.5x. This is also supported by a strong BBB-rated balance sheet with a net debt to EBITDA of 4.1x, sitting below the 4.5x level generally considered to be safe by ratings agencies.

Meanwhile, KMI is seeing strong transport volumes, which grew by 3% YoY during the first quarter. This was driven by the return of one of its service lines and a 10% increase in deliveries to power plants as a result of colder weather.

While distributable cash flow per share was down by 5% YoY To $0.61, it still amply covered the dividend, which recently grew by 2%, at a 2.16x dividend coverage ratio. It’s worth mentioning that the first quarter is traditionally strong for DCF due to winter temperatures, and full year DCF to dividend coverage is expected to land at 1.88x, based on 2023 DCF/share guidance of $2.13.

Lastly, KMI appears to be trading at an attractive discount at the current price of $16.21 with a 7% yield and price to cash flow of just 6.97x, sitting towards the low end of its range over the past 5 years, as shown below. Sell side analysts who follow the company have an average price target of $20.13, implying a potential 24% return based on price appreciation alone.

Investor Takeaway

Kinder Morgan is an attractive midstream energy bargain at present, with a wide-reaching asset base that’s ever more valuable due to less new competition. Its natural gas infrastructure is a mission-critical component to a growing EV future, and it’s also playing its cards right by investing in lower-carbon energy services and locking in attractive expected returns on projects. With a strong balance sheet, generous dividend yield, and low valuation, value investors ought to give KMI a hard look at its currently discounted price.

It pays to have moat-worthy enterprises that operate in a duopolistic industry, especially during times of heightened economic tensions. It’s even better if these companies are trading in value territory and has a solid track record of paying a dividend.

Such I find the case to be with UPS (NYSE:UPS), which, as shown below, currently trades well off its 52-week high of $209. In this article, I discuss why now may be a good time to pick up this dividend giant at a reasonably attractive price.

Why UPS?

UPS is a global logistics leader due to its sheer size of being the world’s largest parcel delivery company. It manages a fleet of 100K vehicles and over 500 planes, with a presence in 220 countries and territories. Last year, UPS generated $100 billion in total revenue.

UPS isn’t immune to challenges in the global economy. It started the year strong with higher-than-expected volume in January, close to management’s plan in February, and significantly lower than planned volume in March, as retail sales contracted.

It appears that consumers are feeling the pinch, as food as a percentage of household budgets rose to 9%, up 200 basis points from 7% two years ago, before inflation took hold. With a historically low unemployment rate, labor inflation has caused households to shift dollars away from goods towards services.

These aforementioned factors drove revenue down by 6% YoY during the first quarter to $22.9 billion. Moreover, cost inflation negatively impacted profitability, with operating margin declining by 250 basis points to 11.1%, driving operating profit down by 23% to $2.6 billion.

Long-term risks to UPS include its customer, Amazon (AMZN), which makes up 11% of UPS’ revenue. Nonetheless, Amazon still depends on UPS for much of its shipping needs, and with much of its capital focused on growing its AWS Cloud business, Amazon may not have the inclination to make heavy investments in order to entirely displace UPS and bring its shipping internally.

Moreover, it’s simply hard to compete with UPS’ vast retail network, which includes more than 5,100 locations in the U.S. This gives customers convenient access to drop off packages they’ve sold online or to return packages to sellers. This is reflected by 85% of the U.S. population living within 10 miles of a UPS store.

Plus, management feels confident about reaching an agreement with the Teamsters union by the end of July, and healthcare as an incremental growth opportunity that remains largely untapped. This includes a recent acquisition of Bomi Group, a healthcare logistics provider in Europe, and global expansion of its Premier service, as noted during the recent conference call:

We are continuing to invest in the global expansion of UPS Premier, which is now available in 45 countries with four more to be added this year. Our goal is to become the number one complex healthcare logistics provider in the world to help us get there who plan to open a total of seven dedicated healthcare facilities this year. As a reminder, in the fourth quarter of 2022, we completed the acquisition of Bomi Group and to date, revenue and cost synergy are running ahead of target.

Meanwhile, UPS stands out for having a strong A credit rating from S&P, which should come in handy when it comes to borrowing amidst uncertainty around higher interest rates and U.S. debt ceiling negotiations. It’s also lowly levered, with a net debt to TTM EBITDA of just 1.06x, sitting far below the 3.0x level generally considered safe by ratings agencies.

Recent share price weakness has made the dividend yield attractive at 3.8%. The dividend is covered by a 51% payout ratio, and comes with a 12.5% 5-year CAGR and 13 years of consecutive growth. As shown below, UPS’ dividend scores A and B grades for safety, growth, yield, and consistency.

While UPS isn’t dirt cheap at the current price of $171.57 with forward PE of 15.9, I believe it’s reasonably attractive considering the moat-worthy nature of the enterprise and the very strong balance sheet. Plus, it trades comfortably below its normal PE of 20, as shown below. Analysts expect a return to bottom-line growth next year, and have a consensus Buy rating with an average price target of $190, representing a potential 15% total return over the next 12 months.

Investor Takeaway

UPS has strengths from its wide-reaching scale and retail network, and has ambitions to become a global healthcare logistics leader. While it has near-term headwinds from economic uncertainty and cost inflation, I believe these factors should improve over time, and are already priced into the stock. With a near 4% dividend yield and strong balance sheet, long-term investors could see meaningful total returns from the current discounted price.