DLR – Digital Realty: You Can Get Paid To Ride The AI Wave

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.