Companies:

Digital Realty (DRT)

by Alex Mason | Companies, Episodes

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Mental Details

The History of Digital Realty

  • The company was initially formed out of the consolidation of assets from private equity firm GI Partners. The firm purchased consolidated 21 data centers from bankruptcy auctions, packaged them together, put a management team in place, and formed a new company, Digital Realty.
  • They sold out of part of their position by taking the company public in a 2004 IPO, at which time the company had 23 data centers. Over time they gradually sold shares until they were completely out by 2007.
  • Over the course of the next several years after going public, the company began to acquire additional data centers around the country. They acquired properties in Arizona, Massachusetts, Philadelphia, Connecticut, etc.
  • In 2015 they purchased Telx, another large data center firm for approximately $1.8 billion. This move doubled the company’s size.
  • Another big move was acquiring several data centers in Europe from competitor Equinix for over $870 MM.
  • This REIT has a relatively short history, and like other REITs, achieves growth primarily through acquisitions.
  • Late in 2019 the biggest acquisition to date was announced, and the company purchased Interxion, a data center company from the Netherlands, for $8.4 billion. This will help DRT make the move from having around 200 data centers to acquiring an additional 53 that are spread across different key European cities (London, Paris, Frankfurt, Amsterdam, etc.)

Business Overview

  • Let’s talk about data. The digitalization of the world has been happening for some time and it continues to happen fast.
    • In 2017 there were about 3.4 billion internet users, and that is expected to grow to 4.8 billion by 2022 (7% annual growth). Consider that the entire population of the earth is about 7.6 billion right now. So in just a few years over 63% of the earth’s population will be exposed to the internet
  • When you and I listen to a podcast, play a Youtube video, or read an email, we’re interacting with the internet – and we often do so all day long.
  • Data used to be primarily stored in hard drives – that is physically on the device that you use. This was the way to go because connectivity between devices was either poor or nonexistent, so people needed things to be easily accessed and locally stored on their devices.
  • Now, data is increasingly shifting to “the cloud”. Let’s explore what that means.
  • The cloud is another way of saying “the functionality of the internet”. The internet itself connects computers together. An analogy that helped me understand this better is that of electricity. When you need electricity, you don’t source it from your own home (unless you have solar panels, which would be pretty cool). You get it from a local utility, delivered via power lines. Cloud computing is electricity that you can use to do useful things like powering you home. The internet is the system of power lines connecting everything.
  • When you use Google Drive (which I was using as I was performing research for this episode!) you’re using the cloud. Apple’s iCloud? The cloud. Slack for communicating with your friends or co-workers? That’s the cloud too. Whenever you stream videos from Netflix, that data is being routed with cloud computing (specifically, Amazon Web Services).
  • With all of this digital information moving around, it has to actually be stored somewhere right? That’s where data centers come in. Data centers house the servers that are the hardware involved in transferring data. They are the conduit through which all digital information flows.
  • The term “data center” in a traditional sense means that a company owns its own set of servers, managed by an in-house IT department. This is becoming the case less and less though, because of the significant costs involved in a company managing their own data. It is being outsourced to cloud service companies, most notably Amazon Web Services, Microsoft Azure, and Google Cloud. There are also other players like IBM, Salesforce, and “wholesale” data centers like Digital Realty.
  • There’s another term that is important to understand here: colocation. Colocation is effectively a digital economy of scale you get when you position servers next to each other and allow them, for the sake of speed, to freely share data between one another. It is the provision of the physical space, the racks, the power, and the cooling of someone else’s servers.
  • In summary, modern data centers and cloud computing companies are to us now what the telecommunications industry was back in the 20th century. Although cell towers and other telecommunications technologies still have importance, the amount of data and velocity that it moves is increasing on a worldwide basis.
  • Ok. With that background let’s get back to Digital Realty. DRT started out essentially as a landlord for data centers (colocation). Now, with purchases from Equinix and Telx, they are shifting more towards the technology front by providing both cloud and colocation services.
  • Fundamentally, the business provides a mixture of real estate and technology services.
  • Their customers are other businesses – from small businesses to large corporations who want to outsource their IT infrastructure.
  • They have 225 properties spread out over 13 countries, which comprise 36 major metropolitan areas. Of these, the most important to revenue are those in Northern Virginia (24% of revenue) and Chicago (13% of revenue).
    • Over a third of revenue stems from data centers in these two regions, which is a bit concentrated.
    • On a customer basis though there is more diversification, with no single customer accounting for more than 8% of revenue.
  • Speaking of customers, you probably recognize some of them: Facebook, Oracle, IBM, Comcast, Verizon, J.P. Morgan, China Telecommunication Corp., etc.
  • They have over 36.6 million square feet of leased space, and another 6.3 million either under active development or held for future development. From these numbers, they have the ability to increase their capacity by a fair amount (17%).
  • When companies come to Digital Realty, they have a wide range of products and services to choose from. They can go “bare bones” and just have DRT provide the physical infrastructure if they want. They can set up a private cloud with them, or they can opt for a hybrid cloud approach. The hybrid cloud option is becoming popular because it allows the speed and efficiency of using a public cloud for some data transfers, but keeps a private cloud available for organizations with sensitive data.

Financials

2012 2019 CAGR (%) / Comments
Sales 1.3 3.2 13.7%
FFO 557 MM 1.4 14%
Shares Outstanding 125 MM 209 MM 67% increase over this period. Lots of dilution.
FFO per share $4.44 $6.66 6%
Cash 56 MM 90 MM
Total Debt 4.3 10.1 Total debt and credit facilities have more than doubled.
Operating Cash Flow 543 MM 1.5 15.6%
Investing Cash Flow (2.4) (275 MM) Usually in the billions, due to acquisitions
Financing Cash Flow 1.9 (1.2)
Dividends 334 MM 921 MM
Dividends per share $2.92 $4.32 5.7%

Valuation and Closing Thoughts

  • Thinking about this and researching this, I am amazed I have not studied data-based companies until now. I have heard it said that data is the new oil. I think that’s true (but oil is still more important than most people realize). Data is scalable, requiring minimal capital expenditures relative to physical assets, and because so much data is sensitive, it can attract a premium valuation.
  • Many companies out there own and create data (think about Apple, Amazon, Google, Facebook, etc.) Each has a different value proposition based on the type of data they collect. For example Facebook has powerful data that can profile a person’s interests and social network. Google has powerful data that profile what people want to know (especially what problems they want to solve).
  • Instead of creating data, Digital Realty manages, secures, and moves it, which I think is a very interesting business model.
  • The company itself is doing well – solid double digit top line growth and bottom line growth. The acquisitions the company is making are indeed making more money – but at what cost?
  • Instead of seeing your share of the profits go up 14% annually, because of the excessive share dilution that management has utilized to raise funds, you only saw your share of the profits go up by about 6% annually. This is still ok, but definitely moves this stock from “potentially growth opportunity” to “slow grower” from a shareholder’s perspective.
  • The share dilution might be ok if the company was only using equity to fund its expansion and was more prudent with its debt. But no, management has more than doubled the debt load over the past several years too. Not to mention, there are preferred shareholders that need to be paid too (preferred stock is kind of like a bond).
  • The business is certainly expanding and experiencing solid growth, but the shareholders are not being taken care of here.
  • The price is at around $155/share. Based on FFO per share of around $6.66 in 2019, that is a P/FFO of 23x. This is irrational. This is a company growing at a decent rate in a fast growing and exciting industry, but the shareholders are being left behind. Gradually increasing dividends are nice, but the growth is not as high as it seems once you look beneath the surface.

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