|Msg 14150 of 14247 at 3/3/2021 8:18:02 PM by
Digital Realty’s More Connected and Global Footprint Makes It the Strongest Competitor to Equinix
Digital Realty’s More Connected and Global Footprint Makes It the Strongest Competitor to Equinix
Business Strategy and Outlook | by Matthew Dolgin Updated Mar 02, 2021
Digital Realty has transformed its business from one that merely provided large companies vast amounts of space and power (a typical wholesale data center) to one that can offer customers of all sizes the full spectrum of space, power, and connection needs. With a sizable presence across nearly every continent, it is also primed to accommodate the needs of global enterprises that want a fluid solution across their data center footprint. Along with Equinix, we think this makes Digital Realty one of only two data center providers that can offer this breadth and set itself apart from the rest of the pack.
Prior to its acquisition of Telx in 2015, Digital Realty garnered almost 95% of its total revenue from wholesale data centers and had virtually no interconnection revenue. At the end of 2020, a year in which Digital Realty also acquired Interxion, a firm with almost exclusively colocation and interconnection revenue, we estimate that annualized rent from the largest customers--those taking greater than 1 megawatt of power--made up only about half of total annualized revenue, and interconnection revenue was about 9% of the total.
In our view, Digital Realty was smart to get into the more attractive co-location and interconnection business, and we think its ability to provide those services in conjunction with the capacity to offer wholesale space to the largest cloud providers leaves it well positioned to win in an evolving technological landscape, where huge cloud providers drive the industry but need to connect to virtually all other enterprises. In Digital Realty's data centers, tenants can directly connect to their cloud providers or other partners, resulting in reduced latency and superior security. Even when in different Digital Realty locations, customers can bypass the public Internet to connect with other Digital Realty data centers via direct fiber connections within cities or through a software-defined network between cities. We expect connected data centers to become even more important with growing reliance on multiple cloud providers and greater demand for Internet of Things and artificial intelligence functions.
Economic Moat | by Matthew Dolgin Updated Mar 02, 2021
We assign Digital Realty a narrow economic moat, the result of cost advantages and switching costs.
Digital Realty has traditionally been a wholesale data center provider, meaning that it has tended to lease very large amounts of space and power to relatively few tenants per facility. It was primarily a simple real estate operator. In recent years, however, it has bought network-focused data centers and companies and now has a more differentiated portfolio of network-dense properties, where network providers meet each other to exchange Internet traffic and cloud companies connect to their customers and network providers. Digital gets almost 80% of its revenue (and at least 18 of its top 20 customers) from cloud, information technology, network, and content companies, with the remaining coming from financial services (11%) and other enterprises (11%). Digital's business model has been in contrast with rival Equinix, which leases space by the cabinet to tenants that use the space primarily for networking functions rather than storage and computing needs. However, following Digital's acquisitions of Telx in 2015 and Interxion in 2020, it has placed greater emphasis on co-location and interconnection, which typically lead to better returns.
In our view, switching costs provide Digital Realty's biggest competitive advantage, as there are numerous reasons why tenants are unlikely to churn to a competitor, namely the significant monetary costs to deploy equipment and the risk in moving critical equipment. Digital Realty, citing statistics from Align Communications, estimates that a client deploying equipment to use 1.125 megawatts of power—a fairly large customer, but the type Digital Realty traditionally caters to—would spend $15-$30 million to set up its equipment. Migration of equipment from one facility to another would cost an additional $10 million to $20 million and bring with it a host of other challenges. Migrating to a new data center often requires the services of a company like Align, which specializes in it, and typically includes extensive planning, a multistep process, and involvement of many people within an organization. Migration risks include down time, which can be extremely harmful and expensive. Migrations thus typically include equipment mirroring, which is costly, to guard against down time. Given the monetary costs and business risks, we don't expect that tenants take a decision to move lightly, and we think they are effectively precluded from price-shopping once they are in a data center. Digital Realty claims most churn results from tenants merging or no longer needing a data center presence because of company-specific issues, such as their own business struggles.
Based on the number of data centers, square footage, and power, Digital Realty is the largest owner of data center space globally, and we think its cost advantages stem from its scale and property ownership. Digital Realty has said it is one of the largest consumers of generators and air conditioning equipment in the world, and it receives modest discounts on them as a result. It also has recently begun negotiating power needs on an aggregated basis within given metropolitan areas rather than for each campus individually, leading to even more favorable deals with electric utility companies. For example, the company locked in rates in Chicago through 2022 at a price 20% below the current market and secured lower than market rates in Texas.
We are convinced that the current environment results in a sustainable competitive advantage that makes it likely Digital Realty will earn excess returns over the next decade, but the evolving nature of technology keeps us from labeling Digital Realty a wide-moat firm. On balance, the advent of the cloud has been good for data center businesses, as the number of firms reducing their own data center needs has been much more than offset by those that increasingly move off-site for interconnection with cloud service providers for their hybrid cloud needs—the most common model for large enterprises. Data center companies are excited about the next wave of the cloud, with Digital Realty indicating that it stands to benefit greatly from artificial intelligence, the Internet of things, autonomous vehicles, and other technologies that require exponentially more data. However, the speed with which technology changes and data centers' close connection to it leave us wary about making a 20-year assumption with any confidence.
In addition to our concern that enterprises will have less need for data centers as data storage and computing power is concentrated in a few cloud service providers, hardware advances and software virtualization continue to increase capacities for a given physical size. As a result, customers that remain data center tenants may need less space. Also, as cloud service providers become even more dominant, we expect they will have increasing control over data centers' fortunes. While they seem to be great customers now, we can't bank on that holding true in the future.
Fair Value and Profit Drivers | by Matthew Dolgin Updated Mar 02, 2021
We are maintaining our $125 fair value estimate for Digital Realty, implying an EV/adjusted EBITDA multiple of 21 and price/AFFO multiple of 22 based on our 2021 forecast. Our multiples include the value we assign to Digital Realty for its unconsolidated joint ventures, which add $10 per share.
We project organic revenue growth to average 7%-8% annually between 2021 and 2030. We see the company getting a boost from greater exposure to retail colocation tenants, coming from the 2015 acquisition of Telx and 2020 acquisition of Interxion, as well as the global, interconnected footprint it can now provide customers. The top line should benefit from the higher revenue per square foot that retail tenants pay compared with the larger-scale customers, but more importantly, the enhanced quality of its portfolio should enable Digital to capitalize on the increasing data use and traffic that cause Digital’s customers to keep growing their presence around the world. The network-dense properties also give the firm greater opportunity to compete as a cloud on-ramp provider. We forecast the firm to add over 3 million feet worth of new leases annually for the next five years while seeing churn of 3%-4% annually on existing leases. We project average rent per square foot to rise modestly over our 10-year forecast.
We don't see significant opportunities to enhance profitability, especially since we see the increasing power of hyperscale tenants squeezing pricing. However, we think a shift in the mix toward more retail tenants and a higher number of interconnections will result in modest margin expansion. We forecast adjusted EBITDA margin to rise to over 59% by 2030, up 400 basis points from 2020. We project capital spending to fall from 45% of sales in 2020 to just under 20% by 2030 as new data construction slows.
We value the joint ventures at just over $2 billion, using cap rates and EBITDA and funds from operations multiples that vary for each JV, depending on its strategic importance and growth profile. Digital’s biggest stakes are in JVs in Brazil and Japan that are growing fast. Our total JV valuation is based on a blended weighted average cap rate of 6%, EBITDA multiple of 24, and AFFO multiple of 26.
Risk and Uncertainty | by Matthew Dolgin Updated Mar 02, 2021
We rate Digital Realty as a high uncertainty stock primarily because the capital-heavy nature of its business minimizes its ability to be agile in the face of a market downturn. If demand for third-party data centers weakens for any reason, Digital would find itself with too much capacity and a weakened cost profile.
We think technological advances pose the biggest risk to Digital Realty's long-term prospects. The company's future growth depends on cloud service providers and enterprises needing more data storage, compute power, and interconnection as the world becomes more data-centric and connected. However, technological advancement could result in an environment where those increasing needs come to fruition but data centers are not the beneficiaries. Virtualization and Moore's law could result in a scenario where Digital Realty's customers satisfy their exploding data needs with less physical space. Similarly, an increase in the amount of data companies can push through a given fiber connection could result in fewer necessary cross connects for the same amount of traffic. Finally, a greater shift by enterprises toward infrastructure as a service, or IaaS, cloud adoption could reduce their own need for server space, as their data is shifted to cloud providers' servers and stored more efficiently.
Power becoming concentrated in the big cloud providers is the other big risk we see for Digital Realty. Digital's top 20 customers account for almost half its revenue, and cloud and IT service companies account for 45% of total revenue. We expect cloud providers' importance to continue growing, leaving Digital Realty more susceptible to these companies playing hardball. We don't think cloud providers want to compete in a retail colocation business, considering the difficulty we believe they'd have in mimicking a similar network of customers, but they could use their leverage to extract concessions.
Stewardship | by Matthew Dolgin Updated Mar 02, 2021
We assign Digital Realty a Standard capital allocation rating. Our rating is based on the health of Digital Realty’s balance sheet and our outlook in regard to investment in the business and shareholder distributions. We think business investment is likely to be the critical factor in determining shareholder returns.
Digital Realty has been investing heavily for several years and made numerous sizable acquisitions. In our view those decisions have been wise because they have significantly enhanced the network density of Digital Realty’s data center portfolio and have positioned it firmly to be the sole company that can compete with Equinix on a global scale. We think these decisions have strengthened Digital’s moat sources and positioned it to thrive for many years.
However, the acquisitions have not come cheaply, and they have strained Digital’s balance sheet and depressed returns on invested capital in the near term. We project ROICs to gradually rise over the next decade to the point where the firm is again earning economic profits, but it will require good execution given the economic losses the acquisitions have prompted in the near term. The balance sheet is stretched, with the firm’s net debt to EBITDA ratio holding stubbornly above 6.0 for the past five years and total debt accounting for more than one quarter of Digital’s enterprise value, both high among industry peers. Nonetheless, we don’t expect difficulty, as only about 15% of total debt matures within the next three years and EBITDA has covered interest expense by more than 5 times over the last five years, on average. Provided that the company doesn’t continue making big acquisitions, we think cash flow generation will enable the firm to take down debt and provide an even bigger buffer for interest payments.
We believe Digital Realty’s shareholder distribution strategy is appropriate. It sports an attractive dividend (in the 3% yield range throughout 2020), and its payout ratio as a percentage of adjusted EBITDA has averaged less than 50% the over the past five years. As a REIT, the firm is required to pay out 90% of REIT taxable income, and the dividend has grown 6% annually, on average, for the past five years. The firm has historically not repurchased shares, which we think is appropriate given that we believe focusing capital allocation on investments has been a good strategy. We don’t anticipate substantial share repurchases in the next several years.