Digital Realty

Moat: 3/5

Understandability: 4/5

Balance Sheet Health: 4/5

Digital Realty is a real estate investment trust (REIT) that develops, acquires, and operates data centers. They serve a diverse global customer base, providing colocation and interconnection solutions.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Digital Realty’s business model centers around leasing out data center space to its clients. This provides the company with steady income streams, which are considered recurring in nature.

Business Overview

Digital Realty (DLR) is a Real Estate Investment Trust (REIT) specializing in the ownership, operation, and development of data centers across the globe. Their clientele ranges from large enterprises and hyperscalers to cloud and colocation providers. DLR provides a crucial service in the modern digital economy, offering the essential physical infrastructure for data storage, processing, and networking.

  • Revenue Distribution: Digital Realty’s revenue primarily comes from leasing data center space to its customers. The leasing structure tends to be contractual with predictable, recurring revenue. Their services are categorized into colocation, interconnection, and development leasing, with the vast majority of revenue coming from leasing. They have a global and diverse customer base with most revenue coming from North America.
  • Industry Trends: The data center industry is experiencing significant growth, largely fueled by the expansion of cloud computing, artificial intelligence, big data analytics, and IOT, with a positive long-term outlook. However, the industry is quite competitive. Power, fiber availability, regulations, and cost are all big factors in an enterprise’s ability to expand and grow in a specific region. Furthermore, companies need to be fast and flexible in adapting the latest technologies. This trend can reduce the competitive advantage from physical properties as technology moves at breakneck speed. The emergence of AI is expected to drastically increase demand, but the cost of implementing AI servers can be higher.
  • Margins: Digital Realty historically has enjoyed strong margins which are a hallmark of the industry. However, as competition increased, those margins may be under pressure. They focus on operating efficiently and reducing operating expenses through the use of data, analytics, and technology to keep these margins in a competitive range.
  • Competitive Landscape: The data center market is fiercely competitive, with many players vying for a share, from large hyperscalers to small regional players. Some of their main competitors include Equinix, CyrusOne (now part of KKR), and CoreSite. Price, location, power availability, connectivity, and services offered are the main differentiators between the competition. The need for “hyperscale” infrastructure has allowed a few select firms to dominate in the market for that.
  • Differentiators: Digital Realty has invested heavily in its global platform, providing customers with a wide array of locations to choose from. They provide multiple connection points in each of their data centers, helping them serve multiple cloud environments. Their customer base has a higher degree of concentration as opposed to other similar companies. They have more than 3,000 customers across a massive global footprint. They provide more than just basic infrastructure such as security and cooling, and are trying to be “a one-stop shop” for all a client’s data center needs. In 2021, they started a strategy based on “a multi-cloud interconnection-focused approach,” and they are shifting their business to provide those connectivity solutions to clients.
  • Other Relevant Info: One trend in the sector is to establish joint ventures with customers and their subsidiaries, both for the advantages to the company and for the tax advantages. DLR also faces an ever-changing compliance and taxation environment. Also DLR have increased focus on “PlatformDIGITAL” which allows the company to provide new solutions for its clients. This is a way for DLR to act as an advisor to its clients. This makes the company more sticky to the client base, making the client more and more integrated to the company’s business.

Financial Analysis

In the following sections, I’m focusing on results as of the latest reporting period, which is Q3 2023.

  • Revenue Growth: Digital Realty’s revenue is on a trajectory to reach $5 billion by 2024. Core revenue is set to continue growing with large-scale acquisitions and expansions in high-demand markets. In Q3 2023, revenues increased by 15% YoY with growth in both colocation and interconnection revenue. They had total revenues of $1.4 Billion for Q3 of 2023.
  • Margins: In Q3 2023, the operating margin stood at 16.1%, with EBITDA margins higher at 50.5%. The rise of prices and the expansion of their higher margin products and solutions helped improve the EBITDA margins. However, increased operating expenses did take a toll on the operating margins.
  • Profitability: Digital Realty’s earnings are quite sensitive to increased interest rates, since they have to borrow money to finance development. They also show higher earnings than profits, mainly due to the nature of their operations and the noncash depreciation and amortization expenses. They also had high special and nonrecurring items due to their acquisition programs. In their latest earnings call, they mentioned that they will focus more on profitability going forward instead of growth.
  • Capital Structure: DLR is a debt-heavy business, given its status as a REIT, and it has a large percentage of its capital coming from debt financing. Over 70% of their capital structure is derived from debt. Due to the higher interest rates, the cost of debt has been high for them and also debt refinancing has been more costly. They also have a high exposure to fluctuating interest rates, putting them in a more precarious position. On the most recent earnings call, they said they will bring down debt to the low 40% range by divesting assets.
  • Cash Flow: While cash flows are not as predictable as the leasing revenue, DLR has a steady operating cash flow, but significant expenses for development has resulted in very low free cash flow. They do not have as much excess cash. They focus on cash from operations, so they can repay their debt and fund expansion into other regions.
  • Other Financial Items: They focus on long term contracts that are often above 10 years, providing them with long term revenue visibility. They often use sale-and-leasebacks of facilities, which increases their cash and profitability in the short run, but is a net negative in the long term.

Moat Assessment

Based on our analysis, Digital Realty does seem to have a moat, although it may be a narrow moat rather than a wide moat. The key drivers for the moat are as follows:

  1. Network Effects: DLR is very well positioned geographically with their interconnection-based facilities. Their platform operates at an incredibly wide scope, allowing them to capitalize on the massive interconnection benefits and providing higher switching costs to clients.
  • The network effect benefits them with scale as more clients join their network.
  1. Scale advantages: DLR is very large compared to the other players, which allows for more cost control, better pricing power, and flexibility in the supply chain. They are also able to reach better deals and have better leverage over key suppliers.
  • However, scale economies in this business are not as strong as they might be in other businesses, since many regions are fragmented and require smaller localized data centers.
  1. Switching Costs: DLR offers customized solutions to large and mid sized enterprises. These companies would have a hard time switching to a different data provider, since their data and applications are heavily integrated into DLR systems.
  • Switching costs are relatively important in this industry, but are lower than in other industries since these contracts are not as rigid as other industries and have an average lifespan of 5-10 years.

The key risks to DLR’s moat are:

  • Technology Risk: Technology moves rapidly in the data center industry, which means that today’s advanced technology can be obsolete in a few years, requiring newer and better technology. Some companies that make the infrastructure better may come along and challenge DLR’s dominance. This creates an inherent risk of disruption.
  • Competition: The industry is highly competitive. Though there are many players, many of them are consolidating. And DLR might have a hard time keeping its advantage as newer companies gain expertise in data center management.
  • Financial Risks: As discussed earlier, DLR has very large debt which makes them susceptible to interest rate risks. A slight downturn in their operating income due to competition could put their ability to service their debt in a riskier position. Also their frequent use of sale-and-leasebacks has a negative effect on long term profitability.
  • Regulatory Risks: Regulations in various countries can make it harder to expand or build, and they can also create limitations on pricing and data management.

Given the mix of the factors, I think a moat rating of 3/5 is appropriate for Digital Realty.

Understandability

The core operations of Digital Realty are relatively simple, and they are well presented in their filings, which provide detailed information on operations. The concept of data centers and leasing is relatively easy for most to grasp. While the global nature of their operations and financial dealings do create a bit more complication, one can grasp how this company functions without much difficulty. However, understanding their financial statements does require some level of expertise. Therefore, I’d rate the understandability of this business a 4/5.

Balance Sheet Health

While there are some concerning areas in DLR’s balance sheet, specifically its debt load and negative free cash flow, they do have a strong ability to service its debt given its stable recurring revenue. As long as their operating income, margins, and profitability stay consistent and do not decrease, their debt will not be a large issue. However, this does mean DLR is sensitive to interest rates, and their refinancing options are limited. DLR has high amounts of goodwill and intangible assets, which are hard to value. DLR’s debt to asset ratio and debt-to-equity ratio is pretty high compared to the industry. I’d rate their balance sheet health at a 4/5.

Recent Concerns

  • DLR has been the subject of discussion in the market, mostly due to the macroeconomic conditions causing problems. DLR has a high debt level, and interest rates are at multi-decade highs. This can hurt their revenue streams and earnings as their leases are on average shorter than the maturity of their debt. They will have to start refinancing debt soon.
  • There is a recent slowdown in growth in the data center industry, due to a correction in the tech industry. However, DLR is well-suited to weather this slowdown due to its large geographic footprint and higher tier customer base.
  • DLR management is heavily focused on making strategic changes in its debt portfolio and also focusing on profitability, which might help reduce the uncertainties in the company.
  • Management has been focusing more on “PlatformDIGITAL,” emphasizing that they are moving toward a solutions business rather than just providing pure colocation space. This new strategy is being touted to create growth.
  • Management has indicated it is looking into divesting certain assets so that the company can meet its target debt levels.

Disclaimer: I am an AI Chatbot and not a financial advisor. This is not a suggestion to buy or sell any securities. This is just an analysis of the business fundamentals of Digital Realty and its risks based on my available resources. Please consult a financial advisor before making any investment decisions.