5 Signs Digital Realty Trusts Best Days Are Ahead

By Markets Fool.com

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Data center REIT Digital Realty Trust (NYSE: DLR) has performed remarkably well lately. Even after a recent pullback, the stock has delivered a 63% total return over the past year. While this is a truly amazing return, there's reason to believe there is more potential to the upside over the months, years, and decades to come.

Growing demand for data storage

Even though the demand for data storage has exploded over the past decade or so, it is predicted to continue to grow at a breakneck pace for years to come.

According to a report by Cisco, global IP traffic will grow at a 22% compound annual growth rate through 2020, and there will be 26.3 billion connected devices by that time that's 3.4 times the entire global population and 10 billion more connected devices than exist today. As a result, mobile data traffic is projected to increase 700%.

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As more people become "connected", the need for data storage will increase dramatically. A report by MarketsandMarkets found that the global cloud storage market is expected to grow at a 28.2% CAGR through 2020, at which point it will be $65.41 billion in size.

In a nutshell, this means that there will be tremendous demand for data storage going forward, which translates into not only expansion opportunities for Digital Realty, but pricing power as well.

Geographical expansion

Digital Realty is already geographically diverse in the sense that it owns data centers all over the globe. However, the vast majority (80%) of the company's rental income still comes from the United States.

Source: Digital Realty investor presentation-Data as of 6/30/2016

So, there is tremendous opportunity for geographical expansion. After all, the demand growth discussed in the previous section included global projections. Digital Realty recently took a big step toward international diversification by acquiring a portfolio of eight European data centers for $874 million. Inclusive of this acquisition, the U.S. concentration falls to 75%.

I'd like to see the company continue to target attractive international opportunities and continue to spread their rental income sources out. And, the recent activity is a good sign of things to come.

Foreign exchange headwinds won't last forever

Digital Realty is growing at an impressive rate, but it could be even better. Specifically, foreign exchange headwinds have been dragging down growth metrics, and by a significant 50-100 bps margin. Just take a look at how foreign currency fluctuations affected the company's year-over-year growth.

Metric

As reported 2Q16

Constant-currency basis

Revenue growth

5.2%

6.2%

Adjusted EBITDA

7.1%

8.2%

Same-capital cash NOI growth

3.3%

3.6%

2Q16 Core FFO

9%

9.9%

Full-year Core FFO (projected)

8.4%

10.3%

Source: Digital Realty investor presentation

I think we can all agree that the difference between 8.4% year-over-year FFO growth and 10.3% growth is significant. Fortunately, this currency drag isn't likely to last forever, and while there's no telling how long it may persist, this is a temporary issue that's preventing Digital Realty's full performance from being seen.

Financial flexibility

As Digital Realty continues to grow and diversify, its financial flexibility has increased. As of the end of the second quarter, the company's capital structure is made up of just 25% debt, most of which is at fixed interest rates. The company's fixed charge coverage is at 3.4x, meaning that there is more than enough income flowing in to cover the debt obligations, even if revenue were to drop sharply.

This low debt-to-equity ratio and the quality of Digital Realty's portfolio has given the company an investment-grade credit rating (BBB/Baa2), allowing it the financial flexibility to pursue attractive investment opportunities as they arise. The company has a total of $3.6 billion in revolving credit and term loans, which should be plenty to meet its growth needs going forward. Digital Reality is anticipating $750-$900 million in CapEx for 2016 at average stabilized yields of 10.5%-12.5%, and I see no reason this can't increase even further in future years.

Reasonable valuation

There has been some coverage in the media lately claiming that Digital Realty is "too expensive", so let's take a look.

The best way to analyze a REIT's income is funds from operations (FFO), as opposed to earnings or net income. If a metric such as normalized or core FFO is available, it's even more accurate, as it makes company-specific adjustments.

For 2016, Digital Realty recently increased its 2016 core FFO guidance to a range of $5.65-$5.75 per share. Using the midpoint of this guidance range and the stock's price at the time of this writing ($101.40), we see that Digital Realty trades for a valuation of 17.8 times core FFO.

While this may sound on the pricey side, consider that the company generated 9.2% year-over-year core FFO growth and is showing no signs of slowing down. And, Digital Realty actually trades for a significantly lower valuation than most other sector-leading REITs -- for example, retail giant Realty Income trades for a P/FFO multiple of 24.2 and only grew its adjusted FFO by 4.4% over the past year.

It's not too expensive...yet

One mistake long-term investors should never make is assuming that just because a stock's price has gone up significantly in a relatively short period of time, it must be too expensive to buy. Many people feel this way right now, not just about Digital Realty, but many other REITs have delivered similar performance and may seem a bit pricey at first glance.

Keep in mind that a stock's price is just a number that is meaningless without knowing the valuation metrics behind it. Digital Realty still has lots of growth potential, and is reasonably valued when considering that potential. So, Digital Realty could make a great addition to a long-term growth portfolio, even at share prices over $100.

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Matthew Frankel owns shares of Digital Realty Trust. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.