It is an indisputable fact that the stocks behind the best businesses in the world can experience temporary setbacks, because market sentiment can shift dramatically and quickly. Even former market darlings can be left in the dust.
Shares of the data center real estate investment trust (REIT) Digital Realty Trust(NYSE: DLR) have fallen by 18% in the past 12 months, significantly underperforming the broader market. This raises some questions: Are the fundamentals of the company intact? And should income investors still buy the stock? Let's peek at Digital Realty Trust's core elements and valuation to reach a conclusion.
Major growth catalysts coupled with some valid concerns
The reasons that make Digital Realty Trust a compelling investment have remained unchanged for years now. For one, the company is a leader in its sector, with 310-plus data centers and approximately 5,000 customers around the world. Such a vast and diverse customer base has the benefit of providing Digital Realty with a consistent stream of demand for its data centers.
Second, the promise of the industry is too much to ignore. This is because of the necessity of data centers, which are responsible for processing and storing data. The functions of this modern infrastructure make it possible for us to carry out a variety of everyday tasks and activities, including online shopping, gaming, browsing the web, and checking emails. Simply put, data centers are the backbone of our digital society that is only growing more prevalent with each passing year. That is why research firm Allied Market Research anticipates that the global data center market will surge from $187.4 billion in 2020 to surpass $500 billion by 2030. As a result, it's reasonable to conclude that the REIT will keep building out its network of data centers around the world with new projects to meet demand.
But with these noteworthy advantages in mind, Digital Realty isn't without its potential risks, either. The biggest risk facing the company in the near term is its growing debt load: Digital Realty's net debt-to-adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio has risen sharply from 6.2 in 2018 to 7.1 as of March 31, 2023. Despite this high debt load, the major credit ratings agencies have maintained their investment-grade credit ratings on the company's debt. This implies that the ratings agencies are confident in Digital Realty's plan to unload more than $2 billion of capital from joint venture opportunities this year to repay debt. Along with near-double-digit EBITDA growth that the company expects in 2023, Chief Financial Officer Matt Mercier believes this will get REIT back to a leverage ratio around 6.
A more long-term risk to Digital Realty is one that applies to all REITs operating in the data center space: The booming industry outlook could lead to an abundance of data centers being built in the years ahead, which could lead to a glut of infrastructure. That could theoretically harm the company's occupancy levels and rental rates moving forward.
The dividend remains covered
Digital Realty's 4.7% dividend yield is nearly three times that of the S&P 500's 1.6% yield. Fortunately, this high dividend income doesn't appear to be too good to be true.
Using its midpoint guidance of $6.70 in core funds from operations (FFO) per share for 2023, Digital Realty's dividend payout ratio is poised to come in around 73% this year. This builds at least somewhat of a cushion into the company's payout, which is why I'm confident dividend growth can continue in the future.
Valuation may compensate for the risk profile
Prospective and current Digital Realty shareholders alike should monitor whether the company can execute its plans to deleverage this year. If the REIT can deliver on this promise as some expect, there could be some meaningful upside ahead. This argument centers around the fact that Digital Realty's current-year midpoint price to core FFO per-share ratio is just 15.8. That is why analysts have an average 12-month price target of $118, which would represent 11% upside from the current $106 share price.
10 stocks we like better than Digital Realty Trust
When our analyst team has a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*
They just revealed what they believe are the ten best stocks for investors to buy right now... and Digital Realty Trust wasn't one of them! That's right -- they think these 10 stocks are even better buys.
*Stock Advisor returns as of June 12, 2023