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Digital Realty Trust(DLR-N)

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The Risk of a Dividend Cut Has Dropped Sharply for This High-Yield Stock

Motley Fool - Sun Jul 30, 10:01AM CDT

Digital Realty(NYSE: DLR) is investing heavily to expand its data center operations to capitalize on tailwinds like digital transformation and artificial intelligence. However, because of the company's stretched financial profile, accessing capital to fund its growth is getting more challenging. That has increased the risk that the company might need to reduce its dividend to finance expansion projects.

The company has been working to avoid that fate by executing a roughly $2 billion capital recycling strategy. It recently completed a big piece of that puzzle. As a result, its 4.2%-yielding dividend is looking a lot safer.

In a tight spot

Digital Realty is investing $2.3 billion to $2.5 billion this year to develop additional data center properties to support growing demand. The data center REIT has been working to cobble together a capital plan to fund its expansion without causing further deterioration to its financial profile.

It has a higher dividend payout ratio (78% of its adjusted funds from operations) than digital infrastructure REIT peers Equinix(NASDAQ: EQIX) and American Tower(NYSE: AMT) (43% and 62%, respectively). As a result, it's retaining less cash to fund expansion. Digital Realty also had an elevated leverage ratio of 7.1 (compared with 5.2 for American Tower and 3.4 for Equinix). That gives it less flexibility to borrow money to finance developments, especially with interest rates rising and making debt more expensive. Meanwhile, the company's stock price has been under a lot of pressure (it's down nearly 35% from its high), making stock sales more dilutive.

These obstacles led the REIT to pursue a capital recycling plan to raise $1.5 billion to $2.5 billion through asset sales or joint ventures. That would help limit the need to issue new debt to between $1 billion and $1.5 billion.

Failure to execute that capital plan could have forced the company to cut its dividend. A payout reduction would allow it to retain more cash to fund capital projects and shore up its balance sheet.

Minding the gap

While it has taken a while, Digital Realty finally made meaningful progress on its capital plan. The data center REIT recently formed a joint venture (JV) with alternative asset manager TPG. That company's real estate investment platform, TPG Real Estate, will acquire an 80% interest in three data center properties in Northern Virginia. The deal values the portfolio at $1.5 billion.

Digital Realty will hold the remaining interest and manage the properties. It will receive $1.3 billion in gross proceeds from the deal, which it will initially use to repay debt.

That deal is its third JV transaction in recent weeks. The company also formed a joint venture with GI Partners to own two data center buildings in Chicago. It's selling a 65% interest in those properties for $743 million in gross proceeds. GI Partners also has the option to acquire an interest in a third building at that campus in the future.

Meanwhile, Digital Realty recently signed a three-way joint venture with Brookfield Infrastructure and Reliance Industries. The partners will develop data centers in India, each funding a third of the cost. While that deal won't bring in cash, it will offload a portion of the future capital cost of the projects to its partners.

Before these deals, Digital Realty had only signed one transaction. It sold a non-core data center in Texas for $150 million in early June. Given its lack of progress up to that point, the company had to raise $1.1 billion in equity capital by selling stock to help support its 2023 capital plan.

The company's recent success in executing its capital plan has put it in a much better financial position. It now expects to receive $2.2 billion to $3 billion of proceeds from joint ventures and asset sales this year. Accordingly, it will issue only $740 million of new long-term debt this year, which it has already secured. Together with the equity it issued through stock sales, the company expects its net leverage ratio to fall to a more comfortable 6.3.

A much-improved financial picture

While it has taken a while, Digital Realty has finally had some success with its capital recycling strategy. It has already raised over $2 billion in asset sales and joint venture deals and sees the potential for more. Meanwhile, it was able to sell some stock.

These cash infusions have helped meaningfully reduce leverage, taking a lot of pressure off its balance sheet. This success has significantly reduced the risk that Digital Realty would have to cut its dividend to fund growth and strengthen its balance sheet. While the company has more work to do, its high-yielding dividend looks much safer.

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Matthew DiLallo has positions in American Tower, Brookfield Infrastructure, Brookfield Infrastructure Partners, Digital Realty Trust, and Equinix. The Motley Fool has positions in and recommends American Tower, Digital Realty Trust, and Equinix. The Motley Fool recommends Brookfield Infrastructure Partners. The Motley Fool has a disclosure policy.

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