76report

October 29, 2024

Digital Realty sees record-setting demand from AI

Investing in well-managed companies with strong market positions and nice growth prospects is a great starting point for long-term investors in stocks. It may sound simple, but buying into solid, high quality businesses tends to work out pretty well over time.

The only drawback to putting your money into “good” companies is that, at any given time, you are probably not the only investor out there who recognizes a good company’s strengths. The risk is that a stock’s valuation already reflects these positive attributes. In other words, it’s priced in.

When investors become overly enthusiastic about any particular business, the shares can become overvalued. The result may ultimately be sub-par (or negative) returns even if the company delivers good (but not great) financial results.

The best investment scenario arises when a good company is underappreciated or misunderstood by other investors—like a valuable antique foolishly being sold for $5 at a garage sale. At 76research, we are continuously on the hunt for good companies that, for one reason or another, are trading at discounted prices.

When you find a high quality, well-positioned business that the market is pricing as if it were a challenged one, the return potential can be very high.

Even when a good company is properly priced, you can still do quite well as the company delivers on its value creation strategy. But when a good company is underpriced, you can benefit from additional share price appreciation as the market comes to recognize its mistake.

Digital Realty Trust (DLR) is a prime example of a good company that was also severely underpriced when we first presented it to subscribers.

While the share price has risen significantly since then and outperformed, DLR remains a top holding within our Income Builder Model Portfolio. We still view DLR as a compelling long-term opportunity as the company capitalizes on a global AI data center buildout that remains in early stages.

On the heels of a truly impressive third quarter earnings report, DLR is displaying excellent momentum across all areas of its business. This recent success solidifies its financial position, de-risks the growth outlook, and bolsters the overall investment case.

We initially profiled DLR, our very first stock pick, back in June 2023, in the inaugural version of the newsletter sent to pilot subscribers. This original memo has been made available on our website since our launch.

We chose DLR as our first focus investment because we saw a disconnect between the market perception of the company and profound shifts that were clearly underway in the data center space.

What the market got wrong

Shares of DLR were depressed at the time for two major reasons.

First, DLR is a Real Estate Investment Trust (REIT), and the REIT sector was generally weak because of the high interest rate environment.

Second, certain short-sellers, most notably Jim Chanos, were promoting a (highly flawed) bearish thesis on data center REITs like DLR. This short thesis centered around the idea that they would be rendered obsolete as enterprises shifted their data storage to the cloud via hyperscalers like Microsoft Azure and Amazon Web Services.

What investors were failing to appreciate at the time was a major inflection point in demand for data center capacity. Interestingly, this inflection was not a well-kept secret.

NVIDIA (NVDA) shares were surging on the back of extraordinarily strong financial performance. NVIDIA’s CEO Jensen Huang was effectively shouting this from the hilltop, which we noted in our initial report.    

In the future, it's fairly clear now with generative AI becoming the primary workload of most of the world's data centers generating information…. We're going through that moment right now as we speak while the world's data center cap ex budget is limited, but at the same time, we're seeing incredible orders to retool the world's data centers. So I think you're seeing the beginning of, call it a 10-year transition, to basically recycle or reclaim the world's data centers and build it out as accelerated computing. - Jensen Huang (5/24/2023)

Just over a year later, we are pleased to note that our belief that DLR would benefit from the AI transition was entirely justified. On October 24, 2024, DLR reported third quarter earnings. While the financial results were generally at or above expectations, what really caught the market’s attention was the jump in bookings, which refer to new leases that were signed during the quarter.

Source: Digital Realty Trust

As tech giants plead with government officials to invest in our electrical infrastructure to meet their AI power needs, we are witnessing a wall of demand for data center capacity. Being one of the largest owners and developers of data center capacity in the world, DLR is a natural beneficiary.

DLR shares have advanced approximately 11% since the third quarter earnings release, as analysts have revised upward their long-term expectations. Since we initiated DLR as a top holding within the Income Builder Model Portfolio on March 1, 2024, shares of DLR have now delivered a total return of 24% versus 14% for the S&P 500.

Since we first published our memo on DLR on June 22, 2023, DLR shares have returned 81% versus 33% for the S&P 500.

On the conference call following the earnings release, DLR management attributed approximately 50% of the new business to AI-related demand, especially among large customers. These customers include major hyperscalers, which in some cases operate their own data center facilities and in other cases lease space from independent data center operators like DLR.

It is important to note that customer demand was robust across the board. Smaller data center bookings also saw record growth, suggesting AI-related demand is having a positive knock-on effect on traditional computing requirements.

The favorable supply/demand imbalance is benefiting DLR in other ways as well.

Pricing is strong. As leases with existing tenants expire, DLR is able to charge more for renewals. Guidance for the year was lifted from a midpoint of 6% on cash rental renewal growth to 9%.

New leases are also being signed with higher automatic annual escalators, which are now around 4%. This enables DLR to lock in a high level of rental growth on data center leases that are typically five to ten years long.

While DLR’s existing footprint of some 300 data centers is becoming more profitable as customers scramble for space, it is important to remember DLR also grows through development.

With substantial land holdings in key locations, proprietary opportunities to expand existing facilities and a strong development team, DLR is a leading developer of new data centers. DLR also has strategic partnerships with some of the most important players in AI, including NVDA and Oracle (ORCL). These relationships are helping to fuel its growth.

On October 23, NVDA founder Jensen Huang joined the King of Denmark to launch the country’s first AI supercomputer, Gefion (named after the Norse Goddess of agriculture). The supercomputer is hosted at a DLR data center in Copenhagen.

Jensen with the King of Denmark

Surging demand is improving the economics of new data center development for DLR. In the most recent earnings call, management noted a 50% sequential quarterly increase in its development pipeline.

DLR now anticipates an impressive 12.0% yield on new development (versus a reported 10.4% in the prior quarter). This means customers are paying DLR more to develop new data center capacity for them, which improves DLR’s return on investment.

Is DLR still worth owning?

DLR shares have returned approximately 39% year to date, versus 22% for the S&P 500 Index. Whenever there is sharp price appreciation, it is essential to question if the higher valuation is justified and if it is time to sell.

The “easy money” in DLR may be gone. A year ago, DLR was arguably perceived by the market as a potential victim of technological change. Now it is clearly a beneficiary. Much of the performance over the past 12 to 15 months represents a reversal of sentiment on that subject.

The long-term growth outlook for DLR has improved substantially, however. The outlook has also been de-risked by a flow of new business on favorable terms. Looking across financial metrics, the current valuation strikes us as justified.

It was just over a year ago that the stock market was essentially giving DLR almost no credit for the long-term AI opportunity. Now that AI-related spending is manifesting itself in the financial results, we have seen some nice movement in the share price.

We are still, however, in very early stages of the AI data center buildout. DLR has a premier global data center asset base and development platform. There is ample room for growth in the years, if not decades, ahead as data centers come to play an increasingly important role in the future of computing, as Jensen Huang has described.

Investment lessons

Whether an investment works or fails, it is good practice to reflect on the experience and the decision-making process. We can identify a few important takeaways from the recent success of DLR.

(1)  Pay attention to other companies.

Last year, NVDA management was providing extremely clear signals regarding future AI-driven data center demand. It is possible that many REIT investors were too siloed and failed to pay sufficient attention to broader technology trends.

(2) Don’t be intimidated by short-sellers and hedge funds.

Many investors were probably spooked by the bearish calls of prominent short-sellers like Jim Chanos, who articulated negative views on the data center sector. Notwithstanding their billions under management and Hamptons mansions, short-sellers and hedge funds frequently misinterpret industry trends. In our experience, they are at their best when they are identifying financial frauds; pay close attention when those are flagged.

(3) Get the big picture right.

Investors, especially professional investors, often get bogged down in details, but the most important thing is to be directionally correct on the key points. To justify an investment in DLR a year or so ago, one really only had to recognize that we were on the cusp of a meaningful uptick in data center demand. Sometimes investing can be easy.

Digital Realty Trust (DLR): Company Snapshot

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