Why Stifel Believes Data Center REIT Digital Realty Is Now A Buy

Stifel on Monday released a research note, "Leaner and Meaner with Pathway to Growth More Visible," upgrading Digital Realty Trust, Inc. DLR from Hold to Buy.

Stifel views Digital Realty as a "best-in-class" operator in the wholesale data center space and views the recent pull-back in share prices "has created a compelling opportunity for investors."

Tale Of The Tape

Stifel noted that DLR shares had retreated 11 percent from January 2015 highs.

Stifel – Digital Realty Buy, PT of $73

Stifel noted a "total return potential of 15 percent - 20 percent from current levels over the next twelve months." Their rationale included these four points:

1. Recent selloff presents attractive entry point.

• Digital is "currently trading at 14.4x FY16E EBITDA, 15.4x FY16E AFFO, 6.7 percent implied cap rate, and 5.1 percent dividend yield."
• Stifel's "$73 target reflects a 4 percent premium to NAV (based on 6.5 percent cap) and 17x [its] FY16 AFFO estimate."
• Stifel also noted a "bull-case valuation of $76 [which] reflects a 6.2 percent cap rate and 17.6x AFFO."

2. Return optics improving on capital recycling initiatives.

• Digital Realty "has raised approximately $600 million in proceeds from the sale and/or JV contribution of properties deemed to be non-core or generating subpar returns" since it began the initiative in late 2013.
• Stifel believes that "these initiatives have had their desired effect on operating efficiency and returns, as property-level ROIC began to inflect in early-2014 and has now increased in three consecutive quarters, rising 60 bps y/y in FY14."

3. Fundamental backdrop remains healthy.

• "Given relatively tight supply/demand conditions in major US metros [Stifel expects] DLR to wade back into development mode with its newer modular design concepts and just-in-time inventory."
• Stifel noted that Digital has not begun any major development projects during the past 18 months, and believes that "the company is poised to re-ignite the growth engine in 2016 and beyond."

4. Accretive M&A more likely as strategic review winds down.

• Stifel expects Digital Realty's "portfolio review process to be largely complete by 4Q15, with several properties likely brought to market" during the first half of 2015.
• Stifel noted since "mid-market leasing / retail colo [was now a] top strategic priority for the company… [it would not be surprising if] DLR sought to acquire one (or more) of the many smaller public/private operators beginning in late 2015 / early 2016."

Risk Factors – $73 PT

Risks to the Stifel target price included:

• Changes in "the currently favorable supply and demand environment"
• "Deterioration in market fundamentals such as lower pricing and return on capital for development projects"
• "Macroeconomic risks including recession and/or a rapid increase in long-term interest rates"

Related Link: 3 Things Moving The (Formerly) Red-Hot Data Center REIT QTS Realty

Investor Takeaway

The catalyst for the Stifel upgrade from Hold to Buy appears primarily to have been a valuation call. However, a potential game changer noted by Stifel would be the acquisition under terms favorable to Digital, of one or more companies to accelerate it mid-market/colocation leasing initiative.

The Stifel base case PT of $73 represents an approximated 10 percent upside from the prior close of $66.38; which, combined with the current dividend yield of just over 5 percent, represents a total return of approximately 15 percent.