May 24, 2022

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Digital Realty: Business Transformation, Strategic Expansion (NYSE:DLR)


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Digital Realty (NYSE:DLR) is the world’s wholesale data center leader and is the world’s second biggest data center colocation provider with an 8% share of the USD 54 billion market, behind market leader Equinix (EQIX) with a market share of 11%, and ahead of third-ranked China Teletech (OTCPK:CNCT) with a 6% market share. Like rival Equinix, Digital Realty enjoys a geographically diversified portfolio, but unlike Equinix, Digital Realty owns bulk of its properties while Equinix rents as much as 41% of its space from other data center operators – including Digital Realty and then subleases them to other tenants. Equinix has long been one of Digital Realty’s top 10 biggest customers, accounting for about 2.6% of Digital Realty’s revenues.

Digital Realty reported a 13% YoY increase in revenues which reached USD 4.43 billion in FY 2021, and a 24.5% increase in operating income which reached USD 694 million. In the medium term, the data center industry is generally expected to enjoy favorable demand trends driven by a number of factors including hybrid work, online learning, a growing shift of enterprise workloads from on-premise to the cloud, and growing online video consumption among others. Estimates from numerous market research providers anticipate double digit growth rates for the data center market in the coming years.

Business Transformation On Track

Digital Realty has traditionally focused on the wholesale data center business (massive data center spaces leased to large scale clients who would house their own equipment), however over the past few years, the company been increasingly focusing on the retail colocation and interconnection business (smaller spaces within data centers and interconnectivity services offered to customers who, in addition to renting these smaller spaces, would also often rely on the colocation provider for other IT-related services as well). While wholesale data center leases are generally larger, retail colocation leases can be more lucrative with higher margins and greater user stickiness. Digital Realty’s acquisition of European colocation player Interxion in 2020 helped the company emerge as Europe’s second largest retail colocation provider, and overtake Equinix in Cloudscene’s Data Center Ecosystem 2020 Leaderboard in EMEA. Digital Realty continues to remain the leader at the end of 2021 while Equinix continues to dominate the remaining regions.

Data Center Ecosystem Leader board H2 2021

Cloudscene

The transformation however means Digital Realty is emerging as a stronger competitor with a diversified product offering capable of serving wholesale and retail customers. The company reported record new bookings of USD 156 million for Q4 2021, and USD 500 million for FY 2021, with a roughly 60/40 split between one MW (generally refers to larger, wholesale customers such as hyperscale cloud providers) and less than one MW plus interconnection (retail colocation customers).

Digital Realty Lease distribution

Digital Realty 2021 Annual Report

The wholesale business however still has considerable influence over the company’s performance with renewal rates dropping 4% in Q4 2021 driven by negative re-leasing spreads on greater than one megawatt renewals outweighing positive releasing spreads on sub-one megawatt renewals.

Digital Realty Q4 2021, re-leasing spreads

Digital Realty Q4 2021 investor presentation

Nevertheless, Digital Realty has been busy divesting legacy, older, non-strategic facilities which should reduce their influence going forward. Furthermore, some of these facilities generally have older technology and infrastructure such as power supply, generators and cooling systems, making them relatively costlier to maintain. Last August, 11 legacy data center assets in Europe were divested to Ascendas REIT, and 9 legacy data center assets were sold to Menlo Equities.

Aggressive Investments Amid Market Consolidation

The industry has been going through a wave of consolidation lately. CyrusOne was taken private by KKR and Global Infrastructure Partners this year. Equinix expanded into Chile and Peru through its acquisition of data center assets from Chilean telecom company Empresa Nacional De Telecomunicaciones S.A. (“Entel”) this year. Private equity behemoth Blackstone acquired QTS Realty Trust in August last year. Yet, with the top 15 data center colocation providers commanding about 50% of the global market, and with the bottom half of the market being extremely fragmented, there is ample room for further consolidation.

Africa has emerged as the latest battleground with both Digital Realty and Equinix making acquisitions to capture share. Africa’s monthly data consumption is projected to soar by more than 300% according to a report by the International Finance Corporation and Google, as the pandemic forced much of the country’s activities online and drove internet usage across the region which in turn is expected to propel the country’s internet economy. The potential is enormous; Africa has a one billion plus population most of whom are youth (media age is just 19.7 years), and internet penetration in sub-Saharan Africa is estimated at less than 40% (statistics vary with GSMA estimating just 28% of the population are connected while the International Financial Corporation estimates about 40% of Africa’s population have internet connectivity). Growing internet penetration, and an expanding internet economy means more data consumption which would require more data centers. The opportunity has attracted a slew of tech giants; Microsoft (MSFT) was the first major cloud provider to set up shop in the continent with the company opening a data center in South Africa in 2019. Amazon’s (AMZN) AWS followed suit, setting up its first cloud data center in South Africa in 2020.

Digital Realty too has already made its moves in the region with the company acquiring Nigerian data center firm Medallion Data Centres in October last year, and Kenyan data center operator iColo in 2019. In January this year, Digital Realty made a bigger splash when it acquired Teraco – South Africa’s largest data center operator for a whopping USD 3.5 billion, marking Digital Realty’s third acquisition in the region. Teraco operates seven data centers located in key South African cities including Johannesburg, Cape Town and Durban. South Africa, the continent’s most advanced economy, is expected to remain as the data center hub for the region due to its advanced infrastructure and other advantages, and the acquisition nicely positions Digital Realty to benefit from this opportunity.

Equinix meanwhile entered Africa this year through its acquisition of African data center operator MainOne which operates three data centers across West Africa (Ghana, Nigeria, and Côte d’Ivoire). Both transactions (Digital Realty’s Teraco and Equinix’s MainOne) are expected to close in the first half of 2022. With the Teraco acquisition however, some pundits are of the view that Digital Realty has an upper hand over Equinix, at least for now.

Financials

Digital Realty’s revenues have been growing at a faster pace than Equinix.

Revenue growth YoY %

Digital Realty

Equinix

FY 2021

13.4%

10.6%

FY 2020

21.6%

7.9%

FY 2019

5.3%

9.7%

FY 2018

24%

16%

Digital Realty is generally on par with Equinix in terms of profitability. The company’s ROA jumped in FY 2021, however much of that is due to one-off gains associated with asset sales.

Return on Assets %

Digital Realty

Equinix

FY 2021

4.7%

1.8%

FY 2020

1%

1.4%

FY 2019

2.5%

2.1%

FY 2018

1.4%

1.8%

Digital Realty has a considerably better debt profile compared to Equinix. Amid a climate of expansion and consolidation, a better debt profile could give the company an advantage.

Total Debt To Equity %

Digital Realty

Equinix

FY 2021

83%

138%

FY 2020

85%

131%

FY 2019

113%

150%

FY 2018

117%

157%

Summary

Digital Realty’s ongoing business transformation is on track and results are generally positive. With the industry offering positive medium-term growth prospects, and amid ongoing market consolidation, the company is aggressively expanding through a combination of organic growth and acquisitions, while strategically divesting non-core, legacy assets which helps maintain balance sheet flexibility.

Analysts are overall split on the stock with about half being bullish and half neutral.

Digital Realty analyst rating

WSJ



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