Last Thursday, shares of Digital Realty Trust (DLR) fell sharply after hedge fund manager Jon Jacobson discussed their short opinion on the company at an Ira Sohn Conference. I did not attend the conference, and all of my information about the short thesis is derived from outside third-party sources. I have already analyzed Digital Realty Trust (DLR) a few weeks ago, and liked the growth in FFO/share to purchase some shares in the Real Estate Investment Trust (REIT). In this article I will try to rebuff the arguments from the short seller. I am going to use publicly available information in the company’s most recently posted Annual Report for 2012 available on the SEC website. If hedge funds learned about this secret weapon available only to retail investors, they would probably make a killing in the markets.
The thesis behind the short is as followed:
1) The company taps into the capital markets to fund its dividend
This is the point where I realized that this short seller does not know what he is talking about. A real estate investment trust is required by law to distribute over 90% of its earnings to shareholders. In order for REITs to grow, they issue shares and bonds in the markets. I discussed this in my article on the five things to look for in a REIT.
In 2012, the company invested 1.56 billion in properties. The company also put $845 million in Improvements to and advances for investments in real estate.
The company borrowed almost $1 billion and raised $1.04 billion by issuing stock. Given the low cost of dividends at 4.5% - 5% and the low cost of debt at less than 4.50%, these acquisitions should be accretive to existing shareholders almost immediately I also like the conservative capital structure of Digital Realty, where almost two-thirds of investing activity has been financed by equity. That way, when interest rates increase in the future and the real estate investment trust has to refinance those obligations, they would not suffer as much as other companies.
When you add back depreciation expense and a few minor adjustments, one can see where the Funds from Operation (FFO) is calculated. One can see that the REIT has ample room to pay the dividend. If nothing else, they also have room to increase it over time.
Please refer to last paragraph, that showed a breakdown of revenues and expenses, as well as net income to FFO reconciliation. Digital Realty manages to earn $171 million after subtracting regular depreciation and regular maintenance of approximately $380 million each. In calculating FFO, the REIT adds back only depreciation, to come up with FFO of over $550 million. This makes annual distributions of $373 million paid in 2012 very sustainable. I am not even sure why the hedge fund manager would even bring maintenance expenses, other than as a tactic to scare the weak hands holding Digital Realty Trust stock. Smart dividend investors however know that a high yield dividend growth stock should not be sold, especially when fundamentals are great and business is growing. There are few companies that both yield a lot, and also manage to grow distributions quickly. These are the types of stocks to hold on to.
3) There are no barriers to entry in the business and there is increased competitions
This is a subjective evaluation, that is often prone to investor biases. When a bullish investor who has not done a lot of research on a company tries to justify their position in a stock, they typically claim that a stock has solid competitive advantages. (Of course some investors are right for the likes of Coca-Cola (KO) for example). Similarly, an investor who has not done a lot of original research when making a short sale simply claims that a company does not have any competitive advantages.
I am simply going to put the advantages identified by Digital Realty in their latest 10-K report:
- High-Quality Portfolio that is Difficult to Replicate.
- Presence in Key Markets
- Proven Experience Executing New Leases
- Demonstrated Acquisition Capability.
- Flexible Datacenter Solutions.
- Differentiating Development Advantages
- Diverse Tenant Base Across a Variety of Industry Sectors
- Experienced and Committed Management Team and Organization.
You can read more about those advantages in the 10-K report on page 3.
If only the hedge fund manager had taken the time to read this report through page three, I would not have had to spend my Sunday writing articles, instead of enjoying the nice weather.
The only factor that I found interesting in the short case is the fact about competition. I think that this is the only item that would make me lose sleep at night as an investor. If technology companies decide to buy and operate their own data centers, Digital Realty would lose out. The REIT could also lose out from competitors stealing away business. I find it difficult to believe that a large organization would move their servers every year, simply to save on rent. Anything that involves information technology change in most organization usually is resisted because of the hidden costs of transferring important corporate information. Luckily, the REIT signs long-term leases with its tenants. As of December 31, 2012, their original average lease term was approximately 14 years, with an average of approximately seven years remaining.
If everyone moves to the cloud, Digital Realty might not lose too much, since the cloud is still housed on servers somewhere. Interestingly, one of the companies that was cited as a competitor to Digital Realty, Amazon.com (AMZN) is actually a tenant of the REIT. Digital Realty Trust earns $14 million/year from this tenant.
4)The stock price should be $20/share
I am not in the business of forecasting stock prices. A stock price can fall by 50% or rise by 50% easily from here. If the economy experiences another event like the 2007 – 2009 financial crisis, shares of this REIT could easily fall 50% from here. However, as long as the fundamentals are sound, a stock should be a hold, with additions to existing positions made at attractive valuations. I believe that Digital Realty Trust has been wisely allocating new capital, and as a result has been able to grow FFO/share and the dividend per share nicely over the past seven years. Investing in stocks is risky, and those who cannot sit through a 50% decline in share prices should invest in CD’s instead. If Digital Realty can fall to $62.40/share, which is equivalent to a 5% yield, I would add to my position in the REIT.
Selling a stock short is very expensive. When someone is short a stock, they need to borrow it from a broker, and have to pay an interest rate to the individual who they borrowed the stock from. If a stock is difficult to borrow, a short seller might end up paying a double digit interest rate. In the case of Groupon in 2011, a short seller had to pay an annual interest amount equivalent to 100%. That meant that even if the company went bankrupt in one year, a short seller would still lose money. In addition, when you are short a stock, you are also charged an amount equal to the dividend payment for the security. If we assume a short interest rate of 5%, and a dividend yield of 5% , this would means that this short position is really expensive for the Hedge Fund manager. In addition, the danger behind short selling is that theoretically their risk is unlimited. For example, if Digital Realty fell to zero, all I am going to lose is the money I invested. However, if Digital Realty increased by more than 100%, a short seller would lose more than the money they invested initially.
Because selling stock short is so expensive, the short call by this hedge fund manager looks more like a last attempt to cover their position at a minimum loss. This cry for help from the Hedge Fund manager makes me very bullish on Digital Realty. If it drops to $62.40/share, I would be adding to my position in the stock.
Full Disclosure: Long DLR, KO
- High Dividend Growth REITs: Digital Realty Trust (DLR)
- Five Things to Look For in a Real Estate Investment Trust
- Spring Cleaning My Income Portfolio, Part II
- Four High Yield REITs for current income
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