A Little-Known Income Stock that Acts like a Growth Stock

Adam Fischbaum's picture

Wednesday, May 25, 2011 - 1:00pm

by Adam Fischbaum

During any sort of boom, the businesses that provide supplies or any ancillary services to those chasing the boom usually make the most money. The California Gold Rush of 1849 is a prime example. A young immigrant named Levi Strauss realized he could make more money selling picks and shovels to the 49ers than the 49ers would ever make looking for gold. Eventually, he would also sell them rugged, canvas pants that became known as "blue jeans."

As the Internet emerged at the close of the 20th century as the new backbone of communication, tens of thousands of businesses sprang up to provide the picks and shovels: Cisco (Nasdaq: CSCO) for networking, Oracle (Nasdaq: ORCL) for database management software, Dell (Nasdaq: DELL) for enterprise server hardware. Even more amazing is that the computer technology business has grown in what seems like the blink of an eye compared with the century or so it often takes other industries to develop. With the exponential growth comes the need for space. But providing real estate and related services for high-tech industry is very different than what it takes for other industries.

Boston-based Digital Realty Trust (NYSE: DLR) has taken the idea of focusing on commercial real estate tailored specifically for high-tech companies and has run with it in a big way. With a $6.9 billion market cap, Digital Realty owns and leases more than 14 million square feet of commercial space. The company's primary focus is data centers (server farms and other cloud-related installations) offering turnkey data center solutions and build-to-suit data centers.

Recently, the company began offering data-center architecture services. If you're familiar with cloud computing, then you know that the "cloud" is merely a huge warehouse full of servers and storage devices used to store data offsite. Besides requiring huge Costco-sized warehouses, cloud computing also requires much more specialized attention than your basic class "A" office space. And as the companies involved in the cloud (think Amazon (Nasdaq: AMZN) and soon -- in a BIG way -- Apple (Nasdaq: AAPL)) see that line of the business grow exponentially, expect Digital Realty's business to follow suit. [See: "How Apple's Big Secret Could Spoil Netflix's Amazing Run"]

A REIT that acts like a growth stock
Historically, real-estate investment trusts (REITs), which are publicly-traded companies that invest directly in different types of real estate, provide investors with a steady income stream and a liquid, diversified approach to investing in real estate. Yields can be quite attractive and well-run REITs can increase their dividends substantially over time. However, capital appreciation is usually a secondary objective. That's why Digital Realty is so different.

Digital Realty's first-quarter revenue numbers were superb: $196.7 million compared with $152.5 million for the first quarter of 2010, good for 28.9% growth. I don't care what kind of business you're in, that's strong. Of the 14 million square feet of space in Digital Realty's portfolio, 93.5% is leased. Few companies in the commercial real estate space can boast such an occupancy rate. What's more, Digital Realty is getting a $57 per-square-foot rate, an increase of 3% over last year. Again, commercial rental rates throughout most of the country are relatively stagnant. Rising rent? Good. 93.5% occupancy? Good.

Asian Pacific expansion is a major growth opportunity for Digital Realty. Recently, the company entered data-center joint venture projects in Singapore and is on the verge on entering the Australian market. Emerging-market exposure? Let's call that a bonus.

Of course, a spectacular growth story comes standard with challenges. The most pressing concern is the pending acquisition of Savvis (Nasdaq: SVVS) by Century Link (NYSE: CTL). Savvis, a global information technology infrastructure services provider, is Digital Realty's largest tenant, representing 10.7% of the company's annual revenue. Naturally, any change in corporate decision-making makes any landlord nervous. However, the Digital Realty seems comfortable that Savvis' data-center strategy won't change in the near future.

A more general issue would be a loss of cloud momentum due to systemic failure or malfunction. The recent Amazon cloud crash and Sony's (NYSE: SNE) crisis concerning the personal data of millions of its PlayStation customers being snatched has raised worries about the integrity of cloud computing. Due to the need for stricter security and control, a company offering cloud services may have second thoughts about leasing a data center and opt to build its own instead.

Action to Take --> It's rare to find a growth story wrapped in a real estate investment trust (REIT). It's even rarer to find a 20%-plus growth story. Digital Realty currently trades for about $59.86 and pays a dividend yield of 4.5%. Revenue is projected be $1.06 billion for 2011 and $1.22 billion for 2012. Funds from operation (FFO -- the REIT equivalent to earnings per share) are expected to be $4.10 per share this year and $4.55 the next. This comes out to 15% revenue growth and 10.9% FFO growth.

Based on these numbers and the growth of the cloud build-out that's likely to continue, a 12-month price target of $73 makes sense. Factoring in the dividend, that brings the possible total return for this stock to 26.5%.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.