At the Ira Sohn Conference earlier this month, Jonathon Jacobson of Highfields Capital Management outlined a short case against Digital Realty Trust (DLR) that was one of the best we had ever heard. Since then (and at the time of this writing), the stock has declined about 9%. DLR is heavily shorted with 17.7MM of the 128MM shares outstanding short as of the end of April.
Based on the presentation we heard, this made perfect sense, and we would not have been surprised if the stock had been down more. When we investigated Highfields’ claims, we found that everything they said was factually correct. We also believe that they have misinterpreted these facts and that the stock represents a buying opportunity ahead of the company’s presentation at the NAREIT Conference which begins on June 5.
In examining Highfields’ case, we want to emphasize that we do not believe they mislead anyone or that they did bad research. We do think they missed a few critical points that invalidate the thesis. We will do our best to properly state their thesis and we invite Highfields to contact us if they believe we missed or misstated anything.
Highfields’ first claim is that Digital Realty is understating their recurring capital expenditures. This would have the effect of increasing DLR’s adjusted funds from operations, a non-GAAP measure that Real Estate Investment Trusts (REITs) use to calculate their ability to fund dividends from their ongoing operations. Since Digital Realty tends to pay out about 80% - 85% of adjusted funds from operations in dividends, and since REITs tend to trade off of dividend yield, understating recurring capital expenditures would lead to an unsustainably high stock price.
Highfields suggests that $413MM in maintenance capital expenditures is the correct number, and we believe they are calculating that by assuming a 20 year life on all non-land and non-lease investments in properties from the balance sheet. There are three problems with this analysis:
-This assumes that Digital Realty’s assets all have a 20 year life and will be worthless at the end of that period. Many of these assets have much longer lives including the buildings, electrical cabling, raised floors, pipes, and diesel generators. In fact, we believe that only 30% - 45% of the cost of building a datacenter is for assets that need to be replaced on an 18 – 30 year cycle.
-Highfields is ignoring the $380MM the company spent on property operating and maintenance expense last year. DLR is spending plenty to maintain its assets, but it is running those expenses through the income statement instead of capitalizing them.
-Highfields’ analysis ignores the difference between cash and accrual accounting. There’s no question that DLR will need to replace some of its capital equipment in the future, but with relatively new datacenters, it doesn’t need to spend much on that now. Not paying a dividend now because it might need to replace an HVAC unit in 20 years seems a bit extreme.
Highfields’ second claim is that Digital Realty is paying dividends from issuances of debt, preferred, and common equity instead of from free cash flow. While Mr. Jacobson avoided saying “Ponzi scheme”, he did point out that there was a term used to describe a business enterprise that pays existing investors out of money raised from new investors.
We note that all REITs are required to pay out most of their income in dividends to maintain their tax-advantaged REIT status. This means that most REITs grow through raising capital rather than through retained earnings or cash flow. In fact, if Highfields’ analysis were applied to all datacenter REITs (as well as most REITs), they would register as Ponzi schemes.
Our view is that the entire REIT industry isn’t a giant Ponzi scheme. While Highfields didn’t make that claim either, their claim against Digital Realty applies widely. We would be interested in hearing if they think all REITs that raise capital to pay for new assets and that pay a dividend are also Ponzi schemes.
Directly addressing the situation at Digital Realty, the company has enough cash flow from operations to cover the current dividend, maintenance capital expenditures, and reserve for replacing 45% of its non-land assets on a 25 year cycle. This seems reasonable to us.
Highfields’ final claim is that Digital Realty is about to face intense competition from companies like Google and Amazon. We acknowledge that this is a possibility in the future. We also would point out that Amazon and Google offering cloud storage is not the same thing as running a latency-intensive high-security datacenter where thousandths of a second matter. Cloud storage is fine for school papers and music. The regulatory and record keeping requirements of large investment banks, high speed trading operations, pharmaceutical companies, and telecom companies call for a much more high-end solution. This is what Digital Realty does.
For Highfields to get confirmation their short thesis is correct, they would need to see DLR’s access to the public funding markets shut off, a huge and statistically improbable increase in equipment failure, or enough new entrants into its capital-intensive market space to make its existing facilities unprofitable. These events, if they ever happen, could take years.
On our end, we see that Digital Realty is heavily shorted and the stock is down due to a broken short thesis based on misunderstood facts. The company is likely to respond to this short thesis at the NAREIT Conference next week, and to do so in a convincing fashion. Even if the short case turns out to be correct, it could be many years before the shorts get confirmation or a catalyst. Being short a growing and dividend-paying REIT indefinitely seems like a risky proposition.
About the Author
Gary Brode is a Managing Partner and Portfolio Manager for Silver Arrow Investment Management, LLC. He started his career in the Mergers & Acquisitions Department at Morgan Stanley & Co. and spent the last 19 years working for hedge funds, including Seneca Capital, Brahman Capital, and the Event Driven Group of John A. Levin & Co.; all funds with up to $2.5 billion in assets. He was a Founder and Managing Partner of Akita Capital Management, LLC, a value-oriented long/short equity hedge fund.