Digital Realty REIT Not Growing as Much as Cloud Expectations

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Digital Realty Trust, Inc. (NYSE: DLR) is supposed to be the landlord of the cloud. That should imply not only endless growth but dividend growth as well. Unfortunately, the growth of the cloud is not universally translating to higher earnings, dividends and share prices. This is a provider of data center solutions, and it counts many of the largest technology leaders among its clients.

Digital Realty Trust reported funds from operation (FFO) per share, a REIT earnings per share equivalent, of $1.10 in the third quarter of 2013. This is down from an FFO report of $1.13 per share in the third quarter of 2012. The drop reflects a $10 million, or $0.07 per share, non-cash straight-line rent expense adjustment. The core FFO would have been $1.16 per share, versus $1.13 a year ago.

Where this gets a bit murky is that the cloud’s landlord also has a $500 million share repurchase plan. REITs typically are not aggressive when it comes to stock buyback plans. REITs have to pay out at least 90% of their taxable income in the form of shareholder dividends each year, which means that REITs generally may not retain their earnings. In short, stock buybacks in REITs might not be the biggest welcoming sign to shareholders, even if they are well thought of in most corporations.

Digital Realty also said that it signed leases during the third quarter that are expected to generate $47.3 million in annualized rental revenue. That is apparently the third highest quarterly gain in its history.

Where the story goes awry is that Digital Realty has lowered its FFO guidance. The new range for 2013 is $4.60 to $4.62 per share, versus a prior range of $4.73 to $4.82 per share. The core FFO for 2013 has been revised to $4.65 to $4.67 per share from a prior range of $4.74 to $4.83 per share. The adjustment in FFO was for a property in New York and dates back to 2010, and the lease has been extended out to 2024. Thomson Reuters had a consensus estimate of $4.79 per share.

Michael F. Foust, CEO of Digital Realty, took a negative tone here. He said in the summary:

We are disappointed with the third quarter financial results, but the robust leasing velocity gives us confidence in the underlying health of the business as well as customer demand for Digital Realty’s data center solutions. While lease commencements have lagged our initial expectations, the solid backlog of leases signed-but-not-yet-commenced represents contractual obligations for future rental revenue, and sets the stage for healthy growth in cash flows over the intermediate term.

Digital Realty had $4.8 billion of total debt outstanding as of September 30, 2013, comprised of $4.1 billion of unsecured debt and $0.7 billion of secured debt.

Guidance for 2014 also came in lower than many of the cloud’s bulls were expecting here. Digital Realty said 2014 rental rates on renewals are expected to be roughly flat on a cash basis and modestly positive on a GAAP basis. Its operating margin is now expected to be approximately 25 to 75 basis points lower than the historical run-rate. Financing charges are expected to be higher in 2014 as well. The company is targeting mid-single-digit growth in FFO per share.

What investors need to know is that the prior growth expectation by Wall Street analysts was closer to 9% in 2014. With a lower 2013 base and a lower growth rate in the mid-single-digits, that implies that lower dividends are possible.

This is very unwelcoming news for REIT investors, particularly those who thought dividends would be on the rise in 2014. Shares were down 15% at $49.50 and there were almost 4 million shares traded in the first hour Wednesday, versus an average full day’s volume of only about 1.5 million shares.

The consensus analyst price target was up at $66.61 prior to the report. You can bet that this figure will be ratcheted down handily after this unexpected news. Raymond James has made very cautious comments, after having been a long-time bull of Digital Realty, and the firm slashed the Strong Buy rating down to Market Perform.

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