November 21, 2022

To buyback or not to buyback?

What’s New 

• A resounding yes for proposed acquisition and potential fundraising when share price recovers 

• Upsized debt-funded acquisition or share buyback to generate further DPU accretion 

• Share buyback to potentially generate up to 2.0% and 3.4% in DPU and NAV accretion 

• Maintain BUY with TP of US$0.90

Investment Thesis 

Maintain BUY with TP of US$0.90. We previously revised our projections for Digital Core REIT (DCREIT) to account for higher borrowing costs, as the REIT has hedged 50% of its outstanding loans. The assumptions baked into our valuations are: (i) US$140m of debt-funded acquisitions by the end of FY22 and (ii) all-in financing costs averaging 3.0% in FY22F and 4.0% in FY23F. 

Earnings underpinned by solid fundamentals. A portfolio of fully occupied data centres and a long WALE of c.5 years ensures income stability and visibility. In addition to the booming data centre industry, annual rental escalations of c.2% for its portfolio provide for organic growth in its earnings. 

A pipeline that could make DCREIT one of the largest S-REITs. With a strong commitment from its sponsor, DCREIT has been granted a Right of First Refusal (ROFR) for c.US$15bn worth of data centres globally. In addition, the sponsor has data centre developments worth a further US$5bn that could potentially be made available to DCREIT when completed. Although the cap rate spreads in the US are currently in the negative territory, DCREIT could look at pipelines in Europe and Japan. 

Valuation: Our TP of US$0.90 is based on a DCF valuation with a WACC of 6.2% (risk-free rate of 3.5%). This implies a normalised target yield of 4.2% in the next two years. We have assumed a debt-funded acquisition of US$140m. 

Where we differ: Execution of the US$140m debt-funded acquisition by endFY22F at a yield of c.4.5%. 

Key Risks to Our View: Key upside risks to our view would be slower-than-anticipated rise in interest rates and larger-than-expected acquisition.

What happened? 

At its EGM held on Friday (18th Nov) morning, DCREIT received overwhelming support for the proposed acquisition of a 25% stake in the Frankfurt DC. The resolutions to issue new units has also been approved and we understand that management has committed to only carrying out an EFR if it can be done close to NAV. 

What next? 

At its current trading price of US$0.585 (c.31% discount to NAV), it seems unlikely that DCREIT will be able to carry out an EFR in the near term. However, DCREIT will still have ample debt headroom to upsize its acquisition of the Frankfurt DC. Based on the proposed debt-funded acquisition of a 25% stake in the Frankfurt DC, DCREIT’s gearing will go up to c.33.5%. If DCREIT were to double its acquisition stake of the Frankfurt DC (upsize its take to 50%), its gearing would only go up to c.39.5%, still within Management’s long-term gearing target of less than 40%. This could potentially double the DPU accretion from c.2.0% to c.4.0%.

Our thoughts 

The ability to carry out a share buyback to generate DPU and NAV accretion provides DCREIT with an alternative option to create value for unitholders. Moreover, the current environment makes it challenging and provides limited options for DCREIT to embark on further accretive acquisitions. With ample debt headroom, a share buyback will be immediately accretive for unitholders and beyond the financial metrics, it also signifies the Manager’s commitment to its unitholders and belief that its shares should be trading at a higher price. However, if DCREIT has the option to upsize its stake in the Frankfurt DC (up to a 50% stake), we would much rather they utilise their debt headroom for the acquisition. Over the longer term, given the continued structural growth of the data centres sector, a larger acquisition will be more beneficial for the REIT and for their earnings. Although DCREIT could embark on a smaller value in share buybacks (less than 2% of outstanding units), it may not be feasible as the accretion could potentially be too marginal. We will be maintaining our BUY recommendation with a TP of US$0.90.

Company Background

DCREIT is a real estate investment trust that primarily invests in stabilised income-producing data centres as well as assets necessary to support the digital economy globally. Its portfolio currently comprises of 12 properties located in major data centre markets throughout the US and Canada.

BUY by DBS Group Research.  Share price closed at US$0.58