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Earnings Will Tell if Digital Realty Shorts Were Right

NEW YORK (TheStreet) -- Digital Realty (DLR) will report second-quarter results this week, and the report should either prove or disprove the short positions generated since the first quarter.

On May 8, Highfields Capital made a case that the $13.6 billion (total cap) data center real estate investment trust was worth about two-thirds less than the market price at that time.

Digital's shares slid from around $69 on May 7 to a low of $56.28 on June 20 -- a 23% drop. Highfields was not the only deterrent for Digital; Federal Reserve Chairman Ben Bernanke was also a hindrance for all REITs, especially the blue-chip companies with strong dividends.

Like most REITs, Digital has recouped some of its losses, about 14%, as shares closed Friday at $64.40.

Highfields argued that the data sector is not sustainable and that the demand for cloud computing space will shrink over time. Highfields maintained that competition is increasing, and large tech companies such as Google (GOOG) and Amazon (AMZN) are beginning to offer cloud services that will compete with Digital's data-center business.

Competition in the cloud storage sector has increased. Digital had enjoyed first-mover status, had the field essentially to itself for the first couple of years, and had generated tremendous returns. Those outsized returns have attracted competition. The question is whether there's enough demand to support several data-center providers.

While I can't tell you whether Digital Realty will be a blue-chip REIT in 10 years, I can show you why Digital Realty is a blue-chip REIT today.

The FAST Graph below illustrates Digital's strong dividend fundamentals including a 6.8% dividend increase in 2013. As illustrated with the aqua blue shaded area below, Digital has increased its annual dividend for nine years in a row, raising its dividend by an average of 15.3% from 2005-2013.

With a healthy adjusted funds from operations payout ratio of 84.1%, Digital has become a dream for many SWAN (sleep well at night) investors.

Source: FAST Graphs

Digital also has an attractive P/FFO (price to funds from operations) valuation of 12.2x, and I consider the fundamentals to be sound. Driven by growing world-wide demand and high-quality tenants, Digital is a leader in data centers.

Digital's first-mover advantage has allowed it to build a commanding barrier-to-entry model in which its scale provides access to capital and expertise in the global cloud supply chain.

The dividend yield is 4.84%, and the shares are still trading 23% below their 52-week high of $79.31 on July 30, 2012.

If Digital meets or exceeds its earnings projections, I expect the market will give it more credit than it's getting now.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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