Lets talk about – DLR

Dear Readers,

In investing, as with most things in life, we all have our winning moments and we also have our not-so-glorious moments. And while there is a strong human tendency to keep make bombastic remarks about our winning moments, there is usually very little commentary around our mistakes. Why so? Well, why would anyone want to admit that they were wrong. There is, of course, the optics of the situation. It is hard to look smart while talking about your mistakes. On the contrary, you appear to be a genius when talking about your winners. For content creators, there is also the risk of losing your subscriber-ship or viewership or followers etc.

I want to take a different stance. Investing is hard. Individual stock picking is even harder. And as an investor, you are bound to make mistakes. This is a fact and there is no way to circumvent this. And we need to learn from our mistakes in order to become better at investing. This adage is true about most things in life. And the only way to learn is to be open and frank about where you think you might have gone wrong with your decision making process. Refine your strategy and ensure you never repeat this mistake again.

So with background out of the way, let me talk about one of my biggest investing flops. Lets talk about Digital Realty Trust (ticker: DLR)

What is DLR?

Since I have not yet covered DLR in a deep-dive post on this blog, it is only fair that I spend a few sentences explaining what is this business all about. DLR is a leading provider of data center and interconnection solutions for customers. Its primary focus lies in owning, acquiring, developing and operating data centers. Per their latest 10-K report, as of Dec 2022, they own a total of 316 data centers around the world, of which 132 are in the USA, 114 in the Europe and the rest scattered across Asia, Africa and Australia.

The company boasts of attracting a high-quality and diversified mix of customers (over 4000) which includes names such as IBM, JPMorgan Chase, AT&T, Verizon, Oracle, Meta etc.

The data-center narrative

If you consider any major technological advancement in the last 5-10 years, or in the upcoming 5-10 years, it would be hard to disassociate this from some form of technology in data processing. This includes areas such as internet traffic, artificial intelligence, communication networks etc. the amount of data generated in each of these areas is vast. And enterprises that have an expertise in data management are considered to be the technological power-houses of today and are in an enviable position for the next decade.

Research indicates that cloud computing market is expected to grow at an astonishing CAGR of nearly 15.8% over the next 6-7 years. It is hard to argue against these numbers given the evidence today.

DLR, and DLR like businesses, have benefited from this narrative. If you are investor and you strongly believe in this narrative, you can play this in the real-estate sector through investing in REITs such as DLR and Equinix, two of the largest players in this industry.

The rationale is pretty straightforward. It is incredibly hard for a new player entering this market to steal market share away from the big-boys. Owning and maintaining such data centers is an expensive proposition so it becomes very hard for new players to compete.

The data-center business landscape

Lets first take a step back and explore the landscape of the data-center business. If you study the large software enterprise companies, there are three primary ways in which they can manage their data:

• Manage your data in-house: Yes, software companies can choose to store and manage their data in-house on their own servers. This is the best-case scenario because such companies have full control over their data. There are no concerns regarding security, as the IT team that manages these servers, the servers themselves and everything else related to the data management are fully controlled by the company in question.
• Relying on co-located data centers: The in-house solution, while great, is not a scalable solution. Obviously, once the data set grows to a large enough size, maintaining them on in-house servers becomes problematic. Then, the cost associated with maintaining these servers i.e. physical real-estate, cooling solutions, backups, recovery time, server maintenance etc. is a huge headache. Enter the co-located data centers i.e. players like DLR and Equinix. This option allows the enterprise firms to use the servers at a server farm maintained by the co-located data centers. The legacy data centers, in turn, collect a rent and are responsible for providing the high-bandwidth network connections, performing routine maintenance etc.
• Hyperscalars or Cloud-solution providers: The third approach, and the one that is seeing massive growth especially in the last few years, are cloud-solution providers like Google (Google Cloud), Microsoft (Azure), Amazon (AWS) etc. This allows enterprises to host their data on the servers owned by these cloud-providers in exchange for a “rent”.

Per the recent trends, while the co-located data centers generated peak revenues around the 2016-2017 time frame, returns on invested capital since then have been very poor. On the contrary, the returns from hyperscalars such as AWS, Azure etc. have been extremely impressive. It is therefore clear that hyperscalars are gradually stealing market share from the co-located data centers.

There is an interesting dynamic here: While the cost associated with spinning up a new cloud-based data center is orders of magnitude cheaper than a brick-and-mortar co-located data center, there are situations where the hyperscalars would choose to use a physical data-center provided by a legacy data-center company because of the cost associated with ramping a new cloud data center vs the returns generated at a particular location, makes it more favorable to go with the physical co-located data center at that location.

This makes the hyperscalars some of the largest tenants of the co-located data centers. But when it comes to pricing power, it appears that the pricing power favors the hyperscalars, NOT the co-located data centers!

The bear case

Obviously, there is more to this story than meets the eye. And I was lucky to actually have a fellow member of the dividend community, and someone whom I respect immensely, @EuropeanDGI point this out. It all started with a comment from him on one of my posts here on this blog, where he asked me what I thought about DLR’s inability to grow their FFO/share over the last few years. He was right in asking a very pertinent question.

It got me thinking and revisiting my investment thesis in this company. I decided to look at the period between 2018-2022.

Indeed, if you look at the FFO growth for DLR, it has basically gone nowhere in the last few years, growing at a laughably slow rate.

Another useful metric to look at when evaluating REITs is NOI (Net Operating Income). The trends here are also not encouraging.

From a dividend safety point of view, I always want to consider the generated free-cash-flow from a business. All else being equal, this is a definitive indicator of the quality of a business. FCF/share has also gone nowhere during this period.

While a dividend investor can rely on the EPS payout ratio for a traditional business, REITs are a little different. REITs are expected to pay a large portion of their earnings out as distributions to their shareholders to (a) not be taxed on these earnings, and (b) be qualified as a REIT in the first place. So the EPS payout ratio is a little misleading on that front. That said, there are no such gotchas with the FCF payout ratio. As one would expect, the FCF based payout has been trending upwards and well above the range for where the dividend can be considered as safe.

If this was not concerning enough, I also read in the news that Jim Chanos has a short stake in the legacy data center business. Chanos is of course legendary for having first raised concerns about Enron before it collapsed completely. Most of what he saying seems to match up with my own research. But he also raised concerns about the CapEx being reported by DLR which I found very interesting. Per Jim, DLR is deliberately understating their maintenance CapEx in order to paint a false picture of economic profitability. I wanted to dig into this claim further, so I looked into the numbers.

Indeed, CapEx during this period has grown by an astonishing amount, but what is interesting is that DLR is claiming that over 80% of this CapEx is being directed towards “Developmental Projects”. Interestingly, only ~10% of this CapEx is directed towards maintenance of the existing data center farms. In my conversations with peers from the industry, maintenance for these data centers is a very capital intensive proposition. This involves expenses such as running the air-conditioners, the physical location i.e. geography of the data center itself and external climatic conditions etc. I find it hard to believe that DLR while growing the number of data center locations around the world, has managed to keep their maintenance CapEx nearly constant during this duration. Something just does not seem to add up here.

Indeed with revenue generation being as slow as it is, and DLR burning an astonishing amount of ~$2.5B in capital expenditure, this business is burning way more cash than what is being brought in. Given this run rate per data center location, with a growth in number of data centers around the world, the business is actually shrinking in size rather than growing. The return on invested capital here is far less than the cost of capital, a recipe for disaster as far as an investment.

To their credit, DLR has been able to secure debt at a lower fixed interest rate, but in an environment where interest rates are rising, and given the capital intensive nature of this business, I was having some serious concerns about the safety of the dividend. A growing dividend seems completely out of question for the next few years.

And so I bailed out…

I submit that it would be hard to imagine companies like DLR and Equinix going obsolete anytime soon. But I got into this business expecting that the secular growth trends in the data center business would propel businesses like DLR. Hence I had this business as one of my “growth like stocks” in the REIT space. What I am learning now is that this is more like a mature slow-growing business that will struggle in rocky times. There are far better quality businesses that I can invest in that fit that description instead of DLR.

I also do not want to invest in businesses which seem to be a direct competition to the likes Amazon, Microsoft and Google in the cloud business. That seems like a money-losing proposition any which way I look at it. If I want to invest in the cloud business, I am better off investing in these big-tech giants rather than the likes of DLR and Equinix.

For these reasons, I sold out of DLR completely. I made a loss on this investment, but I did not want to waste a minute after I realized what a jackass I had been for misunderstanding this business completely.

Lessons learned

• Investing in individual stocks is hard as is. Investing in REITs is even more harder. Frankly, I had a migraine after reading through DLR’s 10-K because it is not a straightforward business to analyze.
• Businesses evolve. DLR had a great run around the 2016-2017 time-frame. But it has been a terrible business to invest in since then. It is important to not be suckered into the narrative around a business, because that is only part of the entire picture. Numbers never lie.
• DLR continues to be touted as a “great” dividend growth stock on #fintwit/#divtwit. However, I have yet to come across a cohesive and coherent bull thesis for DLR that can refute the findings of my own research or that of Jim Chanos.
• Don’t get defensive when someone raises a pertinent question about your investment decision. In fact, welcome such questions, because they will force you to go back and deeply introspect and think about your investment. You will either come out with a stronger thesis OR change your mind completely and avert a potential disaster.

Summary

Investing is no different than life. You win some and you lose some. This was one in the latter category. And just like I love to discuss my winners, I should also discuss my losers because both are a part of my journey as an investor.

Cheers,

LWD

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Lets talk about : 3M

In my last post, I mentioned that I was closely looking at my position in 3M especially in light of all the negative news surrounding the company. I had a similar post last month about another company, Intel, whose stock has been slaughtered after a disastrous earnings report. In fact, I am planning to make both these articles part of a series called “Lets talk about”, with the general theme being discussions around what is going wrong with the companies being discussed and how that impacts my outlook for them.

While I would always like to own companies that would be high-flying winners with no negative news, this is simply not practical. In fact, the bigger the company, the greater the risks as they always seem to have a target on their back for one or the other reasons.

3M at a glance

I have not had an opportunity to do a deep dive post on 3M on this blog as yet. But this is a well-known company to the general public and one of the darlings of the dividend investing community. The origins of the company can be traced back to five businessmen who started this company as a mining venture to mine corundum in Minnesota back in 1902 (hence the name Minnesota Mining and Manufacturing Company, and hence 3M). Since then, the company has grown leaps and bounds and expanded into so many fields that it is impossible to keep track of the progress. Per 3M’s website, they have a portfolio that is more than 60,000 products and acquire more than 3000 new patents annually on an average!

As far as dividends, the company has been paying a dividend since the last 100 years, of which they have managed to increase their quarterly dividend for 64 years!! No wonder this dividend king is a darling of the investing community!

I remember reading a quote somewhere (could not trace the source for this) that stated that you are never more than 10 minutes away from a product manufactured by 3M. It would be hard for me to dispute this given their vast portfolio.

My first introduction to 3M was oddly through a floppy disk. There is a good chance some of you may be wondering what does a floppy disk mean? Looking at this image here:

Remember these? Yes! this were not “3D printed Save Icons”, these were actually a thing! Back in the mid 90s, some of the kids from my generation used to use floppy drives to save files and carry computer data. Yes, the capacity was just 1.44MB. If you are laughing, I don’t blame you. Computers and storage media have come a LONG way since then.

Recent trends

Unfortunately, since about 2019, 3M has been struggling to record meaningful growth. The pandemic kind of threw a spanner in the wheels as Industrials as a sector has been struggling since then. Supply chain issues have not helped them as well. This is further evidenced in the dividend increases for the last two years, which have been lousy 1c increases, much to the disappointment of several dividend investors who have invested in this company.

In my case, although I was disappointed with the dividend increases, I had faith in this company and my investment. As far as fundamentals, the company, even during these times, was generating enough free cash flow. Here is the FCF/share for the last 5 years:

Year	2017	2018	2019	2020	2021
FCF/share	$8.15	$8.26	$9.31	$11.45	$10.11
Dividend/share	$4.70	$5.44	$5.76	$5.88	$5.92
FCF dividend payout %	57%	65%	61%	51%	58%

As one can observe, aside from 2021, 3M managed to increase its FCF/share and the dividend payout w.r.t FCF was also hovering around the 50-60% mark. This ensures that the dividend is safe and that management could slow down increases in what is a very difficult economic environment.

Also, if one were to look at the company’s R&D expenses for the last few years:

Year	2017	2018	2019	2020	2021
R&D expenses (in mill)	1870	1821	1911	1878	1994
% of net sales	5.9	5.6	5.9	5.8	5.6

Here again, the company was spending a fairly significant portion of their revenue towards R&D. This is a pretty important consideration to retain competitive advantage.

While all of this was good, I wanted to see something more from the management as far as company direction in what they were anticipating to be turbulent times. While they were silent for most of 2021, to their credit, they announced their decision to spin-off their food safety business towards the tail end of 2021.

The “Sh*t hitting the fan” moments

As 3M were navigating these uncertain waters, they are now also facing legal trouble from two different lawsuits:

1. 3M’s PFAS chemical production allegedly leading to ground water contamination: While there have been cases related to these in the US, these have now also been reported in parts of Belgium.
2. Allegedly defective ear plugs produced by Aearo Technologies, a 3M subsidiary.

The second litigation has received a lot of coverage in the news since it involves nearly 230,000 separate cases from affected army veterans. 3M, in response, has since decided to also spin-off its health care business, while also placing Aearo Technologies under bankruptcy per Chapter 11. This is eerily similar to a strategy J&J used to deal with their talc powder lawsuits. Unfortunately for 3M, the bankruptcy judge has struck down the case and refused to temporarily halt the ear-plug lawsuits. 3M and Aearo have since claimed that they will appeal this decision.

So what does all this mean?

Well, there is a lot to unpack here. Firstly, if the earplug litigation goes through, 3M is believed to be facing up to $100 bill in damages. And this is just with the defective earplugs lawsuit. I am still not sure what the PFAS related lawsuits would result in, in terms of damages.

At the time of writing this, 3M has a market cap of $68 bill.

I do not foresee 3M being able to raise their dividends by any meaningful margin. Add to this, the economic environment that we are in and the possibility of a recession, this is not looking good at all!

Lessons

Phew!! Well this is looking horrible for 3M. But I wanted to take a step back and see what this means to me and my portfolio:

• 3M is listed as one of my Core positions with a target allocation of 4%. While the stock has tanked, I am not selling at this time. I am instead choosing to hold and watch this situation to see how it evolves. I will also need to go ahead and downgrade this to one of the lower tiers during these times. I will not be buying at this time as I see better opportunities elsewhere.
• I have written previously about the importance of diversification and this situation reemphasizes that notion. If I had a concentrated portfolio with 3 stocks like Warren Buffett and/or Charlie Munger recommend, with one of them being 3M, that would be a disastrous situation. No matter how well I know the company, I simply could NOT have seen these lawsuits coming.
• These are testing times for both me and the businesses I own. It is easy to own stocks when life is all song-and-dance and the stock price can only go upwards. The real test of patience as an investor is when the businesses you own are navigating troubled waters.

3M has been an iconic company, one that has rewarded its shareholders for several decades. Its consumer products have been used the world over. I genuinely hope this is nowhere near the end of the road for this great company. We shall see how this situation evolves in the months ahead.

Lets talk about : Intel

Dear Readers,

I have been taking my own sweet time to process the quarterly earnings of a few companies that I wanted to give some more close attention. Typically, I only try and focus on annual earnings reports and go back several years to try and look for interesting trends. However, if there are some companies that are in the news a lot for all the wrong reasons, I decide to study the quarterly earnings as well to try and detect a trend as early as possible.

Intel (ticker: INTC) is one of the companies whose stock tanked after its recent quarterly earnings report. As an engineer who works in the semiconductor industry, I would like to believe that I have an advantage in understanding companies like Intel. With the previous management at INTC headed by Bob Swann, I could detect BS in the earnings calls and/or interviews. I could also see a management team that was just sitting on their backsides and doing nothing of significance and losing market share in the process at an alarming pace.

With Pat Gelsinger, a former engineer who learned his trade at Intel, coming in as CEO about an year ago, I was (and still am) hopeful that things would change. Obviously, with INTC so far behind the 8-ball, this turn-around is not going to be an easy task. And so that was it, I was happy to own a beaten-down company that was turn-around play.

So with all that background out of the way, let us get into the earnings report. You know that you are not going to like reading the report when it begins with the following statement from the CEO.

“This quarter’s results were below the standards we have set for the company and our shareholders. We must and will do better. The sudden and rapid decline in economic activity was the largest driver, but the shortfall also reflects our own execution issues.”

Ouch! I was thinking to myself “Gosh, just how bad is it going to be?”. I scroll down towards the financial statements and the numbers said it all. The Client Computing Group (essentially the processors used in the PCs) business segment’s revenue was down nearly 25%. The Data Center and AI group’s revenue was down nearly 16%. The operating income for both segments were down by 73% and 90% respectively. Furthermore, they went on to slash their full year guidance with a nearly 9-13% reduction in revenue (around $65-68B) and a 9.1% YoY decrease.

I wanted to probe each of these points a little further and so some digging around in the earnings report and the earnings call which led me to the following conclusions.

PC business

The slowdown in the PC business was attributed to OEMs reducing their inventory, per Pat, “at a rate not seen in the last decade”. I wanted to test this assumption a little bit, and so I dug around the earnings reports for AMD and Microsoft. Each of them, in one form or another, attributed to similar slowdown in OEM revenues. Some of these were due to COVID related shutdowns in China and some were due to an overall deteriorating demand during the month of June. None of this is particularly surprising. With inflation rates being sky-high, lot of consumers will be focused around cost cutting and reduced spending wherever possible.

Data Center business

The part that surprised me quite a lot was the Data Center business and the associated shortfall. One of the analysts probed Pat on the same question during the earnings call and Pat’s response was rather interesting:

The DCAI point, as I said in my formal comments, we were disappointed. Some of that was driven by the macro; it was also match set issues that we’ve been struggling with as well. And Ethernet components, power supply components, et cetera have been challenged. But as we also said, we had some of our own unique execution issues and we kept the quality bar high on Sapphire Rapids and thus we did another stepping, which was a forecast, which put some inventory and reserve issues in front of us as opposed to high ASP new product revenue.

Pat noted that NVIDIA had selected Sapphire Rapids to pair with NVIDIA’s Hopper GPU chips in their new DGX-H100 enterprise AI architecture.

So what does all this mean?

With a disastrous earnings report and the negative news all around this company, I thought it was important to step back and put things into perspective:

1. My reasons for adding Intel to my portfolio still remain intact. I knew going in that this is a turn-around play and this turn-around is going to take a few years to play out. This intermediate period is going to be rough. What I am seeing is a manifestation of the same thesis.
2. I have factored in the risks of this bet going “south”, and there is a good chance that this might not turn out the way I imagine. But the opportunity cost is significant and I am willing to take the risk.
3. I cannot stress the importance of quality management. A decent company in the hands of incompetent management can push the company back several years. Unfortunately with Intel, this is exactly what happened under the previous leadership group under Bob Swann. Undoing all this and getting this ship back on track is not going to be a trivial task.
4. My general sense speaking to a few friends who work at Intel currently is that the overall mood with Pat Gelsginer at the helm is positive and there is a lot of confidence in the current senior management. Unfortunately though, Intel is a dinosaur of a company and things move rather slowly. Obviously, this culture needs to change and this change will not happen overnight.
5. As a person and an engineer, I like Pat. He is a good guy and he means well. I actually appreciate him coming straight to the point and acknowledging that his company has their own internal execution issues. This is far better than some other CEOs who beat around the bush and BS around. However, as an investor, ultimately I will need to see past all the smooth-talking and look at the results on the ground. I am sure Pat understands this and is attempting to correct this. Perhaps, he should take a leaf out of his own suggestion to the Congress and relay some of that dynamism to his engineering staff.

For what it is worth, I think the overall strategy of investing the $60-70 bill towards fabs is the right approach. And while this will increase capital expenditure over the next few years, it should place Intel in a good position over the long-term. I also believe that PCs are not going to go anywhere. In-fact, Satya Nadella had something very interesting to say regarding PCs in Microsoft’s last quarterly earnings:

We’ve seen a structural shift in PC demand… More than ever, people are turning to PCs to exercise their agency and unleash their creativity, whether it’s meeting in virtual reality or for remote work, writing code or collaborating in documents, livestreaming video or playing games, or for graphic design and engineering design…As new use cases are born every day, and existing ones see a resurgence, we’re experiencing a PC renaissance, with increases in time spent on PCs, and PCs per household.

Indeed as an engineer, I cannot imagine not using my PC for my development/work activities. Intel is going to be a huge beneficiary if we are to believe this trend.

There was a statement in the earnings release from the Intel CFO that read as follows:

We remain fully committed to our business strategy, the long-term financial model communicated at our investor meeting and a strong and growing dividend.

While this might be a cursory statement that management is required to make to assure shareholders, I would honestly hope that Intel does NOT focus on increasing the dividend over the next few quarters and instead focus on carefully spending their cash and be very cautious. While this might sound counter-intuitive, I think this would be beneficial for both the company and the long-term shareholders in the long run.

I will continue to watch this company and hope that things turn out well over the next few quarters.