It seems like every company in the world is talking about how it can use artificial intelligence to improve its operations.
In a recent survey by MIT Technology Review, every enterprise that responded said it would increase its spending on artificial intelligence infrastructure over the next year. Businesses can't afford not to look at the ways AI could help them improve their results -- to do otherwise would put them at risk of being left behind.
A few businesses are particularly well positioned to benefit from the forthcoming growth in AI spending. Among them, one of the best options for investors is Digital Realty (DLR 2.17%). The real estate investment trust specializes in data centers. And management says it's just starting to see the impact of growing AI spending.
Even with data centers, real estate is all about location, location, location
Digital Realty owns a portfolio of properties located in more than 50 metro areas across six continents. Its global footprint is unmatched in its niche, and it gives the company a meaningful competitive advantage.
A big focus in artificial intelligence is on training large language models. Those tasks are very time- and energy-intensive, and it takes a significant amount of space to house the hardware necessary to provide the computing power they require. As such, it can be done way out in the middle of nowhere. So, in that regard, Digital Realty doesn't have much advantage.
But business and investing is about skating to where the puck will be. And businesses know they'll need to be in Digital Realty's data centers in the future.
NYSE: DLR
Key Data Points
"The public consumption-consumer consumption is well outweighing the enterprise [consumption of AI]. That's going to change," CEO Andy Power said on Digital Realty's third-quarter earnings call. That's going to make the location of data centers running AI applications increasingly important. Enterprises want low-latency connections to their servers to help drive decision-making in real-time. Otherwise, the use cases for AI can be much more limited.
Chief Revenue Officer Colin McLean noted, "We also feel pretty strongly that core market orientation -- i.e., proximity to eyeballs and GDP -- is still going to remain a core requirement for much of this AI workload." That's where Digital Realty's 300-plus locations play an important role.
Building the on-ramps to the public cloud
Not every business is a multinational enterprise that needs space in data centers all over the world. For smaller businesses looking to use public clouds like Amazon's Amazon Web Services, Digital Realty is becoming more appealing.
It's increasingly focused on serving customers that require less than 1 megawatt of power. Last quarter, 28% of its total bookings came from such customers. Importantly, those customers' contracts generally produce higher margins than its deals with big wholesale customers.
Moreover, it's working on building entry points to public cloud services like AWS to allow businesses to connect to public cloud service providers without using the public internet. That increases privacy and security.
Cloud providers put on-ramps in data centers that have high-density network connections because it makes it convenient for businesses to connect equipment directly to cloud providers. Last quarter, Digital Realty added on-ramps for AWS and other large cloud service providers, giving smaller enterprises more reason to use Digital Realty.
Despite its efforts, Digital Realty still trails rival Equinix in its on-ramp portfolio and network density. But growing demand should prove a tailwind for its efforts to expand that part of the business. Meanwhile, its ability to offer wholesale space to lease to businesses like Amazon remains an advantage for attracting more of their spending.
Does Digital Realty belong in your portfolio?
One of the most straightforward ways of valuing real estate investment trusts is based on funds from operation, or FFO. FFO gives investors a better picture of the cash earnings power of a REIT by adjusting for non-cash expenses like depreciation and amortization and removing one-time gains and losses from asset sales. As such, it's a better valuation measure than net income for REITs. So, the price-to-FFO multiple for REITs is similar to a PE ratio for stocks.
Digital Realty is currently trading at 23 times its trailing 12-month adjusted funds from operations (AFFO). That's a slightly better valuation than its biggest rival Equinix, which trades closer to a ratio of 24.5.
Both companies should benefit from the growing demand for computing power and space to run artificial intelligence applications. However, Digital Realty is better positioned, literally, to take advantage of customers' growing needs for a global presence. That should enable it to grow its top line more consistently. Meanwhile, the growing share of its business coming from smaller enterprises should allow it to produce better operating margins over time.
Digital Realty's dividend yield is also better today than Equinix's. At the current share price, it yields 3.6%, and management should consistently boost the payout as the REIT produces better AFFO every year by raising rents and expanding its footprint.
As such, investors interested in capitalizing on the growing AI spending from just about every company in the world should consider adding Digital Realty to their portfolios.
