An Under-The-Radar Deal Income Investors Should Love

When the going gets tough, the tough go shopping.

I recall seeing that on a bumper sticker somewhere. But it could certainly apply to corporate America right now, too. Many businesses are choosing to grow profits the old-fashioned way: by buying them.

According to Dealogic, there were 4,545 merger & acquisition (M&A) transactions in the first half of 2019, totaling $1.17 trillion. That's a 20% increase from the same point last year – and the most active first half on record.

Barely a week has gone by without some type of wheeling and dealing. To date, there have been 22 mega-deals ($10+ billion) announced, accounting for more than $700 billion in dollar value. That’s about one every twelve days on average.

Several of my Daily Paycheck holdings have been involved in these colossal deals. And I suspect M&A activity will remain at elevated levels next year. While rising stock market valuations have given some executives pause, funding is still cheap and widely available. Plus, businesses across every industry are aggressively courting partners that will help move the earnings needle or provide a strategic advantage.

Small Deals (Like This One) Can Mean Big Gains

For every high-profile mega-deal that captures headlines, there are dozens that go almost unreported. While these smaller transactions might not involve eleven zeros, they can still be powerful upside catalysts for the parties involved.

Some of these mergers are meant to reach new customers and penetrate untapped markets. Others bolster research and development capabilities and deepen the product development pipeline. And, of course, most will also yield cost-saving synergies as overlapping functions are eliminated or consolidated.

They won't all pan out. The market is riddled with examples of ill-fated mergers that ended up squandering capital. They usually result in a hefty goodwill write-down on the balance sheet.

All the more reason to invest in companies with trustworthy management – like Digital Realty (NYSE: DLR), which just recently unveiled plans to acquire Interxion (Nasdaq: INXN). If it goes through, the deal would create the world's largest provider of specialized data center space.

According to terms, Interxion stockholders will receive 0.70 shares of DLR for every share of INXN (or 70 for every 100). That values INXN at around $94 per share – or $8.4 billion including the assumption of debt.

Based in Amsterdam, Interxion's footprint extends through most of Europe's largest metro areas, including London, Frankfurt, Vienna, and Paris. The company operates 53 facilities in 11 countries from Austria to Denmark. This covers markets that represent nearly three-fourths of Europe’s GDP. Digital Realty operates mainly in North and South America as well as Asia. It only has a modest presence in Europe. So in terms of geography and customer base, Interxion is complementary. Citing the "ongoing migration toward cloud and digital content platforms," it produced a healthy 26% increase in EBITDA last quarter.

There's more where that came from. Interxion is in the middle of a $1 billion expansion wave that will boost its capacity by 40%. These development projects will be completed within the next 24 months, and the company has already begun pre-leasing space to tenants.

Digital Realty is inheriting a sizeable debt load ($1.5 billion) from Interxion. But it intends to refinance most of it by using its investment-grade credit rating. In the meantime, the company topped expectations with funds from operations (FFO) of $1.59 per share last quarter. And it signed new and renewal leases that will produce $220 million in annualized rental revenue.

While this deal has some clear benefits, it's difficult to weigh the full merits because the financial details weren't fully disclosed. There was no estimate given for potential cost-savings synergies. Only a general statement that the merger would lead to a more efficient structure and industry-leading margins.

Management did say that the deal would be "accretive to the long-term growth trajectory." I would hope so – you don't invest $8+ billion otherwise. The precise wording here indicates that it will take time for benefits to materialize, meaning the deal may be a drag on per-share earnings in the near-term.

It's worth noting that INXN has actually drifted lower since the announcement. In fact, the stock is trading in the low-$80s, well below the offering price of $94. That reflects some skepticism that this merger will be consummated. Many analysts believe INXN is worth more than $100 per share. Some of its larger institutional stockholders have balked at the price. They may be reluctant to sign off on the deal and tender their shares.

Action to Take

While some INXN investors may grumble at the modest premium, this deal is still likely to gain shareholder and regulatory approval and close sometime next year. It may take a couple of years to break even (which is why some short-sighted DLR investors are exiting). But this transaction looks to be a powerful upside catalyst over time.

Digital Realty has enjoyed a strong 13% compounded annual growth rate (CAGR) in FFO since 2005, leading to 14 straight years of dividend hikes. But growth rates have stalled in the saturated U.S. data center market. Most of the new construction (and fiercest demand) is taking place in Europe. Interxion has the inside track and has cultivated relationships with more than 2,000 customers. Digital Realty has both the capital and experience to get the most out of these prized assets.

Merger-related uncertainty could weigh on DLR shares over the next six months. But with a solid 3.6% yield, this is an attractive entry point for patient, long-term investors.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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