Digital Realty Trust Inc (DLR) — Q2 2019 Earnings Call Transcript

Thank you, Andrea. The speakers on today's call are CEO, Bill Stein; CFO, Andy Power; Chief Investment Officer, Greg Wright; and Chief Technology Officer, Chris Sharp, who are also on the call and will be available for Q&A. Management may make forward-looking statements, including guidance and the underlying assumptions. Forward-looking statements are based on expectations that involve risks and uncertainties that could cause actual results to differ materially. For a further discussion of risks related to our business, see our 10-K and subsequent filings with the SEC. This call will contain non-GAAP financial information. Reconciliations to net income are included in the supplemental package furnished to the SEC and available on our website. Before I turn the call over to our CEO, Bill Stein, I'd like to highlight the key points of our second quarter results. First and foremost, consistent execution against our customer success initiatives drove all-time high new logos, our second highest interconnection and renewal leasing and our third highest total bookings. Second, we leveraged our global platform to prudently allocate capital, allowing us to achieve the most attractive risk-adjusted returns around the world, creating significant value for shareholders. Third, we extended our sustainability leadership with the publication of our inaugural ESG report and official recognition as an ENERGY STAR partner. Last but not least, we capitalized on favorable market conditions to execute a $900 million liability management trade, clearing our runway out to 2022 and extending our weighted average duration by nearly half a year while reducing our weighted average coupon by 10 basis points. And now, I'd like to turn the call over to Bill.

Thank you, John. Good afternoon and thank you all for joining us. The durability of Digital Realty's global platform was on full display in the second quarter of 2019. Our team was incredibly productive over the past 90 days. We delivered the third highest bookings in the Company's history. Demonstrating the strength of our globally diversified portfolio, we also signed the second highest volume of interconnection bookings as well as renewal leasing, and we expanded our colocation offering into the Asia-Pacific region with a multi-market new transaction and customer expansion. We landed an all-time high number of new logos this quarter, an encouraging indication that our efforts to penetrate enterprise demand are bearing fruit and a promising sign for future interconnection revenue growth prospects. Along those lines, I'm pleased to announce that we will be hosting MarketplaceLIVE at Spring Studios in New York on November 7, a daylong event connecting the community that builds the cloud network and Internet infrastructure. The event attracts a broad swath across the tech ecosystem and we expect over 600 attendees from network engineers and startups to solution architects and cloud service providers to CIOs at Fortune 500 companies. We further extended our global platform during the second quarter and took steps to secure our supply chain with several strategic land acquisitions. We closed on three smaller strategic land parcels in Northern Virginia to further connect our market-leading campus footprint. We also re-entered Paris with new capacity based on significant verified customer demand. Earlier this afternoon, we announced that we are under contract to acquire a parcel in Frankfurt, building on the success of our sales in the second quarter as well as our recent investment in Western Europe. We also closed on a land parcel in Tokyo through our MC Digital Realty Japan partnership and announced our entry into South Korea with plans to develop a carrier-neutral facility in Sangam Digital Media City in northwest Seoul. We announced the grand openings of an expansion in Dublin in May, the second phase of our Osaka connected campus in June, and most recently, we announced that our Latin America platform, Ascenty, opened four fully leased facilities in Sa Paulo during the second quarter. We have a commitment to sustainability and have published our inaugural ESG report and were officially named an ENERGY STAR partner. We continue to invest in our human capital with several key hires and achieved the Amazon Web Services service delivery designation for AWS Direct Connect. Lastly, we further strengthened our balance sheet, locking in our lowest ever 10-year U.S. dollar bond coupon and terming up our 2020 and 2021 maturities. Let's turn to market fundamentals on Page 4. Following record absorption in 2018, the primary data center metros in North America have been relatively quiet in 2019, particularly in Northern Virginia, which is not only the largest data center market in the world, but also the most competitive. Even for prime locations, the supply-demand balance has shifted toward customers with new entrants providing speculative supply while the most voracious consumers remain in digestion mode. We believe we have significant competitive advantages in Northern Virginia, given the scale of our footprint and our established customer base with a strong desire to grow adjacent to their existing deployments and the longest growth runway to support their growth. Ultimately, we believe it's a question of when, not if hyperscale procurement cycles enter their next phase of growth, and the pendulum can swing back quickly. In the meantime, the current supply-demand dynamic may lead to dislocation in the market, which could create investment opportunities for disciplined, well-capitalized competitors. The New York metro area, however, has seen a resurgence in demand, and the market has gradually tightened as excess inventory has slowly been absorbed. In Dallas, despite a number of competitors with available supply, we continue to enjoy success, particularly on our Richardson campus where existing customers consistently expand with us. Recent developments in Chicago have also been encouraging. The state of Illinois recently passed legislation creating data center tax incentives that put Chicago back on par with jurisdictions actively encouraging data center investment. Although we have not signed major new leases in Chicago since the governor signed the bill on June 28, we have seen an uptick in customer interest and are optimistic this bill will spur a rebound in demand. We commend the governor and the Illinois State Legislature for their leadership in adopting this legislation, as well as the Digital Realty Central region portfolio management team who worked extensively alongside business and labor communities to advance this bipartisan legislation. Supply remains scarce in Santa Clara, which is arguably the tightest market in the U.S. and generally commands a pricing premium. During the second quarter, we saw strong demand from cloud and enterprise in Santa Clara. Back across the pond, recent market leadership in Europe has shifted from London to Frankfurt, which has been the standout metro in 2019. Following our success with an enterprise customer on our Frankfurt campus last quarter, we signed a major cloud service provider brand new to our Sausenheim campus with a large and growing deployment. Although requirements in Europe remain smaller than in the U.S. partly due to data sovereignty considerations, they are getting bigger. The Global Connected Campus strategy is uniquely positioned to capitalize on this consumption pattern. You may have seen that Amsterdam recently placed a 12-month moratorium on data center construction. While the potential impact on future projects is unclear, from our perspective, barriers to entry just got higher, and incumbents such as ourselves have a competitive advantage. We are positioned well, given the network density of our interconnection hub at Amsterdam Science Park. We have current permits on projects under construction at our De President campus and visibility to incremental capacity adjacent to, but not subject to the municipalities imposing the moratorium. Across the Asia Pacific region, demand remains robust in our key markets, primarily driven by global cloud service provider requirements. We have seen notable strength in Osaka, where we landed a major Japanese integrated communication service provider as a new logo, validating our Connected Campus strategy for the Kansai region. Similar promising pipeline supports our ongoing campus development projects in Tokyo, Singapore, and Sydney. Market inventory remains mostly in check, and we remain optimistic about our prospects in the region given our first-mover advantage into Osaka, barriers to entry in Tokyo, government involvement in Singapore, and rapidly growing cloud adoption in Sydney. While the IT infrastructure landscape continues to mature, we see significant growth potential for years to come. Lastly, we see a strong pipeline of demand in Latin America, focused across Brazil and now Chile from leading global cloud providers along with new potential customers. We are pleased with our performance in this region and believe we are poised to capture an outsized share of demand characterized by significant upside from growing Internet adoption alongside limited availability of institutional-quality data center capacity. Overall, we believe customers view our global platform and comprehensive space, power, and interconnection offerings as key differentiators in selecting their data center provider. Let's discuss capital allocation on Page 5. The data center sector is maturing as an asset class, and we've seen an uptick in fresh capital targeting the sector, which has naturally compressed returns, particularly in the U.S. This trend has both positive and challenging implications. On one hand, it positively impacts the value of our existing portfolio, while on the other, it makes it harder to achieve external growth through acquisitions. We believe our global platform represents a competitive advantage regarding capital allocation and access to capital, allowing us to allocate capital where we see the most attractive risk-adjusted returns globally while accessing the broadest and lowest cost pools of capital in the countries where we operate. We are also adapting to the growing demand in the data center investment sales market by harvesting capital from mature U.S. assets and redeploying proceeds into higher growth opportunities elsewhere. The current global economic expansion continues, especially in the U.S. where the recovery is now in its 11th year. Nonetheless, both fiscal and monetary policy remains supportive, and the U.S. stands out in terms of global economic growth. Data center demand is not directly correlated to job growth; we are fortunate to operate in a business linked to secular demand drivers growing faster than global GDP and somewhat insulated from economic volatility. McKinsey estimates that digital transformation will add $13 trillion to global GDP by 2030, driving demand for distributed digital infrastructures that we are uniquely positioned to address with our global footprint and interconnected scale. During the second quarter, we saw early indicators of digital transformation demand on our platform, capturing a record number of new logos led by our enterprise vertical, as these customers deploy and connect components of their digital infrastructure globally. Given the resiliency of the demand drivers underpinning our business and the relevance of our portfolio, we believe we are well positioned to continue sustainable growth for customers, shareholders, and employees regardless of the broader macro environment. With that, I'll turn the call over to Andy to take you through our financial results.

Thank you, Bill. Let's begin with our leasing activity here on Page 9. We signed total bookings of $62 million, including $6 million from our Latin America platform, Ascenty, at our pro rata share, and a $9 million contribution from interconnection. We signed new leases for space and power totaling $53 million with a weighted average lease term of a little over five years, including an $8 million colocation contribution. As Bill mentioned, this was our third best total bookings quarter and our second best interconnection quarter. I'd also like to clarify that Ascenty's second quarter bookings are in addition to the leases signed in the first quarter with a leading global cloud provider to anchor our entry into Chile. We also expanded our digital realty colocation offering into the Asia-Pacific region with a multi-market new transaction and customer expansion, as shown in the leasing activity table in our press release. Although this was a relatively small transaction, it hopefully is a harbinger of bigger things to come as we move toward officially launching our first fully productized colocation offering in the region later this year. In general, we are winning a greater share overall as well as larger multi-market and multi-geo colocation deals, reflecting our growing traction within the enterprise segment and these customers' global hybrid cloud use cases. Some of these wins are landing in non-productized colocation data centers. Even though these customers consume remote hand services and interconnection solutions commonly associated within colocation facilities. As product lines blur, we are contemplating changes to our disclosure to provide insights consistent with the way we run the business while maintaining transparent shareholder-friendly communication. During the second quarter, we delivered solid leasing volume, up 24% sequentially, with balanced performance across sectors, products, and geographies. We also saw an acceleration of our channel business with healthy double-digit growth compared to the first half of 2018. We added an all-time high of 57 new logos during the second quarter, driven by strength in our Enterprise segment, which accounted for 40 new logos. This was also a record quarter for new logos sourced through our channel partners. We continue to benefit from our strategic partnerships while securing notable wins, including major technology companies and customers deploying hybrid multi-cloud connected deployments globally through direct and partnership efforts. Second quarter highlights include HCL, an alliance partner, which is one of the largest next-generation technology companies helping enterprises reimagine their businesses. HCL selected Digital Realty to host their Oracle Demantra infrastructure and SAP cloud environments for a top 10 U.S.-based food and beverage company with over $10 billion in revenue and a global distribution network. Digital Realty’s global platform, coupled with HCL's solutions, allows this customer to respond quickly to consumer demands worldwide. We have also facilitated partnerships with IBM and a major global manufacturer relocating their headquarters closer to strategic partners by leveraging IBM Direct Link dedicated hosting to boost their VMware environment capabilities. This partnership facilitated a seamless migration plan for both the customer and Digital Realty. We are seeing traction with our global interconnection platform. Mavenir, the only End-to-End, Cloud-Native Network Software Provider for cloud service providers, is leveraging Digital Realty's service exchange to redefine network economics. Let's now turn to the composition of our customer base on Page 12. Don't forget, the cloud exists in a data center, most likely a Digital Realty data center as evidenced by our extensive customer base. The network segment constitutes over 25% of our customer base, and these connections are essential for cloud migration. Resellers account for 15% of our total revenue, which we view as somewhat unique, especially given our long-term relationships with these customers, as they typically deploy in multiple global markets. Lastly, Enterprise makes up just under 25% of our total mix. Financial services, as our largest vertical, continues to show strong buyer behavior. We also see growing relevance in FinTech as they evolve their architectures to achieve efficient data analytics in hybrid multi-cloud architectures. In terms of second quarter operating performance, overall portfolio occupancy decreased by 80 basis points to 87.8% due to a previously mentioned customer bankruptcy and developments in Frankfurt and Osaka. Same-store cash NOI was down 5%, partly due to a 90 basis point FX headwind and a tough comparison due to a sizable property tax refund collected in the same quarter last year. We face a double whammy on property taxes facing higher assessments in the Central region this quarter alongside the prior refund. We intend to contest these assessments actively, leveraging our track record of successful appeals. The U.S. dollar remains elevated compared to last year’s currency rates, representing roughly a 100 basis point headwind to year-over-year growth. Moving to our economic risk mitigation strategies on Page 16, we manage currency risk by issuing locally-denominated debt to provide a natural hedge. Besides managing foreign currency exposure, we also mitigate interest rate risk by terming out short-term variable-rate debt with longer-term fixed-rate financing. Given our strategy of matching our long-lived assets with long-term fixed-rate debt, a 100 basis point move in LIBOR would have less than a 50 basis point impact on our full-year FFO per share. Our near-term funding and refinancing risk is well managed, with our capital plan fully funded. In terms of earnings growth, core FFO per share decreased by 1.6% year-over-year but was essentially flat on a constant currency basis due to tough comparisons from the prior year’s sizable property tax refund. While we confirm our 2019 core FFO per share guidance when looking ahead, we do recognize a few pushes and pulls in drivers over this quarter. We previously raised the net income range by $0.25 last quarter reflecting non-core activity through the P&L but are bringing the range back down by $0.15 this quarter due to the loss on the early retirement of debt from the refinancing as well as a non-cash charge related to the redemption of Series H preferred stock. These financing charges are added back to core FFO. Moving up the guidance table, we updated our assumptions considering the actual outcomes of the refinancings. Our recurring CapEx guidance has also been raised by $15 million due to capitalized leasing commissions related to several strategic renewal transactions. Lastly, we believe our expectations for cash re-leasing spreads have improved from down high single-digits to down mid-single digits. We recognize the competitive dynamic in select U.S. markets; however, the cash rent roll-down on our 2019 vintage expiration does not appear as pronounced as previously believed. Overall, while pleased with our quarter-on-quarter improvement in bookings, we recognize that most activity is concentrated in facilities still under construction. The eight-month lag between signings and commencements means that recent bookings will not significantly impact the top line for 2019. However, the composition of these recent activities positions us with incremental opportunities to offer move-in ready space in the coming months. Now, let's turn to the balance sheet on Page 18. Net debt to EBITDA stood at 6.1 times by the end of the second quarter while fixed charge coverage remained healthy at 4.2 times. Pro forma, the settlement of the forward equity offering brings net debt to EBITDA in line with our targeted range at 5.5 times, with fixed charge coverage just under 4.5 times. We expect to realize latent cash flow capacity from signed leases, including 24 megawatts delivered by Ascenty coming online in Q3, yet not contributing to our last quarter’s annualized credit stats. Additionally, we aim to utilize capital recycling proceeds to maintain our target leverage profile. In terms of capital markets activities for Q2, we completed the redemption of all 365 million of our 7.375% Series H preferred stock, replacing it with 210 million of permanent capital under our 5.85% Series K Perpetual Preferred. In June, we raised $900 million of 10-year U.S. dollar bonds at 3.6%, achieving the lowest ever coupon on a dollar-denominated 10-year paper. This was an opportunistic liability management exercise and we used the proceeds to tender for our 3.4% notes due 2020 and our 5.25% senior notes due 2021, settling over 80% of outstanding bonds during Q2 and redeeming the remaining ones in mid-July. This execution reflects our best-in-class global platform, providing full access to public and private capital to prudently fund our growth while the recent financings extended our weighted average debt maturity to 6.4 years and lowered our weighted average coupon to 3.3%. Over half of our debt is non-U.S. dollar denominated, acting as a natural FX hedge for our international investments, with 85% of our debt fixed rate to guard against rising interest rates and 99% of our debt being unsecured, providing flexibility for capital recycling. Lastly, our balance sheet is well-positioned to withstand economic shocks and fuel growth opportunities globally, consistent with our long-term financing strategy. This concludes our prepared remarks, and now we would be pleased to take your questions.

I have a couple of operational questions. First, regarding the major U.S. markets, where do you see the leasing or demand pipeline the strongest or quarter-to-date bookings geographically where that has been strongest? Bill mentioned a couple of examples in the script. And then regarding Asia, specifically Korea, how do you view capital deployment in that market given the role it could play in accommodating hyperscale demand? And finally, any updates on the new land parcel in Hattersheim and expectations for how quickly capacity could potentially develop there? Lastly, could you speak to the demand dynamics in the London market?

I'll weave the questions into coherent answers, and I think we're going to probably ping-pong around the team here. To start off with U.S. markets, the second quarter had pockets of strength in some unexpected places. The Northern New Jersey and New York metro market has continued to tighten, with wins across financial services and related verticals this quarter. In Dallas, we continue to expand our Richardson campus, landing both existing and new customers. Santa Clara remains extremely tight, with both enterprise and top cloud service provider wins in Q2. Looking ahead at the second half of the year, the Toronto market is also tight, with a few customers landing and looking to expand in our brand-new asset there. In terms of Chicago, although we have not signed major leases since the bill was signed, there is rising customer interest post-legislation. Now regarding Frankfurt, as mentioned, it has been one of our hottest markets, with strong absorption reflected in our leasing developments. We are rapidly running out of capacity there. The new land parcel is subject to various conditions including power zoning and planning, which will likely take 24 to 30 months for development in that area. Lastly, in London, we are excited about our Cloud House in Docklands and have seen strong opportunities for growth and renewed interest across our other campuses, including Crawley.

Speaking for Frankfurt, the timing here centers around our ability to create the conditions necessary for development. The site is exciting because it's only three miles from the Frankfurt airport. Overall, in London, we’re enthusiastic about our Cloud House's interconnected strategy, the recent developments in Docklands, and strong incremental business growth in Crawley and areas of our London portfolio.

Regarding Korea, we think it will develop similarly to our experiences in Japan. We're still deciding whether to pursue that market independently or with a partner. Our entry into Osaka several years ago created a successful connected campus that has performed well, and we have been expanding in Tokyo similarly. South Korea is the next step in our global strategy.

Earlier this year, I recall comments about the second half adjusting upward concerning bookings, but there has been some mixed commentary across the industry. Please provide an update on your expectations for the second half?

Sure, Michael. Our second quarter performance aligns with the confidence expressed in March—the momentum is clear. With our third highest bookings quarter and record new logos, we expect continued improvement moving forward. We anticipate that international will play a significant role in the back half, alongside North American bookings. We remain confident in the long-term demand drivers, such as big data, mobile, and the Internet of Things, and appreciate our global diversified platform's strength.

As a follow-up, could you walk us through the rationale behind some of the new market entries and expansions you announced today? What insights about the customer relationships guided those decisions?

The new market entries and expansions into Frankfurt and the re-entry into Paris are guided by direct conversations with our customers—this is not a purely speculative move.

You've mentioned Northern Virginia as being oversupplied, and I am curious about any emerging opportunities you see there. Additionally, how confident are you regarding Northern Virginia's market dynamics in the second half, given the comments on supply absorption?

In Northern Virginia, we've seen significant competition. While we acknowledge pricing pressure for new opportunities, our dialogues with clients indicate optimism about future growth. Our focus extends on finding customers who value our unique global platform and can expand within our network—a strategy that allows us to be selective in our deals. Despite a competitive landscape, we believe our installed customer base and existing relationships position us favorably for growth ahead.

Regarding these opportunities, do you foresee the potential for acquisitions of land parcels and does your upcoming leasing capacity align well with your demand expectations?

We are mainly focused on securing land associated with our existing campuses and improving connectivity. While we don't foresee significant acquisitions outside of necessary expansions, we embrace opportunities to find new growth avenues; however, that won't primarily come from new land acquisitions. Clients are looking for collaborative relationships with dependable partners who can support their long-term growth.

Can you weigh in on the supply-demand dynamics in Northern Virginia and how confident you are regarding pricing strategies in this market?

Certain private competitors are relying on aggressive pricing to fill capacity, but our focus is not solely on price competition; it’s on delivering value. Our strategy involves being selective about customers who genuinely appreciate our offerings, and we’ve been achieving successful outcomes on those merits. We believe demand remains strong and will likely increase cycling back through the competitive pressures as constraints ease.

Can we consider your forecasts around same-store NOI, particularly where the challenges arise, and how those might carry into the next year?

We face headwinds such as FX, customer bankruptcy, and a higher property tax burden this quarter that directly impact our same-store NOI forecast. However, when normalized, the decreases appear more manageable. There's still upside potential based on our pipeline and continuous efforts in securing new leases and renewals across our markets.

Could you provide insight into the broader impacts of cloud migration on your operations and what changes you're seeing in churn rates?

Certainly, cloud demand continues to significantly impact our business. We've maintained a steady churn rate, unlike some peers who have reported fluctuations. Our latest quarter illustrates this strength, with noteworthy international wins and an exceptional number of new logos that affirm our strong positioning as the digital transformation accelerates.

Regarding renewal rates in your PBB business, what led to the recent drop?

The drop was due to a smaller sample set—only four renewals in the quarter versus larger aggregates in the past quarter. It's an anomaly rather than a trend, as PBB typically reflects high retention rates given the substantial capital commitments involved.

First, regarding renewal pricing changes, is the assumption that the legacy DuPont customer may not renew in 2019 influencing the mid-single digit renewal guidance? Also, could you clarify your cash FFO guidance considering various updates you've discussed today?

The legacy DuPont situation is not the sole factor. Over the near-term, we have ample capacity across markets to maintain momentum and achieve success based on current performance. Our guidance takes into account FX impacts, bankruptcy risks, and management's renewed confidence from activities in the second half of the year. We have numerous capacities coming online that will contribute positively to our growth trajectory.

Thank you for joining us today. To recap our second quarter highlights, we delivered all-time high new logos, as well as our second-best renewal leasing and interconnection bookings. We extended our global footprint with strategic land acquisitions, re-entered Paris, secured a second campus in Frankfurt, and announced our entry into South Korea. We remain committed to sustainability, reflected in our inaugural ESG report and recognition as an ENERGY STAR partner. Additionally, we further strengthened our balance sheet through debt redemption and opportunistic capital issuance. Thanks again to the Digital Realty team for their dedication, and I look forward to seeing many of you at MarketplaceLIVE in New York in November.