Digital Realty Trust, Inc. (DLR) Earnings Call Transcript & Summary

Hi. Thank you, everyone, for joining us today. I'm Sami Badri from Crédit Suisse. Thank you for joining us at our Communications Conference. I'm the senior equity analyst from Crédit Suisse covering the communications equipment, comm infrastructure sector. Today, we have the Digital Realty team. Bill Stein, thank you for joining us. Greg Wright and John Stewart, all joining the group.

And I wanted to just talk to you, Bill and John, and give us a little bit of an overview for 2020. In some of the most recent guidance -- guideposts you've laid out with regard to integrating a major acquisition, I was hoping to just kick it off, the conversation, from there and then have follow-up questions.

Sure. So Sami, thanks very much for hosting us today. And thank you, everyone, for joining us virtually this afternoon. To summarize our recent performance, we feel that we've demonstrated the resiliency of our business during this very trying time. In the process, at the same time, we've completed several transformational transactions. We've maintained 100% uptime for our facilities throughout the COVID-19 crisis. We took immediate steps to maintain service levels while prioritizing the health and safety of our employees, our customers and our partners -- excuse me, let me put this on mute, one of the beauties of virtual. We're also in a position -- we're fortunate to be in a position where we've been able to give back to our communities. We've undertaken philanthropic initiatives to combat the pandemic and to support our communities. In terms of transformational investment activity, there have been several initiatives in that area as well. As you noted, we completed our InterXion combination in March, which was a highly strategic and complementary transaction that we believe has the potential to change the global data center landscape. We closed on the acquisition of our partnership's interest in the Westin Building in Seattle, which is one of the most highly interconnected facilities in North America. And we also closed on the sale of 10 assets to Mapletree, generating approximately $550 million of gross proceeds. We had very solid execution in the first quarter of 2020 with our second-highest quarterly bookings, which did not include $10 million from InterXion. And this momentum, we believe, is carrying forward into the second quarter. We recently announced our entry into Mexico through our Ascenty JV. And looking ahead for the rest of the year, I would say without a doubt, successfully integrating InterXion is our first, second and third priorities.

All right. Thank you for that update. I think that one -- well, among the many things that have impacted [indiscernible], 2 big things, I believe, that [indiscernible] performance in North [indiscernible] and the speed at which the InterXion deal got closed. Now ever since COVID-19 got introduced into the dynamic in 2020, has that slowed the integration of InterXion or is that -- is currently on plan and no real delay?

Yes. Sami, let me answer that question, but I just want to note for the operator that, at least on my end, your audio was a little chopped up, so that maybe the operator can make some adjustments. InterXion integration is well underway and is going according to plan. We've launched an updated org structure for the combined company, with David Ruberg, who was their CEO, as the CEO of our EMEA business, along with some changes which will integrate the classical Digital Realty EMEA team under David. The functional teams are being brought together with representation from both companies. The sales teams are already working very closely together, and we're seeing out-of-region referrals that are taking advantage of our global platform, which, of course, is one of the things we'd hoped for. Overall, we think the teams are behaving and interacting very well together despite the obvious challenges posed by COVID-19. As I said before, we think this combination has the potential to change the global data center landscape. The combined organization is well placed to meet growing demand from cloud and content platforms, IT service providers and enterprises looking for colocation, hybrid cloud and hyperscale data center solutions. These are global long-term opportunities that we think are ideally -- that we are ideally positioned to address. The combined company offers a comprehensive global platform for our customers and gives us runway for significant growth. Clearly, there's more work to do over the next several quarters, but I couldn't be more pleased with our progress to date. Greg, would you like to add anything to that?

No. Look, I think, Bill, you've covered it. As you said, we're very pleased with customer receptivity and in [ view ] and dialogue that's going on with the platform. So nothing more to add, Bill. I think you got it covered.

Okay. Great. I think one thing that we're definitely starting to see is the level of development is starting to turn around in Europe and the level of competition [indiscernible] come with it [indiscernible] a dialogue. But InterXion's assets were already very robust also in the first place. But given the turning of the tide really and the competitive forces increasing, are you starting to see the competition increase now in EMEA? Or has it really been kind of relatively stable and predictable over the last 3 to 6 months?

Look, Sami, several U.S. providers have established what I would characterize as a toehold position over the past couple of years, acquiring existing businesses, and these include firms like CyrusOne, QTS and Iron Mountain. None of those businesses have nearly the footprint or the successful track record of the 2 leaders in the region, Digital and Equinix. Other competitors include some Japanese providers, Telehouse and NTT, who've recently rebranded their companies. There are also some local providers in various markets. These typically cover just a small part of Europe, along with some private equity-backed players. In addition, KKR just announced plans to fund a start-up that's led by the former CEO of Zenium, which was acquired by CyrusOne, and they're entering the market, targeting hyperscale customers. This market in Europe, we think, remains very strong. We think the combination of Digital, InterXion, along with Equinix, are the clear market leaders in the region. Digital now has 15 metro areas. We serve 15 metro areas in 11 European countries, and that represents approximately 440 megawatts of increased capacity. In addition, I will tell you that Europe, in many ways, is different than the U.S. But from the standpoint of development, it's far more challenging to develop in Europe than it is in the U.S. First of all, land is not as abundant, and it simply is not as easy to entitle the land for development, to access the power or the fiber. And given data sovereignty, it's important to build data centers in each country. You can't service Germany from the U.K., for example. It's not like building in Virginia and servicing the eastern half of the U.S. Greg, would you -- is there anything you'd like to add to that?

No. Again, Bill, I think you've covered it, other than to say that with that competition in Europe, we -- as Bill mentioned, we've seen some of it, but the good news in Europe is the time to procure land and develop and to get products online takes a lot longer. So by definition, that's helping maintain a pretty healthy supply-demand balance there, and our outlook is very positive.

Got it. Thank you for that. So I wanted to shift gears and move to North America where we see some of the major hyperscalers continue to build and probably outsource [ at least to ] Digital Realty and some of the other big builders. How would you characterize the demand environment in the market in North America today, at least from these major hyperscalers and enterprises that have capacity or build [indiscernible] capacity?

Look, I think we've been blessed and we're very fortunate that our business has continued to be quite healthy post-COVID. The demand has been both steady and strong throughout the crisis. We believe that the comprehensive shift to digital is here to stay. A portion of the remote working arrangements that we've seen during COVID will likely be permanent as well. Enterprises that were on a digital transformation path pre-pandemic are the ones that are thriving today because they have accelerated those strategies to remain relevant and competitive. Data infrastructure is going to be shored up in the form of increased cloud and data center capacity and services to support a more robust global digital economy. We expect that we will see more IT spending in these areas going forward. We're committed to helping our consumers accelerate their digital transformation, not just in the new normal environment, but once we get past this pandemic as well. As always, supply-demand varies from market to market, but we believe that we are well positioned to continue to deliver highly consistent growth. We have new capacity coming online in numerous markets around the world with a solid level of pre-leasing and exceptionally healthy customer demand.

Got it. Thank you for that update. One thing I think that is a lot of investors are focused on as far as North American leasing is actually pricing for those leases, and that includes new leases and renewals coming up. How has pricing [indiscernible] so far progressed? Have you seen it on a relative decline or are things looking a little bit better just given the demand backdrop is being tied to [indiscernible]?

Greg, do you want to cover that one?

Sure. Thanks, Sami. Look, pricing, of course, is going to vary from market to market based on local conditions, but pricing has been fairly stable since late 2019. And most of our markets are seeing firm pricing trends, I would say. We do see some of the smaller players who typically may try to come in and compete strictly on price. We see that as a timing issue, that's not a long-term strategy. And once they get their fill rates up, that should subside. We haven't really seen much change in either direction year-to-date in the U.S. in terms of pricing. In EMEA, InterXion has seen steady pricing for quite some time, and that has continued. When we look through Ireland, we expect to see improvement in pricing going forward. As the team indicated in our recent earnings calls, we've already begun to see pricing stabilize on the heels of fairly significant absorptions over the past several quarters, and that was reported prior to the current crisis. Again, demand remains steady and it even picked up due to COVID-19, where if we've seen some construction delays which would only contribute to firmer pricing. So again, overall, again, we're feeling cautiously optimistic there.

Got it. And then maybe just a follow-up on that, Greg. Regarding some of the COVID-19 challenges in [indiscernible] and because of the restrictions on some [indiscernible] movement and agility, have you seen issues with expansions, development or even your customers not being able to ship gear to the actual data centers? Has that in any way been an impediment to you guys [ cementing ] capacity?

Sami, I apologize. You broke up there a little bit. Can you please repeat the question? I'm sorry.

Sure thing. As a follow-up to the prior question, mainly tied to [indiscernible] construction [indiscernible] the challenge during the COVID pandemic, would you say that it's either [indiscernible] or an inability to get things on time, at least the way that it normally does, just given the COVID-19 impacts or even potentially customers. Customers that [ haven't ] now commenced on time because gear hasn't arrived on time.

Look, I think it depends on the platform and who you are. I think from our perspective, we've been pretty fortunate. I think we mentioned on our earnings call, we saw some slight impacts in Hillsboro, in Toronto, in Singapore, but nothing material. I would say we had some issues with labor and the like in some of those markets, but they were temporary, and I would not call them as significant -- I would not -- I -- would characterize them as bumps.

We're experiencing some technical difficulties here.

Yes.

And have relationships like we have. Go ahead, I'm sorry.

Fine. You broke up a little bit. But I think we caught what you're trying to say. And glad still on track and the impacts are [indiscernible], nothing very [indiscernible].

That's right.

One thing I want to shift over to is connectivity. You just picked up InterXion, a highly protected asset, or at least a portfolio of data centers that have been very protected, and you've already -- you picked up Westin in North America, a big [ legacy ] infrastructure of customers with already a lot of interconnectivity taking place. Have you seen your [indiscernible] continue to ramp up as a percentage of total revenue or at least total deals? Or have you seen the dynamic come in line really like what your original expectations really were? Any kind of positive surprise to that revenue run rate so far?

Do you want to handle that, Greg?

Yes. Again, I'm having a little trouble hearing, Sami, but I think you were asking about the run rate impact on InterXion, is that right?

So InterXion, InterXion's interconnectivity and its revenue stream coming from that. And given with the Westin Building also being contributed to the overall company, are you seeing a combination of just an uptick in interconnectivity or overall connectivity for the overall Digital Realty portfolio now with InterXion, with Westin integrated?

Yes. Look, I would say when you take a look at in terms of connectivity, we've seen very steady demand on that front, particularly with the advent here of the COVID-19 crisis. We've seen our customers in those areas continue to see strong demand for their product. We don't see that subsiding. In fact, we see as things go forward here, we don't see that declining, if you will, materially, once we get through this COVID-19. And I think, clearly, when you look at assets like InterXion and the Westin Building, I mean those are very -- internet gateways, highly connected. Those assets are benefiting tremendously from this kind of environment. And again, while it's been highlighted during this COVID-19 crisis, we think those positive trends for those kind of assets are here to stay.

Got it. Got it. Shifting gears a little bit, some of the announcements you made in 2019. You announced your first kind of big partnership with an edge data center, you announced with Vapor IO. I just wanted to get a take in terms of how that relationship or partnership has been progressing. Any kind of go-to-market alignment or even deals or customer wins that you have announced together? And if not that, has there been progression or development among the 2 companies as far as working towards kind of a unified offering in the event that there is a big uptick in edge data centers?

Sure. I'll take that one, Sami. So you're right. Late last year, we announced a partnership with Vapor to deploy the Kinetic Edge Exchange to interconnect key Vapor and Digital Realty assets in Chicago and Atlanta. Since then, we've also added Dallas to the mix. That partnership is key for us because it enables new distributed workloads that require a continuum of core and edge infrastructure. We're basically looking at various cutting-edge use cases that we think we can support through this partnership. Vapor and we, Cole, their CEO, and I, in particular, are working together with a couple of customers on proofs of concept right now. In fact, I had coffee with him this morning to talk about it, along with plans to expand the partnership to additional markets over the next 12 to 24 months. So we're pleased with the progress and are optimistic about where this will lead.

My follow-up question has to do with returns on invested capital yield, and that has become a focus as the industry becomes a little bit more mature. But it's probably nothing new for you guys. You guys have always kind of watched margins, watched yields and pricing fairly carefully. I think what changes the conversation or the question today is you have InterXion, which is a relatively high yield -- high ROIC-yield asset being integrated in. Could you give us an idea in terms of where ROIC yield will come in once InterXion is integrated into the overall DLR entity? And then where is the expected trajectory of those yields over the next couple of years?

Greg, do you want to take that one?

Sure. Sami, I think as you pointed out in your re-initiation report when we reported our Q1 '20 results and gave our 2020 guidance for the first time, we raised our guidance for development returns from, I believe, our historical range was 9% to 12%, up to 9% to 15%, and that clearly underscores the benefit that we're anticipating from the InterXion transaction. I do believe that investors generally appreciate the strategic value of the InterXion transaction for us, but I also believe our development return guidance was a little lost in the shuffle in the first quarter of 2020, given everything else that was going on, including the COVID-19 pandemic. But look, consistent with our strategy of being the leading global provider with a full spectrum of product offering, we've been improving the quality of our global portfolio by adding assets with better growth potential and higher returns. And going back even to Telx, and InterXion and the Westin Building, those are the kind of assets that we've been increasing exposure to over the last couple of years. And we've been pruning assets through capital recycling, assets that are probably better described as lower growth with lower return profiles. And you saw, I think we did $1.4 billion, $1.5 billion of that last year. I think you'll see the benefits of this improving mix over time show up in our metrics, including the higher returns that you've picked up on.

Absolutely. Now maybe kind of like a question perhaps John can chime in on is, do you think investors are crediting the company with these higher yields and perhaps the sustainability of higher yields above the corporate rate and your valuation multiple? Or do you think that's an education curve that some investors have to understand kind of why that's a [indiscernible] feature within the [ company's build ] profile?

Yes. Thanks, Sami. I do think it's an education curve and process. Again, I mean as Greg said, I think we got some benefit from just closing InterXion sooner than expected, executing on that transaction. But yes, no, I think -- I definitely think I have my work cut out for me in terms of continuing to spread that gospel. So we're definitely not done yet.

Got it. Got it. So just maybe 2 more questions, one for Bill and then one for Greg. Bill, when you look at the data center landscape, you've been in the industry for a while, you've seen some cycles, you've seen the idea of data centers going to obsolete being front and center in the media; to data center growth hitting record-high levels with outsourcing accelerating and the pendulum really swinging to the other side. So we've seen polarizing sides of the debates or expectations. In about 1 to 2 years from now, what do you think is going to be the big observation or positive surprise people will see as it pertains to the data center industry? This could be significantly more volume growth, this could be cloud providers fully outsourcing, that could be interconnectivity riding across the entire data center ecosystem in a more robust way. What would you think is kind of like your big 2- to 3-year observation that may positively surprise people?

Well, I don't know if it will surprise people, but I do think that data centers have gone -- I mean when we IPO-ed in 2004, and CS was actually on the cover of that, it was a $200 million offering, and it was a little engine that could, that almost didn't could. Yes, it was a very difficult IPO, and we were definitely a niche play. Today, I would say data centers have become core. Post -- or we're not post-COVID, we're in the middle of COVID, but I was looking at some market cap studies a few months back that John Stewart actually pointed out to me. And I believe it showed that data centers as a group had the highest market cap of any of the property sectors, which is pretty amazing. And if you look at the top 5 REITs, and I'm not talking about the RMZ, I'm talking about just the top 5 REITs in the country, 4 of the 5 are what I would call tech REITs. You have 2 tower REITs and 2 data center REITs. So I think that the data centers have definitely gone mainstream. I think this pandemic crisis has definitely demonstrated not only the staying power of data centers, but the fact that they should be a core holding for any -- not only dedicated REIT investor, but probably a generalist as well. In terms of what the fundamentals of the business will look like a few years out, I think that the -- I think that there's a potential for extraordinarily high growth. We're not giving guidance that way, but if you just think about the trends here, with the -- I would say, the accelerating digital transformation of enterprises around the world, with a decent chunk of that moving to the cloud, some of it will remain on the company's own servers, but probably more than half will end up outsourced to the cloud. That portends a very strong outlook for the data center group and I think particularly for ourselves as the largest owner of data center footprint in the world. So I'm very optimistic. We have the balance sheet to meet our customers' needs. We have the relationships with our customers to serve them. We gained their trust. We continue to gain their trust, but I think we've definitely enhanced our position with them during this very trying period. And I am looking forward to what the future holds for our sector and our company in particular.

Absolutely. And then, Greg, perhaps your insight on a very similar question. Is there something that could come up in the next 2 years that has also been a positive surprise or a negative surprise to the industry, depending on how you're looking at things? Your insight would be very appreciated.

No. Look, I think Bill touched on what probably is an impact that I'm not sure investors are fully appreciating. And Bill touched on this a little bit, about the asset class becoming more of a core asset class. I mean historically, you think of apartments, you think of retail, you think of office, those kinds of assets as being core, and the reason they were core is things like stability, creditworthiness and the income stream, contract term and the like. And look, I think we're seeing all of those things, particularly as it's playing out through the pandemic, that it really is stability and predictability, that the data center sector is actually -- is shining through in a really bright light. So look, I think what you may start to see in that respect is really a price benefit, if you will, or evaluation benefit to the underlying sector, as some of these investors that haven't historically invested in data centers over time come to appreciate the asset class more and more. And that -- we hear from folks all the time, I would say even within the last month, 6 weeks, the number of investors or the number of potential private investors with different pockets of capital that have reached out to us to figure out if there's a way they could partner from us, to buy from us, the like. It's increased exponentially just in the 1.5 years I've been here, and I think that is going to have a pretty dramatic impact on the space.

Got it. Got it. Well, thank you both for contributing. And we're actually going to be talking to one of the companies that you have an ownership stake into, Megaport, right after this. Bill, Greg and John, thank you very much for joining us today at the Crédit Suisse Communications Conference. And for everyone else on the webcast, we have Eric Troyer from Megaport coming up right after this, so stay tuned. And thanks a lot for joining us, Bill, John and Greg.

Thank you, Sami. Appreciate it. Take care. Bye.