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

Welcome, everybody. I am Jon Atkin with RBC. Please to host the next 30 minutes of fireside dialogue with Digital Realty Trust. From the company, we have Bill Stein, CEO; Andy Power, CFO. And I'm going to ask a number of operational questions, getting a little bit into balance sheet, strategy, financial metrics and so forth. Starting off operationally, wanted to maybe get a little bit of a recap, Bill, on the pressures that are currently facing the sector around materials, labor, or other factors that might be affecting development pipelines, how is Digital Realty managing through these? Any notable differences by region?

Thanks, Jon. Thanks for having us. Look, I don't think there's any question that the government stimulus package, particularly here in the U.S. are creating upward pressure on both labor and material costs. That's across all sectors. But I think, fortunately, for us, given our scale, our financial strength and our global reach, we have a clear competitive advantage versus smaller subscale players. Which, for us, we think, will create evidence of an even widening competitive moat between us and the smaller players. Relative to the current projects that are in the pipeline, they're largely insulated from this because of the existing contracts that we have with the general contractors, and we lock in material program. We lock in the supply programs for 3 years. So I think we're pretty well set for the next, call it, 2 to 3 years. And 3, 4 years down the road, we'll likely see a -- we're thinking about a 3% or 4% bump in some of our costs.

3% or 4% bump in costs over kind of the medium to longer-term then. Okay. And any -- I guess maybe just focusing now on Interxion. You're now more than a year into the integration. Any operational changes that you would highlight, whether it's sales and marketing, construction development or anything else to kind of note as you're now functioning as one company?

Look, I think we're really, really pleased with the way things have gone there, especially when you consider that we're still working remotely, and it's hard to cross the ocean with COVID. Sales and marketing teams have been fully integrated since January 1, and they posted excellent results. Q1, the EMEA sales teams also generate enterprise deals that were exported a ton of regions, 38% of their bookings in that quarter went out to North America, APAC or Latin America. So that's really a nice plus for that deal. In terms of design and construction, I think we've created significant value over there by executing not only against the existing pipeline, but acquiring the freehold interest under leaseholds in both Frankfurt and Paris and securing land for additional growth in the region. So bottom line is, I think, we're doing a great job of building a solid foundation, which will allow for the assimilation of our businesses. We're quite proud of what we accomplished and I think that's showing up in our bookings.

Great. And then turning to organizational topics. How can you maybe describe the role of David Ruberg, the former Interxion CEO, given some of the nuances around his employment agreements and then I think recently sold some shares, what is his role going forward?

Yes. So David has been a wonderful partner for me. He's recently transitioned into a global strategic advisory role. So he's responsible for the development and oversight of corporate strategy, including an effort to organize and execute a program to develop communities of interest around the world. He continues to play a leadership role with certain key important accounts, bringing his long-standing relationships and thoughts to bear. He's a voting member of our investment committee, where he weighs in on every deal, and we appreciate his insights. He's also directly involved in overseeing our investments in Africa. In terms of stock sales, David turned 75 in March. And while I haven't discussed his personal finances with him, I would expect that he's acting in anticipation of perhaps significantly higher capital gains rates here in the U.S., beginning most likely next year.

Great perspective. And then last sort of organizational question. Any kind of leadership changes to highlight in your overseas properties, whether it's the Brazilian joint venture, Germany or elsewhere?

I mean, just stepping back, keep in mind, we now have over 3,000 employees. And so we're occasionally going to lose people when you have a work base that is that large. That people leave for various reasons, I think, very rarely, people go to competitors. If I were to track it, I think most of our departures that I'm aware of are going to customers. But relative to Germany, in particular, we recently announced the appointment of a gentleman by the name of Volker Ludwig as our Managing Director and Country Leader in Germany. Volker has more than 20 years of data center experience and he previously worked for Interxion, Germany in various roles. He was recently responsible for sales and marketing as a member of the executive management team at e-shelter, which is a part of the NTT Global Data Center business. Volker's predecessor left for non-data center opportunity in Munich, which is where he's lived and he was commuting from there. So we wish him all the best, and we're confident that we're going to have a seamless transition, especially Volker's previous tenure with Interxion.

And then Brazil?

Brazil, I'm not in a position to comment on Brazil right now.

So turning to maybe, Andy. I appreciate you joining us as well. Balance sheet topics. Current funding position, how far out do you wish to be funded, given your current development pipeline and your view of prospective demand?

Thanks, Jon. So we were quite active ending last year and the beginning of this year in terms of building liquidity, capital recycling, terming out maturities. So we stand in a pretty strong position today with a liquidity position to call it $2 billion on our undrawn line of credit. I think we have over $200 million of cash on the balance sheet because we -- based on the closing with some dispose. And we also just closed on, call it, $700 million of noncore capital recycling activity. So feeling really good about where we stand in terms of a balance sheet of all liquidity, no nearly debt maturities and well-funded. As we move through the rest of this year, we'll continue to probably turn to some capital recycling activities as the main driver of continuing to also look at liquidity and kind of push us out into 2022 in terms of any material capital needs.

Any thoughts on the financing mix? What types of capital sources that you consider, given some of the changes in macro conditions around interest rates and inflation?

Yes. I mean, I think our financing strategy is -- remains consistent. It's keeping our fishing pole in all the different pools of capital. So if one heats up or cools down, you have a lot of flexibility and agility to respond. But talk -- I mentioned selling out of noncore locations, slower growing assets has been a key lever in terms of straightening the balance sheet and redeploying with the higher growth opportunities like we've been doing. We've also taken advantage of, call it, private capital around select joint venture assets. There's nothing on the docket immediately, but I think that expanding that effort is certainly a tool in our toolkit and will continue to utilize. We've also been doing a lot of blocking and tackling. We redeemed, call it, $700 million of preferred equity with north of a 6% handle over the last 12 months. So we're just continuing to try to grind down that cost of capital, fortify our liquidity, term out of maturities and make sure we have the most competitive cost of capital available.

How do we ballpark how much incremental capital you could raise based on the further sale of either owned assets or some of your JV minority interests like the Prudential portfolio?

Yes. I mean we've said holistically over a multiyear journey, which we've started down, and we've made great progress on. It'd be multiple billions over multiple years. We've kind of put a guidance range where we've already, based on the activity closed at the end of the first quarter, call it, slightly nudged up the lower end of that guidance. But we left a little room with a couple, say, $100 million or $200 million or more could transact this year depending on market activities. Right now, it's a lot of smaller things like some land holdings, so non income-producing assets that we don't see future investment opportunities in, I would say, the nearest item. We have a -- there's a portfolio we own with a joint venture partner, where we have a minority interest in, so that would be a smaller slug of capital as well. But a lot of these little smaller slugs do add up. And I think they're, again, a good effort of -- capital recycling and focusing on the core is what we're trying to do here.

Bill or Andy, but maybe I'll just ask Bill first to give him the first shot. But recent cap rates that you've seen in the market, there's been the announced Mapletree transaction with Sila. And then even an AWS shale transaction in Virginia quite recently that I think was at the lower end or below the low end of recent cap rates, but thoughts on either those or other deals that you're sort of seeing out there in the industry.

Sure. I mean, things are coming down. That's the bottom line. But the AWS shale in Virginia, I think, at the point we heard that was a sub 4 cap. A 15-year PBB lease to AWS. But there is the Sila sale to Mapletree. That's been in the market for a while. The cap rate hasn't been disclosed, but we're hearing that maybe there was a mid 5 cap rate on that since that seems about right because there's been further cap rate compression since we sold the Mapletree in September of '19. But I think this also -- that particular deal demonstrates the depth in demand for data centers as an asset class, particularly in the Singapore market with that transaction. And the 2-point transaction we completed with Mapletree and the [indiscernible] Investments, and our recent European sale, the [indiscernible] have been involved in a lot of very large data center transactions over the last several years.

Anything to add, Andy, on either those sorts of examples or others that I might have left out?

I think it's a net positive for the industry and for Digital. I mean, we were never deploying capital into those type of returns. But it's a maturation of the sector as more capital rotates and provides greater value for the simple owned and operated assets that we have at Digital. So it's not -- it's been baby steps coming a long time here, but I think it's a positive for the sector and it's positive for our -- value of our portfolio.

For, I guess, Bill, you can take the first shot unless you want Andy to take it, but thinking about same-store cash NOI as you sort of look at the business today, given some of the design changes that we've seen around N plus 1 rather than 2 N for a generic wholesale stabilized assets, and assuming the market is more or less an equilibrium, should this theoretically increase, stay neutral or decline over time for wholesale? And then when you add interconnection, retail into the mix, kind of the same question is what do we sort of expect around same-store cash NOI development. Andy, do you want to cover -- Andy, do you want to cover that one?

Sure. Happy to, Bill. So I mean the industry is going through a few changes. And the one you mentioned, Jon, I would say, is pretty far in the rearview mirror about the step shift in terms of redundancy design. The other change is that it's become more competitive and contracts that were signed 10, 15 years ago, certainly had pricing pressure that we kind of rolled through our P&L. I don't think that's set up to repeat again in the future because we have a pretty robust and well [indiscernible] supply and demand market. And we're also running up into barriers to our business in terms of new capital deployment and those returns. So when I kind of look at the other side of the call going through the cycle, I would say the order footprint capacity scale or hyperscale should be inflation like returns, 2%, 3%, NOI growth once stabilized. Obviously, our portfolio is -- we're working through the re-leasing of some nonretaining capacity, so they have embedded upside to those cash flows, which will be near-term upside to our cash flows as we release that until what is a vacant data all here or there. I think on the retail side, in the interconnection side, driving more value to our customers through mix of those customers, connectivity offerings, both physical and software-defined service providers, network providers, drives incremental stickiness and pricing power to us as a provider, which I would say is just gravy to those growth rates. And at last, I'd say, the lines have been blurring for some time. The legacy definitions of wholesale and scale versus retail and colo have been shaping and shifting as power densities have changed, deployments have changed. Those typical customers that's been in enterprise space that want to do multi-hybrid cloud deployments, they can't just go to the old legacy page and cabinet colo desires -- designs. They need to have more flexible and agile providers. And I think the diversity of our footprint at Digital really lends itself to support those customers in achieving their business objectives.

Turning to renewals, perhaps sticking with you, Andy. But over the next 2 years, which metros have the greatest exposure.

Yes. I touched a little bit on the call. So if you -- you slice it into, call it, the 2 major flavors of our capacity called the less than a megawatt. Those are mostly concentrated in our highest pricing power, stickiest locations. So within North America, it's the 60 Hudsons, 56 Mariettas, 350 Cermak, the major metropolitan capacity. And then obviously, a large increase in exposure to the legacy interaction footprint, which is highly connected communities of interest with high pricing power. So those are the largest, but it's a very diverse mix within that. So numerous customers with various contracts, but I would say, a positive or a tailwind to our trends in fundamentals. On the larger footprint, greater than megawatt, Ashburn is our biggest market. So you got to imagine, Ashburn is a big chunk of that. But we've kind of been working through some of that. And some of that we've got already back at the very first quarter of this year. And then after Ashburn, I think it falls off quite quickly in some of those non-U.S. markets those less mature markets who haven't gone through the renewal cycle like in North America, but are in higher barrier markets in Europe or Asia Pacific kind of come next. So I kind of -- this kind of speaks to, I think, the front view mirror in terms of where we're going in terms of exploration and mark-to-markets and retention, it's heading into better territory than we kind of shop toward that for the last few quarters or years, for sure.

So Equinix is leading a number of their sites, as they've indicated to their customers. And in some cases, the building is being sold, in some cases they may be choosing the voluntary exit. But one of those is 56 Marietta, which you own and operate. And I'm just interested in what you see as the risks or opportunities with that exit and how you manage through that?

I see it as an opportunity, Jon. I mean, that building is full, and we don't have to get that space back and lease it at a higher rent, which they lease that capacity now at power show rates. So once they move out, we're going to be able to mark that -- we'll have to fit it out for a little bit. We'll be able to sell it, I think, at a much higher rate. There won't be a problem. The demand is extremely high there.

Jon, I would just touch on that, not explicitly to that scenario. But I mean we are Digital Realty, we own 56 Marietta in Atlanta, 350 Cermak in Chicago, Sovereign House in London, 600 West 7th in L.A., the Westin Building in Seattle, numerous locations across EMEA and APAC. In fact, I think we own close to 90% of the fee simple. So it's a value proposition to our customers of future-proofing their growth, and it's been part of our strategy from really day 1 that Bill architected over 15 years ago.

That's important. That's an important point. Fortunately, we'll never be in a position where we have to ask our customers to leave.

So thank you for those perspectives. So sort of across region view on yields. In Europe, you bought Interxion. And before that, you didn't have that many sort of internet gateway sorts of assets. You did get to divest the Telecity assets, I guess, as well. And then in the Americas, you've got a mix of Internet gateway and conventional wholesale for a lack of better term. And then in Asia, it's a different mix and still. So as you think about your next 50 megawatts of investment in each region, how do we think about the yield profile across -- or amongst those regions? How would you kind of contrast those levels and what you're targeting?

Do you want to handle that, Andy?

I'll give it a try. There's a lot in there. So -- I mean, let me do the quick round the world, Jon. So here in North America, we are looking at both expanding our offerings in some of those highly connected destinations that I just rattled off, and you mentioned with adjacent capacity given the value position to our customers and the pricing power that some of those locations provide. That's in addition to growing some of our major campuses like in Hillsboro or bringing on capacity in Toronto or down in Ashburn, bringing on our latest build banner. Lowest North America, most mature market, it's the lowest returns on our development schedule, but we do think it's still creating significant value for our shareholders. And it's on the higher end when you point to those connectivity rich colo location type product offerings, I described. Moving over to Europe, the returns in shop, call it, we're talking a couple of 100 basis points based on what we have in-flight now. And it's a -- I would say, it's a more blended version of stories. The Internet gateway connectivity locations in many of the EMEA markets are very much ensconsed in a campus like footprint. We're able to continue to bring on a healthy customer mix of growth, whether it's in Paris or Frankfurt or Amsterdam. And I also am quite pleased with the opportunities we're seeing outside the flat markets, being able to support top CSPs and enterprises landing at those major flat market -- non-flat markets. Moving to APAC. The returns are called -- feel like other -- could be 100 basis points in certain locations. Our Singapore market has been one of our strongest markets where even large-scale footprint deals are well into the mid-teens. So that's like hyperscale returns because -- are often to the customers in an incredibly supply-constrained market. Also very excited about what we're doing in Seoul, South Korea, bringing on the first carrier-neutral location, have great activity there. And I would think of returns have been the higher end in that market. Japan has come on more recently, both Osaka and Tokyo, lower return market, obviously, the lower interest rate market. But still a lot of great value creation opportunities for our customers. And then Latin America is one of our highest return markets as well. So the theme is, as you offer this global platform offering for our customers, I think we'll continue to differentiate what we bring to the table for the customers, and we're also competing in more and more markets that have higher barriers to new competition, and our offering I think has a really distinct value prop that stands on its own in addition to being part of the platform.

And then last question before we hit the bottom of the hour, but just around international, you mentioned Asia. You mentioned possibility of entering 1 to 2 new markets this year. Any kind of update on that. India was a market where you had a sort of an MOU partner, and that relationship has gone sort of elsewhere. We've also seen Iron Mountain to enter the market through acquisition, but thoughts on remaining opportunities to enter the Indian market, which clearly you have been interested in as well as other possible new markets that you consider entering?

Sure. I mean, India remains a very attractive market for us despite the, obviously, horrible public health issues that they're currently experiencing. We have a tremendous amount of respect for the Adani Group, but decided to part ways earlier this year. We just felt that we weren't strategically aligned the way partners should be for a long-term success, but we wish them all the best. We're currently working with a new partner there and who we think is better aligned with our approach to the market, and we hope to be announcing something there relatively soon.

That's great. That completes it for our question session, fireside, and really appreciate both of you taking the time to be with us today.

Thank you.

Thank you, Jon. We appreciate it.

Thank you.

Thanks, Jon. Thanks for having us. Bye.