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

Hi. Good morning. This is Michael Funk with Bank of America data center analyst here. I have my colleague, David Barden, who heads up the telecommunication services and infrastructure team as well. We're really pleased to once again have Digital Realty with us at the Global REIT conference. We have Andy Power, the Chief Financial Officer from Digital Realty. Andy, thanks for being here with us.

Michael, Dave, pleasure to see you guys again. Thanks for having us.

No, of course. And I just want to jump right in, if you don't mind, if any clients have any questions during the presentation, you can go ahead and e-mail me actually at [email protected], and I'll try to get those questions in. But I did have a list of my own for you, Andy, if you don't mind if we get started.

Fire away.

Yes. So first is on the financing and capital market activity that you did equity forward sale a couple of weeks ago, I think 6.25 million share, about $1 billion raised. Not surprised that you raised equity. I was a little bit surprised, I guess, by -- on the size of the offering. So I wonder if you could walk us through your thinking around the timing of the equity forward and then the size of the transaction as well.

Sure. So I mean, in terms of size, I mean, we're a fairly large company these days with large global capital commitment. So 300 megawatts of data center capacity under current development. And if you just kind of look at our litany of press releases over the last 6, 9 months, you can see that number is likely to kind of stay constant, if not potentially increase slightly, given we're entering new markets. So any time we're raising capital doing larger scale is typically more efficient. The timing was really on the backs of some investor interest. And we obviously were kind of started to turn the page into 2022, 2023 planning and said, "You know what, we can take some chips off the table here, derisk our funding plan out in the future." The forward structure, well, I know it provides a little bit incremental complexity. It does really work quite well in terms of being able to line up the actual uses of those proceeds to our development needs. We'll also continue to be active in the capital slant and front, which has different timings of different asset sales, always moving parts there. So really, that was really the forward structure lends itself to let us bring down those proceeds when we need them and call it to fund our business plan for quite some time now.

And then some other potential sources of capital. You mentioned capital recycling is one, there was a story in the press this summer, talking about potential Singapore IPO, that I think have its structure similar to kind of the JV a couple of years ago with some of the assets. Can you bring us to speed of your thinking around that Singapore IPO and what that kind of structure hypothetically might look like?

Yes. I mean -- maybe just take a step back and make this less about, call it, market rumors. When we, for some time said that we believe and call it capital recycling, and that has almost 2 different flavors to it. A noncore flavor where we sell 100% outright certain assets that we don't see long-term robust and diverse demand from our customers and growth. And we've done that recently at the beginning of this year. We sold a portfolio across EMEA, about $700 million, whether it was certain markets or assets or other elements that said, "Hey, we're not the best owners, and this is not additive to the strength and growth of our platform." That's a noncore -- to various buyers, private and public. The other flavor is what I'd say is our continued use of core-like capital partners around core assets. Assets that Digital Realty really views as long-term strategic hold, supporting key growing customers in top markets. But assets that we've essentially fully constructed, fully leased out with a long term remain lease contract, and we essentially call it squeezed all the juice of that asset. So we can bring in some more passive-like partners like we've done coincidentally with the Singapore REIT but also with an insurance company and also with a nontraded REIT and maintain a minority interest, operation control, no disruption to the customer. That's the next evolution of trying to find equity sources that match the risk profile of those assets and allows us to kind of accelerate our growth from even more efficient capital sources. So that news article you're referring to, I'd say, is more in the latter bucket of continued next-generation capital sources for Digital to help accelerate our growth.

And that latter bucket would include some sort of management fee income as well, correct, as you would maintain the kind of manage the control or data, the operating control of the asset, correct?

Yes. We do want to -- the sign of the building will be Digital Realty, the customer experience will be Digital Realty, operations, day-to-day, and there's obviously compensation for those services and capabilities we're bringing to bear. And we're prudently choosing partners that don't have those capabilities, who are really investors almost in a passive context that say, "Hey, I want to put some money into this space into a long-term hold asset at the appropriate risk-adjusted returns. And I'm going to trust Digital Realty, the operator manager of those assets which we get compensated for."

Understood. As you mentioned earlier, Andy, there have been a number of transactions the last few years, asset divestitures, acquisitions, a number of dilutive transactions, at least looking year-over-year at the FFO per share. You've also talked broadly about targeting longer-term, high single-digit FFO per share growth. So can you talk kind of broadly about over time, is that aspiration? Does that include the need for these types of transactions like asset divestitures to shift towards a higher growth portfolio, but with those kinds of transactions potentially be additive to that longer-term growth target?

I'd say a few things on that front. One, we think we worked quite hard over the last several years to put together a powerful platform with some incredible assets, some puzzle pieces that fall into permanent homes forever. And I believe we've been the largest acquirer of that type of capacity in the last 3, 5, whatever, 6 years. And obviously, some of that transaction activity had year 1 or so dilutive to our bottom line, but ultimately, accretion to our FFO and AFFO per share growth and really more -- a higher pricing power, higher growth platform. And I think we're coming out of that cycle because we're really coming up on I guess, 2 years since the announcement of our interaction transaction. And whether it's that, the Westin Building, Telx acquisition, our growth with Ascenty in Latin America, a lot of that transaction activity has been more in the rearview mirror than the front view mirror. The noncore sales and those things I just described, honestly, I think in the other day, it will be incremental tailwinds for long-term growth. But more in the near term, they've actually been a headwind, given the valuations that those assets transacted and relative to where we trade. So we've been taking doses of dilution through capital recycling, simply by the fact that you sell a fully constructed asset. And the day you sell it, the next day you lose 100% of the income and replacing that income takes time because we have an active development pipeline that those proceeds are recycled into. So I think the capital recycling efforts are all done in the vein of building a stronger platform that can better support our customers and provide greater long-term growth. But I would say they've actually been more of a headwind to near-term growth than any type of tailwind.

I mean does it make you think about quantity or kind of the size of asset cycling, just given your point about the kind of the immediate dilution thing about the kind of the immediate dilution and then you're kind of putting the capital back into the system to drive longer-term growth. I know it was something that QTS mentioned in their deal proxy. For one reason, they went forward with that deal rather than trying to raise capital through asset recycling. I mean does that change your thought process on the size of deals? Or are you purely just focused on the lower -- lowest cost of capital and that being the lowest cost?

Listen, we have the pleasure and the pain of being a public company, right? If we were having this context in a private format, we probably would not spend so much time on what was the year 1 impact to our cash flows per share and be more focused on a longer horizon growth in general. And I'm not being dismissive of that because I think growing your bottom line in the end of the day is incredibly important. And I much rather have a smooth trajectory of growth and something that has much more volatility to it associated with dilution. We are measuring that every year. I don't think we can [indiscernible] be our only guiding light as to making decisions that help us in the next year but hurt us in the long term. But we're very cognizant of the near-term impacts to our per share from dilutive activities in general. We prepared for this day, quite frankly, that's why we've operated with a coverage of our dividend or AFFO payout ratio that's very low, call it, 70%, i.e., any dilution we've done never has put our dividend to our shareholders at risk. Same thing could be said about our balance sheet and other topics as well. So it's a factor in our calculus, but it's not the sole item line, this is the bottom line.

Andy, I wanted to shift now -- maybe it's more operating discussion. 2020 was a much better year for industry leasing anticipated. I think you also outperform expectations, '21 year-to-date has been better than I think some people expected for leasing activity. But your commentary has been pretty consistent really since late 2020. Not expecting '21 to be another strong demand here for both hyperscale and enterprise. As we move into the back part of 2021, what is your visibility for the next 12 months? Are you still projecting stable demand from the hyperscalers? Is enterprise ramping back up? Can you talk a little bit about demand environment for us?

Yes. I would say, I mean, Digital is in a fortunate category because I think we strengthened our platform and our capabilities, improved upon our execution really heading into a pandemic that at the outset, not sure anyone knew what was going to play out for any in general. We, I would say, further had the benefits of demand remaining robust through 2020 and into 2021 across both of the customer -- major customer segments called it top CSPs or hyperscalers as well as the enterprise. I think within the enterprise, which was probably my biggest surprise because having lived and worked inside global corporate enterprises, isn't always felt the whims of volatility, changing behaviors. I think the demand held firm, and we upped our game and took market share, quite honestly. And I see us continue to build upon that. And I still don't think we've fully maximize what we can be doing in terms of [ penetrizing ] the enterprise pool of customer with global capacity needs. I think I'm very proud of our team and what we've accomplished over now several quarters, but I think there is more to be done there in terms of upping our execution. And on the hyperscale front, I think you saw a demand backdrop that probably accelerated at the backs of COVID. We entered markets like Mexico City with hyperscalers during the pandemic and continues to, call it, stay firm. And I see the trend is our friend, whereby those hyperscalers are narrowing their partner list to truly global infrastructure partners like Digital every day. So I can't promise every quarter is going to be a record. There won't be any modest volatility. But I think the breadth and diversity of our platform across 47 metros, now 4,000 customers, plus the 100-plus customers we add every quarter, the mix by geography or product suite has certainly take a little bit of the volatility of the quarterly lumps. And based on what I'm seeing in the front view mirror here, I see -- I think those demand trends, as we put up more recently, Digital is going to somewhat remain intact.

No, it's great color, Andy. I think that we're asking a lot of the companies in the supply chain and whether or not the supply chain is creating issues with your own development and/or for your customers and installations. We had Tom Bartlett with AMT on this morning, and he was saying that one area they were seeing some impact was on things like generators. So presumably, you're probably also seeing maybe some impact on equipment for data center builds. Is that correct? Or are you not seeing an impact yet?

I mean this is a topic given its prevalence in every person's life whether -- when you're paying at the pump or going through the gas station or reading The Wall Street Journal, that I'm incredibly reticent to quote whistle by the graveyard on. That being said, to date, our supply chain has done a really nice job, our [indiscernible] team and our design and construction team and our operations teams are doing a really nice job insulating us against the cracks of the supply chain in general. I would say that's more of a testament to our global scale, our consistency and experience of consistently operating, designing and building this infrastructure. And so I've not seen that creep in, but I mean we're in a great new world when it comes to inflation that probably many on this phone call never even experienced in their careers, given it's been so long. And so I'm very focused on continuing to get out in front to mitigate that risk. But so far, our platform has done a nice job of insulating us against that risk.

You just mentioned inflation, Andy, my next question actually is -- can you just walk us through how -- maybe you are shielded in the near term from inflation, kind of how you're contracted under development? What the fixed cost there might be? Just where you are protected, the inventory backlog that you might have? I know it's something you talked about last year with inventory backlog. So help us think about looking out the next 12, 24 months, your visibility on the inflation impact on your business primarily on development, less so on the operating side.

So on the development side, we're the largest developer of third-party capacity globally. One of the competitor, which I'm sure you're familiar with, is shortly after us, and then the bars descend quite quickly. So there's a big gap. I think that and the fact that we've been consistently in that position for many, many years has allowed us to build relationships, enter into attractive better managed -- vendor-managed inventory programs to insulate us from a hard cost standpoint. Not universally, but many, many components. We also are building a large scale in, call it, half [indiscernible] markets. And we've done that for a long time. So we've been able to bundle our work for our GCs in the subs and keep them consistently on our sights time and time again. That relative to a newer entrant, subscale entrant here today, gone tomorrow or vice versa type of competitor has a major leg up that's labeled to help us insulate our costs when it comes to our new development pipeline. Some of this could similarly be said about our operations capacity as well. Net-net, if the inflationary environment was to continue for a sustained amount of time, it will have some impact to our next slide, call it the 2022 version of our development financial supplement that you see on that page, so a year plus out or something like that. At the same time, I think they're going to -- you see outsized impact to newer, smaller private entrants to our space. And having a $60 billion installed base plus a development pipeline in flight, I think that inflation trend should benefit us as it limits new competition and hopefully transfers some of that pricing power back to the incumbent providers given there's less choices for those providers or for those customers to go to. So I'm not sure inflation in our industry and our asset class is 100% a one-way street of negativity. I do think, given our position in the long run, we're positioned well to weather it and that does have some potential mitigation and bumpers that help support us on the other side of the coin.

Andy, I've got a related question from a client here asking if you can discuss the impact of rising energy prices on your business? And could a Europe shortage slow the timing of development deliveries? And I think that means shortage or delays in [ cell to station ] delivery, I presume. But can you discuss those 2 points?

Yes. So I mean probably many on the call, I mean, so there are certain parts of the world that are having, call it, earth and stars, moon and sun, call it, alignment or energy issues just on where they are in terms of natural gas, abilities, where they are in terms of renewable energies, and that's playing out in certain parts of our portfolio. We are fortunate that 2 things: One, we have installed customer mix that has a significant amount of pass-through energy. So this really is ultimately borne by the customer and not Digital. And it's not like they have a choice to say, you know what, the price of energy has gotten more expensive. I'm going to use less of my data center. These are kind of uncorrelated use cases. Two, we have a hedging program in place that insulates many of our customers from these energy shops. We're not fully hedged because depending on where you are on the hedge, if you can have the wrong side of the bed or the right side of the bed, but we do have substantial amount of hedging programs in place to insulate customers and ourselves when we do take power risk for those energy disruptions. I think the second part of your question, Mike, was about substation delivery?

Yes. It seems more European shortage and slow timing of development deliveries, it seems to be related more to substation construction, which I think also has been an issue in Northern Virginia and Silicon Valley as well. So maybe just broadly discuss that potential issue.

I put those both in the categories of friction and barriers of new supply, new competition, new metrics, right? We've been operating in these markets that we are in today, most of the new markets we're in today, I mean we've only entered a handful of newer markets, but we -- for many, many years. And we've got ahead of the planning in terms of our land entitlement, in terms of conduit use, in terms of our substation deliveries, in terms of backup plans in the event of something going wrong. So I don't see any major disruptions. And quite honestly, we just survived a pandemic where municipalities were shut down human access to our infrastructure. So I think I don't see that as a material disruption to Digital's day-to-day operations. Yes, there'll be tactical things in the one-off markets where we're going to have to, call it, pivot and react, but is not a material impact to Digital. But I think the broad thing is -- and it's not just the energy situation, whether it's the running up to the constraints on infrastructure in markets like Ashburn or Silicon Valley or other parts of the world, it's putting incremental hurdles on new supply, which is a good thing for incumbent providers like Digital Realty. So having a more measured and a little bit more thoughtful process to this, whether it's done intentionally or it just happens because the resources are exhausted, I don't think that's necessarily 100% bad, I think, for Digital. And we're highly experienced in navigating these problems, so I think I've put a lot of trust and faith in our team to do so. And I think that help again shifts that pedaling back to the incumbents in terms of pricing power.

And then another topic that's been discussed pretty widely the last couple of years, and it's been renewal rents. And I mean you've obviously got into it each of the years and I mean, quite frankly, I think outperformed what the guidance was at the beginning of the year in terms of the step-down. So hoping you could maybe just walk us through why the outperformance, so is it the kind of spot rents have improved relative to original expectations? Is it negotiating position relative to larger tenants? Has that shifted? We're able to maybe renew them above spot because their switching costs were so high? What are the factors that have led to that outperformance in the renewal rents the last couple of years?

I'd put a couple of flavors to this. One, that is a very tricky stat to provide guidance on because it's not just what's contractually coming due in a given year or a quarter, but it also includes when we report what gets early renewed, which that's a negotiation with our customers. But we are -- if they want to renew something early, we can't say no, please wait, right? So we engage with our customers on that. So the Vegas odds on that is a tougher line in our guidance to project than some of the others. Two, we've been chopping wood through some of our, call it, toughest vintage years, right? Our highest volume years, our highest rate years relative to the market exposure or the current rates and some of our biggest customer concentrations. We're not fully out of the woods on this topic, but it has been getting better as you said. And then three, our mix has been shifting. We've been selling assets, 100%, as well as joint ventures. And we've been adding assets with greater pricing power, be it interaction, what we've done in Greece and Croatia, the Westin Building. So we've been, call it, changing our mix of contracts along the way here. This company has come a tremendous way in a few short years here in terms of really transforming ourselves into really platform capabilities with higher pricing power assets and locations. And I think I put that as 1 of the 3 things that 2 of which are other ones I mentioned that's translated into us to do a little bit better, not a -- not like totally different category of outperformance but a little bit better than we were handicapping at the beginning of the year.

And just the last one here on the renewals, Andy, your supplemental provide the expiration schedule. We look forward expiring leases, right, have a lower price per kw than previous years. And presumably, that would help with the renewal rent. That's an aggregate number of the entire portfolio. So specifically, what markets or where do you see the risk to repricing lower because they were making -- should be getting better space on the average per kw of what's expiring?

It just mean the markets where we have the greatest pricing power is where our offer is the most differentiated. We have the greatest installed base of potential other customers that could take the backfill space, which allows us to have greater negotiating power. Or we have a customer that wants to grow with us, hence, they're not going to be leaving if net growers. And we compound that with markets that are just running up to some of those infrastructure or other supply challenges. Outside the U.S. are some of our tightest markets, Frankfurt, Singapore, in terms of Europe and Asia Pacific. Marseilles is another great market, Paris, some of the other Asian markets. Back in North America, Santa Clara, Silicon Valley, Toronto. And in the markets where we have less pricing power are certainly the markets that were the most impacted by [indiscernible] I think we've done quite well in terms of executing and keeping our portfolio very full. So we've done a lot of significant amount of leasing. We've sold that installed a growing customer base. We've imported demand from around the globe. We sold the full product spectrum. But there's no secret, Ashburn is not a super tight market. And when you don't have a super tight market, you're a little bit more in the back of the heels when it comes to negotiation on renewals. Likely, I think we chopped a lot of wood on some of our renewals in Ashburn for some time, and we've kind of gotten a lot of the bigger deals behind us. And as long as we've kept the portfolio tight, that's helped benefits at the same time. But I think you're right, the portfolio is a mix. It's a mix by product, it's mix by geography. And that's why I think we're getting -- we have been and continue to getting a little bit better territory than what we previously navigated.

And earlier, Andy, what I was asking about the kind of the asset divestitures and the deals. I think you said that it's kind of hard to move beyond those big events, where you see kind of the large near-term dilution from an asset sale or the impact from an acquisition. So presumably, that means that you shouldn't expect any large acquisitions in the near term, so mostly organic growth. And related to that, we haven't quite touched on it yet, but Latin America or South America and the aspirations to grow larger in that region and how you're thinking about growing larger in that region to supplement the Ascenty portfolio and ride that way to growth.

Just so to clarify, your first question was about dispositions or acquisitions, just to make sure I...

Before you buy anything.

Okay. Yes. Can you see me okay? I got like grimaced frozen screen there for a second. Who's that young man there? No gray hair, not picture. The -- listen, I think we are quite pleased where the portfolio is. It's been, call it, almost 2 years since we had a major, major acquisition. We have been doing tuck-in activities, whether it's Greece, Croatia. And we have organically been opening new markets whether it's Seoul, South Korea, expansions in Japan, expansions in Hong Kong, entering India. And I think there's some incremental new markets on the horizon in a more organic or tuck-in fashion. But I can -- and we were on a similar call like just a week or 2 ago. I'll refer you to our CEO, Bill Stein's comments from our earnings call, the first Q&A, I think he said it best, "We're not -- we don't need to get bigger for the sake of getting bigger. And we're not looking at any redundant capabilities out there." And when it comes to Latin America, I'm incredibly pleased with the Ascenty team with continuing its lead in the Brazilian market, supporting the growth of top customers as well as some of our international enterprise customers landing down in Brazil. As well as new market expansion success in Santiago, Chile, 2 sites across Mexico City. We'll probably have 1 new Latin American market in the next 12-plus months or so. By and large, that's a part of the world with very substantial growth, but I don't see really much value any of the other competitors from an M&A standpoint. Hence, I think we're going to go it alone in terms of our organic development of our land banks and new capacity for our customers versus any tuck-in or large-scale M&A in Latin America.

That's very great color, Andy. We have about 2 minutes left. So I want to sneak one more in if I could. I mentioned AMT this morning, and they were talking about edge data centers, and it kind of got me thinking about you guys. You haven't really done much there and obviously much more focused on core data center infrastructure. But I have been hearing more companies talk about wanting to building out edge data centers and the use case making more sense today. How is Digital thinking about edge data centers? Is it a business you want to get into? Do the returns make sense to you when you're running the numbers, Andy? Maybe just quickly how you're thinking about it.

Other than the fact that the name says, similar to the word cloud can mean a thousand different things, which is the last thing our industry needs in terms of potential confusion for our various constituents. I think edge is going to be a net benefiter to Digital in our platform today. It's going to drive incremental use cases, incremental data that's going to flow through our network hubs, through our cloud computes. And I think it's going to be a benefit to our existing assets that we have are building today. I think when you think about these accretive fashion where we're going to structure partnerships and extensions in various either joint ventures or wholly owned forms of relatively modest capital employment, but really platform extensions where we can continue to make it easy for our 4,000-and-growing customer base to tap into edge use cases and tie back to their infrastructure in a seamless fashion. I don't think we're all of a sudden become an edge company, and that's going to be the lion's share of our capital. But we've done many creative ways of structuring and partnerships in joint ventures and various formats over the years. So I put us up amongst the best when it comes to that capability. And I think that's the type of route we'll take to extend our platform for our customers to the edge.

That's a great place to stop, Andy. Thank you again so much for being here with us, and I look forward to seeing you soon.

All right. Thank you, guys, so much. Really appreciate it.

Take care. Have a good day.

Bye now.