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

Good afternoon. Welcome to our 5 p.m. session at Citi's 2022 Global Property CEO Conference. For those of you I haven't met, I'm Mike Rollins, and I'm with Citi Research, and we're pleased to have with us Digital Realty and CEO, Bill Stein and team. This session is for Citi clients only, if media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those joining us here in-person today to ask a question, you can step up to the mic that we have located in the center aisle of the room. And if you're joining us remotely, simply type your question to the box on the screen. They'll come directly to us, and we will do our best to ask them during the session. And so I'm also joined by Michael Bilerman with Citi Research. And Bill, I'm going to turn this over to you. We're going to ask you to introduce the company and your team that's with you today. And then we'll get right into our Q&A. It's great to see you in-person.

Great. Thanks. Thanks, Mike. So I'm joined today by Andy Power on my left, who is our President and CFO; and on my right is Greg Wright, our Chief Investment Officer. And I really don't think -- I think most people in the room know who Digital Reality is, so we'll save time.

Greg Wright is on the right.

Greg Wright is on the right, as he always is.

As the M&A transaction.

[indiscernible] always.

Well, that gets us to our first question. So what are the top 3 reasons an investor should buy your stock instead of any other listed property company?

First of all, we are a clear beneficiary of the tailwinds that are generated through digital transformation. So that's a trend that's affecting global enterprises and it's also affecting consumers. Second, we have a full product offering, full product spectrum from small cages and cabinets all the way to large megawatts as well as interconnections. And we offer that product on a global basis. And we're the largest provider of data center services in the world. And finally, we -- I think we've done a significantly -- a significant job of transforming this portfolio over the last 3 years. Today, well, pro forma for the Teraco South African acquisition, we're going to stand at about 50% highly network-dense assets. Those are assets that have much higher internal growth than the other part of the portfolio.

So as you look at the strategy over the last few years that we've been talking about the Digital Realty strategy, you've been repositioning markets and assets, and you just mentioned the highly connected assets with the target of 50%. What does that do for Digital Realty in terms of how investors should think about your growth rate both on the top line as well as on the profit per share line?

Sure. So we've worked quite hard over several years now to do several organic and inorganic initiatives to reshape this company into a truly global platform supporting customers from the enterprise colo customers seeing [ hybrid IP ] deployment to the hyperscalers, many of whom, we're their trusted partner in 40-plus locations around the world. What it does is it increases our value proposition to both ends of those customer spectrums. This is a one-stop shop within the [indiscernible] of deployment, operating model, form of contract, whether it's a network-oriented deployment or a data hub, whether you need that in Athens, Greece or Ashburn, Virginia. And it also makes it essentially more [indiscernible] eventually to our pricing power and in terms of being able to drive higher growth to our bottom line. Now we've been going through a transformation where there's been headwinds to that growth. But I think you can see some of the fruits of our labor. Now we call it a string of 7, 8 consistent quarters of sizable signings, so double-digit percentages of our revenue base, including a record fourth quarter signings. We added about $0.5 billion of signings in 2021. We added nearly 500 new logos to our 4,000 customer base. We're exporting more and more demand. We've been recycling out of slower-growth assets that we see as noncore as well as slower assets that we see as core into an incremental company called Digital Core REIT listed on the Singapore Exchange. And again, to fund also the bottom line, we're increasing -- our FFO came in -- we guided last year 4% at the midpoint, came in at 5%, including a hit from Chicago taxes, excluding the benefits of PPA and promote, and we guide to 5% this year in bottom line, while absorbing 150-ish basis points of FX headwinds, and near-term dilutions are temporary from buying one of the most connected assets in the world and certainly in Africa with the investment in Teraco.

Andy, where do you think you are in that transformation? What inning are you in? Because despite sort of that level of growth, I would say, the market expectation likely has always been higher than that, right, in terms of deliverable especially as you've embarked on significant M&A over time and some of that M&A having a long tail, given its development nature. But I always said that there's always something else each year that comes about that has delayed, I think, some of the stock price performance. And so maybe just talk a little bit about where -- at what point do you just say, okay, we got it? Is now just tinkering rather than moving big pieces of furniture?

Yes. I would say if you look at our portfolio and whatever support [indiscernible] whether we call it near the seventh inning stretch, we're kind of making a tremendous amount of progress in, a, globalizing this company to 50 metropolitan areas around the world, 26 countries, 6 continents, diversifying our offering so that 40% of that [indiscernible] new signings within the less than a megawatt interconnection category. The mix is probably a little over 60% North America, 33% are sold in Europe. We still have a ways to go in installing our APAC presence, but we are proud of what we have with the first carrier-neutral destination to South Korea along with the hyperscale build in Western Seoul. Leadership role in both the Tokyo and Osaka markets, one of the top providers in Singapore. So I think there are many elements here. We've extended our lead with the hyperscale service provider customers, and we played a tremendous amount of catch-up and really being 1 of 2 global providers to enterprise colocation customers. And I think that gap between us and any potential third relevant competitors continues to widen. So I would say we're down the road of very far away in terms of reshaping this company and our value proposition and enhancing our growth.

So seventh inning stretch?

Take me out to the ballgame.

And so where -- how many innings have you played in the last couple of years? I'm just wondering the slope of this thing. I think -- I mean, do you not feel as though the -- I mean, is it the investor base that's just asking for too much? Because I think the way the stock has reacted to some of these transactions -- and this is not the first time you and I have had this conversation, right? So it's not something that's only acute to one thing.

I think it's very opportune that we're at a traditional real estate conference, which are more traditional real estate asset classes than the nontraditional, the niche data centers and we've been doing a massive transformation of public markets that included us buying things that were initially dilutive but ultimately accretive to our cost of capital, selling things that we viewed as lowering our growth and of lower value at attractive valuations outright that were noncore and joint venture in things that are core to us, but are also slowing our growth. All those events typically do not lead to acceleration or accretion to your bottom line. And we've been trying to have a [indiscernible] in the public format. And we started out with a very welcome conservatively covered dividend. We never put our dividend at risk and grown it each and every year since we've been a public company since 2004. We, as a team, made very tough long-term decisions with transactions near the end of performance plans that said, you know what, we think this is the right thing for our company and our shareholders. And we think we're really strengthening this platform over the last 5, 7, 8 years or whatever you want to call it at the time period, certainly under Bill taking the helm here. And I'm as anxious and eager as the last person to accelerate every metric. And I think we're coming a point of maybe in the pricing cycle where that pendulum is starting to swing back in our favor due to numerous things that we've done as a company as well as a broader market backdrop. And so don't wait forever, but I think there are some progress points we've proven along the way in our execution.

Michael, if you think about the innings analogy, I'd say the first inning was in 2015, when we bought Telx, which is the second-largest interconnection player in the U.S. And you could say every year after that represents an inning. So we are in the seventh year since Telx, and maybe it's the seventh inning. But when I look at our guidance this year, which is 5%, it has 150 basis points of headwind from FX. It has 100 -- the same-store has 100 basis points of headwind from property taxes in Northern Virginia. And then you have the Teraco transaction, which year 1, we said it was negative 100 basis points, year 2, it's even, and year 3, it's 100 basis points. So we have a 200 basis point swing from that.

Is there a possibility...

We can go from -- it can go from 5% to 6.5% to arguably 8.5% just with that, and that's without any positive pricing from inflation.

Right. But investors own -- they all know all that today. You can't -- I hate it when companies say, well, our portfolio is doing great except for these 3 assets. It's like, well, yes, I still own all that because I own a share of the entire company. But how do you think about the building blocks in '23, '24 and '25? So we're looking at a 3- to 5-year growth. And are you able to sort of -- because you've done so many things, and there are a lot of moving pieces where it's dragging on 1 year and accelerating in the other, of being able to clearly lay out how that growth could accelerate in the future from all of these things that you have? I mean, is that something that you would entertain, providing to TheStreet at this point?

I think the puzzle pieces are there and maybe we need to do a little bit better job articulating them. Let's start with the organic puzzle pieces. Say cash mark-to-markets were negative -- better than guidance but negative last year, and we're guiding to flat this year in terms of what's coming due. The mix is much more heavily interconnected, much more less than a megawatt category, 18-ish percent. On the bigger stuff that has more pricing pressure at the ball, let's call it, 200 basis points smaller, it's more international. So we're moving to better territory. They will obviously flow through our organic same-store growth. We're also re-leasing some of the nonretained capacity that we've gotten back or we're getting back. It is a large [ sums of ] space in some of our weaker markets such as in Ashburn, but we're making great progress on that. And we're also -- those leases will commence throughout the calendar '22 and certainly for a large -- if not all of '23. And as we look at the horizon beyond that, we see an exploration schedule where we don't see these large swaths of nonretained capacity that we've taken back, and we see a tighter pricing environment, given the mix of what's coming due. We are at the short final strokes of our noncore dispositions. We've done a few -- almost a few billion over a few years. We view that every asset of the portfolio is reviewed for the long term on an annual basis, when we think we're going to do really a very short list by now. And then when it comes to our equity funding sources for our $2.5 billion of development spend, it's a 9% to 12% unlevered return on the cost. We obviously historically predominantly use the equity market in addition to noncore dispose. We think the creation of Digital Core is an excellent partner vehicle to really efficiently fund at an attractive cost of capital at risk and caliber of the assets that we're contributing that are core to digital, but slower-growing than DLR. So this format, in my opinion, speaks to a growth acceleration. And I think we're widening our gap from a competitive landscape in terms of value proposition to both the hyperscale customers and the enterprise customers broadly.

Yes. I think it's outlining some of these drags too that -- some of the risks to numbers so that the market is clear on potential headwinds, whether they be FX tariffs, you talked about some of the transaction activity, but being very clear maybe in the supplemental pages of building blocks, because it tends to be -- your stock tends to be much more volatile on earnings where it shouldn't be. And then I would say also, if you think about like someone like Prologis, a global company, we don't hear about FX issues because they've gotten their balance sheet down to 95%, 97% USD even though they're a global player. And so I'm just trying to understand, are you not hedging the right way? Is it not swapped right? Are you not borrowing enough in foreign currency? Why is it coming more of an issue for you versus other global entities?

I wouldn't say we've had a history of FX issues. I think FX is just prominent this particular year in terms of headwind. I don't recall coming to this conference the last 7 years talking much about FX quite honestly. Now we have become more global, more recently. We are a very big borrower in the non-U.S. dollar bond markets. I barely got invited to your Investor Day [indiscernible] because I haven't done a U.S. dollar bond in many, many years. So we're doing similar playbook to Prologis that we didn't invent with Eurobonds, Swiss bonds, Sterling bonds.

You're just not there from a net equity perspective yet to minimize that FX impact? I mean when that merger happened, they were like 50%, right? So it was a massive big headwind for them.

We also closed on an $8.5 billion European business [indiscernible], right? So -- and that was a stock-for-stock transaction that is going to just take time in terms of our debt needs to get there.

So one of the transactions that you mentioned earlier, Teraco. Can you unpack what you're seeing in that market that has the company excited? And can you unpack the valuation for that transaction? And how that -- you mentioned the accretion, but how that scales from either a multiple or return perspective?

Sure. Sure. Thanks, Mike. Look, I think let's take a step back on Teraco and look at a couple of the key components. So first of all, there's 187 megawatts in Teraco today. Now of that, there's 75 megawatts of capacity in place. That's not leased yet, a portion of it is leased, and there's leases signed, but a lot of that revenue is not in place yet. So booked but not billed. So that's 75 of the 187. We then have 20 megs that are under construction. Again, a good portion of that is pre-leased. So again, none of that NOI, if you will, is in the 3.5% or contributing to the 3.5%. And then finally, that leaves you with about 92 megs of capacity in future development. Now I think it's important to understand, these are not disparate sites just somewhere in South Africa. I mean these are immediately adjacent sites on some of the most highly connected campuses in the world. And I know when you say that, people always want to take [indiscernible] in the world. Yes, in the world. I think when you look at this, when you take a look at where the subsea cable landing stations are in this portfolio, they have all the major carriers, all the major networks, all the content distribution folks, you name it, and they have them in this portfolio. The question that I'll ask you guys. You look at One Wilshire, right? Everybody thinks of that as sort of the mecca of connectivity. How many cross-connects do you think that has, give or take?

I bet you know the answer.

I do, 10,000 to 11,000. Johannesburg 1, 13,000. My point is, that's significant. So when you go and look at this portfolio, this portfolio is over highly connected. So it's important. So we broke down those components. We broke down what the underlying business is. Now let's go through the math. So as you sit here and look at this, that's a 3.5% yield on the most highly -- one of the most highly connected portfolios in the world. So you're going to say, what are the returns? What is that 3.5%? That's what everybody wants to know. We look at this, and we always look at everything on a risk-adjusted basis. And when we look at underwriting and the like, and we see an unlevered IRR that's 1,000 basis points over the 10-year treasury, so the 10-year treasury is 9%. So we're looking at the high teens to low 20s unlevered returns over time. Now it's come in over time, you're going to finish building out these pieces of the puzzle. But when we look at that, and I promise you, we scrutinize this closing. We're looking at currency risk. We're looking at country risk. We're looking at development risk. I mean you can adjust for all these things. So in our opinion, when you get one of the most highly connected portfolios in the world and then get what we think are appropriate risk-adjusted returns, in what is really a gateway of a continent that we think has got a lot of upside. When you look at the average age, it's a young population. You look at the digitization metrics, right, whether you're looking at mobile phones, whether you're looking at social media, any of the digitization metrics, they are all getting stronger and stronger, they're projected to get stronger in Africa. And so we view South Africa as the gateway to Africa. And don't forget, the whole continent has got 1.4 billion people. So it's 20% of the world's population. And it's not coincidence when you look at this, you look at the positioning, you look at what we have in Marseille and Western Europe, how that comes down. You go to Eastern Europe and you look at Croatia and you look at Athens, that's not a coincidence either. And you started to almost look at the 5 legs, if you will, then look at Nigeria. We bought a company called Medallion there, very highly connected. You look over in Kenya through iColo, then Mozambique and, obviously, South Africa. We view that as really sort of a crossroads of connectivity, if you will, that's going to become very important strategically over time. I mean that's generally how we look at it.

That's really helpful. And in terms of the inflation topic. Can you talk about how inflation affects your business, whether it's on an operating basis or in terms of the cost to build new data centers and what that does for the business model?

In terms of cost to build, we're hedged through '23 with our vendor-managed inventory program. After '24, I'm sure we're going to see some bumps and our construction folks are estimating 5%, but obviously, it could be more than that. From a labor standpoint, and so far, we've been in pretty good shape. We've not had much in the way of increases at all, but that could change as well. But -- and labor on the sites, so the construction labor costs, there, we're in a good place, too, because we're the largest builder of these things in the world. So we keep these firms very busy and move from one project to the next. And I think they really appreciate that. It helps them to keep their workforce fully engaged. It's better than sort of stopping a project than having to find another one.

And in terms of pricing, in some earlier conversations late last year or early this year, the management team has talked about maybe some opportunities to get pricing in this environment. How is that going? And in terms of whether it's on renewals or new business.

I mean we're definitely pushing price in markets where it's appropriate. And those markets are where there's a limited supply, and we own the supply, and the demand is generally high everywhere. And we're finding that's happening in a lot more markets this year than last and more last year than the year before. So I'd say the trend is definitely positive. And we're not bashful about asking for increased prices. Andy, you want to add to that? The same on renewals.

And so is that effect -- as you're now looking deeper into this year and have more time operating this year, does that strengthen the conviction on what renewal spreads should be for Digital?

You're asking if we can change our guidance. Well, we just put the guidance for 2022 about 2 weeks ago. So I don't have any change in guidance, but we have a really compelling value proposition for our customers, a global solution across the product spectrum in a world where inflation is increasing cost for competitors, supply chain bottlenecks or slowing supply, various markets are slowing the progress of growth of data centers, various sites are being more challenged and power too. And across 50 metropolitan areas, we have extensive campuses that include highly connected destinations all the way to land banks, which improve our customers' growth. And in a world where our demand has had these secular tailwinds that benefit us with consistent growth for numerous quarters and years now, including some pretty sizable quarters like the fourth quarter, which was a record partly for the industry and for Digital Realty, that backdrop says we've got a lot of value for our customers, and we're just trying to get a fair commercial return for that offering.

And given the global portfolio and exposure, is there any exposure that you have, the Russia or the Ukraine?

We are -- No, we're Germany, Croatia, Greece would be the closest in terms of countries. Poland, Ukraine, Turkey, anywhere called -- in terms of Russian customers, it's a fairly short list that is immaterial. We've got 4,000 customers at Digital, [indiscernible] customers less than 1% of our revenue. And Russian customers in total is very immaterial. We probably have one that may end up on sanction, so we might have to disconnect. We'll see when that time comes. But I wouldn't view this as a material impact to our business.

As you look at the portfolio, you can look at it by customer vertical as well as geography and market, are there certain verticals or markets that are really strengthening the performance as you look at the exit from 2021 and you're now looking into 2022? And are there any areas that we should be mindful of that might be softening to any significant degree?

I think the theme I just mentioned in the context of pricing has been a little bit of a rising tide that's lifting all ships in terms of market, but to lesser degrees, probably North America and much to a greater quantity in the non-U.S. markets, be it Europe, Latin America and Asia Pacific. If you look at a customer lens, on the hyperscale front, I would say we continue to extend our lead, has been a trusted provider of choice to those hyperscalers in 40-plus locations, and we're making great inroads with next tier platforms. Some companies you probably didn't hear of just a few years ago, but are also entering the megawatt plus purchasing category. On the enterprise front, I think we've done -- made great strides. And you can see that in the execution of 40% of our signings in less than 1 megawatt, massive contributions to our new logos, a significant amount of exporting of demand to different regions. Certain sectors have been top performance of financial services, I think we've been a stand out, we've had great success in gaining the media. And I think we've got more progress. We're going to continue to making that in terms of really harvesting fruits of our labors in that arena.

The stock relative to prepandemic levels, right, so if you go back to February 2020, stock down a couple of percent. NASDAQ, up 31%, Broad market, up 24%, [indiscernible] up almost 10%, [indiscernible] dividends. And Equinix is up about 5%. So when you look at the stock price performance, what are you backed by what should have been in hindsight, right? Would you say that digital side should have been much higher, right, just given what has happened in the last couple of years? So when you look at the valuation today, what do you think the market is missing? And what are you going to try to do to change total return? I mean or do you view it as an issue? Or do you view your stock price performance is fair? Maybe I'm saying that it's been bad, but maybe you think it's the right level.

I think right now, we're in a period of time for whatever reason or not, there seems to be a sizable dislocation between fundamentals and long-term business trajectories for not just digital, but you could just quote Equinix being in the same vicinity. Two global leaders in a business that has tremendous tailwinds with digital transformation, we're not necessarily fighting each other based on a competitor deployed data center customers out of one from another. We're talking about new incremental demand, use cases, applications, come in many markets. Unlike a lot of the other asset classes that are attending your conference. So I'm not -- I'm less about the relevant because I'm no longer steep than the other asset classes so -- but within -- I look at our business, and I look at the business, it's tremendously strengthened in just the last 2 years in terms of what we own today, our funding sources, our execution. And I really like the tailwinds to our industry for the future. And this is a time to [indiscernible]. So I'm obviously biased in that, but it's -- I think that there's upside to our business. And I think we're going to be less prone in the long run to the impact that these higher-flying current sectors are going to potentially stare us down the road.

But Mike, I would say also, I think it's temporary because like I think if you had asked that question on December 31, it would have been a very different answer because you wouldn't have the same series of statistics. So I think you need to ask yourself what's happened since year-end. And there's a couple of things, right? There's rising interest rates, interest -- actual interest rates have gone up. There's also lots of job owning by the banks on TheStreet, whether it's going to be 5 increases this year or 10 increases, not insignificant. I also think the fact that you're coming out of the pandemic. I think during the pandemic, I think people highlighted how important this digital infrastructure was. And now that it's -- now that you look at the number of Omicron cases coming down, I think that's having an impact. And that I think disproportionately not only affects us but others in the digital infrastructure space. And finally, you have the tech selloff. So when you look at all that, you talked about the REIT market being down 10%, the NASDAQ is down 20%. So I think if you look at the combination of those factors, and it would tell me in my experience, that it's temporary. But I think when you look at the underlying fundamentals and what we're trying to do, I think that's strong, and I think we got to just keep doing the right thing. But I think those temporary factors -- well, I shouldn't say temporary, I don't know how long they're going to last, but they're impacting your stock price, disproportionately.

Yes. I mean the NASDAQ up 20% this year, but it was still up 31 point to point. So you follow the same decline this year, but you didn't have as much upside as things went, right? I know it's all point to point. but there's still a differential there at a time where you had 3 privatizations in your industry, right? So it's a little bit contrary to you have private capital that's paying massive premiums for companies that do your product.

But again, they didn't pay those since December 31, right? I mean that's not -- paid them last year. It's a different market today.

No, I know but even if you go year-to-date, Greg, there's still -- it's not like you're outperforming by such massive degree.

No, no, that's right.

You got to take the academic debate offline, but let's just put a cover over the stock price for a second. Since the COVID pandemic happened, Digital Realty has become the #1 or #2 in every European market [indiscernible] interaction, further extended by buying the fee simple out of the leasehold interest in that -- for that company, spanning in Greece and Croatia with other similar investments, done almost a version of interaction called circling Africa to North and South. We've organically brought colocation capacity onto 5 or 6 APAC markets. We've put up 8 successive solid signing quarters with a mix of almost 40% in less than 1 megawatt. We've sold billions of dollars of what we view as noncore assets that someone would say, very attractive valuations. And we've created a partner vehicle to be the home for our hyperscale business that we can serve those customers and protect those customers and those assets but have a more attractive funding source. That seems like a pretty good 2 years to me. So no, I don't feel like the stock price is appreciating.

Right. And that's what I'm trying to figure out of, like, is it a communication issue? Is it the market not understanding the numbers? Is it the other sort of onetime things? What's holding it back for you? And what are you going to do to try to get people -- I mean you've had 2 days of meetings, so I'm curious what the investor feedback is.

Michael, I think the one very important thing for us to do is demonstrate pricing power. So we need to push hard on prices. And I think if we're successful in that area, that will filter through to same store, and I think that will be very helpful because that's what we've been hearing, too, pricing power and same-store.

You don't control pricing power, right? That's going to be much more of a factor of demand and supply. You can ask for -- I'd love to rent my apartment for a big number, but if no one's willing to pay, I can't really push pricing power. So how do you influence that?

Supply is shrinking, and demand certainly is not shrinking. Demand is still expanding. So it's like our economics in each market.

And so maybe one question on this topic is, if you take your portfolio and you look at the 50% that's going to be more connectivity-centric in nature, and you take the other half that's going to be more hyperscale and enterprise. Over time, what should be the stabilized same-store revenue growth for each of those pieces? If you think of escalation, you think of the churn, you think of the digital services that you're offering, just a rule of thumb of what you look at in terms of the relative growth rates for each of these sides of the portfolio?

The stabilized portion that has less pricing power and has more holding to the contractual bumps is call it 1%, 2% type of growth over cycles in my opinion. And the more pricing power piece with more connectivity which -- how should we -- I mean should be 5-plus percent growth.

So that means, over time, if you take the blend of that, the same-store constant currency growth opportunity is, call it, if I do the math on this, like 3% to 4% type of range?

True same store. I mean we're going through a massive transformation here in a time when pricing dynamics are shifting on the global business. I think, listen, maybe I'm conservative on the blend on that. But when you just talk about the revenue on a constant currency basis, when you're talking about escalation and pushing cash mark to market on something that's apples to apples, period-over-period, I think that's probably we come out on those numbers.

Very helpful, right. So we'll hit in no seconds, same-store NOI growth?

[indiscernible]

All right, definitely really quick.

Make sure no one goes to cocktails before we get through this, please.

Store NOI growth for the data center sector overall in '23?

Low single digits.

10-year treasury yield?

3%.

More or fewer data center companies a year from now, data center REITs?

I don't know that we can get much lower. Same.

All right. Thank you.