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

[Audio Gap] But I think the criticality of our service offering and the efficiencies, productivity gains and, call it, future-proofing in many of our customers' business by moving to some hybrid IT type of deployment using numerous cloud providers. At the end of the day, I think it's improving their business and not necessarily in the discretionary type spend to most corporations.

And the leasing backdrop, particularly for hyperscale, has been incredibly strong of late for both digital and the industry. Can you talk about the drivers and the sustainability of some of those demand trends?

Well, you're right. The leasing demand has been tremendous. We've had 2 record quarters in a row here. The 2 primary drivers of demand are hyperscale and enterprise. The hyperscale providers are building out their presence, which is primarily the cloud all around the world. And they've been a growing part of our demand backdrop now for almost a decade. And I can say that the demand from that group of customers is broader and stronger today than I've ever seen it. Enterprises, too, are undergoing a digital transformation with existing applications that are migrating away from their owned applications to new applications that they frequently involve emerging technologies like artificial intelligence. I think the recent pandemic, which is hopefully behind us, serve to accelerate many enterprises' digital transformation plans. Those that were further ahead did better during the pandemic, and -- but we do think that we're in the early stages of this transformation.

And within hyperscale, is there any risk that some customers have taken on too much capacity?

Look, in the past, we've seen what we call digestion periods following periods of elevated demand on the part of the hyperscalers. That doesn't appear to be the case today. This likely is more a confluence of hyperscalers in various markets throughout their global expansion, just growing capacity, many of them growing in different markets around the world. So I think it's going to be different this time.

And I think the other data point that -- I mean we're always concerned of a pull-forward demand is there going to be a pocket at the front is that not only are they signing new business with us, but they have incredible urgency on the delivery time lines and pressing us to bring those time lines in and meet those rapid time lines, which if I was a customer, just putting a marker on some space for future needs. I wouldn't be spending so much energy in cycles and focus on those deliveries.

And I think on that have you seen your vacancy rates come down quite a bit. Are you seeing more of those hyperscale customers trying to almost secure space for future needs and maybe lengthen commencement time lines?

I wouldn't say that they've lengthened their commencement time lines. They have asked for ROFRs on a lot of space and reservation rights. We're seeing a lot of that. And what's happening is though the move into their -- the space that they agreed to lease. And I mean, before we know it, they hit the ROFR and they're signing more space. And then they're trying to get additional ROFR space. So it's a very interesting time to -- and the business, as I said, has been extremely strong.

Maybe shifting to same-store NOI growth. It's been uneven quite a bit over the last couple of years. And the full year guidance calls for a 3% decline. Can you unpack the headwinds that are creating a drag? And what are some of the tailwinds that would improve the trajectory moving forward?

Andy, do you want to cover that?

Sure. So first off, we're in an incredibly volatile FX environment. And with the portfolio now shifting to be fairly geographically diverse with a large contribution from Europe overall. We've had significant couple of hundred basis points of FX headwinds to these numbers. It's kind of, yes, it's a headwind to the P&L. But quite funny, on the other side of the coin, Europe is our largest development market. So if you look at the cash flow statement, our CapEx going to building new data centers, actually, those -- that FX depreciation is a benefit on a conversion rate of our cost to build. And we're not repatriating euros back to dollars. We're building more data centers, growing our footprint in Europe. Beyond that, we are -- the 2 major drivers have been some downtime associated with releasing some recently vacated capacity as well as some headwinds on the cash mark-to-markets. The good news is we're making good progress in leasing that recently vacated capacity. As you pointed out, the vacancies in many markets getting tighter and tighter, and that's allowed us to sign more and more into those available capacity with high flow-through revenue to our same-store pool and to lead our EBITDA. And the pricing environment is starting to firm. I would say we call it on the dawn or the beginning of the pendulum pricing, call it, shifting back in our favor more and more, which you saw some of our cash leasing spreads in the first quarter and our outlook for the full year as well.

Yes. Maybe on that topic, just pricing more broadly, how is it evolving? Is it broad-based from a market standpoint? Where are you seeing the strength? Where are there still maybe pockets of weakness?

We're seeing strength generally around the world at this point. There are 2 sides to this equation. One is demand. And demand has been, I'd say, consistently strong, but the other side of the equation is supply. And there's been a fair amount of supply in a number of markets around the world, but that supply is drying up. There's been a lot of absorption, so that's part of it. But the other piece of it is, it's getting harder to develop in a lot of markets. There's less land. There's less power. There's more involved in getting entitlements. And frankly, the supply chain has probably helped in that regard as well. Because really, it's harder to get the material and labor is tighter. So it's made for better pricing pretty much around the world.

Andy, you mentioned the re-leasing spreads, maybe the outlook looking a little bit better. It's been a little bit volatile in recent years. Are we through the worst of it? Or are there still some volatility to come.

I think 2 things have played out in the last 12 or so months or even more recently. One, we've done a lot of hard work chopping through some of our toughest renewal comps in some of our markets impacted by supply, where we had the greatest pricing pressure, along also some larger customer contracts, multiple contracts with large customers. So we made -- chopped a lot of wood working through that and faced at the beginning of this year, call it, a comp set that was much more heavily leaning towards or less than 1 megawatt, more network dense, connectivity rich, stickier, higher pricing power components of our portfolio and as well as in the greater than megawatt categories, more of our non-U.S., our international footprint, where we also have higher pricing power due to some of the barriers to entry that Bill is mentioning on bringing on new supply. In addition to that, as I mentioned, this pendulum pricing has started to move in our favor. I say we're at the beginning of that because we've had some headwinds for several years now, especially on the larger footprint -- part of our portfolio in terms of pricing pressure. But given that consistency of demand for, call it, 10 quarters of $100 million of GAAP or more, capped off by 2 records in a row in the fourth quarter and the first quarter and the supply chain bottlenecks, it's allowed these pricing to flow through to our spot rates on new deals and allow us to have a better negotiating position on our renewals as well, but they all contributed to what you saw in the first quarter and our change in outlook for posture just about a month ago.

And maybe just on pricing. How are you thinking about that in an inflationary environment? I think, typically, escalators have maybe been in 1% to 3% range, give or take. Does that conversation change in this environment?

It's definitely changing. I mean we're pushing initial pricing and we're pushing escalators. We're trying to push -- I mean in Europe right now we have many of our customers already on CPI-based leases. But in the U.S. here with our customers, we're trying to move new deals to CPI-based escalators with floors.

And then how should investors think about core FFO growth for Digital? FX has been a drag, as Andy mentioned. But outside of that is 7% to 8% kind of a reasonable range and expectation longer term.

We've purposely done work on the portfolio, both organic and inorganic that have created headwinds toward year-over-year growth, which we think have been prudent investments, be it Interxion or Teraco to come that we have accretion over time with slower growth as well as our capital recycling aspects. Last year, we guided 4% FFO per share growth. We came in at about 5%, 100 basis points ahead, excluding a windfall from a power purchase agreement, so a really clean and core beat. This year, we guided to 5% at the beginning of the year. We have maintained that guidance, absorbing some issues from one of our customer bankruptcy as well as over 200 basis points of FX headwind to the point where we're at constant currency core FFO growth at 2022 of almost 7.25%. We're not even at halftime of 2022, so 2023 guidance isn't ready to be rolled out here already, so I apologize if that was the next question. But as I think things are firmly up on the pricing side, the leasing trends have remained intact, including consistency as well as some records. The overall price environment is improving, which should also move away from a tailwind -- of a headwind to a tailwind. We're signing more and more capacity into that move-in-ready capacity as flows to the bottom line and paying up a backdrop that we should have continued acceleration to our core FFO per share growth. And I've said this for most of my conferences, I think, when we get to 7% as reported, not constant currency growth, that feels like something that's very attainable that we can execute on as a business. I don't think going beyond that would be something I'd be rushing for. Because honestly, I would be pushing to do incremental contributions and growing Digital Core REIT as our partner vehicle, which I think will also continue to give us more sustainable long-term growth to the bottom line for years to come and absorbing those headwinds beyond that. But for now we're measuring and metering that out in terms of that year-over-year drag.

Is there a number for Digital Core REIT around -- for that REITs in terms of how much you would expect to allocate to that? Or is it going to be somewhat random?

So as part of that process, that IPO process, at the end of last year, essentially, there was definitely a desire for -- from the market for us to articulate how big we think we could grow this vehicle based on what we, Digital Realty, control today in terms of our current portfolio and our development pipeline and what we think fits the profile for that vehicle, which, as a reminder, our core digital assets, parts of our campus, large and growing customers, fully stabilized-type assets, we think that we can grow that vehicle from, call it, $1 billion and change to $15 billion over time. That's not going to happen overnight. There's obviously restraints on how big that market in terms of raising capital. But the true governor at this very minute is we're moderating that to our capital needs and monitoring that to the amount of dilution we have from losing income-producing assets before that capital makes a way back out the door and generates a much higher return on investment in our new development capacity. So that's what's really solving for that, call it, $500 million to $1 billion-ish type of capital recycling number in our guidance.

If anyone has any questions, happy to take them. All right. Maybe shifting to the development side. What are you experiencing there from a cost standpoint? And to what extent, if any, is it impacting yields? Or how are you passing those on to customers?

Well, for our current development program, we've locked in our pricing from our suppliers through what we call our vendor managed inventory program, and that's going to keep our costs very predictable until early 2023. It also ensures that we have supply of materials. So that deals with all projects that are currently under construction. For projects that are beyond the current development schedule, there will be higher pricing, obviously, because there is inflation. But we would expect that the rents that we'll receive from our customers will at least offset those increased costs. So yields will be at least flat and could quite likely be higher.

And any impact from some of supply chain challenges that are out there on either development or lease commencement time lines?

Not really, nothing yet. Not to say it won't happen, but so far, so good.

The vast majority of your business passes through energy prices to customers. Where that is not the case, what has been the impact? And I know no customer likes higher prices, but how receptive have those -- has it been?

Sure. Based on the face of our P&L, I can see 88% to 90% of our power is passed through. We have a hedging program, feathering hedges across our deregulated markets, call it, 85% hedged. We also, as part of our sustainability initiatives, are a very large contractor or power purchase agreements that create the creation of wind farms and solar plants. That also have a, call it, derivative-like hedging effect for our cost of power. Net-net, it's a couple of pennies of headwinds at the currently elevated power exposures. I would say Europe, in general, has been at the eye of the storm relative to our size of our portfolio in power. I don't -- we're very transparent. We're very open and communicative with our customers. That's in good times and bad, and that comes to this power topic, whether there's a snowstorm in Texas that cause a spike in the power or something more macro and global like we're seeing today. What we have not seen is this really changing the buying behavior to date. Going back to my commentary on the economic impact, the cost of the power and the total cost of occupancy is not changing our buyers' behavior just saying, "I want less data center space." It's just a critical piece of infrastructure they need for their business. And we're doing our best as a business to help them navigate that and insulate them with our hedging strategies and our efficiency projects. And I think the communication has been as good as it could be given the news we're delivering.

And for some of the largest customers that are not on metered power, is there any push from them to move towards metered power given where energy prices are.

Most of the customers that would make sense to be metered power, i.e., dedicated data hauls or large swaths are already on meter power. They kind of -- water finds its own level when you kind of move from cabinet shared environments, move from just smaller footprint or network-oriented and you need larger compute, you kind of make that leap as a customer in terms of the product you're buying from us already. I wouldn't say there's very few customers that, call it, are dangling behind and just haven't gotten to a power bill that is metered.

Maybe on the competitive backdrop, there's been tremendous amount of consolidation within the industry. What has been -- or what are you seeing as a result of that? Some of the companies that have gone private now have maybe better balance sheets or more capacity to develop at higher levels than they were previously. Is there any -- are you seeing any impact from a competitive standpoint as a result?

Better balance sheets.

More leveraged balance sheet.

Here we haven't, actually. There's -- I mean one of our competitors, I think, had a fair amount of absorption we've heard in the fourth quarter. But now I think they're out of inventory, at least in Northern Virginia. And then we've heard that another one of the public companies that's now private has gotten out of the enterprise space is only doing hyperscale. So that's -- both of those factors are good factors from a competitive standpoint. But we haven't seen any pressure on prices, and we would expect, frankly, the opposite since their capital is clearly very sophisticated capital. And I think if that capital knows that they have the opportunity to raise price, they will certainly take advantage of that to push price and earn higher returns.

Maybe shifting gears. From a sustainability standpoint, what is Digital doing to minimize the environmental impact of the immense amounts of power consumed by data centers?

Well, we take sustainability very seriously. And we've won a variety of awards that reflect our leadership in the area. I mean you hear at Nareit, we won the Leadership in the Light Awards every year since there's been a category for data centers, which I think is 5 years. We're very proud of that. But we were the first data center provider to set science-based targets to reduce carbon emissions while we continue to grow our number of green buildings. We're a leader in renewable energy, and we do that by sourcing renewables directly from the source rather than by simply REX. That's an important distinction. We also build our data centers to be increasingly energy-efficient. So that means we have lower PUE, so that means less energy to cool. And we put innovative green solutions in where we can. For example, in Marseilles, we've used a river cooling system that uses cold water from an underground river to naturally cool those facilities.

To the extent there are costs associated with some of these initiatives, are customers willing to pay for it?

I would say, absolutely. In many instances, having a green data center solution will, if you will, a renewable power is a prerequisite to getting the business.

Is that -- does that hold true for both the hyperscalers as well as lot of your enterprise [ customers ]?

I think it's more hyperscale than enterprise. Enterprise is taking smaller footprints.

Maybe on the balance sheet, I guess, Andy, this one's for you. Just how are you thinking about leverage is probably a little bit above where you'd normally be? What's kind of the ideal leverage number that you'd kind of target? And how big trend from where we are today?

We're a little higher on an as reported debt-to-EBITDA basis, but well in the comfort zone of our fixed charge coverage. And I would say it's temporary. We haven't lost our religion on having a strong commitment to investment-grade rating and a conservative balance sheet. And the as-reported number is a little bit misleading given the moving parts in our business, including sales and joint ventures of noncore assets, losing the income immediately as well as an equity forward. We haven't drawn down $1 billion as well as downtime and re-leasing and commencing leases for vacated capacity that's going to drive significant amounts of revenue and EBITDA at the bottom line because we're already operating that infrastructure and that cost structure in our P&L today. So we see ourselves getting back into the mid-5s range, call it, end of next year and into '23. And on the equity side, our funding source is really from turning to a continuation of some of our noncore asset sales as well as contributions to Digital Core REIT in that $500 billion territory. And we are very fortunate to term out a lot of debt from the beginning of the year with close to $1 billion, and they call it sub 2% at the beginning of the year, and we'll look to continue to tap numerous currencies across the globe, funding growth on the debt side going back in the back half of the year next year.

Maybe last chance, if there are any questions in the audience?

[indiscernible]

We're really not doing a lot of -- we're not doing any new market expansion right now in the U.S. but we are adding capacity in existing markets. So we -- Northern Virginia is -- there's a lot of demand in Northern Virginia. We're building out in Portland. Toronto is a very strong market. Dallas and Chicago have gotten strong again, even New Jersey is strong. And then from a [ colocation ] standpoint, our core markets looked like Atlanta, Chicago, Seattle and L.A. are very important, and we're quite excited about those. And we're looking to add capacity in all those markets.

All right. Great. Thank you, Bill. Thank you, Andy, and good luck with the rest of Nareit.

Thank you.