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

At Citi's 2023 Global Property CEO Conference. For those of you I haven't met. I'm Mike Rollins with Citi Research, and we're pleased to have with us Digital Realty and CEO. Andy Power. 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. [Operator Instructions]. So with all those details out of the way. Andy, great to see you. Welcome back. We're going to turn it over to you to introduce your company, any members of the management team that are with you today, provide some opening remarks, if you like, and then we'll get into our questions.

Great. Thanks, Mike. Really appreciate having us back here at Citi. Digital Realty is the largest owner or operator and developer of data center and connectivity capacity worldwide. We support north of 4,000-plus customers across 50-plus metropolitan areas, 30-plus countries on 6 continents, spanning the full customer spectrum of capabilities from enterprise-oriented cages and cabinets all the way to dedicated data halls for many of our hyperscale customers. With me on my left is our newly appointed, new and improved CFO, Matt Mercier. In my right, former Citi Alum as well, Head of Public-Private Investor Relations, Jordan Sadler.

Great. Well, the first question we're starting off with everyone here at the conference is what are the top 3 reasons an investor should buy your stock today?

So first and foremost, we're in an industry that is just incredibly blessed by secular tailwinds of growth above and beyond macroeconomic trends, and those trends continue to compound themselves in terms of growth. Digital transformation for our customers certainly has been unfolding for years. The pandemic certainly accelerated that. And whether it's our enterprise customers saving hybrid cloud deployments with -- on our platform or our hyperscalers, opening new markets and the incremental new demand that is being opened through things like artificial intelligence, which we talked a little bit about on our earnings call, the tide is rising in terms of demand. Two, we believe we've assembled a platform that has really created a competitive moat for the -- that stand -- will stand the test of time. In the enterprise category, we are on a very, very short list in terms of being able to offer these global capabilities, and we are the largest and most trusted partner amongst the hyperscale customers. And we stitch that together in terms of infrastructure capabilities and connectivity solutions on a global scale. But also at the same time offering local expertise. Last but not least, times have changed at Digital. times have changed in terms of the fundamentals. You saw from our guidance, we've had an inflection in pricing power. If you were here last year at this conference, my track of the pendulum was moving more and more in our favor. You saw that come through our results in our new rates on new signings. You saw that move as we went -- inflected to positive cash releasing spreads for the first time in many years. We've guided now to greater than 3% on the cash releasing spreads as well as same-store growth and occupancy increase. So the price of power element to our story is coming into the fold in addition to some new changes with the management leadership team as well as the Board over the last, call it, year. So I think we have a bright future ahead, a great platform and the trend is moving in our favor.

Speaking of change in governance, digital put out an announcement today on some changes at the Board level. And I'm curious if you could share a little bit more details of what's happening with the Board. And as you think about the changes to the Board, the management team, has this adjusted the way the company thinks about its north star in terms of goals and aspirations for what you're going after?

I would -- so our -- the press release that was -- clearly hit the wire today, just for those who didn't pick it up in the busy conference schedule, was essentially our most longest tenured directors are 2 former independent chairmen, who have basically been on the Board for 18-plus years around the time of the IPO, we bid a fond farewell. And this called Board succession, corporate governance continue to bring fresh, diverse thoughts has been unfolding at Digital for years had come in the proper and prudent succession planning. And it harkens back to new directors we added in the last several years, who brought new and diverse perspectives. It happened with Mary, who I think is in the room somewhere, becoming our new Chairman of the Board. Mary Hogan Preusse was a long-time both buy side and sell side, and ultimately, our investor. And I'd say the changes at the management level, including myself and Matt and some of the things I've done since being appointed the last 60-plus days, I think, was at the tops of Digital Realty, looking at a big, bright future and making sure we're best equipped to tackle a tremendous opportunity ahead.

In terms of just the changes, just to finish out this topic, should investors expect additional changes to come? Or is the new team fully on the field?

So in a relatively short time, obviously, a appointed Matt as my successor, which Matt, for those who are less familiar with him, has been at the company, predated me. He had tremendously growing responsibilities in remit from FP&A to accounting to tax, treasury, capital markets. He comes from a different background than I do. I obviously came from more of a banking background, so it brings diverse and different perspective to that seat. And I think in a short time, he's called -- leaned into the opportunity and been a great replacement for me. I also made a few other changes in the first week of the year. I aligned with -- under our Chief Investor Officer, our Strategy and Segments team, kind of putting our dollars, invested in our line towards our strategy and put all of our technology in one house under our CTO, including our CISO, cybersecurity and our newly appointed CIO, Chief Information Officer, who joined us from Poly, and last but not least, did some incremental streamlining of the organization. So by and large, the leadership team in the field is the go-forward team. On the margin. I think I do have some incremental plans that will bolster that team. And I think there are elements that I think will align with where our strategy is going in terms of bringing incremental leadership, either internally promotions, or external.

Moving over to the demand environment, how would you characterize what you're seeing? And maybe we could split the conversation between the demand for the under 1 megawatt deployments and over 1 megawatt deployments. And also, as you're doing that, can you share the visibility of these segments and how long you see out for the demand for bookings and opportunity for revenue growth there?

So starting with the less than 1 megawatt, which I'd call more of an enterprise colocation rich environment, smaller deals. We've turned, I'd say, perspective, a little cautious, call it, in the third quarter with -- at that time, we thought the recession, probably more imminent than it's actually going to be proven to happen. We had a strong third quarter in that category that followed with the fourth quarter that I'd say was better than our expectations, so the momentum continued. And despite my reticence of if an economy is turning in towards a recession, that corporate enterprise is going to pull back on purse strings, that appears to not have been taking place, at least not yet. And I can tell you that from not only our fourth quarter results but also our progress we're making in the first quarter on that. Now we've been making a strategic push into that arena. We think it's a wide field. We and our other large competitor, I think, are 2 of the best options to place that critical infrastructure for that cohort of a customer. And I think we are collectively taking share from smaller subscale regional players. And I also think the priorities of IT executives, CIO. CTOs, remain around digital transformation in the data center is at the heart of that, go into a hybrid cloud environment and incremental technologies that are coming on the scene, like we talked about on the artificial intelligence or commercial Internet of Things, topics. So, so far, so good. I say I still just don't whistle past the graveyard when there's storm clouds potentially head, but it appears that our industry is going to have those secular demand trends that will bolster even a potential downturn in the economy. On the greater than a megawatt capacity, demand remains robust and intact there as well. The story there is that the value proposition to those customers, from Digital's lens, has strengthened tremendously over the last year. And that goes back to my priorities and making sure that we are true value-add even to the biggest and the most global customers and making sure our platform is not in commodity-like negotiations with those hyperscale customers. Those customers have gone through probably one of the more dramatic changes in the existence of those companies, massive layoffs relative to what they've ever experienced. Now those customers are still probably at staffing levels that are just prepandemic if not even past that. So there are still large companies. The buying behavior of those companies does not seem to have shifted or pulled back. And quite honestly -- the -- many of those customers entertain self-build or do it themselves as well. I think those programs have been falling behind, but not due to the economic reasons or cost of capital or capital availability reasons. And I think all these elements are continuing to push those hyperscale customers to a trusted partner like Digital that can support them across 50 metropolitan areas around the globe.

So off of that point, we're getting questions about how the changes in cloud growth will affect their interest for hyperscale deployments. Questions about the chip side, the semi side, supply chain. As you look at what's happening there, you gave us, of course, some comments on the cloud just a moment ago, are there things that you look for that would raise the concern level for how it would affect demand or bookings for your business model? And are there some items that you look at that give you additional comfort around that?

I mean we look at all the externally private or public available data on that from all the derivatives of the demand cycle that you can point to. I think the best data points or the dialogue frontline with the customers and staying in front of your customer as often and intimately as possible to really understand what's going through their process. And it's really triaging these customers from multiple angles, not just the procurement department or the buyer, but multiple levels of executive engagement, multiple departments, getting on the frontline engagement with the actual sellers of their cloud. And that's honestly my best read of the tea leaves of where the demand trends are going.

If we flip to the pricing environment, can you -- you mentioned the renewal spread opportunity of over 3% cash in the 2023 guidance. Can you give us maybe a little bit more detail of what's driving the pricing strength and how much of it might be coming from that under 1 megawatt versus over 1 megawatt hyperscale type of deployment?

So we just saw -- we exited '21 into '22 and the pendulum just started slowly moving back in our fashion here. And that was combination of demand remaining intact and broad-based and robust. It wasn't isolated to one big customer doing all the signings. It was really diverse, and it met with a backdrop of supply just getting tightened and tightened and tightened, compounded by externalities or events where power basically being disrupted in certain markets, NIMBY-ism around the asset class, permitting hurdles, supply chain deliveries, a whole host of factors. And that dynamic has certainly helped both of the less than a megawatt as well as the greater than a megawatt. I also, quite honestly, believe, when inflation became a bingo buzzword across every newspaper and just not -- won't go away has made these pricing dynamics much more easy to have conversation with our customers. And I saw this because we're operating in very vastly different inflation markets between the U.S., Europe, Japan. I mean, I've had conversations with customers saying there's never going to be inflation in Japan. There's -- well, I say, well, it's 4.3% last quarter, so there's inflation in Japan, so it just unfolded. In the grade less than a megawatt, that is contracts have been turning. We've been enhancing our capabilities. We've been selling more of our platform offering. So those things have been winds on our back to see acceleration in that category. And those have been, I'll call it, the lead horse in driving our releasing spreads in 2022. We had some positive quarters on the greater than megawatt in 2022. We had some negative quarters, the whole thing baked into a positive cash mark-to-market just under 2% after guiding to being negative at the beginning of the year, which is the first time in several years that we had that inflection. The guidance for '23 is greater than 3% overall. So further acceleration or inflection in the fundamentals. And we believe that will be an incremental step-up in the less than a megawatt category. And we believe, while we can't promise every quarter will be positive in the greater than a megawatt, we believe the full year for the greater than a megawatt will be not negative, so 0 or better. And that has to do with -- we've been chopping a lot of wood on our renewals. We've been selling out of places where we have less pricing power, even on the larger footprint side, and the pricing panel continues to move in our favor.

How much of the 27% of space you have coming up do you think will renew?

Sure. So the 27%, John, that you're referring to is largely the less than a megawatt category. As the greater than a megawatt category, it's -- the bar's fairly modest in terms of size. On the less than a megawatt category, I think we're at 90% retention or so in the last quarter. On both, the whole pie, this appears will be a stickier or lower churn year than we've seen for several years.

Because it's highly variable over time, right?

We've been moving more -- as we reshape the portfolio to bring more enterprise colocation, it has a more granular customer base and it has a short contract duration of usually 2 to 3 years to start with usually many 1-year renewals. Now normally, you would say that's not a great thing. In this environment, it is a positive thing as we're able to capture these pricing uplifts more rapidly. And on the chunky stuff, we actually are in a better territory, because we went through some of our higher rate renewals and the renewals that we have left are stickier, and they're in markets where we have greater pricing power.

One of the other points, I think you referenced this earlier when you're discussing the business, so one of the other points that you're, I think, guiding on this year is higher utilization in 2023. And curious if you could unpack where that incremental utilization is coming from. And is there further room on a multiyear basis to keep this moving in a forward direction.

I'll let Matt hit that one. He is more conservative than I am on this topic, so I'll give you his perspective first.

Sure. So yes, I mean, we've already started to see that improvement. I mean -- and we saw that, I think, in a fairly meaningful way, especially in the fourth quarter within our stabilized pool, which is where, obviously, the majority of that, call it, available capacity today is going to be sitting. So I think year-over-year, at the end of '22, that pool increased occupancy roughly 80 basis points. And we're also guiding to close to 100, depending on -- close to 100 within -- call it, within a spinning distance at the midpoint of the range that we gave for total portfolio occupancy, which we did last year and then we're guiding to that again this year. The majority of that, just by the nature of where our portfolio is, where it should be roughly, 80-plus percent of it is in that stabilized pool, so we're -- we expect to continue to see that improvement in utilization within the stabilized pool, which then, in addition to the positive mark-to-market that we've been talking about in terms of our -- the pendulum swinging in terms of pricing power, is giving us that greater confidence, and therefore, the guide of the 3% to 4% stabilized pool of cash NOI growth. Going forward, I think longer term, I think we still see an ability to continue to push utilization within the overall portfolio, I would say giving some cautious tones like Andy mentioned. I think there -- as you work through that, the space that becomes left becomes harder to fill up, whether it be because of the location configuration. But I think over time, the focus of the team here in the business is to continue to improve that utilization and continue to drive it further upward along the trends that we've been seeing in the last 2 years.

And on the -- speaking of earlier, the pricing discussion, one of the other elements that's different this year is the power pass-through situation. And how are you seeing customers respond in terms of continuing to pay for the higher energy costs? And are there any follow-on effects that you're starting to see some greater focus on optimization or any other movement between regions as customers try to calibrate to this new cost environment?

Do you want to set the table on how power impacts us first and then I can give you the customer lens perhaps?

Yes, sure. So we'll break this down in terms of, generally, how our contracts are structured and how we talk about externally. So starting on one end, we'll call it with the hyperscale greater than a megawatt category. Practically, all of our contracts within that group are full pass-through on power. So as you noted, we're seeing increases in utility costs across our major regions, I would say, the largest being mainly within several countries within Europe and they've been aware of that. Customers have seen the increases that have come across over the last year. And we're also starting to see -- I think we started the year in a slightly better territory than where people expected, but still higher than where we were year-over-year. So within that category of contracts are greater than the megawatt, we expect to be able to recover 90-plus percent of that as we have historically as we are able to pass through those costs just directly 1:1. And that's, call it, roughly 65% of our total revenue base at the end of the year. Flip to the other side, the 0 to 1 megawatt category, call it roughly 35%. We feel very confident in our ability to pass through increases in utility costs within that group as well. And that comes through contract terms that allow us to reprice for what power increases we are seeing within the regions in which they operate. So that comes through a different line item within our P&L just from a geography perspective. So we split out our utility revenue and utility expense. Most of that utility revenue and expense tends to be tied to the hyperscale contracts, what I started with. And for the more retail colocation, 0 to 1 megawatt, the reimbursement will come more through a revenue just because of how those contracts, again, are structured. So overall, we're very comfortable that we'll see minimal, call it, bottom line impact from what we are seeing in terms of power costs. In terms of customers, we'll call it acceptance. I mean, we've already started passing those through, both on the -- that has been happening every month, essentially with our greater than a megawatt. With our 0 to 1 megawatt, we started in earnest in December and into January for a number of the contracts, again, particularly in EMEA, which has seen the outsized and the customers, I think, partly because of what's been in the news for many months. And to our communication and outreach, they understand where it is. We're not the only ones that are passing these on and we have not seen any material pushback from those increases.

And we've not seen it impact demand or utilization of infrastructure.

And just one other clarification. So correct me if I'm wrong. I think the guidance midpoint for revenue growth this year is 23%, of which you mentioned on the earnings call, 14 percentage points is going to be from energy. Those 14 points from energy, does that include both the under 1 megawatt and the over 1 megawatt impacts?

Correct. Yes, correct. That includes both what we're seeing in terms of full pass-through as well as the portion, which is the majority of it, again, back to how our revenue contracts are structured as well as the portion that we're expecting that'll run through the revenue line item as well.

And just while we're on the topic of energy, what is your #1 ESG priority for 2023?

I think it's -- I mean, we've seen it in more recent announcements with -- from our PPA in Germany. I mean, it's continuing to greening power sources. The rapid rate of growth in our infrastructure and our footprint and our power needs, we need to think into newer -- new and different routes to bring sustainable green power to our footprint. Now given what Matt just described, as the pass-through nature of that, that needs to be really in partnership with our largest customers because that, obviously, has cost and other implications. But luckily, almost all of our large customers have called -- gone all in on greening our grid and their commitment to sustainability.

We're getting a number of questions from our online system. I want to get to a few of these. Before we do. I have a question about the balance sheet. And then just to give you a little preview of what's on the screen here, some questions about development and some market-specific questions. [Operator Instructions]. On the balance sheet, curious if you could just give us an update as -- anyway, so on the balance sheet, curious if you could give us an update on the current net debt financial leverage level and the plan to reduce that leverage over the course of 2023. And then is there also a plan that -- where you need to continue to reduce that leverage into future years after you get through what you're planning for '23?

Yes, sure. I'll start off. So we ended the year at -- our leverage was around 6.9x, which had some. I'll say, just based on where average versus spot rates are, you kind of neutralize for some of the FX. It was really closer to 6.7x. And we put out guidance in terms of our capital spending. It was a little over $2 billion. We also, as part of that, provided, we'll call it, sources of capital, largely from disposition and/or joint venture activities that we expect to be able to raise the majority of that through those efforts. So with -- bottom line with that, we're guiding or expecting to bring leverage back down closer to the 6x areas, continuing to make incremental progress over this year as we fund our development through largely capital recycling efforts. And then going forward. I think in the '24, we'll continue to make progress on our leverage, bringing it down ideally under 6x. But I think what we'll see is that as a result of the strength in the core that we've had, the core business that we're having this year, again, around the number of talking points we had pricing power, improve stabilized cash NOI, mark-to-markets. We'll see -- we'll be able to do that also through an increase in EBITDA, which we guided towards this year at 9%, then we think will have a good second half and give us that trajectory into '24 to continue to bring leverage down from growth in -- largely from growth in the core business as we also then are able to continue to fund what we view to be attractive investment opportunities that we expect going forward just given the strong demand and secular drivers that are behind Digital Realty.

One of the questions that we're getting, which relates to this topic is an update on the capital recycling efforts and your thoughts on delivering on the aspirations for 2023 in terms of total program.

So 2022, obviously, our funding plan was disrupted by the markets, be it interest rates, capital markets overall. And what we did on the backs of that, in the back end of the year, we bolstered our liquidity tremendously, $2-plus billion of debt financings to free up revolver balances, increase the revolver during the year. So did a whole host of activities to plan for a potential rainy day. What we also did is we readied our activities on 3 different fronts in the back half of the year. One, we basically brought together our noncore dispositions and brought the marketing for those in different portfolio subsections, because they probably don't belong to one buyer and launch to market or staging launching to market all those programs. We've gone to private capital sources to essentially be partners on our hyperscale stabilized JVs, i.e., a private version of our digital core REIT listed in Singapore given that vehicles' cost of capital has also been impacted like Digital Realty. And three, we've expanded to conversations and dialogue with existing partners and new partners. many of whom have been knocking on our door for years to partner on our hyperscale development programs in North America and EMEA. This is not something completely foreign to Digital. We've done this in Latin America with the likes of Brookfield, Mitsubishi in Japan. All 3 of these activities, we've started to attack in the back half of the year. They are on various timetables because they're not the same exact buyer universe for each of those pools of capital. And I -- we have a lot of conviction that we're going to be successful in this arena. And what we're benefiting from, more than anything, is despite the disruption, despite interest rates, despite whatever you want to say, is a reason that assets are not trading as prevalently broader in this conference, that there's this massive rotation to digital infrastructure. The capital has come off the sidelines, and there's very, very few places for that capital to go, because there's no -- this is not a mom-and-pop industry. We roll it up. There's not a slew of private portfolios that trade hands frequently. And we believe we are a best-in-class partner to those financial partners in various shapes and forms.

In terms of the long term of the business model, when do you anticipate that the revenue growth will then lead to core FFO per share growth that's at or better than that revenue growth where you're getting the operating leverage and the benefit of financial leverage for investors?

So we just did our '23 guidance 3 weeks ago. Give them the '24 now.

Yes, we don't have '24 guidance. But I think if you assume that we're -- we're in an environment where interest rates aren't going up by 400% or 500% within a year, we get to a place where leverage is back to where we want it. I would say there's really nothing that's preventing that revenue from falling to the bottom line. We have -- you look at where our portfolio is in some of our largest markets. Northern Virginia, Frankfurt, Paris, Singapore, Japan and we build at scale. We build in a campus style. We're able to have those efficiencies from an operating cost perspective, so we feel pretty confident that, with demand at our back, with where the market is moving in terms of having that pricing power, continuing to improve our occupancy, all those things that we're now -- having those tailwinds, that should give us an ability to really be able to bring that revenue all the way down to the bottom line going forward.

And we're getting specific questions from our audience on Northern Virginia. And so in the last couple of minutes, can you give us an update in terms of what's happening in that market? And is this putting Digital into a position where it can better monetize the development as well as the existing footprint in that market?

That market has had a reversal of fortunes in the last handful of months. especially if you look on a year-over-year comparison. The issues about power arriving in that market from transmission, not generation, continue. We were cautious on our third quarter call of what we were able to secure vis-a-vis the power companies, but we were optimistic that we'll be able to deliver on behalf of our customers. And when we rolled into the fourth quarter, our optimism proved right. And our development pipeline of, call it, 80-ish megawatts will be able to be delivered for our customers. I would say I'd reiterate that same theme as that we're cautious but optimistic we'll be able to bring on incremental speculative capacity in that market through various sources. I can't promise that now with 100% conviction, but we're optimistic on that. And during this time, the supply-demand pendulum has rapidly moved in favor of the providers, and we are the largest third-party provider data center capacity in that market. And I've heard customer unsolicited feedback on pricing dynamics where the rates they were signing 18, 24 months ago got as low as 70, and now they're as high as 140. We have not signed a rate at that level to date, but I believe that is where the market is -- will be soon, if not already.

And that's per kilowatt or per...

Yes. 140.

Great. We've got time for our rapid fire. So real quick, what will same-store NOI growth be for your property sector overall, not your company in 2024?

Greater than 3%.

What is the best real estate decision today? Buy? Sell? Build? Redevelop? Or hold?

You go ahead.

I think it's like -- I'd say, obviously, it's -- like, we're doing, it's a mix of both. We're recycling capital that we have and redeploying that into what we view as more accretive investments, so a mix of the 2.

And will your property sector have more, fewer or the same number of public companies a year from now?

I think the same.

Thank you very much for your time. Great to see you.

Thank you.

Thanks.