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

All right. Let's kick it off. Thanks, guys, for joining us for a session after the lunch. I hope you enjoyed that Spa Salad situation. So thank you for joining us. I'm Dave Barden, Head of Telecommunications and Comm Infrastructure Research for Bank of America. Based in New York for the U.S. and Canada. I'm really pleased to have with us today, Andy Power, the CEO of Digital Realty; and Jordan Sadler, the Head of IR, to join us for our conversation today. So thank you guys for joining us.

Thanks for having us.

Pleased to have you. So we're doing a little thing, real estate questions for every company. We're trying to compile views from the real estate industry on these topics. And topic #1 is, do you think the Fed is done hiking? And do you believe that rates may fall in 2024?

I'm going to let Jordan yell in.

Well, we have a little bit of debate about it internally, but because I spent more years on Wall Street than him. I get to -- I did. I'm older, 1 year. So I think the market is bigger than we are in terms of the expectations around rates, in terms of what the Fed is going to do. I think the market is telling us that the Fed is generally done. Maybe there's one more increase, we'll see what happens on the CPI brand. But in general, it looks like we're through most of the hiking cycle, if not all of it. So I think we're -- our expectation is that rates, particularly on the short-end, are not headed significantly higher. And -- was there a second part of...

Are 2024 rates coming down?

So I think the market's also tell you, I guess, on the short-end, we'll see some cuts next year. So I think we'll probably start to see something like that as well. I don't know how aggressively without an event. But it would seem like we're pushing into a little bit of a moderation in the economy, and we'll start to see rates pare back a little bit, particularly on the short end.

As a former CFO, is this -- does that kind of perspective have a bearing on what Matt Mercier, your CFO is going to be doing from a financing standpoint, fixed and variable and all such of other stuff?

The -- I'm sure [indiscernible] calculus, but I think our playbook is pretty straightforward in terms of -- we're bringing capital, largely private capital to bolster our liquidity and deleverage our balance sheet and position us for greater growth that lies ahead. And I think that's regardless of rate cuts, hikes, sideways, whatever you want to call it.

All right. The second question, I think this is more for more traditional real estate companies, but maybe it's relevant to you guys since you're active is, do you think that there's going to be a meaningful pickup in real estate activity transactions, M&A in the next kind of -- in 2H '23, 2024?

I'd just be guessing on traditional asset classes. It obviously seems like there's a lot of wait and see of valuations and waiting for debt maturities and other issues to come to force transaction activity. I think in our space, digital infrastructure, I do think you're going to see a pickup in activity given the demand environment and the rotation of capital away from [indiscernible] asset classes towards digital infrastructure and trying to be a part of this growth opportunity.

Interesting. I guess the final of the big 3, this is not the way you typically get this question, but do you plan on -- do you have some current run rate applications of AI in the Digital Realty business and do you plan to be investing more aggressively in adoption and application of AI to your business?

I mean we've been using AI in various shapes and forms for several years from, call it, sales forecasting tools to RFP response tool and to automate faster, more efficient and accurate response times. We are part of my mandate upon taking the seat 8 or so months ago, the middle one was integrate to innovate, bring together acquisitions, our data, remove the internal friction from our customers and build that foundation for external customers to have better outcomes and efficiencies. And AI has definitely been part of that story. I don't think it's going to be a massive dollar amount, but it's something that's been part of our history and definitely we're looking over.

Okay. That's the big 3. So I'll let you look on those. So changing gears, look, I think we'll start with the Digital Realty funding story. I think that's what everyone wants to talk about. At a high level, I'm just going to throw round numbers out. We've got $1.5 billion of operating cash. We've got $2 billion of CapEx. We've got $1.5 billion of dividend. And so on a run-rate basis, we're kind of at a $2 billion deficit every year. And with rates having done what they did and where the leverage found itself after the Teraco deal, you had to get a little more creative in terms of the funding outlook for 2023, and were 3 pieces to that. One was divestitures of which you've done about $300 million to $500 million. There was kind of steady-state JVs, of which you've done, I think, more like $1 billion in a quarter over the $750 million target, then there was development JVs, of which you've done 0 out of $750 million. And then you kind of threw in a fourth extra, which was the equity raise about $1 billion earlier in the year. So I guess the first question is with kind of the clock ticking on 2023, is development JV still a thing? And can you elaborate a little bit on if it is, why is it taking so long?

Sure. So your numbers are pretty close to -- I think we're closer to $2 billion on the hyperscale stabilized, which was exceeding our expectations. And just because we have done 0 of $750 million sitting here second week of September, I wouldn't count our efforts in that areas of global failure.

How you'd say that?

Because of the -- the way things played out, I think we quite honestly did some of the hardest activity first. And we didn't do this in a linear fashion. We went out with all these activities, both noncore stabilized hyperscale, development hyperscale to the right parties for each of those types of buckets of activity. We've outperformed on hyperscale stabilized front and development, I believe, is proving to be the most attractive to the broadest pockets of private capital, giving us return complexion. The only thing I could say on timing is we've won -- it's been -- as we had the success, things have come our way in terms of valuations and structures of each and every development or each and every transaction we've done as well as the ones that are underway. There are more thoughtful transactions. It's very easy just to joint venture a stabilized asset with very few moving parts [indiscernible] by a noncore asset to a new owner. We're looking for partners to be side by side with us not only investing with us and what we put in the ground to date, but also going forward are like-minded on those projects. So both being thoughtful about who the partners are, the projects and the fact that we've had other success that called -- allowed us to be more deliberate on development JVs, does not diminish my conviction and commitment to getting those done. I can't promise you 2 JV announcements on the next earnings call like the last one, but I see no reason why they won't be coming shortly thereafter.

So when you say that, do you think about these as maybe discrete projects? Or do you think of this more as maybe a funding pool of partners where it's kind of like -- it's just kind of revolving credit type of partnership?

For the development JVs that we're contemplating, these are very much tied to specific series of projects, not married to a new partner for regions or long [indiscernible]. Now these partnerships thrive. We're happy to continue to grow them. I would say, holistically, all the activity, whether it was the stabilized hyperscale joint ventures or this development contemplate joint venture, we had urgency and we could not let perfection be the enemy of good in 2023. We've come across some great partners. I think the next partners we announced will be great partners as well. But I think the longer game here is to evolve this into more direct LP partnerships and fund management models for our hyperscale business. So that's not to take anything away from our partners to date, but that's where I think this business is going in terms of capital intensity. I think Digital Realty has a major game of plan.

Yes, so that's great. So you've had success kind of getting the funding addressed this year. There's more that you'd like to do to kind of maybe create a safety net at the margin. But -- so one of the interesting things is that -- the reality, though, that you get pushed back on is as we think ahead to 2024, we think ahead to 2025, and we do this math that EBITDA is growing $200 million a year. We can lever that up maybe 5 times, we can raise $1 billion of incremental funding using that, but that's kind of expensive capital still. These other methods of selling existing assets that's dilutive, selling steady-state JVs that's dilutive, the equity is dilutive. And so as we look ahead, we see kind of -- we'll talk about the fundamentals, which are strong, but we've got these mid- to high single-digit top line drivers, but they're kind of winding up being low- to mid-single-digit AFFO per share drivers because of the dilution that exists between creating that top line and how you get there. Is there a solution to that? Is there a time when this isn't a headwind to AFFO per share that it looks like it is today?

This company has gone through a tremendous amount of change in the last year or even predating that in terms of reconfiguration of our portfolio and our capabilities. And we had to take steps backwards on a per share basis through selling outright or selling joint venture stakes that we lose earnings and get redeployed. Just like almost everybody else in this conference, we're a REIT, so we really can't retain much of our cash flows, and we have to be a REIT that's in a sector with a platform that has tremendous new capital opportunities at our fingertips. And I believe when it comes to data centers and cloud and hyperscale and, certainly, the AI to come that a combination of public and private capital sources is the most prudent way to fund this business and maximize value for our shareholders and our partners. What we're doing this year that's different is what we talked about is sharing the development piece of the equation with private capital sources, which will make the balance sheet more efficient and allow the organic fundamentals, which, by the way, just recently inflected. I mean that's -- the inflection is not a long story. I'm speaking for many quarters and conferences of negative cash mark-to-markets and poor same-store NOI growth. In 2022 and 2023, we see this inflection in a backdrop demand outpacing supply and going towards pricing power and higher ROIs. So this development JV is going to allow us to, call it, hopefully turn the needle into '24 and '25 and beyond, and allow us to accelerate our bottom line growth at the same time.

So let me ask this question. With respect to these development JVs, do you look at this as a force multiplier, where you plan to spend the same amount of CapEx but get a lot more bang for your buck? Or do you plan to use a JV as a substitute for the capital that you might otherwise have spent, which will kind of maybe accelerate deleveraging and other things?

It's going to be both, quite honestly, right? The supply-demand dynamic -- assuming we do what we said we're going to do, which I think our track record so far has been pretty good. The supply demand dynamics drive where the capital allocation goes, so we get the balance sheet back in order. I look at that dynamic, and I see the opportunities increasing at better ROIs. So we haven't put our -- finished '23 to put a budget for '24, but the CapEx intensity overall can maintain the same, even potentially increasing. But I think a pro rata share of that will go down, i.e., the partners we bring in today, we're going to raise an investment for their share of what we've already extended into the ground, in the shelves or certain -- to clear the halls and then they're going to fund alongside us and carry some of that nonproducing value through the development cycle. So force multiplier will obviously order fees to the platform, lighten our balance sheet. And that's a very much [indiscernible] in the [indiscernible] by carrying nonproducing assets through the year.

One of the funding vehicles that hasn't been open that was a big opportunity when it was launched with DC REIT. Could you talk about how does DC REIT kind of fit into the current and future profile of funding the business?

The -- obviously, very disappointed that the DC REIT has not been able to be a bigger part of our story because I think it elegantly meets both theirs and our objectives in terms of shareholders. It obviously had a major customer bankruptcy. That process -- the specter of that process has been playing out for a while now. The technical bankruptcy process didn't start until the beginning of summer that had most recently had an extension in that process, but we'll bring it closer to the end of the year. So it's kind of -- we're seeing the light at the end of the tunnel. I don't know what's going to happen on the heels of that definitively. But I think any form of clarity of that -- of any realistic outcome, I think it's a good thing for DC REIT. And I think that -- with already, you've seen a rebound in its cost of capital maybe prior to resolution of its tenant bankruptcy. I think it breathe a second life where we can continue to monetize or vend assets into the vehicle with third-party fair valuations and it takes our hyperscale exposure that we have a significant amount of -- on our balance sheet. It allows us to generate external growth.

With respect to Digital Realty, specifically with respect to that Cyxtera bankruptcy, you guys took about $0.05 to $0.07 out of the outlook for AFFO per share. At the time, you said it was kind of a worst-case scenario kind of budget. I think -- based on the process unfolding, is there a reason to believe it's not a worst-case scenario or if you don't know it yet, is there a moment between now and when we finally get the end of the bankruptcy that you could have clarity on that?

I wouldn't call it a worst-case scenario, but I don't think -- when we put those numbers out there in July or when I view the factors now, I don't think it's gotten any worse potentially, maybe gotten better. We're kind of coming to the end, as I mentioned, we have not had any lease rejections to date. The -- I think $0.02 of the $0.06 are prepetition, which I would not count on recovery of. The majority of that, there could be a recovery through lease being accepted or if leases are rejected, we can then have the underlying customers in this capacity. I think what we know more of now is, I think the last 90-day extension just got triggered. It appears that based on bankruptcy filings that there is a potential buyer that's not Digital Realty. And they're also very much committed towards an alternative path of the lenders becoming the equity and the pro forma balance sheet they've shared, actually, I would say, surprised me to the upside. I think it's like roughly 2x debt-to-EBITDA. So they obviously -- if they take the business back, they appear to be looking to do it in a much more conservative levered balance sheet which is a good thing.

And I guess the theory is that even if there are leases that are rejected that had some short-term dilutive effect that -- we're in an environment where there's pretty healthy demand in general, right, because those represent re-leasing opportunities that would be future growth.

We -- so one thing that's different about us when it comes to data center land is we don't believe we built or acquired the 300 best plus data center on planet Earth that will stand the test of time. We actually went into our portfolio and continue to optimize and monetize things that we don't believe are core to our strategy or have longevity or pricing power for the long run. We've sold $700-ish million of noncore dispositions, a large piece of -- had concentration to that customer in stand-alone one-off sites outright going 3 or 4 years back. The majority of our remaining exposure are in either a combination of multi-customer locations thinking highest demand pricing power location in Chicago or Singapore, Frankfurt or if they are a stand-alone customer locations in tight markets like Santa Clara, where SVP won't have power until 2030. So -- and we've been to this movie more many, many times in the evolution of history of data [indiscernible] reseller has really been -- we work models, essentially go upside down. But in this case, instead of just office tenants, we have people with critical infrastructure in there and they want to stay and we can help support those end customers. And we've done this -- we've been through this. We know how to operate through this and navigate it.

So you mentioned something -- I think that people debate a little bit, which is the strategy. I think that people look at the data centers in kind of a bifurcated way. You're either a retail guy who caters to smaller customers with focus on interconnection and you have a large sales force that beats the bushes to find the customers. And/or you're a wholesaler, you build large data centers with relatively fewer tenants and it's kind of an old school real estate model and they have longer leases and sometimes those counterparties can beat you up at the end of those leases. And you think that people think that in the old builds time days, the old Digital Realty was an kind of an old school, wholesale real estate business. Any power comes in and we're buying interaction and we're buying retail assets. And I think that the question now is, is Digital Realty a wholesale data center company, a retail data center company or a hybrid? If it's a hybrid, why is that the right approach?

I'm not going to stand-alone as the characterization of your question suggests to take credit for all this activity. But I think what you've seen from our team here is we have continued to build the capabilities to have a global enterprise colocation interconnection that is adding 130, 140 new customers each and every quarter with supporting 5,000 customers across 50-plus markets on 6 continents and doing better and better in that capability in an arena where there really is a small, small set of competition on that stage. At the same time, we also believe in the addressable market when it comes to hyperscale. And we are serving the hyperscale cloud customers in 20, 30, 40, 50 different locations and while we don't pray to the God of trying to have 100% of the market share, we pick our spots as to where we can provide value to them and create excess return from that value add, places where they've landed their availability on where it's hard to do business, where we can future-proof our runway for growth. And what's different or newer or is that we're trying to accelerate that growth in the less-than-megawatt interconnection, the customer count, the connectivity, the penetration of the enterprise customer base. And we're trying to take our hyperscale business and brief tweak a financing strategy to it and bring in private forms of capital with stabilized assets and development to maintain more pricing power of same-store organic growth on the public company DLR.

The -- just on that point on the hyperscale opportunity, there's been a lot of capital to be poured into kind of the -- what I would call like the bespoke data center market, companies like aligned and other guys are out there with private capital building custom data centers for the hyperscale guys. Is that a threat or is it a reflection of the opportunity where a rising tide can flow all the boats and the dive might be a lot larger than we see even in the public markets?

I would characterize the private capital is really solely flowed towards hyperscale business. They've shown very little of interest in the run to create a third or fourth horseman to ourselves and our major competitor in the enterprise colocation and it's been going after a small subset of big customers with big deals has been the move. And the likes of the names you mentioned are solely focused on that. And, listen, they're a product of -- the demand just being so robust and diverse, right? And they filled in gaps where we elected not to play. We -- one of the -- there's a report came out just recently on the Phoenix data center market. That's a market where we still operate. We have a highly connected downtown destination. We've got a campus in Chandler, which is a very supply-constrained market. And years ago, we said, you know what, we're not going to chase hyperscale into the deserts of Phoenix. We sold a land site we owned. We sold a land site we inherited from DuPont Fabros, and here we seeded opportunity. Why hyperscale business got built there by 10 or 12 different names, all doing exact same thing and all fighting in commodity-like dialogue and conversations with the hyperscalers, which is fine. We picked our spots at Santa Clara, Ashburn, Paris, Frankfurt, Singapore, Osaka, Tokyo, Sao Paulo, South Africa were places where we could support these customers in a different way and generate better returns. So that's the little difference in what we're doing versus some of our private competitors.

So let's talk about the inflection. You're right. We had -- spot market pricing was below, embedded pricing in the base. Retention pricing is always a north of spot price because no one really wants to leave the data center, but you got to give them a break. But all of a sudden, what we started to see in the last [indiscernible] year is that spot market pricing started to kind of inch north of where the embedded lease pricing was. We have positive re-leasing spreads. And I think you've been guiding to about positive 4% for 2023, I want to dig into that a little bit, but maybe you could just for the benefit, like what made that inflection happen and how sustainable is it?

Our less-than-megawatt category, we've had a long trend of positive, call it, mark-to-market that's just inflected more positively. And I would say that goes to our history and our success in the colocation business, being able to obviously create our customer base and push the needle on pricing in that category even further. The bigger news is that I've been saying for a good chunk of 2022 and rapidly accelerating to '23 is the pendulum on pricing power and move back to the providers. And that's, by and large, pre-AI demand hitting the scene where demand remained robust, intact, and diverse across regions, across major markets for bigger deals, while supply just [indiscernible] on multiple angles and transmission lines into Northern Virginia, 2030 in Santa Clara, a generation in Dublin, moratoriums in Singapore, [indiscernible] environmental concerns, a whole host of factors that allowed us to have greater test of fortitude to push back on rate because it wasn't just try like competition. So that has been evolving, I would say, accelerating as we went through 2023. And I'm going to -- I don't think that dynamic is going to rapidly resolve itself. So -- and that, again, was a pre new AI demand is kind of come on to...

One of the contributing factors to the rising rental revenues that you're getting is not power, you pass power through. Some of the -- your counterparts in the enterprise colocation market have different strategies, which have yielded some pretty strong returns for them. Is there any part of you -- for your business or corners of your business that you might rethink the power pass-through approach to that element of the business?

By and large, on our, call it, less-than-a-megawatt interconnection -- or less-than-a-megawatt colocation piece, we do have a very similar contract, maybe not identical in terms of the frequency that we're able to reset the power cost of the contract, certain contracts have -- are priced with like a margin to the power. But we're similar both when it comes to, call it, shared infrastructure colocation. On the greater than megawatt, the conventional standard has been pure power passthrough [indiscernible]. I don't think we're going to change that dynamic anytime soon.

And so your guidance is for the re-leasing for the year to be kind of 4%-ish. And that's a composite function you've been talking about kind of positive in enterprise colo and not negative in the above 1 megawatt. Could you remind me, what the re-leasing was in 1Q and 2Q for greater than 1 megawatt?

[indiscernible] me honest here, I think we were up at 6.5%-ish or something on the greater-than-a-megawatt. I think the less-than-a-megawatt was 4.8% versus trailing 12 months about 4.2%. So both acceleration. I think we call -- I believe we called it out on the call, we did have shorter-term renewal in the mix there that maybe inflated like 100 basis points, but it's still pretty unhealthy.

So the guidance out there is kind of a 0-ish kind of re-leasing benefit from over the -- greater than 1 megawatt. But the first half of 2023 is kind of in that 500 basis points. What has to happen in the second half of 2023 to make that 0 happen?

Technically, we only got in aggregate. We're certainly coming out of mediating of pricing pressure that 0 felt like an aspirational target for a long time and being on the north side of 0 is a new move.

It feels weird.

But I can tell you the pricing has moved dramatically. I gave you examples on the most dramatic moves with Ashburn be in 70s to down 140. And it feels like it could continue to run. I went over index on -- and I've heard this before, well, if you're this much in the first half of the year and your guidance is still plus 4%, that means your deceleration in the back half of the year, it's -- we're handicapping the greater-than-a-megawatt leasing because the sample set is all a fraction of the size of contracts and these are -- the customers renewing before the contract comes due. We can't dictate if they sign it in the third quarter, the fourth quarter or January 1, right? So...

But when you look at that pricing landscape today and you look at that embedded base, I mean, is there a real risk inside your contracted portfolio that there could be down pricing? Because it feels like prices everywhere in the world are up relative to what the embedded price even that was signed 5 years ago is. So is it possible?

I think it's a tough -- it would be a tough set of hands to have a negative mark-to-market likely in greater-than-a-megawatt.

That's a pretty strong thing for the last decade.

So -- but we'll see, again, if I got a bunch of really good ones, I have 1 contract which is negative and if all the new ones slip to the next quarter and that one got signed like -- but I can't control that. But if I'm guesstimating, I think it's probably tough to.

So I have to do it, and I apologize is to end this on the AI opportunity. We just had a 2-day AI conference here, first ever 2023 Global AI Conference. One of your peers was a participant in that. I know you guys have talked publicly about your role. I think that -- I just want to kind of say that what's your response to the critique that the embedded base of data centers are just old dinosaurs. They don't have the power density capabilities, nor does your development pipeline and that the whole AI thing and the assignment of value to companies like Digital Realty that there is any opportunity AI is misplaced. How do you respond to that critique?

The -- first off, I would -- I've said this before, so I put AI in the category of -- unlike a lot of the buzzword bingo that has come through our asset class or industry, be it crypto or edge, 5G [indiscernible] vehicles to date, AI does feel very real. And I think Digital Realty is going to have a demonstrable role in that. We are -- the first inning would be a massive overstatement of where we are and where this is going. We are seeing demand. We've been catered to AI historically. We're seeing new AI come with a scene, the hyperscale cloud providers are a major piece of this. The training of large language models is what's happening now or just about to happen now. It's probably a better characterization. They need large continuous capacity, that's priority #1, 2 and 3. We've got over 3 gigawatts of that. So there's a role. And while assuring to not be the latency location sensitive today, we are seeing customer preference near availability zones where they have compute because they don't know where this is going. Inference in the future is going to be a multiple of training, private data sets and the thesis to be tested is the proximity down the road, which is a future state. That is not going to be a '24 inferences going to be up and running and we're going to be living in this massive AI world, but having proximity to the availability zones of cloud providers and Digital Realty, hybrid IT or even the network nodes and that may be a stretch of its need and proximity. I don't see how this is at the very least a rising tide is lifting the industry, and I think Digital Realty will benefit in this arena. And I don't see this -- having spent time on the GPU versus CPU and I don't see us emptying out 300 data centers and putting in new GPUs. Even if you take the most bullish predictions of someone's highly incentivized to sell GPUs, there's still a massive GPU for numerous workloads that's going to exist. So -- and we've done the work as to what our infrastructure will need to be retrofit and already tailor new designs to cater to it. And we can do that with the four walls we have today and the capacity we're growing for the future.

I think that's a great place to leave it. Thank you guys ever for joining us today. If you're interested, we did put out a piece on AI and its impact on the data center industry last week. So you can find that in the Bank of America research library. Next up in this room will be Ventas. So enjoy the rest of your conference, everybody. Thank you so much.