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

This session is for Citi clients only, and disclosures are available in the back of the room next to the AV desk, and we also have them conveniently up here. If you'd like to scroll this electronic copy on the iPad, feel free at any time. And with those housekeeping items out of the way, for those of you I haven't met, I'm Mike Rollins with Citi Research, and we're pleased to welcome Matt Mercier, CFO of Digital Realty. Matt, thank you so much for being with us today.

Yes. Thanks for having me.

For everyone in the room, we may do some live surveys during our session. So there's QR codes up here. And there, you just scan them and you'd be able to participate in our live surveys. They're anonymous. We're not tracking the results. So look forward to your participation for that.

So Matt, to get started. It's been a busy year for Digital Realty. And I think back over the past year and all the things that you've progressed with in terms of the business, I'm curious if you could help frame the go-forward strategy on how Digital Realty is positioning itself to grow revenue, profits and improved return on capital?

Sure. So as you know, Mike, we've gone through a bit of a journey over the last 12 to 18 months, really with the objective of putting the balance sheet back in better shape, which we've largely accomplished. Bringing leverage down from what was kind of height of around 7x, we're now down to 5.3x, so really put us back into a position where we can be back a little bit more on what you'd say on offense, $4 billion of liquidity, and really, I think, puts us in the position now to be able to take advantage of what is a very robust demand environment, being able to leverage the broad global platform that we have available, our capabilities across that from both satisfying greater-than-a-megawatt type requirements, which are getting obviously a lot of the headlines today from AI, but also being driven by more traditional workloads like cloud and digital transformation that are also growing at a nice clip. That demand in what has been an environment of more restricted or constrained supply has also led us into positive pricing environment, which accrues to us not only in our existing operating portfolio through better mark-to-markets and better same-store stabilized growth, which we've experienced after a few years of negative results, now being in positive territory over the last 2 years, and is accruing to us in terms of our development pipeline, which is solidly north of 10% on average across the, call it, 430-plus megawatts that we have under development today. So all that being said has now I think put us in a position where we've talked about, even as we started 2024, as we were giving '24 guidance, we were, in essence, already giving '25 outlook at the same time, which we don't typically do. But we've talked about in terms of setting sort of a baseline for '25 growth at 5% as we get the benefits from all the things we just talked about, flowing through to not only the top line, but the bottom line from our organic portfolio, but also as those development deliveries come into operation from some of the significant signings that we've accomplished, not only this year, but into last year, which I'm sure we'll talk a little bit more about. But really sets us up for what is baseline 5% growth in '25, and I think looking out, accelerating beyond that in '26 and beyond.

And so when you think about the outlook that you mentioned for '25, the 5% growth, are there even some headwinds that you're experiencing, whether it's continuing to average up that interest cost or delays between some of the recycling and when the commencements take place for the reinvestment of the development, where the underlying organic growth may be different and better than that 5% for '25 over the longer term?

So I would say in terms of what I call on the capital recycling front, we should be -- we did the most of that work, Greg and his team on the investment side, and really across the company, a tremendous amount of work done in starting sort of the back half of '23 into the first half of '24 in doing the capital recycling, informing some of the development joint ventures that we did with Blackstone, which is really part of being able to satisfy what is a large and growing set of requirements and demand across our hyperscale universe. So I think the impact from that effort, which is also getting us in place in terms of bringing the balance sheet back into good standing, better standing, the majority of that impact I think we're seeing now in '24. So that should not -- that should have less of an impact on '25. What I think sets us up for sort of improving growth in '25 and beyond is more as you start to look at from an organic perspective, as you look at our lease rates, from our expiring lease rates, you start to see that. The comps and the rates continue to get lower over the future years, right? And given an expectation that pricing is going to remain where it is, if not improve, that's going to give us I think a better opportunity for improved mark-to-market and better same-store growth in '26 and beyond. On top of that, I think we're starting to see some of those higher development deals and projects deliver in '25. You could look at the considerable backlog we have currently. That's going to start to hit in '24, but there's going to be a decent amount that's 25, back half of '25 and beyond as it takes time for us to build and deliver those projects. So I think -- and at yields that we've seen that have been improving. So those 2 factors are going to, I think, be more of the catalyst for improved growth in '26 and beyond.

And you mentioned the capital recycling program. Is that based -- you mentioned you're kind of through a lot of it. So going forward, where in the last few years, had a significant amount of capital brought back to the company to reinvest from noncore assets, converting some hyperscale into JVs. Is there a significant amount of that in the future you can use for funding or you're kind of now at the steady-state asset base that you want to be at?

I think we've talked about it in terms of like, sort of step one was diversifying our sources of capital. And I think we've done a lot of that through a lot of the activity that we just talked about through that happened in '23 and has continued in the first half of '24. I think we see that there'll still be a need for having a broad and diverse source of capital. So we talk about it more in terms of evolving our sources of capital. I think we'll see us continue to look for the right capital partners and the right structure that helps us not only be able to fund and take advantage of what is probably one of the most robust and strong demand environments that I've seen in quite some time, but also make sure that we're continuing to focus on what is objective 1, 2, 3, which is back to making sure that we're growing the bottom line in '25 and putting this in a position to be able to improve that growth in '26 and beyond. So it's really putting together that right mix of delivering for our shareholders but also being able to take advantage of this market, utilize outside capital for some of these larger developments so that we're not also overexposed to hyperscale, which has been bread and butter for us for many years, but finding that right mix that gives -- continues to put us in a position to be able to win, not every deal, but I think the right deals in the right markets where we can provide a better value proposition and again, focus on that bottom line growth.

So one of the interesting, I think, features of Digital Realty is you offer data center colocation across the broad spectrum of size and connectivity. So as you continue to operate and evolve the current strategy, how do you look at the success of keeping all these assets together under a single roof and whether this is the optimal strategy going forward for Digital Realty?

Yes. I think it's been an important part of our strategy to be able to really satisfy that broad product spectrum, as you talked about. So our heritage, the DLR heritage has really came from more of that, call it, greater-than-a-megawatt, it's been called different things over the years, but called that scale, hyperscale, greater-than-a-megawatt segment, right? That's been part of our company and our history, having those relationships with those large technology and large enterprise customers. And we've seen that as it's evolved through from digital transformation to cloud, now to AI, and that customer base has been driving a lot of the activity there. At the same time, we've also seen the benefits of, call it, the retail colocation and broader enterprise story in terms of the stability, the stickiness, driving interconnection and really having that as a solid foundation to our overall platform and our overall strategy. And you get customers that span between those two as well. So some of those larger customers are also taking smaller network-oriented workloads and nodes within our portfolio. And I think we see an advantage over time and again, not only sticking to our core markets, which is also part of our strategy and not extending ourselves too far beyond where we have these campuses that can, I think, ideally and optimally bring together both the workloads from scale, hyperscale type customers, but also being able to utilize the connections that we have to the enterprises and to the networks from our 0-1 megawatt and interconnection business.

So you're seeing a magnetic effect between these two bring more parties to your campuses?

Yes. I think there's obviously uniqueness between each of those segments, but there's also -- in the Venn diagram, there's also a powerful connection that I think we see over the long term, puts us in the best position to be able to satisfy the workloads of not only the hyperscalers in our core markets, but also to be able to add on the benefits of networking and other interconnection capabilities within the enterprise segment and really puts us, I think, in the right position to be able to generate stable long-term growth to the bottom line.

You mentioned the strong demand environment. So curious if you could frame further the size of the demand that you're seeing? And maybe it's helpful to think about it because of the way you disclose under a megawatt demand versus over a megawatt demand, and just try to think about the funnel and the opportunity, including from Gen AI workloads.

Yes. So I mean, like I said, this is a strong demand environment as I've seen in quite some time. And I think a lot of the attention gets on the greater-than-a-megawatt hyperscale AI segment, which as it should, that's where we're seeing sort of the outsized growth and where we're seeing the increase in terms of -- the material increase in terms of our pipeline from a demand perspective. But I think it's important to note, again, that it's not just AI, we still have within that funnel a solid amount of demand from the more traditional cloud and digital transformation workloads as well. And on the 0-1 megawatt side, I think what we're seeing there is a continued steady, stable and growing demand set from within that business. I think part of that is not only are we continuing to focus on that as a company, as a business when perhaps some others aren't, so we're able to, I think, take market share within that segment and really focus on growing that while we're also able to, I think, utilize the heritage and the relationships we have to continue to grow within the hyperscale segment. And just to try to frame some of the -- you asked about the overall, I think, just demand picture, to kind of try to frame that. So first quarter of this year, we had a record signings quarter. We had over $250 million of bookings. We followed that up in the second quarter where we had a little north of $160 million, so not a record, but a very solid quarter in terms of overall signings for us when you look at it from a historical perspective. So that generated a first half total of north of $400 million of bookings, which is twice the amount that we had at the same time in the prior year. So kind of I think demonstrates sort of the type of demand and pipeline oriented and success and execution that we've had. Now that's the total amount of signings. And within that, we continue to have, what I'd say, very strong and steady bookings within the 0-1 megawatt segment. We've signed over $50 million a quarter over the last several quarters, and we've seen pickup within our interconnection bookings as part of that. So I think we've been able to successfully execute within both of those segments over this, what's been again a rising and steady view of our demand across our global portfolio.

And so if we unpack that a little bit more. So the over $50 million from the under 1 megawatt side. As you look at the pipeline that you're developing for that and you look at the demand, is this something that not only may sustain, but you might even be able to augment this opportunity over time, especially I know over the last few years, this has been an increased point of emphasis and focus for the company?

Yes. I mean we're continuing to, I'll say, invest and stay focused on growing that segment of the business globally. So the way we're sort of approaching and attacking that, so we look at it from both where within the customer base, where can we expand, call it, share of wallet within the existing enterprise-oriented customers we have. So we have a focus on growing our -- within that segment, looking at our enterprises that are, call it, $1 billion plus in revenue, really looking at where we can expand them across, take advantage of platform Digital, the 50-plus metros we have, the 300 data centers, where do they -- where do we think that they can -- we can land and expand them and really, really taking advantage of those existing relationships and the value proposition we have and grow them across our global portfolio. At the same time, working to cultivate new relationships with customers. And so that's why you'll hear us usually every quarter focused on new logos that we're generating, where we've been generating north of, call it, 100 new logos a quarter over the last several quarters. It's really part of cultivating hopefully what would be the next set of large enterprise customers that can grow with us within our portfolio within that segment and really expand. But for the most part, if you look at our signings, the majority of signings within any given quarter, and this translates to both the 0-1 megawatt and the greater-than-a-megawatt segment. The majority of our bookings still come from our existing in-place customers, which we have over 5,000 of, but we're also making sure that we continue to expand that customer base and provide us opportunities down the road to further grow our existing customers and their share of wallet.

And as we shift over to the over 1 megawatt, it may be easier to ask this question just in totality, whatever is the way that Digital looks at it. What percentage of the demand right now or the bookings are coming from Gen AI workloads? And how does that compare to what's in the pipeline?

Sure. Yes. So I mean, if you think about spending a little bit over a year of sort of the AI -- the AI discussion. So back when NVIDIA kind of first did their -- blow our quarter, which was, I think, in May, May-ish timeframe of '23, so we started talking about on our third quarter '23 call in terms of like percentage of AI that was within our signings. That point in time, it was called roughly 1/3 of our signings back at that point. Fourth quarter was relatively de minimis. And that kind of fits within sort of the pattern that those greater-than-a-megawatt, and this is back when it was more cloud-oriented versus now cloud plus AI, you do see fluctuations in terms of the overall volume just given the size and the types of workloads that we're talking about. You then shift over to 2024, the first quarter, which is our record quarter, $250 million. We talked about half of those bookings were AI-oriented. Second quarter, it was around 1/4 of those were AI oriented. And in terms of our pipeline, I would say that we're seeing -- there's a material amount of our pipeline that's overall AI-oriented in terms of expectations. But there's also -- because again, that's been sort of the adder on top of our existing pipeline. We're still seeing very robust demand from existing, call it, traditional workloads around cloud as well.

As we try to think about the bookings opportunity over time for Digital, is there a way to frame just how much physical capacity that your sales team is out there, marketing to current and prospective customers? There is, of course, the part of your capacity that's built and underutilized relative to its potential. There's the stuff that's in development. But then there's also projects, right, that sit in kind of the waiting room where you could just greenlight those if you get the customer demand. So how should we think about like the total quantum of opportunity that your sales team is bringing to market?

Yes. I mean I'll dive a little bit into this, but the simple answer is our sale. We've got close to 3 gigawatts of potential capacity outside of our 2.5 gigawatts of operating capacity today. So in general, we could double the size of our business. And our sales teams can, in essence, market all of what's available within our operating portfolio and the majority of that 3 gigawatts that could be built out. Breaking that down a little bit further, we've got close to 430 megawatts under development today. Roughly 65% of that's leased, pre-leased, so there's an immediate availability within that 35%. We're then building around a little over 700 megawatts of shell capacity. So that's kind of the next stage of most near term that would be available. We've got line of sight on power for the majority of that capacity as well. And then we have, call it, close to 2.3, 2.4-ish gigawatts of, in essence, land capacity available. And I mean, we've had -- we talked about last quarter, we had an opportunity in Dallas where we, in essence, sold what was not even underway, it was land capacity, and so we've seen where we've been able to sell through kind of all 3 of those different stages of potential available capacity that's within reach within our portfolio today.

So with all this capacity that you could tap into and sell, is there an opportunity for another record bookings quarter second half of the year?

Yes. I mean I'd almost go back to, I think, something that Andy had said on, I think it was our first quarter call when we had our record, that it's hard to do back-to-back records, which we didn't do. We've already had the second quarter. But look, we've got -- with the demand environment that I think we're in today, the capacity that we have available, that's highly attractive to not only the hyperscale community, but also, again, not to ignore our 0-1 megawatt business that's doing well as well, I think there's definitely opportunity for that potential to happen.

And how do you think about the -- like where it goes, like what gets funded on balance sheet versus what might go into the joint ventures?

Yes. I mean so we've sort of -- I mean not sort of, we have -- I mean, we've done that today. Someone answered that. So we've done joint ventures. Our joint ventures, one aren't necessarily new to Digital. We've had a number of joint ventures over our history. And they largely fit in kind of 2 broad buckets. One is where we're utilizing financial capital-oriented partners, which is, I think, a little bit more of what you're referring to, and others were, call it, more strategic or operational, and those would be ones like Ascenty in South America, where there's actually an operating partner company, management team generally behind it. So like Ascenty, Teraco in South Africa and Mitsubishi in Japan, where it's helpful either from a risk or other strategic rationale, bringing in demand in local, more localized expertise in having those partners. From the financial capital partner side, we've expanded on those relationships over the last year. Most notably, I think you're referring to the Blackstone joint venture, which is roughly a $7 billion JV. We've closed the first phase of that, which we did early this year. We expect to close the second phase sometime in the second half of this year. And that's roughly 500 megawatts of capacity across 3 different markets, expect to deliver probably 20% of that capacity in '25. So that's going to be a multiyear sort of journey as we look to -- which is part of that $7 billion in terms of their capital commitment to those sites. And again, I think that just goes back to the fact that this hyperscale opportunity is large. We think it's prudent to have capital partners with us that can help fund that development. We earn incremental return on our invested capital because we're generating fees, and in some cases, related to development projects. We're generating those fees kind of right away from the start so it has an impact to our bottom line as well. And so we think those will continue again as those are just getting started, somewhat of a multiyear journey as we look out to the capacity that's available within that JV.

One of the questions that we get is whether or not this strong demand cycle is going to get to a point where there's just been more absorption by the customers that may be needed for the workloads and it could create some kind of correction in the supply-demand environment. As you kind of look back to the cloud cycle that you went through, where we saw some of those ups and downs in terms of supply-demand environment, are there any learnings or indicators that you can -- you learned from back then that we should be mindful of today? And because of the power constraints, is this just a fundamentally different environment?

I think there's a little bit of the 2 parts, both of those parts that you just mentioned. So from a power constrained business, I mean, we haven't seen this type of constrained environment in, you call it the history of data centers, meaning it's not -- what started as a focus on power constraint largely within the Ashburn market, which is the largest data center market in the world, has now extended across multiple markets, not only in the U.S. but also globally. So I think that constraint alone has kind of, call it, created a level of ceiling where it's more difficult to bring power and be able to satisfy the demand that's out there today, which has also what's led to improvement, substantial improvement in some markets in terms of pricing. And so it has accrued to I think us, as an operator, especially an operator with one of the largest existing operating capacities across several of these markets, including Ashburn in Northern Virginia. So I think that kind of sets sort of the stage around how things are a little bit different this go around. In addition to that, I think from our lens or from how we're -- how we look at it, and a little bit to your point on what have we learned. I think one of the things we're also doing is we're sticking to our core markets. So part of what's happened is you've seen some of this demand go into spillover secondary, tertiary or however you want to describe it. Other markets largely within the U.S. because that's where most of the AI demand is oriented today, although that's starting along the same -- some of the lines of cloud to trickle through into EMEA and into APAC, but still in the early innings of that. But we're sticking to our core markets where we think over time, we see a diversity of demand that I think should enable us to withstand any sort of disruption or slowdown that might occur, although based on what we're seeing in the pipeline. I mean, we don't -- we're not seeing that they're expecting that anytime soon. And I think that -- in addition to that, where we do -- where we are starting developments. I mean, some of the data points we already mentioned, we have a pipeline, development pipeline that's already 65% preleased. We're releasing these to customers over a long-term basis with good to annual escalators in 3% to 4% area. So I think kind of -- and most of these, most if not all of these customers are very high credit quality customers. So given that sense of security, stability around what we're doing and looking out into the future to be able to sustain any sort of disruption mine or major from our lens.

We switch gears to pricing for a moment. So with pricing, you and the team over the last number of months have talked about the positive pricing conditions. If you just take out some of the outliers, whether it's helpful or hurtful outliers, is there a way to frame kind of the average rate growth you're seeing? And I realize you can look at renewals, but really more from a spot price market perspective, what you're seeing? And are you still seeing that growth now continue into this third quarter?

I mean the short answer is, I mean, yes, we are continuing to see positive pricing momentum across the majority of our major markets. And that there are different degrees of that. As you mentioned, I mean, Ashburn has seen sort of the largest -- had the largest decline over several years ago, and as a result, has also seen the biggest uptick and reversal of that trend. So that might be one of the kind of outliers you mentioned, but to use that as an example, we've seen rates that were in the 80s, now they're in the 160 and beyond. And so we've seen that sort of relatively quickly rebound in pricing there. But I would say broadly across most of our global markets, we've seen sort of over the last, call it, 2 years, which is where a lot of this kind of supply-demand imbalance started to really take shape, we probably see anywhere from mid- to high single-digit sort of annual growth in terms of where rates are across most of those major core markets.

And are customers changing the way they engage with the renewal schedule? So are you seeing any change in behavior because of the pricing conditions, customers may want to come to you early and say, "You know what, let's just extend the leases now off what the market is today" and defer the risk of things even getting more expensive as they look out over a couple of years?

I mean we're seeing -- it's I would say, that's relatively isolated at this point, but we have seen that. So we talked about -- we actually talked about one of those on the first quarter. We had sort of an outsized mark-to-market in the first quarter, and we had sort of talked about that in terms of a sort of a preview, if you will, or an illustration of an outer year -- an outer year expiration that was pulled forward into '24. So kind of demonstrating the pricing potential and the uplift for -- as you get sort of further out into our lease expiration schedule. So we've seen that in certain instances, not -- I wouldn't say that's a widespread phenomenon, but I think there's opportunity for that as we start to move through in this environment, continues in terms of a supply-constrained environment, there's potential for that to continue to happen.

So we're starting to learn more from some of our other coverage around hyperscalers signing 20-year IRUs for fiber. And curious, first, if you know if some of these fiber deals are going to your data centers, and if the IRUs are being signed for those longer durations, I think that's longer than the typical initial contract for your hyperscalers. Does this just reinforce the durability of the leasing opportunity from this evolution in workloads?

Yes. I mean so we've started to see some of that. I mean, most of our -- the majority of our portfolio, we already -- for most of it, we already have existing connectivity, so I think we're starting to see this in some of the new builds that we have and building out sort of that connectivity oriented, some of which is -- some of which we help procure, some of which depending on the size and how much of the data center a customer has. There can be the ones more on the forefront of procuring some of that, some of the dark fiber. But that's always been part of, again, back to sort of that being able to combine both not just the hyperscale, but being connectivity-oriented. We've been working with our customers as well as the network providers to bring in connectivity to all of our sites as much as we can. And in addition to that to working with our customers to also connect sites within a campus. So I think one of the things we're seeing that is preferred by customers, but again, it kind of depends on the mix of how much power is available and their time to market. But what we're seeing is there's a preference for customers to land sort of AI requirements near cloud compute because cloud is where a lot of the data is held. So their ability to connect from a building that's on the same campus to where they have an AI workload and using pathways and other connectivity options to bring those 2 data sources together, I think is an ideal environment, something that we're helping our customers to solve.

Maybe pivoting over to the financials. So in terms of capital allocation, dividend has been flat for, I think, at least a couple of years now, the annual dividend?

A little over a year, yes.

Over a year. What's the path? And what should investors look for on the possibility for dividend per share to return to annual growth?

Yes. So I mean we're -- the way we look at it, I mean, we view our best -- our best source of capital is internally generated cash flow. So that also focuses driving growth in internal cash flow that we can then deploy into development yields that are in the 10-plus percent area. And I think as we look to do that, and as we start to grow the bottom line, ultimately, that's going to be sort of the trigger to then look at and say, okay, we're now looking to grow ultimately our dividend in lockstep with our bottom line, so call it core FFO, AFFO per share growth, but also looking to, again, maximize, I think, the amount of cash flow that we're able to retain, which is not easy given that we're restructured. So we're distributing the majority of our cash to begin with. But to the extent we can satisfy both, we can maximize cash flow available from operations after dividends to help fund some of the development growth and the higher yields that we're seeing and also start to continue to grow our dividend as our bottom line growth take shape as well.

In the past -- over the last number of months, you framed the conversation on equity, it's around partly opportunistic related to the demand environment. Is that still the way that you look at the possibility of equity? Or do you prefer, especially now that you have the additional capital partners that you have, to create more of a self-funding model for Digital with the internal cash flow and the benefit you get from levering EBITDA growth to kind of fund the investment needs for the business?

Yes. I mean in the most ideal world, I mean, we'd be able to satisfy our capital need from self-funding. I think we're right now, in our environment though, I think we're at a place where that's why we've set out on a path to have a diversity of capital sources available. I think the statement still hold around equity being demand-oriented, right? I mean we're seeing that as part of this capital deployment, investment in our development pipeline where, again, we're earning 10-plus percent returns, which I think is a good use of overall capital and I think good returns that most shareholders would be happy with. And so I think we're looking at how we can, again, put together the right mix of capital sources across not only cash flow from operations, leveraging EBITDA growth that we have now that our balance sheet and leverage are in a good place, access to debt capital markets and then supplementing the equity side with a mix of both JV capital partner sources as well as public equity where needed.

And just to finish up, you spent a good amount of time, I think, with investors since the earnings. Are there any aspects of the Digital Realty strategy story opportunity that you feel may be underappreciated at the moment?

I don't know if anything is underappreciated. Look, I think we've done a lot over the last year, again, in terms of getting the balance sheet back in place. And ultimately, this is around growing the bottom line, which is why that's our first, second and third focus. And we're in the environment where we see a path to be able to do that, just given the positive pricing environment, the yields we're seeing on developments and the overall demand environment, I think, sets us up well to be able to execute and deliver on that.

Matt, thanks for joining us today.

Yes, thanks again for having me.

Thank you.