Prologis, Inc. (PLD) Earnings Call Transcript & Summary

All right, everyone, it's time to get started here. We've got a packed room and a lot to talk about. So welcome, everyone, to the Prologis 2022 NAREIT Presentation. I'm Tom Catherwood, BTIG's senior REIT analyst, and I am joined by the Prologis team of Dan Letter, Global Head of Capital Development and for the first time on the stage as CFO, Tim Arndt. Gentlemen, thank you for being here.

Thanks, Tom.

And just to level set at the beginning, we're going to be focusing on Prologis' business, the outlook for industrial and macroeconomic factors. We've agreed with the company not to touch on anything that has to do with the Duke offer that is outstanding.

So to get us started, Tim, we're at a very interesting time for the industrial sector. We have record low vacancies. We have record rent growth; we have supply chain reconfigurations ongoing. We have the wrong amount of supply in the wrong places. And yet on the other side, we have adoption slowing when it comes to e-commerce. We have a record amount of new supply in the pipeline, and we have companies like Amazon slowing their uptake of industrial, Target talking about cutting down on its product and its inventories. How do you square these up and which side is right?

That's a great question, and thanks for having us here. I think actually, I might start with that Target story because I think it's one that best reconciles all the things that you're wondering about there. So Target, I'm sure many of you read the article or saw some of their release on how they're saying their supply chain is messed up, frankly, right now. And we all know that. We see that in many other retailers, but it takes reading through kind of the entire article to fully understand what's there and what it means for warehouses. I think off the headline, the headline just sounds bad. They have too much inventory as a generic statement, but it's more nuanced, right? They have the wrong inventory in the wrong places and what they actually are saying they don't need any less logistics or warehousing space, but they need to clear that out, go park it somewhere else, some of the inventory that is not really in season right now, if you will. They pointed to things like summer patio furniture. And they need that room back to make space available for things that are in season and need to sell right now. And that's just the extension of a theme that we've seen and been talking about for many quarters now, really since COVID had commenced in the spring of '20. We have been seeing that there's going to be a shift from goods into services. And -- but in the transition, the supply chain was getting pretty much up, and everybody had their gear in the wrong places. And what Target also said that was interesting that is a real endorsement of our product type was that because of that phenomenon their inventory and not having the right thing at the right time in the right place, they're missing sales. And for those of you following our story, that's something that we've been talking about for probably the last 10 years that our product type has really transitioned from being a commodity from any retailers, they are looking for the cheapest warehouse space, didn't matter if it was far out. This was a cost center for them to -- through the last 10 years, it being really a strategic asset where location was very important, being closer into their customers was very important to not miss the top line sale. And that's exactly what Target was referring to that they're missing the top line sale and the customers going out the door empty handed. So a long way of getting to the point here, Tom, but at the end of the article, they said to remedy that they need in addition to their existing expansion plans. They need 5 additional DCs. And they also are calling on their own vendors and suppliers to get closer in and keep better stocked themselves. So their own inventory turns, and replenishments can be much more real time. And so it's that backdrop that actually that winds up being a good story for logistics in the end that, that is going to be a thesis for why we're going to see in the first part, a correction of what we see as kind of a messed-up inventory to sales ratio right now. Things are -- the inventories are just in the wrong spot and then the need for resiliency of build of inventories on top of that. From our customer feedback, it's something on the order of 10% additional inventories is just what we see our customers is requiring that would all translate to about 800 million square feet of additional space needing to be built out and what get absorbed probably over several years, I think it would take. So that's kind of a new secular driver in this space.

I definitely want to touch on those inventories that rebuild, and the supply chain reconfiguration really ties into that. But before we do that, I do want to touch on Amazon and e-commerce because it's been in the headlines so much. Are you -- how are you seeing them treating their spaces within your portfolio? And are you seeing that broad-based pullback across all e-commerce tenants? Or is it really just Amazon at the very kind of beginning of that process?

Yes. So we have in our presentation that's posted I don't know the page number. But early on in the deck, we have a good exhibit that speaks to this in one way, which is we went through our leasing, the makeup of who is leasing our space in different fiscal periods over the last 3 years or so, and we're segmenting it by e-commerce players and pulling apart the Amazon piece of that, in particular, against everybody else. And you certainly see in that trend line, less take-up from the e-commerce players, including Amazon. But that's supplemented that chart that you'll see with what is our occupancy in the portfolio and it's building the entire time. So it's telling the story that, yes, the e-commerce take-up has reduced, but there's many other players coming in to take the space to the tune of occupancies actually building despite all of that. We had put a paper out on this topic in our research section on our website. Speaking to the Amazon situation generally, and it says a few things. One is just that we have seen this coming. We've been pretty active in talking about it really since early on in COVID, I think, by the middle of 2020 or so. We started understanding that it looks like there's certainly a rush on the procurement of goods from our customers' customer. E-commerce was benefiting. We understood that would change one day, and we should all be on the lookout for that change. But then as quarters went on, we also started to highlight that e-commerce take-up of our leasing was significantly higher than it had been, but that also wouldn't continue, and we expected it to change. So that all kind of played out fully as expected. In our space or our portfolio, we have 147 Amazon leases today. We have 2 of them brewing right now where -- what Amazon is doing, in my view is they've said that they built out their capabilities to the high end of what they saw. Demand has potentially been through the next few years, and they overshot it. We know that. We know how they explained that. They did that on their logistics footprint, but they also did it with their employee base and many other areas, and they're figuring out how to rightsize all of it. On the logistics front, I think they are wisely figuring out how can I now carry what is -- whatever this excess amount of square footage is. And I think there's estimates of 10 million to 25 million feet out there, something on that order. What's the best way to carry it until it is needed? But I'm not really hearing , I don't think they're saying they want to ultimately give it back. I think they are all locations they will need in the long-term. They just didn't have the timing precisely, right? And wisely as a financial play, they're figuring out, well, how can I best carry it in the interim and that might be subleasing or at least delaying taking occupancy of the space. So the space is where that's best done. Tom, our spaces they haven't yet occupied. Clearly, they're not going to take one that they've now outfitted with a lot of CapEx and hired -- I think they have like 2,000 people at some of these facilities, done all that hiring. Those are going to stay occupied most likely, but something that they haven't yet moved in, and they can use neighboring facilities to continue to serve their customers. They're going to figure out ways to do that. And they may sublease that space. We have control over those situations. We would prove who the sub-lessee is. We actually have arrangements somewhat common in the market where we would participate in any upside they might get if there's a difference between their lease rate and what they can get in market rate at the time. So it's not a bad situation, and it is, as I said, limited to about 2 facilities right now on roughly 150. I think the situation -- I'll shut up here in a second, but I think their situation is quite unique. I think you were asking earlier is just a read-through on other e-tailers. Nobody did what they did. I think some retailers might have wished at the time they were able to do what they did in consuming so much space and getting ready for a bigger wave, those companies who didn't do that probably are thankful at the moment, they don't have to deal with having too much. But nobody took down space in the magnitude that they did in that time period.

And that's fair, and that's very much what we're thinking of is what's that demand behind it? Because the fear is that demand for industrial is great until it isn't. And then all of a sudden, the supply coming online issues become an overhang. But we're clearly not there yet. You obviously mentioned 800 million square feet because of the need to carry excess stock. Can you expound a little bit more on that? And any other secular demand drivers that you think give you the confidence that the demand is going to continue as we look forward even beyond Amazon?

Can I hit the supply side first?

Sure.

And maybe come back to the 800 and you can help me on the second part of this. But we -- there's a lot of talk about how much supply is coming out into the markets and -- there's some big numbers, roughly 400 million square feet in our markets, and that is historically high. That number needs a lot of context though. And so we introduced that context in our first quarter call. We came up with a new metric. We call it the true months of supply and what we're doing in that across our markets as we look at the standing vacancy and the stabilized portfolios in those markets, how much space is that? And then what is the unleased development portfolio coming into that market as it stands on at the end of the first quarter. So that is all the vacancy that is either there now or coming very shortly. And we put that in the context of what is the most recent rate of absorption in that market on a trailing 12-month basis. And we put them together and we can say, well, how many months at that pace would it take to absorb all of that supply? And so at the end of the first quarter for our markets that was 16 months, and then you want to know what to relate that to, well, in similar expansionary periods, it's typically 36 months. We also -- we have a chart on this in our presentation as well. So I don't think we would go this far, but those numbers would suggest there's not enough supply at the normal amount of supply that's coming in between standing vacancy and new deliveries. It takes something like 36 months to absorb what typical absorption levels, and we're down at 16%. So we will continue to report out on these 2 months of supply metric. I think we're going to find new ways to cut it by markets and submarkets because I think there's going to be some interesting learnings there as well. But that context on supply is really important. And I'll ask Dan to expand on just how hard it is to bring new products.

Yes. I would say on the supply side, too, there's a big question around where is the supply? We very much have a submarket focus, not necessarily just a market focus. We're in about 30 markets in the U.S., but we're -- again, we are not in the entirety of these markets. We are very focused on the infill nature of the submarkets and the more infill the markets, the harder it is to develop new space. So our entitlement time frames have expanded from 12 months to 24, 36, sometimes 48 months, depending on where around the globe that we're developing. And it's just that much harder. And then, of course, we've all heard and experienced the issues with labor. Labor is an issue no matter where we are, commodity issues with buying materials. So the cost to build, the entitlements needed to build. There's just that much more nimbyism today. It's really, really tough to build new supply. We've built a bit of an insurance policy. Prologis, one of our differentiators is our land bank. We have about $2.5 billion of land on the balance sheet, and that's worth about double because we've been curating this land bank over the last 5 to 10 years, and we've been really focused on buying the right land in the right places, so we can build in these locations for our customers. And we have the luxury of time to be replenishing that land bank for our customers 3, 4, 5 years out now, too, as these time frames to entitle have continually expanded.

So that's -- so it takes care of the supply side of the equation. On the demand side, again, just thinking of what gives the level of confidence going forward, right? Is it an expectation, even though we've seen the pause now, the expectation that we will get more uptake and adoption on the e-commerce portion of retail sales? Is it that customers continue to just need more space as more channels are pushed online? Is it the safety stock, which has it even come into the portfolio yet? What are those secular drivers?

I think you just hit them all pretty well. I mean, it is all those things, and we've got some more exhibits in the book on this. One I'm thinking about to point you to is just, our forecast on what e-commerce penetration is going to be because even though it will reflect that our forecast compared against pre-COVID, we do sure -- show a pull forward of e-commerce penetration for sure. But we don't see a flat line from here. There is still continued growth. And hopefully, many of you are now familiar with. There's these phenomena of a 3x multiplier on the amount of warehouse space you need for every dollar of sales that's moving out of traditional retail channel into e-commerce. So that multiplier tailwind is still present. The big piece of the 800 million square feet, Tom, that we've referenced. Again, this is in the presentation. It's a description of the inventory sales ratio and our thesis for why ultimately, we'll see another 800 million feet of demand driven from it. The need for 10% additional safety stock, we're not making up. We have a huge Rolodex. As you know, we have very good customer relationships. We have Chief Customer Officer. We've put a different focus on the customer than some of our peers. This week, some of our colleagues are out at town. These customer advisory boards that are these events where we take top customers away and really get into what are their strategic plans from here, both 3PL focused and then traditional retailer focused. And it's out of all of those conversations that we've come to understand this need for the 10% that is making up about half of that 800 million square feet. The question I'm going to ask at the end of all that as well, has it started? Where are we with that? Is anybody building in this resiliency? I think the Target article shows. Well, somebody has sophisticated as Target has not -- that's exactly the point of the art they don't have any of that resiliency built in yet. And I was under the impression that we would have seen somewhere in the first quarter because we've been talking about this need for resiliency build for a year or something on that order. So people will ask us, has it begun? And the answer has been no for a long time. I thought maybe around the first quarter, we would start hearing from our leasing and customer teams that yes, we're starting to get requirements that seem to fit the bill more of this safety stock rebuild. I think everything just got disrupted again with the China shutdown. We've got a port labor union negotiation ahead of us. There's just a lot of disruption that I think is precluding everybody from making real progress on that side of their supply chains.

Appreciate that. And I think it does make a lot of sense. And I'm going to want to focus on some of the things that Dan said in a minute, specifically around the land bank and maybe allocating capital incrementally. But before we do that, just finishing up on risks, right? So we've run through why you're not concerned on supply. Run through why you think demand is going to continue to remain strong for the foreseeable future and the secular drivers behind that. So then the risks that you are tracking, what has you concerned? Is it a consumer recession? Dan, you obviously mentioned labor. It's an issue both for Prologis and for your tenants. What are those risks you see in the business?

The risk we see -- I mean, Tim and I have been talking about this the last couple of days. We wake up every day looking for cracks and we feel like we've been building that insurance policy on the land side. So we can -- we don't have to go chase land prices to all-time highs today for just-in-time development. We continue to see broad-based demand; labor is an issue for virtually every sector of the economy. So...

It's hard. We've struggled at this, and we hope we don't look naive on it. I think it comes a little bit from an approach we have at the company. I think the way the new Prologis was born 11 years ago out of the merger with AMB, we've got a very risk-averse approach to managing the balance sheet, controlling development as large as Dan's in charge of a $5 billion development program, it's still one of the larger -- I'm sorry, smaller proportionate to our balance sheet as compared to others. So we're very careful there as well. So we're always in the mode of being cautious and always looking for the cracks. We try to put a lot of our proprietary metrics out there for you. So you are watching the same things we are with regard to what's the pace of customer decision-making by right of our gestation reporting on lease signing. How do proposals look? We give that information out. Proposals per unit is now becoming much more relevant because it might be interesting how many proposals are out there, but now you need the context of, well, how many units are actually available when you're almost 98% occupied? It's very few. Those numbers are tracking very well. So I think we've put all of the right measures up on the dashboard, if you will. And honestly, nothing is being led right now.

Let's appreciate that. Obviously, this comment on the land bank being an insurance policy and not chasing land prices where they are today. And that really ties into that, where do you put your incremental dollar when you're thinking about growth and where to invest your capital? How are you allocating between your different options right now, Dan?

It's a good question. We see 8 to 10, I think we've got 12 deals on the docket for Monday morning. So every week, and this is around the globe. So we deal with every deal as it gets presented to us, right? Our teams are not paid for volume. We don't say, go deploy $1 billion. We guarantee that person will be able to deploy $1 billion if we were paying them that way. So that allows us to maintain the level of discipline. Tim called it caution, I'll call it, discipline. He's the CFO, though, he should do that, right, because what we -- we've really broken away and created a new category of this covered land play and we hear it all over the sector these days. But going back 10 years ago, this was just old school walking the pound of the pavement, knocking on doors and buying land that we -- are buying assets that we knew could be land, basically manufacturing logistics real estate land. And we've had tremendous success there. We've got a playbook there that we've had tremendous success in the U.S. in half a dozen markets. And we're now using that playbook in other markets around the globe. I've been to Brazil have been all over Mexico this year, been to Europe. And we're just -- we take these playbooks and that's the beauty of our scale. We can actually go put it to work over there. And it's amazing as much capital is chasing different deals over the last 5, 6, 7 years with this proprietary data we have as well as the experiences we have, these shared experiences, these compounded experiences and learnings that we have. It's -- it's not one particular lever we're trying to pull at any given time right now. Sure. Are we curious what's going to happen with some price discovery that's going on in the market today? But again, our teams aren't waking up every day saying I've got to go deploy $100 million this quarter to buy new buildings. And we've got the -- we have the luxury of flipping the switch on spec when we see the right metrics in any given market. We see -- again, we have the customer relationships, we have the information on -- at the field level, we have it at the C-suite level, and then we obviously have the local data that allows us to put our land that we've been -- we're continuously curating in play. If I was going to say one thing, I would say there's certain pockets of places where we just need land because we've been going through it so quickly. And again, just not to beat a dead horse here, but our teams can go focus on land for 2027, and we can use that time and all the resources of our company to create value. But again, like we've got $2.5 billion in land on the books, it's worth $5 billion. So there's tremendous value in creating those entitlements.

So [ Bill ], you mentioned price discovery. Right? We've seen -- well, I guess it's a challenging market to figure that out. It seems -- what have you seen so far in your markets, in your geographies as far as recent valuation trends?

Yes. So I guess I did just allude to price discovery, but didn't explain that very well. With the movement in treasury over the last few months, there's been a good portion of the buyer pool has stepped out the field. They're sitting on the sidelines waiting to see what happens here. So call it, half to 2/3 of the buyers we're seeing, depending on who you ask, just sitting on the sidelines waiting. There hasn't been a lot of transactions in the markets which we focus yet. But those that have or on an anecdotal basis, the focus is really on the lower wall. So these investors can get to the growth that we're seeing in the rent growth. And the rent growth is really kind of powering through any sort of cap rate expansion. So on those 3 years or less wall, I'd say it's a small tick up 10, 15 basis points. And then on the longer wall 7 years plus with lower bumps, if you will, just that's more dramatic, probably 50, 75 basis points depending on the location. But I would say actually on a valuation perspective, we saw an 8.5% write-up in the U.S. in our portfolio in the first quarter. And I think we feel pretty strongly that we're going to see write-up here in the second quarter as well, again, with rent growth really powering through any sort of expansion in the cap rates.

And that rent growth continues through the first quarter?

That's correct.

Yes, I was just going to build on that one that we -- this is something that's highlighted in the paper that we had a forecast originally for about 10% market rent growth across our markets and our initial guidance in April. We took that up pretty dramatically to about 20 points, 20%. And in this Amazon paper, we just felt the need to reaffirm as a way of saying no, no this was really news and was in our view of absorption for the year upholding that same 20% on the full year. We experienced roughly 10 points of that in the first quarter. And I think we'll probably see ourselves surprised by a couple of points of what that would have inferred for second quarter. We'll give a reforecast or commentary on that on our earnings call in a number of weeks here. But I expect we will affirm that market rent growth and there's some possibility it could tick up still. If the quarter ends strongly.

So demand is strong. Supply is not a concern. The risks, obviously, your eyes are on it, but they're not manifesting the opportunities are out there, how do you capture more of it? Is there more that you can do given how positive you are in the sector to either pull forward some of that growth or to capture more that's going on, whether it's with your tenants or whether it's going on in the market, what are the other opportunities for Prologis?

Well, go ahead. Well, I'll say our build-to-suit pipeline is as robust as it's ever been. And again, we -- most of our build-to-suites take place on our land bank in one shape or form, whether it be our own land or covered land or our option land. But we're building resources now to capture more of the build-to-suite pipeline out there, we see looking forward into next year and our customers just they have a need. And it's not always perfectly in location that we are located. And sometimes it's even in markets that were not located in. So I would say that there's more of an opportunity to capture our outsized share of that build-to-suite business.

I would just pile on to that. Tom, that for those of you who don't know the company as well, outside of -- we have 3 businesses historically, I would say, our operating business, our development business, and then we have a very large asset management business, our strategic capital business. And those are kind of 3 legs of the stool. But we've added a full fourth here in this -- what we call an Essentials business, where we have looked outside of the real estate and found there's many areas by right of our scale that we can now really offer something to our customers by helping them procure goods that we see them every day with every lease. We lease about 1 million square feet every day. When they're moving in, they need forklifts, they need racks, they're putting in new network systems. Now they want solar, EV is coming. These are all things on our scale that we have great ability to help them procure. Many of them are SME smaller companies. And we can help procure that for them, have a great customer offering in there, but also some margin take for Prologis, right? So that's the thesis behind the Essentials business. It's dropping about $75 million of FFO to the bottom line for us today. We think that will be on the order of 4x that amount by '25 big opportunity for us there is in solar. So there's a lot more I could say about that in the 54 seconds that remain here, but we'll have to save it for another time, but we're super excited about what all the potential is in this Essentials. And I think that's -- we can do all these great things. We did in the other 3 legs of the stool, but now there's a full fourth business we're standing up.

That's great to hear. I think that's a good way to end it. Tim, congratulations on your first time up here as CFO. Dan, thank you so much for being here and give us your insights, and best of luck going forward. Thanks, everybody.