CyrusOne Inc.
Q2 2017 Earnings Call Transcript

Published: 5 Aug 2017

[Operator:]

Good day, everyone, and welcome to the CyrusOne's Second Quarter Earnings Conference Call and Webcast. All participants will be in a listen only mode. [Operator Instructions] Please also note that today's event is being recorded. At this time, I'd like to turn the conference call over to Mr. Michael Schafer. Sir, please go ahead.

[Michael Schafer:]

Thank you, Jamie. Good morning, everyone, and welcome to CyrusOne's Second Quarter 2017 Earnings Call. Today, I am joined by Gary Wojtaszek, President and CEO; and Diane Morefield, CFO. Before we begin, I would like to remind you that our second quarter earnings release, along with the second quarter financial tables, are available on the Investor Relations section of our website at cyrusone.com. I would also like to remind you that comments made on today's call and some of the responses to your questions deal with forward-looking statements related to CyrusOne and are subject to risks and uncertainties. Factors that may cause our actual results to differ from expectations are detailed in the company's filings with the SEC, which you may access on the SEC's website or on cyrusone.com. We undertake no obligation to revise these statements following the date of this conference call except as required by law. In addition, some of the company's remarks this morning contain non-GAAP financial measures. You can find reconciliations of those measures to the most comparable GAAP measures in the earnings release, which is posted on the Investors Section of the company's website. I would now like to turn the call over to our President and CEO, Gary Wojtaszek.

[Gary Wojtaszek:]

Thanks Schafer. Howdy, everyone, and welcome to CyrusOne's Second Quarter 2017 Earnings Call. The team has done a great job executing our plan, and I am very pleased with our performance for the quarter. There's certainly no shortage of opportunities and we remain focused on profitably growing the business. Beginning with Slide 4, we continue to post strong results with growth rates well above those of most REITs. Revenue of $166.9 million was up 28% over the second quarter of '16 and adjusted EBITDA of $90.8 million was up 30%. Normalized FFO of $0.77 per share was up 15%. We leased 136,000 colocation square feet and 17 megawatts of power, and our bookings totaling $30 million in annualized GAAP revenue were 50% above our guidance of $20 million per quarter. We signed the second-highest number of leases in the company's history, reflecting broad demand for our products and highlighting the benefits of the investments we have made in building what we believe is a world-class sales organization. Our backlog of $49 million as of the end of the quarter was up $5 million compared to the backlog as of the end of the first quarter and represents more than $390 million in total contract value. We closed the previously announced acquisition of 48 acres of land in Quincy, Washington, positioning us to offer what we believe will be the lowest-cost data center solution in the country. Subsequent to the end of the quarter, we closed the acquisition of 66 acres of land in Allen, Texas in response to the strong demand we continue to see in the Dallas market. To ensure we have substantial capacity to continue to fund our growth, we increased the size of our unsecured credit facility by $450 million to $2 billion and we had nearly $1 billion of available liquidity as of the end of the quarter. We also gained additional flexibility to pursue initiatives consistent with our strategic and financial objectives. Lastly, we raised $197.5 million through our at-the-market equity program. Even with the impact of the additional equity, we have increased the midpoint of our normalized FFO per share guidance by $0.05, and Diane will discuss in more detail in her remarks. Moving to Slide 5. Our bookings for the quarter were in line with the average over the prior 8 quarters. The publicly traded data center REITs continue to post strong leasing results and we are certainly capturing more than our fair share. Over the last 12 months, our leasing volume of $107 million in annualized GAAP revenue was 20% of base revenue over the same period. Similar to the first quarter, the contribution from smaller footprint deals represents more than 1/3 of total bookings or approximately $10 million in annualized revenue. We also signed 451 leases, which, as I mentioned earlier, is the second highest quarterly result in our history. This is 18% increase over the prior 8 quarter average. MRR per kW signed was nearly $150, a 6% increase over the prior 8 quarter average. The industry has been very disciplined with capital allocation and preleasing levels are significantly higher than 18 to 24 months ago, resulting in balanced supply and demand and a healthy pricing environment. The top of Slide 6 highlights the continued strong growth among cloud companies. 9 of the top 10 cloud companies are customers of CyrusOne and they all are contributing significantly to our growth. The cloud vertical has accounted for between 45% and 75% of our quarterly bookings since the fourth quarter of '15 and currently represents approximately 26% of our rev. While leasing across other verticals remained strong given the underlying secular trends, demand from cloud service providers has accelerated our growth. Based on what they are telling us, we believe that they will continue to have substantial new capacity requirements going forward. Third party forecast reflects similar views, estimating public cloud demand of at least 700 -- several hundred megawatts per year over the next few years. Global server shipments are expected to be up double digits in the second half of '17 compared to the first half of the year, driven by demand from the large cloud companies. Given our relative cost and build time advantages and the fact that investors do not reward them for building their own data centers, we believe that 100% of their requirements should and will be outsourced over time. We continue to focus on educating them about our advantages and are at various stages with each company, but we believe we will ultimately be successful in convincing all of them to outsource. Moving to Slide 7. As we have highlighted over the past few years, the contribution from existing customers to our growth is significant. Unlike some other REIT asset classes, in which companies don't necessarily enjoy repeat businesses -- repeat business with their tenant, we work on establishing partnerships with our customers as we know that they will need additional space and power from us in the future. In each of the last 4 quarters, 80% or more of the MRRs signed was from existing customers. In the second quarter, 94% was from existing customers but we also added 13 new logos across a broad range of industry verticals including, among others, financial services, health care, cloud and energy. The charts on the lower left corner of the slide show the growth in our Fortune 1000 and cloud customer bases over time. The initial deployment of each of these 13 customers was less than 250 kilowatts, reflective of the fact that many companies start out small with us. However, this is not always the case. The chart in the upper right hand corner shows the growth in MRR from our top customers. Of our top 30 customers, as of the end of the second quarter, 21 were also customers as of the end of 2014. The MRR contribution from those 21 customers has increased from nearly $12 million to more than $21 million. This represents a compound annual growth rate of 27%. That growth is either through expansion of their existing deployments or, in many cases, new deployments across different locations, which is why we have worked to establish a national footprint of interconnected data centers in the markets that our customers tell us they want to be in. Today, nearly 70% of MRR is generated from customers that are in more than 1 of our data centers. Slide 8 highlights the continuation of the trend towards longer lease terms and the contribution from ancillary sources of revenue. In the first half of 2017, the average term for new leases signed was nearly 8 years, in line with the averages from new leases signed in 2015 and 2016. The weighted average remaining lease term across the entire portfolio is nearly 5 years, an increase of almost 2 years from the weighted average remaining lease term at the end of 2015. We expect the trend toward longer lease terms to continue as companies want the security of extended terms for their mission-critical gear. The right half of the slide provides an update of some of the key sources of ancillary revenue. Annual escalators generally in the 2% to 3% range are included in the vast majority of new leases as well as renewals. In the second quarter, 83% of annualized GAAP revenue signed included escalators at a weighted average rate of 2.4%. The percentage of total portfolio rent that includes escalators has nearly doubled in the last 18 months from 34% as of the end of 2015 to 63% at the end of the second quarter. We expect this percentage to continue to increase over time as we include escalators in both new leases and renewals. Our interconnection product line, which includes high-margin cross connects as well as our national IX, is producing strong results. Interconnection revenue in the second quarter was approximately $8.5 million and grew 16% compared to the second quarter of 2016. Our portfolio now consists of more than 13,000 cross connects, up 18% from the more than 11,000 cross connects in March of 2016. We are seeing a noticeable increase in the number of interconnections associated with enterprise companies as they connect to cloud customers. We now average more than 13 cross connects per customer, up from 3 cross connects per customer in 2011 and expect this trend will continue to increase. As we discussed last quarter, we have a very successful rollout of our power administration fee, which is a charge we began incorporating into metered power leases in the third quarter of 2015 to recover costs associated with administering these leases. Nearly 2/3 of metered power deals signed in the second quarter included the fee and the percentage of total portfolio of rev that has a fee now is now 11%, up 1 percentage point compared to the first quarter. This percentage will continue to increase over time as we incorporate the fee into new metered power leases as well as renewals. Smart hand consists of miscellaneous services that we provide to our customers, such as tape rotations and handling inbound shipments. Our billings for these services currently range from $200,000 to $250,000 a month. There are other services that we provide today that we currently don't charge for and we are evaluating whether we should in the future. Additionally, we are constantly trying to think of creative ways to monetize our existing assets. Turning to Slide 11. One of the questions we constantly get is how do our yields at locations evolve over time. And our Dallas Carrollton facility provides a very good representation of the property yield progression over time. This is a nearly 700,000-square foot building with capacity for 7 data halls ranging from 60,000 to 70,000 square feet of raised floor. As of the end of the first quarter, 5 of the 7 were built out. The initial investment on land and shell comprises less than 15% of total build cost once the facility is built out. When we brought the first data hall online, the development yield was negative as we incurred expenses that exceeded the revenue that we were generating. Two years later, the development yield for the facility has increased to 13% as we leased up that data hall and built and leased up additional data halls to meet the strong demand in Dallas. The data hall builds are triggered by our late-stage sales funnels significantly derisking our capital investment. Our current development yield at this location is 19% and we expect it to increase as we build and lease up the last remaining two data halls. For a facility of this size, we benefit from significant operating leverage. In closing, we are currently in a very strong position. Leasing volumes have been robust, and even with the $30 million bookings quarter, our sales funnel was actually up approximately 10% compared to the first quarter. We increased our normalized FFO per share guidance even with the equity issuance. And we have nearly $50 million of backlog, which implies continued healthy growth into 2018. Additionally, our balance sheet gives us the flexibility to pursue organic development opportunities as well as acquisitions. On that note, as I mentioned last quarter, we are reviewing a number of options in Western Europe including the purchase of property in Dublin, Ireland. Lastly, the data center industry overall continues to do very well as evidenced by the results reported by all of our peers, and we expect the secular demand trends to continue to drive strong growth going forward. I will now turn the call over to Diane who will provide more color on our financial performance and our updated guidance for the year. Thanks.

[Diane Morefield:]

Thanks, Gary. Good morning, everyone. Gary has already highlighted the significant growth in all our key financial metrics during the quarter. So I would like to just add some additional color on the second quarter and our outlook for the balance of the year. Slide 11 summarizes our growth rates for our key financial metrics, driven primarily by strong leasing across all our markets, the impact of the Sentinel data center acquisition and strength in our interconnection products. Organic revenue growth, excluding the impact of the Sentinel transaction, was 19%. Revenue churn for the quarter was 0.8%, representing a nearly 70% decrease from the prior four-quarter average of 2.5%. We continue to anticipate full year 2017 churn to be towards the lower end of our assumed annual range of 6% to 8%. Moving to Slide 12. NOI increased 26%, primarily driven by the increase in revenue and the adjusted EBITDA margin, which was up 1 percentage point. SG&A as a percentage of revenue was down 2.2 percentage points, reflecting the benefit of scaling the business with less incremental overhead. Normalized FFO increased 28%, in line with our revenue and adjusted EBITDA growth, while normalized FFO per share grew 15%, driven by the impact of additional equity issued to fund our growth and manage our leverage. As the chart at the bottom of the slide shows, similar to the fourth quarter of 2016, there was significant reduction in difference between normalized FFO and AFFO compared to the prior quarter. Sequentially, normalized FFO increased 11% while AFFO increased 28%. This was primarily driven by a reduction in the impact of deferred revenue and straight-line rent adjustments as a result of two factors. As we've mentioned previously, some of the larger leases include brief rent periods to accommodate the phasing of these customers' power requirements. In this case, we had a few large leases with ramps that primarily affected the first quarter and minimal impact in the second quarter. Additionally, during this quarter, there was an increase in nonrecurring charges, which include upfront cash payment for various items including customer installations, but for which we recognize revenue over the terms of the underlying leases. The latter category was a larger driver in the second quarter, resulting in the smaller delta between FFO and AFFO. The deferred revenue and straight-line rent adjustments line item is difficult to forecast when comparing quarters and create some short-term volatility in AFFO, however our longer-term AFFO should continue to grow relatively in line with the growth of our underlying business. Slide 13 provides an overview of the portfolio by market. We have an increasingly diversified portfolio to meet demand across all regions of the U.S. As the table on the right shows, we have grown capacity significantly in the past year, with colocation square feet up 28%. Even with that increase, total utilization is up 5 percentage points. Our stabilized portfolio is 93% utilized, while our prestabilized data halls in Houston and Austin, as well as the recently completed facility in Northern Virginia, are still in their lease-up phases. Turning to Slide 14. As we highlighted last quarter, wholly owned data centers constitute the vast majority of our portfolio. The rent and NOI contribution from these facilities are up 1 and 2 percentage points, respectively, compared to the prior quarter and more than 10 percentage points compared to a year ago. The percentage of owned colocation square feet includes above our development pipeline is now 90%. And as we lease up the capacity under construction, the rent and NOI contribution from owned facilities should converge with the square foot contribution, and we expect the percentage to continue to increase over time as we build more data centers. Additionally, we will be looking to exit leased assets when appropriate and our preference in assessing new acquisition opportunities is generally to own the facility. Turning to Slide 15. It summarizes our development pipeline as of the end of the second quarter. We currently have development projects in Phoenix, Northern Virginia, Chicago, Dallas, San Antonio and Austin that will deliver 477,000 colocation square feet and 73 megawatts of power capacity. Approximately 44% of the pipeline is preleased, up from 27% as of the end of the first quarter. Even with preleased capacity, Northern Virginia and Cincinnati being placed in service during the second quarter. Also, as Gary mentioned, we continue to track a robust sales funnel and expect that as our development pipeline is brought online, a significant portion of the new inventory will likely be under leased contracts at that point. In Phoenix, we brought the fully leased Chandler IV facility online early in the third quarter, and we are continuing construction on Chandler V and VI buildings. We are tracking very strong demand in this market particularly from cloud companies and we expect to complete construction on these facilities by year-end. In Northern Virginia, which has arguably been our strongest market, in the second quarter, we brought online the first data hall at our new Sterling five building and this data hall is nearly 50% leased. The second data hall in that building is currently under construction and we expect to deliver this capacity by the end of the third quarter. We brought Sterling four online early in the quarter at third quarter and this is approximately 85% leased. Again, the sales funnel in this market includes a significant contribution from cloud and financial service companies. In Chicago, we continue construction on the Aurora II building and expect to deliver the initial phase in the third quarter. The building will also include more than 270,000 square feet of powered shell available for future development. We have a robust funnel with demand from companies across multiple verticals, mostly cloud, financial services and health care. In Dallas, we brought 6 megawatts of power capacity online in the second quarter and we are constructing the sixth data hall, which is approximately 30% preleased. The sales funnel consists of a broad mix of cloud companies and enterprises across financial services, energy and various other verticals. Once all of these developments are completed, our portfolio will have basically doubled in size as compared to year-end 2015. In addition, the powered shell and our land bank, including the recently acquired parcels in Quincy and Allen, will allow us to more than triple the size of our footprint to more than 8 million colocation square feet across the portfolio and the ability to add more than 800 megawatts of leasable capacity. But it's been our past practice, we will only develop these locations in phases and to meet our sales funnel over the next few years. Moving to Slide 16. In June, we entered into an amendment to our unsecured credit agreement, as Gary mentioned. We increased the total size of the facility by $450 million to a total of $2 billion. We increased the size of the term loan maturing in January of 2022 by $350 million with the proceeds from the term loan used to pay down borrowings under the revolving credit facility. We also increased the size of the revolver by $100 million to a total now of $1.1 billion. Additionally, through the amendment, we gained more flexibility through various initiatives than we have previously communicated including joint ventures and international expansion. On the subject of joint ventures, we continue to have preliminary discussions with potential strategic partners. However, it is a slow and complicated process. The key discussion points largely pertain to governments as we need to ensure we retain maximum flexibility to make decisions quickly to run our business. There are other items we are working through as well and the timing of a JV partnership arrangement does not appear likely to occur in 2017 at this point. As the debt maturity schedule shows, we have no debt maturities until 2021 and the weighted average remaining debt term is nearly 6 years. We will continue to evaluate opportunities to further smooth our debt maturity schedule over time. On Slide 17, we show the significant financial flexibility we have with a fully unencumbered asset base with a gross book value of $4.5 billion, no near term maturities and almost $1 billion in available liquidity. The ratio of net debt as of the end of the second quarter to last quarter annualized adjusted EBITDA was 5.0x. We're pleased that Moody's recently upgraded our senior unsecured debt and corporate ratings to Ba3 from B1 and maintain their positive outlook. We are managing our leverage to maintain a glide path towards an investment grade rating, and we communicate frequently with the rating agencies to discuss why we believe that we are already positioned to become an investment-grade company. This would have a meaningful impact on our cost of capital and further improved our access to the capital market, which is particularly important given the growth trends and significant capital requirements that the data center industry model needs. Our fixed floating interest rate mix is roughly in line with our 50-50 target although currently more skewed to floating. On a market cap basis, shareholders' equity represents more than 70% of our total enterprise value. And as Gary mentioned, we raised $197.5 million in net proceeds per ATM program in the second quarter. We issued approximately 3.6 million shares at an average price of $56.03. The execution was extremely efficient and at very low cost compared to an overnight equity offering. With the high leasing volume and continued strong sales funnel, we have increased both the upper and lower ends of our CapEx guidance range by $100 million. In connection with the additional capital spending, we felt it was appropriate to issue equity to further strengthen our balance sheet. The ATM program is an effective tool for match funding our development pipeline while managing leverage. We currently have $93 million remaining capacity under our ATM program authorization. Turning to Slide 18. Our revenue backlog as of the end of the quarter was $49 million, representing more than $390 million of total contract value. This is up $5 million compared to the end of the first quarter. And as shown in the bottom chart, we expect nearly $27 million of the backlog to commence by the end of the third quarter and the remainder to commence in the following 2 quarters. We believe this positions us well for continued strong growth into 2018. Lastly, Slide 19 shows our previous and revised guidance for 2017. As you can see, we are reaffirming our previous guidance for our revenue and adjusted EBITDA ranges and increasing the guidance ranges for normalized FFO per share and capital expenditures. We understand that it might not seem intuitive to increase FFO per share while not increasing the revenue and adjusted EBITDA guidance ranges. So let me add a little more color to the reasons why. Regarding impacts on revenue and EBITDA, we have only experienced 2.2% of churn in the first half of the year, but are still projecting total churn to be at the bottom of our 6% to 8% range. So we do anticipate somewhat heightened churn in the second half of the year. We also have some large leases that are more weighted to the end of the third quarter and into the fourth quarter, which will more fully impact revenue in 2018. Finally, we are seeing some slower ramp in metered power than we originally anticipated going into this year. As you know, metered power runs through total revenue guidance but as a pass-through on the expense side. So the combination of these factors is why we are comfortable with revenue and adjusted EBITDA ranges that we reaffirmed in our earnings press release. Regarding normalized FFO per share, we have increased the midpoint of our guidance range by $0.05. The dilutive impact of the additional equity of approximately $0.03 to $0.04 per share is more than offset primarily by the impact of higher capitalized interest related to our heightened development activity and lower overall interest rates compared to our original projections that we built into our guidance for the year. In addition, it's important to highlight that there was only a partial impact of the equity issuance in the second quarter with weighted average outstanding share count during the quarter of approximately 88.5 million shares for the normalized FFO per share calculation. As of the end of the second quarter, however, there were approximately 91.3 million shares outstanding. So there will be a sequential impact on the denominator for purposes of the calculation of this metric. So despite our increase in our annual FFO per share guidance, we anticipate our third quarter normalized FFO per share to be flat to, slightly down due to the additional shares outstanding for the full quarter. And as I just highlighted, we expect the leasing backlog to have a more robust revenue impact on the fourth quarter versus the third quarter given the deployment of a large portion of that backlog scheduled to occur at the end of the third quarter. We've also increased the midpoint of the CapEx guidance range by $100 million reflecting the strong leasing compared to our original expectations that supported our earlier guidance. In closing, we are really pleased with the very strong financial and operational results for the quarter and excited about the robust opportunities we have ahead of us. We have positioned the company to sustain our momentum with the development pipeline to meet the demand we are seeing across our markets and has substantial liquidity to fund our growth. We have a value proposition that is equally appealing to both enterprises and cloud service providers with a flexible product offering, the fastest time to market at the lowest cost per megawatt and a platform to deliver the outstanding service that our customers require. We appreciate your participate on our call and we're happy to take any questions. [Operator Instructions] Thank you. Operator?

[Operator:]

Ladies and gentlemen, we'll now begin the question-and-answer session. [Operator Instructions] Our first question today comes from Robert Gutman from Guggenheim Securities. Please go ahead with your question.

[Robert Gutman:]

So I just want to recap. Last quarter -- you exited last quarter with high utilization and limited inventory in top markets, and a number of power shells under development. So as we move to the end of this quarter, where do we stand now in terms of near-term availability relative to demand in their respective markets?

[Gary Wojtaszek:]

We feel really good. In the table, you can see that we're bringing on almost 500,000 square feet and 73 megawatts of capacity. So by the end of this quarter and into the next, we're going to have almost all of that brought online. So we feel really good about bringing on the inventory to meet demand. And that's kind of like what -- you see another strong quarter of bookings for us, so that's two in a row. You're not seeing a big flow-through yet in terms of top line increase because basically associated with the inventory that's going to be brought on later in this quarter and next.

[Operator:]

Our next question comes from Colby Synesael from Cowen and Company. Please go ahead with your question.

[Colby Synesael:]

Regarding Western Europe and the land that you purchased or looking to purchase in Ireland, is it -- you're going to either do the land or you're going to do a deal in terms of making an acquisition? Or are you intending to potentially do both? Just a little more clarity on how the land par is impacting your thoughts over -- I think that's a new development. And then secondly, you mentioned a portion of AFFO benefited from nonrecurring items. Can you just talk a little bit more about that? I missed a little bit about that.

[Gary Wojtaszek:]

Yes, so we have two different parcels of land we're working on in Dublin. That is larger footprint facilities that we're looking at bringing online there. We're looking at between both properties, roughly 60 or 70 acres of property available there. Our whole focus in Western Europe is basically to expand by bringing big format data center facilities into that part of the region which is just starting to develop demand for those type of big format boxes. So our game plan is to basically continue to look at some of the smaller platforms that are there, so existing operating companies. That gives us a foothold in the market and then we would supplement that through acquisitions of land like what we're doing in Dublin for organic purposes. So we're going to do both of those in tandem. And depending on when Jonathan can get something worked out through one of these acquisitions, we'll close one of those. But in the meantime, we'll continue to push forth on the organic side. But I'll turn over the second part to Diane.

[Diane Morefield:]

So Colby, on your AFFO question, in supplemental disclosure, we gave the individual lines that lead from FFO to AFFO. And as you'll see, when you compare the first quarter to the second quarter, that we had a much higher dollar amount of deferred revenue and straight-line rent adjustments in the first quarter as compared to the second quarter. And as I mentioned in my remarks, so it was a combination really of two things. In the first quarter, we had much higher ramp-up, hence the large dollar amount got adjusted to AFFO, and that was more muted in the second quarter as far as ramp-ups. And then we refer them as NRC's, nonrecurring charges, those are the opposite effect of ramp-up. That's where we get, where we do certain customer installations we build it out. We get paid at deployment, the cash up front, and then we amortize it over the life of the lease which is just how the accounting works. So then that has a more positive impact and causes a lower delta between FFO and AFFO.

[Operator:]

Our next question comes from Frank Louthan from Raymond James. Please go ahead with your question.

[Frank Louthan:]

Just want to see if you can comment on any traction you're getting with federal and state government business and then the hyperscale cloud providers that maybe you're not providing service for, any changes in trends from their demand.

[Gary Wojtaszek:]

Sure. Yes, so we are actively involved in two really large federal contracts. And as everything with the federal government, they always go a lot slower than you may anticipate. But there are two different regions of the country that we're looking at doing big deployment for federal government. Aside from that, some of our cloud companies are -- our cloud customers are also doing a lot of government work, and so we're indirectly the beneficiaries of the work that they're doing on behalf of the governments. In terms of like cloud demand, we continue to see lots of interest from all of the major cloud customers that we are selling to. As I mentioned in my remarks, our funnel is up about 10% from where we've sat last quarter and which is up over 30% where we were last year. So we're still sitting on pretty robust demand across all those 10 key cloud customers that we're serving, and that's in multiple markets with multiple customers.

[Frank Louthan:]

Okay. And with the federal businesses, will it be necessary for CyrusOne to have fed ramp certification? Or can you get that through a partner or not necessary with where you're playing there?

[Gary Wojtaszek:]

We don't need fed ramp certification to do that, but our facilities, our customers are providing that fed ramp certification to their customers. And so by default, we're kind of providing whatever requirements we need to for them to be compliant to sell to their customers.

[Operator:]

Our next question comes from Sami Badri from Crédit Suisse. Please go ahead with your question.

[Ahmed Badri:]

Can you give us some color on the sales funnel and how much it grew year-on-year, or how big it currently is from a dollar perspective? Then I have a follow-up.

[Gary Wojtaszek:]

Yes, the sales funnel grew 10% sequentially and I think it's up 35%, 36% year-over-year. And so the sales funnel is up 10% versus last quarter and that would be up 10% from year-end. Our sales funnel was basically the same in the fourth quarter -- in the first quarter and up 10% this quarter versus those other 2. The -- we don't share the dollar numbers that were -- that we have in that funnel. Although what we're always trying to do is get to -- to get to funnel coverage around 5x our funnel in terms of -- I mean, 5x funnel in terms of the bookings that we're trying to close in every quarter, then that gives us really good comfort that we're going to be able to maintain our continued run rate. Where we're currently not at 5x now, we're about 3, 3.5x coverage so Tesh has got a lot more work to do but we feel that we're heading in the right direction there.

[Ahmed Badri:]

Got it. And as a follow up to an earlier question on the international opportunity and expansion. Other than Dublin, what other international markets are appealing for expansion? And is it demand to go international coming from current major customers? Or are these potentially new customers that you're aiming to get?

[Gary Wojtaszek:]

Yes, so we're looking at all the key Western European markets, so Dublin, London, Amsterdam, Frankfurt. What we're seeing is request from all of our cloud customers in particular from the U.S. looking at doing expansions in Western Europe. The bigger cloud deployments that we've seen develop in the U.S. market over the last 2 years is now starting to take hold in the European markets, and we feel that we're really well positioned to be able to help them in Western Europe just as we did in the States.

[Operator:]

Our next question comes from Jonathan Atkin from RBC Capital Markets.

[Jonathan Atkin:]

So I'm interested in the operating costs -- property operating costs as a percentage of revenues, and if you could maybe address the factors as to what drove the higher percentage there. And then I noted -- I'm interested in Slide 9, Carrollton and any kind of clarification in terms of the number of different customers, number of contracts, average size of deployment as you've been filling that location in Carrollton.

[Gary Wojtaszek:]

Yes, hey, Jon. So I'll take the question on Carrollton. So I mean, typically, as we bring out each of the data halls, we add roughly about 10 customers, 15 customers per data hall. So overtime, you could just multiply 15 by each of those data halls, that gives you a rough approximation. There's probably in total, I don't know exactly, but there's probably around 75, 80 customers in that facility now. And so we still have another 1.5 data halls to go there, so we'd expect that will continue to add customers into that facility. With regard to your question on operating expense.

[Diane Morefield:]

It's really primarily we just experienced higher metered power expense in the quarter as a percent of revenue. That, too, can fluctuate but that primarily explains the first quarter to second quarter.

[Jonathan Atkin:]

Okay. And then the -- real quick, the number 4 customer, IT -- an IT company, looks like they increased their number of locations from 5 to 7 and the rent bumped up by about $12 million annualized. And I'm just wondering, which additional markets did they commenced their leases in with you?

[Gary Wojtaszek:]

Yes, it was Phoenix and Virginia.

[Jonathan Atkin:]

Okay. And then finally, Slide 6 you talk a lot about cloud, SaaS and a lot of the kind of the macro drivers. And I'm interested are you able to kind of pinpoint any specific demand yet related to AI? Or is that still kind of on the come? And is your sense that a lot of that's going to be latency-sensitive? Or could some of that be suitable for more of a, say, a Quincy, Washington type location. Just interested in your thoughts on AI at this point.

[Gary Wojtaszek:]

Yes, we're actually -- we've been involved in one deal, specifically with that deployment. And I mean, what they are looking at standing up was not latency-sensitive at this moment. It was more kind of just -- kind of a petri dish type of experiment to see if they can get that up and running and see how it's going to work. I would suspect over time that depending on the application that it's serving, I would suspect more of those going to be latency-dependent. The one thing I would say, though, that we are seeing a bigger trend on -- and this is something that we had envisioned would happen early on is, when we're originally building out the really large campuses, we were doing so specifically in order for -- so that we can gain capital efficiencies and operating expense efficiencies, which we have done just by design in those facilities. What we also had expected over time which we are seeing is that the large concentration of these customers taking down big format facilities where they're deploying these compute nodes is actually bringing on additional interconnection capacity into those markets. So we're seeing more interconnection and networking dependent focus associated with the concentration of the big format deals that we're doing. And so you see that in some of my remarks on our interconnection business that was up 16% year-over-year and our -- the number of cross-connects was actually up 18%. So when you think about that, we don't -- you don't think about us as traditionally owning like highly interconnected key interconnection points. But what you do see in those results is that the aggregation of big compute nodes and storage nodes in our facilities associated with the scale we have is creating a higher interconnection densities that are being dragged along, and associated with that then is more enterprise customers wanting to do bigger deployments near those cloud companies. So we expect that, that trend is going to continue.

[Operator:]

Our next question comes from Simon Flannery from Morgan Stanley.

[Simon Flannery:]

I wonder if you could just talk a little bit more about Quincy. What's your latest thinking in terms of developing that time lines? When do we see start to see revenues? And I think there's often a question about the economics of these cloud deals. And if you could perhaps provide a little bit more color on how you think about those economics relative to traditional enterprise deal?

[Gary Wojtaszek:]

Sure. Hey, Simon. Yes, so Quincy, Washington, as we mentioned, we are focused on developing a site in that location, which is focused on those applications that are not latency-sensitive and are more cost-sensitive. So that solution there will be the lowest cost data center option in the country from both a capital perspective, so the rental rates as well as an operating perspective given that the power rates there are $0.03 a kilowatt or less. We believe, over time, more and more companies are going to locate those low latency type applications in low-cost environments and we believe that we are going to be the beneficiaries of that. We have not announced any wins there yet, and we will not build anything in that market on a speculative basis. The reason that we had to acquire the property, though, is that we needed to be able to start the planning and permitting process, which you couldn't do particularly when it comes to getting the permits for the generators from the EPA in that area. So the focus in terms of buying that was to basically position us to be able to move quickly and deliver a data center in six months. Once we sign a deal with the customer, we are getting interest from customers that are talking to us about that. But when we announced that we're breaking ground on there, you'll also see a similar announcement on the customer that we're going to be building for there as well.

[Simon Flannery:]

But you wouldn't buy the land if you didn't have some confidence about that funnel becoming real?

[Gary Wojtaszek:]

Yes. Well, I mean just to put it in perspective, I think the land was less than $3 million, so this is relatively insignificant. So it's a small option to pay, but we feel really good about the ultimate demand that we're going to get from customers in that market.

[Simon Flannery:]

So it might hit the back half of '18 perhaps if everything goes well.

[Gary Wojtaszek:]

Yes, I mean, well, in terms of delivering capacity that would be the earliest that we would be able to do it. But if we signed a deal earlier than that, we would announce prior to that. But from a forecasting perspective, I would not assume any revenue for us until the end of '18 at the earliest.

[Simon Flannery:]

And on the returns?

[Gary Wojtaszek:]

Yes, on the returns -- yes, yes, so our returns on all of these deals that we're doing are 14%, 15% returns. I mean, we shared last year the 30 megawatts that we deployed in Northern Virginia, and I think that return was -- was it 14% or 15%? I'm looking at Schafer here.

[Michael Schafer:]

15%.

[Gary Wojtaszek:]

Yes, it was 15%, so there is this kind of urban legend or myth associated with the yields that we're able to generate on our facilities and what we had shared earlier in the year with what we have done down in Miami, is that we can deliver capacity at the lowest cost in the industry and at the fastest times at prices that are the same as our competitors are sharing. So our returns are really high. So we will continue to put up those type of returns throughout the country.

[Operator:]

And our next question comes from Richard Choe from J. P. Morgan. Please go ahead with your question.

[Richard Choe:]

Last year, we saw some seasonality or a drop-off in the second half in terms of signings, knowing that it's volatile on a quarterly basis. But is there some level of seasonality that we might suspect? And then is this a new level of signings. $30 million plus for the past three quarters seems like a lot, but between the two and historical $20 million, how should we think about the second half?

[Gary Wojtaszek:]

I think what you saw just broadly, I think we're the last company to post -- the industry is really-really healthy. Everyone put up really strong numbers this quarter overall. We did really well again. And our focus in terms of what we're expecting that we're going to be able to deliver is $20 million per quarter. We expect that, that is a really healthy bookings number that will continue to allow us to grow into high midteens organically, and that's something that we're comfortable doing. I think in this quarter, now exclusive of the Sentinel acquisition, our base business was growing 19% organically, and we think at that $20 million per quarter of bookings, that will continue to grow at that level through '18.

[Richard Choe:]

And churn has been running a little bit on the lower end, but you said that you still expect the low end of guidance. Is that kind of being conservative? Is it kind of something you know is coming down? Like it could coming under that? Or is it increasing right [indiscernible]

[Gary Wojtaszek:]

Yes, we were guiding to the low end of the range from 6% to 8%, but we expect that while the first half number is lower, we expect it to pick up a little in the second half of this year but it's still going to be at the low end of the range of what we guided to earlier this year.

[Operator:]

And our next question comes from Vincent Chao from Deutsche Bank. Please go ahead with your question.

[Vincent Chao:]

Just wanted to go back to the funnel and some of the cloud demand that you're seeing. I'm just curious relative to late 2015, 2016, are the requirements different that you're seeing out there in the market? Are they generally smaller in size? Or do they also include some of those very large scale deals that we saw sort of in that time period?

[Gary Wojtaszek:]

Yes, we are tracking really -- we're tracking a lot of deals and a lot of really large deals, too. So it depends on the cloud company that you're talking with. Some do -- some deployments are typically, on average, larger than others. But broadly speaking, the funnel has increased across all of them.

[Vincent Chao:]

And then with regard to the churn commentary, Diane, in terms of the back half being up a little bit to get to the low end of the 6% to 8% range. Is that based on sort of the bottom-up discussions you're having with the expiring tenants? Or is that more of a top-down approach where you've traditionally been in the 6% to 8% and you're sort of just projecting to get to the low end there?

[Diane Morefield:]

I think it's on some more specific leases that we know are going to churn. As well again, just based on past performance in this area, as I mentioned, our churn in the first half was only 2.2%, but we think we'll end the year in that low 6% range. So we do anticipate heightened churn from kind of what we know now for the rest of the year.

[Operator:]

Our next question comes from Matthew Heinz from Stifel. Please go ahead with your question.

[Matthew Heinz:]

Apologies in advance for asking a math question here, but just looking at the commencement bridge on Slide 18. Last quarter, you projected that the entire $44 million backlog would commence in 2017. And so I count your Q2 commencements at $24 million and the new bridge has $44 million coming in the second half. So in total, that looks like a $24 million increase in your projected commencements this year versus where you were last quarter. I'm just trying to kind of square that up with the revenue guidance being unchanged. I appreciate the elevated churn you're seeing or you may see in the back half, but it seems like a lot to offset.

[Gary Wojtaszek:]

Hey, Matt, Gary. Can we just -- can Schafer give you a call on that? I'm not sure exactly what your numbers were pre and post but we can give you a more detailed answer after that.

[Matthew Heinz:]

Yes, not a problem, not a problem. And then maybe just one more then on the Dallas market. And the demand you're seeing there that prompted you to go ahead and purchase the land in Allen, I'm just curious if you could elaborate on the nature of your funnel there in terms of hyperscale versus enterprise. I guess we've heard some commentary that suggests cloud providers have kind of bypassed the Dallas market as more of that business has gone elsewhere. But just wondering if that's what you're seeing or if something is changing?

[Gary Wojtaszek:]

Sure. Yes. So I mean, the reason for our expansion was that we knew we were going to be selling out of our existing building within the next 12 months. So we need to make sure we have a line of sight for continued growth in the market. We have been working on looking for property in Dallas for over a year. We picked up the lowest-cost property in the area. We spent a long time on this. So that was really just kind of normal growth aspirations that we have for the Dallas market in general. We continue to do well here. With regard to the split between enterprise and cloud, I mean, we have some cloud customers here, but I think what you're seeing and hearing is correct. The bigger deployments in terms of big cloud deployments are not happening in Dallas. We've got some deals like that but not at the same pace that we're seeing in Northern Virginia or Phoenix or Chicago and other parts of the country. So what we're seeing mostly in Dallas is a bigger enterprise footprint and we expect just as Texas in general, in Dallas specifically, continues to grow really well and attracts more and more enterprise customers that are looking at moving their headquarters to Dallas, we expect that, that enterprise business is going to continue to grow.

[Matthew Heinz:]

Okay. And about the transfer from the lease facility to Allen, once that's completed, how are you feeling about kind of the success level of transferring the customer business over to the new building?

[Gary Wojtaszek:]

Customer -- well, we're not going to transfer business. We're going to build that facility next year. And as the Carrollton facility fills up, we'll bring on additional capacity in Allen. I mean, it's no different than what we have done. And we have a big facility in Louisville -- are you talking about that leased stuff? And -- the customers that are in Louisville that are leased in that building and moving...

[Matthew Heinz:]

I thought you referred to a negative [Indiscernible] in that leased facility?

[Gary Wojtaszek:]

Yes, yes, no, we will keep that one. There we've got the opportunity to control that for a really long period of time. So we have no intentions of migrating those customers out of that facility to the new one. This is really building up the new facility and just having customers grow into that or getting new customers that are going to take down space in there.

[Operator:]

Our next question comes from Eric Luebchow from Wells Fargo. Please go ahead with your question.

[Eric Luebchow:]

Gary, you mentioned that you expect the cloud companies to eventually outsource I think you said 100% of their requirements. Just curious what the pushback has been from them from the cloud companies that continue to build their own data centers. And have you seen any recent signs of that trend changing?

[Gary Wojtaszek:]

Look, I mean, the cloud companies are no different than the enterprise companies that we were selling to all along, right? All the big oil and gas companies, all of the banking, financial institution companies, all of these companies historically, felt that they had some expertise in building and managing their own data centers and they had some risk issues and control issues associated with that. But they've all eventually given up the ghost, realized that what we can do is better than what they could do on their own and have chosen to outsource to us, and that's why we have almost 200 of the largest companies in the world have chosen that path. The cloud companies I don't see are any different. While they may think that there is some advantage in terms of what they have now in terms of building and managing their own data center, the reality is, is that we can do it less expensively at a faster time to market. And eventually, we believe money always goes where it's most wanted, and none of those big cloud companies are incented by any of their shareholders to invest more capital building out data centers. They are incented by their shareholders to -- as Atkin was mentioning earlier about developing AI initiatives, other types of IT services were they really make a lot of money on. It's not -- they only need to be in the data center business from happenstance because there wasn't really an alternative previously, a good quality product now we're showing them that there is and they're outsourcing more and more of their data center needs to a company like us.

[Operator:]

Our next question comes from Andrew DeGasperi from Macquarie.

[Andrew DeGasperi:]

I guess first you mentioned that in your prepared remarks that you're delivering services right now that you're not charging for today, but you're free to charge in the future. I mean, can you give us an example what those are, and then secondly, I know that most of the customers is -- most of the leasing's you've booked in the quarter came from existing customers. But I was wondering was some of those potential consolidations of data center space? In other words, did you see a market share shift?

[Gary Wojtaszek:]

Sure, yes. So to answer your last question, we didn't see any market share space, and you're correct, we had a really high proportion of the deals that we closed this quarter come from existing customers, and that's -- well, it's good in terms of it's a good trend that customers are buying more from you. That's not really what I get excited about. I get way more excited when Gould and Tesh can close more logos because new logo acquisitions is the most important thing for us, and actually, this quarter, we closed 13 new logos. They didn't come in with a big amount of new revenue but we expect that they will continue to grow with us. And what was your -- the first part of your question on?

[Andrew DeGasperi:]

I think in your prepared remarks, you were...

[Gary Wojtaszek:]

Yes, the ancillary services, yes, yes sorry. Yes, so what we talked about in my points was we're currently charging $200,000 to $250,000 per month for services that previously we were giving away. And so this is for shipping and receiving work that we're doing for customers. Security escorts, when some of their -- some of our customers and vendors come in, bringing them to their sites, charging for audit work that we previously gave away, there's a whole series of things that in the past, we were just doing as part of our normal service to customers. But as we have developed the systems capabilities to track everything that our customers are requiring from us, it gives us a lot of insight to understanding where we are spending a lot of time in support of helping them, and then we are going back through and thinking about how to monetize all of those services. So it's really no different than when you go to the hotel room and you pay $10 for the bottle of water that's in the room that you can avoid buying and drink from the faucet in the bathroom. You choose to pay that just for the convenience factor. It's the same thing in the data center. There are many, many services that we have been giving away for free historically and we're trying to go back and bill for those. So all of the services one example, the other thing we pointed out in my prepared remarks was that the power administration fee. This was something that more and more of our customers are doing deals where power is a pass-through. Those are relatively more complex to manage operationally, account for, bill for, and we started charging a 7% power admin fee. And what we've talked about was we started that in the fourth quarter of '15. 11% of our revenue now has that fee. We expect similar to the increase that we've had with the lease escalators, over time that will be in all of our contracts. And the last thing we point out every quarter, the success we've had with inserting lease escalators into all of our contracts, about 16% of our contracts now have lease escalators in it, which is more than double from where we were two years ago.

[Operator:]

Our next question comes from Jordan Sadler from KeyBanc Capital Markets. Please go ahead with your question.

[Jordan Sadler:]

Curious about the development costs. I know that you guys manage those pretty carefully and have been trying to drive them down over time. Looking at the schedule, I just see some tweaks here and there around the edges, but they seem to just be migrating up, at least a handful of them, up couple a percent to 10%. Can you talk about what's driving that?

[Gary Wojtaszek:]

If you're looking at kind of like the just the rough math in terms of the megawatts that we're deploying relative to the capital that we're deploying, you're going to get vagaries quarter-to-quarter on that because you're building a lot more capacity online than you are in those facilities that are bringing on megawatts. So for instance, take the case of Northern Virginia -- or Phoenix, right? We're building two facilities there in shell capacity. So we probably have on a gross basis, probably 250,000 square feet of shell coming online there. We're only powered up in there -- I think we're bringing 9 megawatts online for the first one. So if you looked at the total aggregate costs relative to the megawatts that we're deploying there, the average per megawatt would be high because it's not factoring the point that we're bringing out all the additional capacity there to bring in significantly higher amounts of megawatts.

[Jordan Sadler:]

No, I was really just talking about your total cost that you guys disclosed for each phase, and just looking at them sequentially, they're moving up somewhere between 2% and 10% sequentially. I don't know -- that's the aggregate cost, not on a per megawatt basis, but I think the megawatts are consistent on the one's that I was looking at.

[Gary Wojtaszek:]

Yes. I don't know. If we can may be...

[Jordan Sadler:]

[indiscernible] yes.

[Gary Wojtaszek:]

What you're looking at, but I mean...

[Diane Morefield:]

[indiscernible] yes.

[Jordan Sadler:]

We can follow-up, that's not a problem. Also in Sterling V, it was -- did something changed in terms of that development. Did you table a piece of that? Or is it -- did it lease? I just see the size of that development changed a wee bit. I think it was supposed to be 24 MW and now it's going to 6 MW.

[Diane Morefield:]

Yes, I mean...

[Michael Schafer:]

We brought some capacity online for that one, so that explains...

[Diane Morefield:]

That one in service in the second quarter.

[Michael Schafer:]

Yes, it shows up in the prestabilized properties on the portfolio table.

[Jordan Sadler:]

Was there an impairment in the quarter? Was that related to an asset sold?

[Gary Wojtaszek:]

No, no. That is, we have a lease in Singapore, a lease from actually one of our brethren in the industry's data center and that is set up as a capital lease in there and that impairment charge that you're seeing is associated with that lease.

[Jordan Sadler:]

Did you terminate it or?

[Gary Wojtaszek:]

Well, no, no. When that accounting was first set up, rather than it being an operating lease that was deemed to be a capital lease, and so you are setting up an asset on your book, and that write-down is associated with the asset portion of that lease. So we still have the liability and the obligation to continue to pay rent there through the end of it.

[Operator:]

And our next question comes from Amir Rozwadowski from Barclays. Please go ahead with your question.

[Amir Rozwadowski:]

Gary, just wanted to dial things back a little bit and sort of look at -- think about your outlook relative to the guidance that the multiyear guidance that you provided last year. It seems as though, you're running a bit ahead when it comes to organic growth and perhaps the inorganic portion of your strategy is more focused on new site development versus acquisitions. Is that the right way to characterize things at this point?

[Gary Wojtaszek:]

Yes. Well, so what we had shared at last year's Investor Day presentation was roughly 20% annual growth over the next five years. That broke down to 13%, 14% of that was going to happen organically and the remainder through M&A. What you're seeing now is that our organic growth like this quarter is tracking well ahead of that. We're actually at about 19% organic growth and even faster if you add any additional M&A on it. So we're about -- I don't know probably close to 14% ahead of the plan that we laid out last year and so we're continuing to do well. I mean, our plan is to continue to grow the business organically. We make the highest amount of returns on a capital that we're deploying there. But particularly, it was, I mentioned earlier, about our expansion efforts in Europe. We want to go in and acquire some platforms in there so we can accelerate our growth in that market by acquiring a platform, so you have processes, customers, in place. We would then supplement that with accelerated organic development growth behind it. So if you look at what we're doing in Ireland now, we don't have an acquisition in hand in terms of acquiring a platform but we are going ahead with the organic acquisition of that development and we'll do both of those in tandem.

[Diane Morefield:]

And on the acquisition part of the five year plan that was presented, it was assumed approximately $300 million of acquisitions a year. So for the first two years of that plan, which was last year and this year, it does turn out it's averaged that $300 million year range. There was a $130 million CME acquisition last year, the $500 million acquisition of Sentinel this year. So on average, it actually has tracked around that $300 million.

[Operator:]

And ladies and gentlemen, we are at the end of today's question-and-answer session. I'd like to turn the conference call back over to Mr. Wojtaszek for any closing remarks.

[Gary Wojtaszek:]

Thanks, everyone. I appreciate your time today and look forward to seeing you at some of the upcoming conferences and investor meetings that we're going to have over the next two months. Thanks, and have a great weekend.

[Diane Morefield:]

Thank you.

[Operator:]

Ladies and gentlemen, that does conclude today's conference call. We do thank you for attending. You may now disconnect your lines.