CyrusOne Inc.
Q3 2015 Earnings Call Transcript

Published: 7 Nov 2015

[Operator:]

Good day, everyone and welcome to the CyrusOne Third Quarter 2015 Results Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. At this time, I would like to turn the conference over to Michael Schafer. Sir, please go ahead.

[Michael Schafer:]

Thank you, operator. Good afternoon, everyone, and welcome to CyrusOne's third quarter 2015 earnings call. Today I'm joined by Gary Wojtaszek, President and CEO, and Kim Sheehy, CFO. Before we begin, I would like to remind you that our third quarter earnings release, along with the second quarter financial tables are available on the Investor Relations section of our Web site 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 Web site 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 afternoon 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. Good afternoon everyone, and welcome to CyrusOne's third quarter 2015 earnings call. We had another strong quarter with continued high growth rates across all key operating and financial metrics, including customer acquisition, bookings, revenue, EBITDA, and FFO. Additionally, I am pleased to report that the Cervalis integration is going very well, and we have substantially completed the integration plan one quarter earlier than our initial estimate. As we have previously discussed, last year we chose to highlight the embedded capital efficiency of our business model by focusing on FFO per share growth, and our third-quarter results highlight this fact. As shown on Slide 4, our normalized FFO per share of $0.57 was up 30% over the third quarter of 2014. Adjusted EBITDA was up 40% for the quarter compared to the same period last year, and revenue was up 31%. We signed a record number of leases in the quarter with signings totaling 29,000 co-location square feet, and generating $13 million of new annualized GAAP revenue, which brings our year-to-date bookings to $45 million in annualized GAAP revenue. We are continuing to add new Fortune 1000 customers and now have nearly 170. And based on our updated outlook, we are increasing the guidance for full-year normalized FFO per share with a new range of $2.11 to $2.15, up $0.03 from the midpoint compared to prior guidance. The steps we have taken to diversify our customer portfolio have been very successful. As shown on Slide 5, we now have 929 customers, which is 50% higher than the number we had at the beginning of last year. Our focus on selling to cloud providers has worked out well, and we have signed over 30 new cloud customers since the beginning of 2014. The IT vertical is now our largest and fastest-growing industry vertical, accounting for 28% of our revenue. Further evidence of our diversification can be seen on Slide 6 and Page 22 in our supplemental, which show that none of our top-20 customers account for more than 4% of our revenue, while last year we had seven customers that each accounted for more than 4% of our revenue. Additionally, our top 20 customers now only account for 43% of our revenue, down from 56% of our revenue last year and the weighted average remaining lease term of these customers has increased by 13% to 38.5 months versus a year ago. These are great improvements over the course of the year, and we expect that as we continue to add new customers, we will see further diversification of our customer base. As shown on Slide 7, we have been very successful in growing our interconnection business. As a reminder, our IX business is grounded in the strategic belief that customers will eventually require an interconnected set of data centers that will replicate the in-house data center architecture they have created over the past several decades. We believe that as applications become more distributed and companies take advantage of cloud and SaaS offerings, they will begin to focus more of their efforts on reducing connectivity costs. Our IX product line was designed to be very complementary to our data center offering, but most importantly, we wanted it to be standardized and replicable, so that it can scale with our growth without adding new headcount. Our IX product line has continued to generate strong demand as our interconnection revenue, excluding the impact of Cervalis was up 30% compared to the third quarter of 2014, and up 72% in aggregate, when including Cervalis. Interconnection revenue was up close to 160% from when we launched the product in April of 2013, and now represents 6% of total revenue. We expect interconnection revenue will continue to grow faster than our base business, as this is an area that is relatively immature and underpenetrated in our customer base. Slide 8 and Page 21 of our supplemental highlight the strength and diversity of our product offering. This quarter, we signed a record 392 leases representing approximately $13 million of annualized revenue. Importantly, we continue to see very strong demand for our higher priced full service products, which accounted for approximately two-thirds of the leases signed in the quarter and about 53% of the MRR. Our share in infrastructure solution enabled us to sell a mix of different products to our customers which in turn allow us to generate a higher yield on our assets as we can sell at a higher blended price per square foot. You can see that in this quarter's results, as we had bookings representing 1.1 million in MRR, slightly above our prior four quarter average. However, we only leased approximately 29,000 square feet of co-location space and this quarter our bookings represented the highest price per foot since our IPO. This is also more than 60% higher than the trailing four quarter per square foot average and the result of all the additional products and services we sell to customers that do not require any additional raised floor space. As we have explained in the past, we do not believe that a simple price per square foot metric is an appropriate way to value the business. However, it does highlight the inherent value we believe exists within our shared infrastructure platform, which allows us to sell a mix of different products and services. This quarter approximately 47% of our new MRR signed was from meter power deals with over 40% of the deals below 1 megawatt of power. As we have mentioned in prior quarters more customers have expressed the desire to lease on a metered power basis. We expect that the majority of our leasing going forward will be on a metered power basis. Therefore, these are more administratively burdensome than our traditional retail full service product line that has a fixed price per month and as a result we implemented a policy this quarter of including a 7% power administration fee in metered power contracts as a way to recoup some of these additional costs with providing the service, which is something that other service providers have provided and have started deploying over the last year. We expect that overtime this will help protect profitability especially as usage increases. And similar to the success we've had in implementing lease escalators across our contracts we expect similar success in the launch of this additional price escalator. On Slide 9, 10, and 11, we highlight the incremental returns we have been able to generate over the past couple of years on three of our largest developments during this time period. We made a strategic decision last year to focus on FFO growth by prioritizing investments in existing markets where we had the greatest opportunity to generate higher incremental returns. We did not believe that historical investments that we had made and the embedded earnings growth potential of the portfolio were being adequately valued in the public markets. We have always strived to design and deliver a megawatt of capacity at the lowest cost in the market. Our focus on supply chain efficiency enables us to deploy capital on a just-in-time basis which along with our shared infrastructure backplane allows us to achieve strong development yields on the assets we deploy. We highlight this by showing how the development yields for the Carrollton, Houston West II and Phoenix campuses have increased over time. We have invested more than $400 million of capital in these locations over the past four years. For reference, the investments made in these three facilities accounts for approximately half of the total capital investment we have made in the company over this period. So they provide a good analogue to what we are able to do across our entire portfolio. As you can see, the incremental returns for these large facilities increased dramatically over time, as they are able to take advantage of the upfront investments that have been made to develop and scale these properties as part of our massively modular design approach. Carrollton is currently yielding about 16% on the capital invested in the property which is 300 basis points higher than where it was three quarters ago. Over the last three quarters, annualized NOI at this facility has increased by almost $10 million, while we have only deployed an additional $27 million of capital and still remains only 82% utilized. While there are puts and takes on the analysis, the overall trend across all three locations highlight the inherently high incremental returns we can generate on our portfolio, as we build them out over time. This is something that we understand well, but felt that we needed to do a better job communicating this to our investors. Moving to Slide 12, you can see that we have made significant investments in our portfolio, which will enable us to continue to grow our business in a very capital efficient manner. We estimate that we can increase total co-location square feet in the portfolio by approximately by 60% to nearly 2.5 million square feet with existing undeveloped powered shell. The incremental return example that we highlight in the Carrollton property is analogous to the 60% increase in shell capacity across our entire portfolio. The incremental investment to build out this space is significantly less than our targeted $7 million per megawatt metric, which in turn should increase the incremental return on capital we deploy to build out this space. Furthermore, if we were able to develop the 190 acres we have in our land bank, we estimate that we could grow to 3.5 times our current size, increasing our capacity to more than 5 million co-location square feet at an average build cost of less than our targeted $7 million per megawatt. In summary, we have considerable capacity to grow our company given all the investments we have made in additional shell and land capacity, all of which will enable us to generate very attractive incremental returns on our capital. In closing, I am very pleased with our financial and operational performance this quarter. We are increasing our financial guidance, have essentially completed the Cervalis education, and continue to feel very good about the overall health of our industry. I believe we are the last of the data center REITs to report results for the third quarter, and I'm glad to see that the underlying secular demand drivers associated with data growth and a willingness by enterprises to outsource their data center needs, remain fully intact, as all of our peers have posted very good results across it many different markets. Our sales funnel remains very strong, and we are excited about the future, and look forward to a strong 2016. As I turn the call over to Kim, I want to note that the CFO transition is going very well, and Greg is looking forward to meeting everyone at NAREIT in a couple weeks. Kim will now review our financial performance.

[Kim Sheehy:]

Thank you, Gary. Good afternoon, everyone, and thank you for joining us today. I will provide additional color on our third-quarter financial results, and give an update on the outlook for the full year. Please keep in mind that we closed on the Cervalis acquisition on July 1, and so our third-quarter results include the full impact of the acquisition. Beginning with Slide 14, normalized FFO and AFFO were up 43% and 47% respectively, compared to the third quarter of 2014. This is primarily due to the increase in adjusted EBITDA over the same period, driven by strong growth in revenue, margin improvement, and the impact of the Cervalis acquisition. Revenue for the third quarter was $111.2 million, an increase of $26.4 million or 31% from the third quarter of 2014. The year-over-year increase was driven by a 27% increase in leased co-location square feet and additional IX services. Both new and existing customers are contributing to our growth. Churn for the quarter was 0.7%, in line with the second quarter, and our third lowest level since becoming a public company. We expect churn for the fourth quarter to be between 1% and 2%. Turning to Slide 15, we leased 4.8 megawatts of power and 29,000 co-location square feet in the quarter. Bookings were particularly strong in our Northern Virginia and Dallas market. Based on square footage, our new leases have a weighted average term of 57 months. 70% of the new leases on a monthly recurring revenue weighted basis have escalators at an average annual rate of approximately 2.6%. The new leases signed this quarter represent approximately $13.3 million in annualized GAAP revenue, excluding estimates for pass-through power. Year to date, we have signed new leases representing approximately $45 million in annualized GAAP revenue. By the end of the third quarter, we had commenced approximately 44% of contracted revenue from leases that were signed during the quarter, and we estimate that by the end of the fourth quarter, approximately 89% contracted revenue for leases signed during the third quarter will have commenced. As of the end of the quarter, our total backlog of annualized GAAP revenue stood at $9 million. We estimate that by the end of the first quarter of 2016, almost all of the contracted revenue for leases currently in the backlog will have commenced. Moving to Slide 16, net operating income was $69.4 million for the third quarter, an increase of $17.6 million or 34% from the third quarter of 2014. The NOI margin of 62% was up 1 percentage point versus the third quarter of last year. Adjusted EBITDA increased by $16.8 million to $59 million, up 40% from last year, primarily driven by the increase in NOI. The adjusted EBITDA margin was up 3 percentage points, driven by the increase in the NOI margin, as well as a decrease in SG&A expenses, excluding non-cash compensation, as a percentage of total revenue. Normalized FFO for the third quarter was $41.2 million, an increase of 43% from the third quarter of 2014, driven primarily by growth in adjusted EBITDA, partially offset by increases in interest expense and stock-based compensation. The increase in interest expense was primarily driven by borrowings to fund our growth and acquisition of Cervalis, as well as interest on the Cervalis leases. Taking into account the additional shares issued in connection with the Cervalis acquisition, normalized FFO per share was up 30% over the prior year. FFO for the third quarter was $42.8 million, an increase of 47%, over the third quarter of 2014, driven primarily by the increase in normalized FFO, and the lower recurring capital expenditures as a result of timing. Slide 17 compares our performance on a sequential basis. Revenue increased $22.1 million, or 25% from the previous quarter, driven primarily by the impact of the Cervalis acquisition, as well as incremental revenues from recent signings. This shows comparable increases in NOI and adjusted EBITDA on a percentage basis, with the adjusted EBITDA margin of 53%, flat compared to the prior quarter. The increase in normalized FFO was driven primarily by the increase in adjusted EBITDA, partially offset by higher interest expense related to borrowings to fund the acquisition of Cervalis, as well as interest on the Cervalis leases. The increase in AFFO was primarily driven by the increase in normalized FFO, partially offset by higher deferred revenue and straight-line rent adjustments as a result of higher volume of leases and free rent and ramp periods during the quarter. Slide 18 shows a market-level snapshot of our portfolio, as of the end of the third quarter and 2015 and 2014. Utilization is at 89%, an increase of 2 percentage point compared to last year on a 26% capacity increase, approximately 10 percentage points of which was attributable to the Northeast properties, with particularly strong demand in our Phoenix, Northern Virginia, and Dallas markets. The total footprint was approximately 1.5 million co-location square feet, and includes 31 data centers and two work area recovery facilities across 12 markets. We have approximately 167,000 square feet of raised floor available to lease, primarily in Dallas, Cincinnati, Houston, Northern Virginia, and the New York Metro area. Our second Northern Virginia data hall was commissioned in the third quarter, adding 37,000 square feet of raised floor, and is approximately 40% leased. We continue to see particularly strong demand in that market. Slide 19 shows our net debt and market capitalization as of the end of the third quarter. Our leverage as of the end of the quarter remained relatively low at 4 times annualized third-quarter 2015 adjusted EBITDA. This compares favorably to the broader REIT average of approximately 6 times, and provides the Company sufficient flexibility to support future growth. As of the end of the quarter, we had approximately $478 million of available liquidity, which should provide us with enough finding capacity for the next 18 to 24 months. Moving to Slide 20, we are reaffirming the prior 2015 guidance for revenue and capital expenditures, while moving the range up for normalized FFO per share, and increasing the lower end of the range for adjusted EBITDA. The new range for adjusted EBITDA is $210 million to $213 million. We have brought up the lower end of the range, as we have better clarity on expenses for the remainder of the year. The new range for normalized FFO per diluted share and share equivalent is $2.11 to $2.15, with the new midpoint up $0.03 compared to the prior midpoints. The increase in normalized FFO per share range is driven in part by the adjusted EBITDA, as well as lower interest expense, as a result of the timing of capital expenditures and a slightly lower interest rate than previously forecasted. We expect revenue to be between $398 million and $404 million, based on signed leases through the third quarter and expectations for the fourth quarter. We expect capital expenditures to be between $260 million and $275 million. As noted on last quarter's call, for Cervalis, we have assumed expenditures related to the potential development of property adjacent to one of their existing facilities, which is fully leased up, and there is an active pipeline of existing customers looking to expand. We are currently undergoing diligence on the expansion sites, but anticipate stabilized development yields in the mid to upper teens, consistent with our other developments in our portfolio. We will provide additional details on our development plans as our development plans progress. Slide 21 shows current and planned developed activity by market. As I mentioned earlier, we delivered approximately 37,000 square feet of raised floor in the third quarter, with our second data hall in Northern Virginia coming online. Development continues in Austin, Houston, and San Antonio, and we expect to add a total of 145,000 co-location square feet and 12 megawatts of power capacity in these markets. We are also continuing construction on our Phoenix III facility and we will begin construction on our fifth data hall at our Carrollton facility in the fourth quarter. By the end of the year, we expect to have a total of approximately 1.6 million square feet of raised floor online, up from approximately 1.2 million square feet at the beginning of the year, with another 800,000 square feet of powered shell available for future development across our U.S. markets. In closing, we are pleased with the results of the third quarter, and believe we are well positioned for growth in our markets. Thank you for your time today. At this concludes our prepared remarks. Operator, please open the lines for questions.

[Operator:]

[Operator Instructions] And our first question today comes from Manny Korchman from Citi. Please go ahead with your question.

[Manny Korchman:]

Just had a question on, just in results, there was an additional breakage fee in Austin. Was wondering what that was related to, I thought that all of that was out in 1Q results.

[Gary Wojtaszek:]

Manny, Gary. There was some equipment there that we're going to keep in place, rather than move the associated value, wasn't worth moving it. It was cheaper to just keep it in place.

[Manny Korchman:]

Gary, you mentioned that the integration process was about -- I think you said a quarter ahead of where you expect it.

[Gary Wojtaszek:]

Yes. Yes. I mean, I think in general, we're always on a conservative side and as we had expected, we thought that the integration between the two companies was going to go smooth. As I kind of mentioned culturally we’re kind of like one in the same organization and that's kind of been born out in the whole integration effort. So basically everything was completed from a sales, and operations, and marketing, and call center, all that stuff was basically done this month. The last piece of this that's just cutting over now is the last piece on the billing system, which started actually earlier this month in November.

[Manny Korchman:]

And my last one for Kim, if I look at your ranges for both revenue and EBITDA, what drives you to the bottom or the top ends? I would imagine that with leases that don't commence immediately that the in-place revenues are done for the year. Just wondering about what drives the range?

[Kim Sheehy:]

What drives the range?

[Manny Korchman:]

You've still got a reasonably wide range, right, several million dollars.

[Kim Sheehy:]

Yes. It's mostly just our timing of when leases would come online and when we start recognizing the revenue. And power fluctuations which are still always the more difficult thing to forecast.

[Operator:]

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

[Jordan Sadler:]

First question is regarding the activity during the quarter. Obviously you closed early in the quarter on Cervalis and you're integrating. I'm just curious what the production looked like at legacy CyrusOne versus Cervalis if you have that split out?

[Gary Wojtaszek:]

In terms of our bookings, the majority of it was still CyrusOne. We had probably only about 5% of the bookings or so in Cervalis for the quarter. That said, we're actually, our funnel right now for Cervalis is about $2 million, so we have a really high funnel that we're tracking there and so that thing is developing pretty nicely in line with our expectations.

[Jordan Sadler:]

And then on the interconnection side, can you just shed a little bit of light in terms of what -- I mean, what the opportunity is? Obviously Cervalis adds a nice slug of incremental interconnection to the portfolio. But what are you targeting in terms of interconnect as sort of a total piece of the pie?

[Gary Wojtaszek:]

Look when we launched that product line two years or so ago, we did that with the recognition that we are woefully underpenetrated in terms of the number of our customers that are taking interconnection. Our interconnection strategy is a little different than what others are doing in terms of kind of driving up density in a location for folks that want to get to onramps in particular highly interconnected buildings. Our interconnection strategy is based on the belief that and what we've been seeing in our customers is that they are going to replicate the interconnection architecture that they've developed at the enterprise level over the last couple of decades and that's basically comprised of three or more data centers that are interconnected together from a networking perspective. So our interconnection business is based with that view in mind. And we think ultimately long-term success in this industry is going to be defined by having a robust platform of interconnected data centers. The 6% penetration now is nice. We're up from around 4% than when we started this. We expect that that number is going to continue to increase as we pointed out this quarter and practically every quarter over the last four or five, I mean our interconnection business is growing at roughly three times faster than our base co-location business. And we expected that is going to continue to increase overtime. I think as many know I mean that's a really nice business to get, it provides significantly higher yields on those assets and creates for a much more robust and stickier customer relationship.

[Jordan Sadler:]

Well, along the same lines, I guess if you're -- that's adding to the incremental revenue per customer, revenue per relationship. It seems that you also on the other end of the spectrum continue to be able to drive down the build cost. And I am curious as we look at sort of market rents if you are seeing any pressure on sort of the pure co-location piece of the puzzle?

[Gary Wojtaszek:]

No, no. Actually it is very strong and robust right now. As you point out, we have always focused on trying to be the low cost provider in the space, but that is done just purely as a way to enhance yield. We do not lead with price and we’re feeling really good in terms of where the industry sits at this point in time. Everyone I think has really kind of adopted just in time build designs and that has basically enabled everyone to deliver capital on a just-in-time basis and the derivative of that has been pricing has been very, very stable and we're actually see more increase in pricing. Actually one of the things that I talked about in my points this quarter is we are starting to insert, and we started this quarter, price escalators on power. As you've seen in our results since our IPO, our mix shift has gone from higher proportion of co-location contracts to larger metered power contracts and as a result of that, those things are inherently more complex to manage and deliver to a customer. This quarter, we started adding in a 7% service charge on top of those contracts, as a way to recouped some of the additional expense that we have been incurring, associated with implementing and monitoring those contracts. So we feel really good about the market as it sits today, particularly versus when we IPOed in 2013.

[Jordan Sadler:]

Is there a number, and when you say strong and robust, are market rents of moving up 5% year-over-year? 10%? That range?

[Gary Wojtaszek:]

Those numbers are always so squishy for us, and we've always been reluctant to talk specifically about that. Just because the mix shift in terms of trying to compare products with products is so different. I could say it is very, very solid right now, in terms of the pricing that we've been seeing. Just broadly speaking, it's not really changed much for us in the last six quarters, and it's tending to go up now.

[Operator:]

Our next question comes from Jon Atkin, form RBC Capital Markets. Please go ahead with your question.

[Jon Atkin:]

So I was interested in Virginia, and I think you got the 10 acres. But beyond that, and given how strong the market is, what are the options for additional land adjacent to your additional site, or not, that you might consider adding to the portfolio? And then, on the Cervalis sales funnel that you mentioned, the $2 million as well as the 5% of sales that was Cervalis this quarter, was that mostly new logos, or was that growth from existing customers?.

[Gary Wojtaszek:]

So on northern Virginia, that market has been doing phenomenally well for us. A lot of people were skeptical about our ability to enter a new market and compete successfully when we chose to do so last year, and I think the results that we've seen since we made that decision have been really impressive. We have been -- that's been one of our strongest markets and we didn't talk about it, but it still continues to do really, really well. And not just for us, but for every one of the different players in that space there. We only have one building out there today, so we have the capability on that site to bring in three additional buildings on that, and we are planning to do so, and we expect that, as we continue to grow, we'll look to take down some additional land capacity there, to build out additional space there. Your other question on customers was related to the bookings that we had this quarter, in terms of new customers versus existing? I wasn't quite clear.

[Jon Atkin:]

Yes, that and then isolating on Cervalis and the growth there. So both for the whole company, versus existing customer growth and then Cervalis on a standalone basis, I'd be interested in what that -- if that's meaningfully different trends.

[Gary Wojtaszek:]

So actually this quarter, we actually had close to 50%, I think it was 52% of our new customers this quarter -- of the revenue booked this quarter was new customers. Which is really, really good, because what you're always trying to do is -- I mean -- and I've said it a lot privately at investor meetings, is that the most important leading indicator that we have as a Company is our ability to attract new logos to our organization, because to the extent that you are able to do that, you can drive additional future revenue. We've pointed out historically that roughly 40% of the NPV associated with each customer acquisition is in the business that you don't get on day one, so to the extent that you have a higher proportion of your new revenue coming from new customers, that just solidifies your upside there. In terms of Cervalis' growth in the quarter, they were up about 9%, 10% versus where they sat last year, so a nice growing company. We believe that we can accelerate their trajectory, as we bring in more marketing and sales capacity to that organization. In addition to that, we're going to be bringing on some additional data center capacity in their New York property, so we can accelerate our bookings for that facility, which we are currently -- basically we are sold out at.

[Jon Atkin:]

And then, finally, you talked about the -- or you wrote about the three new enterprise logos, and I was interested -- among the Fortune 500, and I wondered the size of the initial commitment in those cases, and I'm interested in terms of square footage, as well as what type of resiliency requirement those enterprises took?

[Gary Wojtaszek:]

Yes.

[Jon Atkin:]

Were they -- and finally on that same point, were they competitive situations or were these more evangelistic sales on your part?

[Gary Wojtaszek:]

Sure. Yes. So that trend, as we've been talking over the years, has just been increasing. So as customers are coming to outsource for the first time, the size of the deployments is increasing, and so those deals are fundamentally different than the deals we were signing with enterprises five or six years ago. The sizes of these are very large. Not so much in square footage, but in density, they're really large in terms of a dense footprint. We've been successful at attracting those customers. Are they competitive? I mean, yes and no. I mean, I think, customers are always doing their diligence, making sure that ultimately the partner that they choose to go with is good, so they are -- they do an adequate amount of diligence. But our -- and the vast majority of all of our bookings still continue to be generated through our direct sales and marketing efforts. This quarter, I think only about 15% of our bookings came through our indirect channels. And we provided numbers on that in the past, where -- so it's come direct versus indirect, but our preference is to continue to drive revenue through a direct relationship with a customer. We think that's where we add the most value, that's where we can really shine when we are in front of a customer, because ultimately we can provide a very flexible solution that tailored exactly for their needs. And we're going to continue to drive that success.

[Operator:]

Our next comes from Simon Flannery from Morgan Stanley. Please go ahead with your question.

[Simon Flannery:]

Gary, I was interested in your thoughts on some of the industry consolidation. You've obviously taken part in it, but last night we heard Century potentially looking at monetizing their data centers, Windstream's conducted a transaction, Telex has gone into digital realty. So a lot of transactions here at the carriers, and you came from a telecom background. Are looking maybe in some cases to step back from the co-location business, so how does this all play out, and what do you think it means for the industry competitors if we go to a few larger players? And to that end, what are your thoughts on continuing to scale up either organically through maybe moving into more West and Northwest? Or inorganically, once you get Cervalis fully integrated? Thanks.

[Gary Wojtaszek:]

Sure. So there's a couple of different questions in there. Look, I think this just highlights the maturation of this industry. Right? We've talked about that, I think, in the past. But size and scale really matter in this business. It's a very capital-intensive business and whether you look to analogs and railroads, or wireless towers, or the wireless industry, ultimately, scale and size are going to matter more than anything else. And I think, as you see, as the industry consolidates, all of those companies have traded two strategic players, that I think is just evidencing that, just the maturation of the industry. We would expect to continue to play in that space. We'll continue to look to do acquisitions that make sense for us strategically, in terms of further expansion and diversification, in terms of geographic presence, as well as customers that we're trying to target. So while we have 170 Fortune 1,000 companies, that's still only 17% share, so there's a lot of wood to chop to go get the other 83% of the market that we don't have today. So Tesh has got a lot of work to do. With regard to our organic expansion, as we sit here right now, in my talk points here, we provided three different facilities, Carrollton, Houston West, and Phoenix, to highlight the embedded incremental returns that we can generate in our business if we never went to another new location today. We've made a significant number of investments that we can basically grow out our footprint today by 60% on a really capital-intensive nature, and tripling the Company if we built out all of the land. So we're going to continue to deploy capital in those markets as demand warrants, and we feel that with our supply chain efficiency, we can continue to run at high utilization and bring on capacity very quick, given all the work that Kevin and Hatem have been doing on the supply chain over the last several years. We do believe that ultimately we need to have a broader footprint and presence around the U.S., if not on a global basis, in order to ultimately -- we're no different than what we've seen in the wireless industry over the last 15 years or so. So ultimately, we think you need to get in those locations. We've been hesitant, and we scaled that decision for expansion last year back, because we didn't think investors fully appreciated the embedded return profile that we have in our business and that's what we've been trying to highlight for the last year, to show how much incremental FFO growth you can squeeze out of these additional assets. As we look to expand, though, we'll provide a lot more insight into those expansion opportunities, as we go to the Northwest or West and expand the portfolio there.

[Operator:]

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

[Colby Synesael:]

Two lines of questioning, the first one on the 7% power fee was that put in place at the beginning of the course I guess July 1st or towards the back? Just trying to get a sense of what's already in the numbers. And then also just to make sure I understand it that's based on the percentage to which they're spending on power not their total spend with the company? And then I guess the last part to that is what has been customer response? You mentioned that I guess others are starting to implement that too. I'd love some examples since I am not as familiar with that. And then the other question is on the work recovery space that you acquired from Cervalis. Is there an expectation or a desire to extend that into some of your other more traditional CyrusOne markets and what’s the return profile or yield that you would expect to get on that relative to what you would get on your typical data center space? Thanks.

[Gary Wojtaszek:]

So on the power surcharge, so this is in my mind not much different than the decision that we took three or four years ago, we decided to convert from a C-Corp to a real estate investment trust in that when we started putting in place lease escalators in all of our contracts well we never did historically, we made that decision to basically look and feel more like a traditional real estate company. And we started that off at one point in our portfolio we had 0% of those customers had that lease escalation clause. Now a little over 40% of our customers today have that clause in their contract. And as Kim pointed in her talking points, 70% of our new contracts this quarter had that in there. So we expect that that's going to continue to increase over time. This power surcharge is very similar and akin to that, right? Where over -- years ago, we never really thought it was a big deal. We were very accommodating to customers and we were agreeing to do power as a pass-through just as the way we kind of service customers when we were doing full service deals. Well, when you're doing that at scale at a really big footprint, it becomes inherently more complex particularly as we shared last quarter and again we shared this quarter is that the deals that where customers are going on power and a pass through are decreasing pretty rapidly. We talked about the majority of our deals this quarter and also last quarter in metered power contracts being done for customers below 1 megawatt, which is something that I think is a fairly new trend in the industry. So people are recognizing the inherent benefit of doing the power as a pass-through contract and we were very accommodating over the years. However, as we’ve been -- the majority of our business is now on this power, metered power basis, we started wanting to recoup some of the additional expense and fees that we are incurring in our business to be able to monitor that. And that 7% is what we just what we started this quarter. It is something that we just rolled out on the customer contracts that we did this quarter, it's something new, we expect that over time, more and more of our contracts are going to include that in there. And as we've been seeing in our results, and as we got a lot of concerns from investors earlier this year, when we're talking about some of our revenue fluctuations which was all power related, as we were pointing out to customers there was no -- last year, when we see huge increases in power there was no associated pull through in EBITDA performance, because there is no margin. And this year we saw the reverse of that where it didn't grow as fast as we thought and there was no pull through right back to EBITDA. We are going to be putting that in there as a way to kind of drive additional ARPU up on the assets of that we're deploying. So we expect over time if we are successful as we've been with the lease escalators that will provide another same-store sales type increase in metrics similar to the cross connect and some of the other services that we provide.

[Colby Synesael:]

So this is for new customers this wasn't retroactively done to the entire base that are taking either?

[Gary Wojtaszek:]

No, this is all going to be new and I expect that as they mature and customers renew just like in our new contracts, we're putting in lease escalators into all of our contracts as they renew and re-up again. And so, as it relates to other competitors doing this, I mean, this was something that we heard from a couple of different players in this space that were doing it and we thought that was a creative way to recoup some of their costs that we hadn't really thought about. So, we’re really kind of following the lead of some other folks in the industry.

[Colby Synesael:]

And I guess on the recovery space?

[Gary Wojtaszek:]

Yes. So, we do really well with that. So, Cervalis has a really robust kind of product line not surprisingly. I mean they're targeting 80% of their business was financial service companies. So they have a really robust offering there with two facilities in their portfolio which were fully utilized during the whole Hurricane Sandy outage two years or so ago. We've been doing that here as well in Houston, Mike and the teams are going to be productizing that more and offering that has more of a robust product offering. Actually some of the funnels that we’re tracking right now are customers in -- financial service customers in Mike's portfolio that are looking for that type of space actually in Texas. So we expect we're going to be doing more of that and we're going to put some more productization around that offering. The returns on that are very attractive, I mean you would do that all day long rather than any other business that we have, but the returns we are able to generate there are really just the result of the data center business that you do with those customers.

[Operator:]

Our next question comes from Vincent Chao, from Deutsche Bank. Please go ahead with your question.

[Vincent Chao:]

Just wanted to follow up on the power fee, the 7%, it sounds like your cost to manage the metered power business, as it grows, have gone up. I'm just curious if the 7% offer much in the way a significant margin expansion opportunity, or does it just really offset the increased costs that you're seeing?

[Gary Wojtaszek:]

It's basically in response to seeing more and more customers choose that product versus our traditional all-in retail product. And as I was mentioning, it was something that we had done previously. We really didn't think too much about it, but as more and more customers started demanding it, and the size of those deployments have been shrinking, our ability to monitor it and do it is -- it goes up significantly. And it takes -- there is a tremendous amount of support staff involved in that. So whether it is on the implementation side, the monitoring side, the operations side, to your accounting systems, to the additional work you're doing with audits of those contracts for the customers, there is a number of additional cost drivers in there that we have never -- we've just thrown in for the customers really as an afterthought, and now we're going back and saying, look, if we're going to -- if everyone's wanting to do this more, we want to put in some type of escalator in there, where we can recoup some of our expense.

[Vincent Chao:]

Yes. No and I guess that's my point. So it sounds like it's really sort of offsetting rising costs as opposed to being net profitability for you.

[Gary Wojtaszek:]

Well, overtime, as you increase -- you further penetrate your base, you're going to enhance your profitability. I mean, it's no different than when we started our initial lease escalators, when we had 0% of our customers in our portfolio have it, to now 40% of our customers. So that -- and it's close to 3% escalators. This is going to be pretty similar over the next couple of years, as well.

[Vincent Chao:]

And then just going back to northern Virginia, lease up at phase II seems like it's going well, demand in the market is strong. Just curious how quickly you think you can get more product available in that market, and should we expect a shell start here relatively soon?

[Gary Wojtaszek:]

Yes. There's always an internal debate here -- Tesh is always trying to challenge Kevin to force him to run out of space, and Kevin and John always rise to the demand and always have space available. So we can continue to grow in all of our facilities across our entire portfolio, and specifically within northern Virginia, we expect we'll have additional capacity there next year. So we're about 70% utilized right now in that facility.

[Vincent Chao:]

Okay. But I mean the next build out would require a full shell and co-lo square footage.

[Gary Wojtaszek:]

Yes. And we can do that in less than six months. We demonstrated last year with a particular large cloud customer in Phoenix, was that we built from an alfalfa field to a completed data center within three months, which is a record amount of time in the industry. And we think that if any customer comes to us with that type of demand, we'll rise to it and we'll build and deliver that. That's the other thing we didn't really talk about, but our Phoenix facility is also doing really well. That's one of the really strong markets that we are seeing across the country. That is something where we sold a little bit of space, the remaining space we had there this quarter, we'll have additional capacity online in the fourth quarter as well. But that market we're seeing a lot of demand. It's worked out well, and all the customers from California that are looking for a low latency solution at a lower cost are looking at Phoenix as a really strong market to locate their applications in.

[Operator:]

Our next question comes from Barry McCarver, from Stephens. Please go ahead with your question.

[Barry McCarver:]

Gary, I think you mentioned earlier in your prepared comments that you had a record number of leases signed during the quarter, and yet square footage in power wasn't really that high. So I'm wondering what the average size of your new contract looks like now, and maybe compared to what it did a year ago and your thoughts on the long-term returns for this.

[Gary Wojtaszek:]

Yes. I wouldn't read too much into what goes on the quarter-to-quarter basis, Barry. This quarter, I think what it highlights more than anything else is just how broad and robust the product offering we have, in that we can sell almost 400 leases in a quarter at the highest -- the least amount of square footage that we sold in a very long time. And it really just goes to show all the different products and services that we can deliver to that customer. As we've been saying historically and we still don't think it's unchanged, is that the deals that we're doing with customers out of the gate are just bigger and larger and longer term. And we expect that as a trend, that is going to continue. So I think next quarter, we'll probably see something similar again to what we've sold in the past, probably closer to 40,000, 50,000 square feet of space. But I wouldn't read anything into the quarter, other than the fact that we sell a really robust product offering.

[Barry McCarver:]

And then just related to Cervalis, and I know you've already touched on this, but you commented, and I think and repeated it, you are looking at expanding the platform there in the New York market. And I'm wondering, tell us what the Cervalis pipeline looks like, but is the expansion driven more on demand from Cervalis customers, or are you already seeing cross sell opportunities from CyrusOne customers and that's making you think about expanding in New York.

[Gary Wojtaszek:]

Yes. I mean the reason for the expansion in New York is predominately because we're sold out there, right? So they have existing customers that want to grow there in that facility, so we want to bring on some additional capacity in that location. But the demand we're seeing in terms of the synergies is as we had expected, in that most of the demand that we were going to be seeing from the Cervalis customers has been more of their customers wanting to locate in other CyrusOne Inc facilities, rather than having some of our existing customers who want to be located there.

[Operator:]

Our next question comes from Jon Petersen from Jefferies. Please go ahead with your question.

[Jon Petersen:]

Yes. I don't think you have touched on it yet, but I'm just curious about the guidance. So you revised the per-share FFO guidance up, but I didn't really see a change in revenue. There's no change in revenue. $1 million higher on EBITDA, so that's about penny per share, but development seems about the same, so I was thinking maybe capitalized interest is going to be up, but if your development spend is down, I'm just trying to figure out what the increase is.

[Kim Sheehy:]

Yes. Thanks. So I think you hit on most of it, but obviously of the change EBITDA is about penny The rest is really within interest, a combination of in our original forecast we had a slight increase in rate built in, that we don't expect now. We also have delayed spend on CapEx from a timing perspective, and capitalized interest, we are expecting to be slightly lower in the fourth quarter.

[Jon Petersen:]

You're expecting capitalized interest to be lower than what you expected this quarter?

[Kim Sheehy:]

I mean we're talking a couple hundred thousand dollars -- it's really essentially flat.

[Jon Petersen:]

Okay. All right. That's helpful.

[Gary Wojtaszek:]

We're probably going to come in on the low end, Jonathan, of our CapEx.

[Kim Sheehy:]

That's right.

[Jon Petersen:]

Got you, okay. Your recurring or your development CapEx or both?

[Gary Wojtaszek:]

Development. Both.

[Jon Petersen:]

And then, I was just curious high-level on leasing, since you did about $13 million of leasing this quarter, which was about in line with the average over the last four quarters. Now that you have Cervalis on and you talked about having a $2 million funnel there, I'm curious on a quarterly basis how much you would expect leasing volumes to trend up in 2016 from the $13 million that we've been averaging over the last five quarters?

[Gary Wojtaszek:]

Look, the hope is more, right?

[Jon Petersen:]

Right.

[Gary Wojtaszek:]

Our base business is, we're basically assuming that we're going to basically repeat that $13 million a year. If we can get up to $16 million a quarter as we come out of the year that would be great. But these things are so lumpy, right? The most important thing is that you have a really broad funnel that you can sell across to small customers and large customers, because we had a customer that we were expecting to close seven weeks ago, very sizable customer, that actually just closed this week, right? And so we thought for sure that was something that was going to get closed last quarter, and it didn't happen for one reason or another. Our whole goal is to basically continue to drive a really robust funnel and get big funnel coverage, so that you can continue to consistently knock down a number of deals every quarter.

[Jon Petersen:]

Okay. And that $2 million funnel that you talked about, I mean, what's that -- I guess, how do we think about that in terms of timing, like what's the lead times on leases for the Cervalis portfolio maybe relative to other, a quarters worth of leasing in about six months?

[Gary Wojtaszek:]

No. Yes. You don't know. I mean we are sitting on a really strong funnel across our entire portfolio right now, but the timing of when those things are going to turn into a contract and then ultimately manifest in revenue is so difficult to predict. And so, while we're sitting on the strongest funnel we've ever had, to tell you when those things are going to get closed, is really difficult. I mean, we always talk about a lead time from a first engagement to a customer when they are in their funnel to closing. I mean a three or four year time period is not unheard of.

[Jon Petersen:]

All right, that's fair. That's all my questions. That thanks.

[Gary Wojtaszek:]

That's what's nice about the smaller contracts, right? I mean, if you have that capability to sell to a lot of smaller customers, you can reduce some of the volatility associated with just kind of elephant hunting all the time.

[Operator:]

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

[Frank Louthan:]

Thank you. Can you give us a little bit of an update on the verticals that you, what your exposure is after Cervalis? I think you got a lot more financial services, but how is that kind of balanced out? And then some of your larger peers are seeing some success with sort of cloud aggregation models and attracting -- getting large cloud providers and then attracting additional business, any thoughts on that approach and how that would or wouldn't fit in with your model? Thanks.

[Gary Wojtaszek:]

So we kind of talked about it in some of my pieces, but our biggest three verticals 28% of revenue is in cloud, IT services it's also our fastest growing funnel by financial services at 21% and energy at 20%. We made that decision two years or so ago to focus on cloud companies and we've been very successful in there and that's been our fastest growing business. We are in really good position right now with just about every large web scale company in the cloud space and really robust conversations. I think our brand awareness has changed dramatically in the last two year period and we're in conversations with everyone now. I think some of the stuff and the success we've had in Phoenix last year where we were able to deliver that facility in three months is really valuable to lot of the cloud companies, because the biggest challenge that they have is an inability to really accurately forecast demand. I mean just think about how big Amazon's cloud business is and yet they were able to grow it by 78% this quarter. That's a substantial amount of additional data center capacity that they need to deliver in order to sustain that level of growth. And so if you're sitting there, maybe next quarter they do 150% or 100% they don't know. I mean the upside to them is just fantastic. The challenge though is kind of managing that demand capacity and order on the data center side is really, really difficult for them because some of these facilities take upwards of two years to deliver. So, we expect that as we've been demonstrating to our customers the ability to deliver capacity really quickly to them, we think that that's going to resonate really well and our opportunity to work with them is going to increase.

[Operator:]

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

[Ryan Jones:]

Thanks, two from me. This is Ryan for Amir. On the last call you had talked about Cervalis being 9% accretive to 2016 normalized FFO. You've had some time now to integrate the asset I was just wondering if there is any change to the magnitude of those expectations, that's the first question. Second question is, can you talk about the sequential uptick in churn that you expect for the fourth quarter over the third quarter?

[Gary Wojtaszek:]

So just to go over the Cervalis thing, what we were saying is that it's 5% immediately accretive than it is and when you see some of that results in this year, in this quarter's results. The expense synergies was about $0.03 more in that accretion and you'll start seeing some of that come through this quarter. It'll be fully in the run rate by January. The additional amount of accretion there was the additional lease up of the existing capacity that they had available. So as we start filling up those, the space they have there, we'll see that kind of get pulled through in the results for next year. With regard to your other question was on sequential churn. This is like record leading churn. We had 0.7% churn in the quarter up from 0.6% in the last quarter. So these are two of the lowest churn quarters that we've ever had in our history. So we feel really good about that. As we've talked about over the last couple of years, what we are always modeling in our long-term plan is roughly 6% annual churn a year and we expect that we'll have some increased churn next quarter but nothing out of normal in terms of what our long-term planning expectations are.

[Operator:]

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

[Matthew Heinz:]

This is kind of a two part question on the first one, but we saw that you announced an expansion of your relationship with CenturyLink on the network side last week or a couple weeks ago and it looks like the IX routes between your existing sites are now largely filled out. I am just wondering how we should think about this in the context of new market expansion? I guess with California and the Northwest kind of being the largest hole in your existing footprint and then layering on some of the traction you've seen with cloud providers, how are you thinking about new markets in that part of the country and is there a preference for primary versus secondary or tertiary locations?

[Gary Wojtaszek:]

Sure, I think what you're seeing there, Matt, is that the penetration that we've been able to generate in the enterprise space, so those roughly 170 Fortune 1000 customers, is so valuable to a number of different players, right? I mean, so you see that in terms of what CenturyLink is getting out of that relationship. They clearly are targeting those 170 customers, in terms of who they're going after. Cloud vendors are also trying to break into the enterprise space, as well. And so what we've been able to demonstrate is a clear ability to continue to successfully knock down and integrate enterprise customers into our business, which accounts for roughly 75% of our business in aggregate. That is a really valuable opportunity for all those customers, to sell to them, because it's easy to do so, because all of those customers are concentrated in 30 locations throughout the U.S. I would expect that over time, as more and more customers decide to locate in our facilities, which, as I pointed out, could basically increase by 60%, it is extremely capital efficient for them to go to build out in those facilities, knowing that we could basically increase the number of customers in there by 60%. So I expect more cloud companies and more carriers are going to want to locate in our facilities. With regard to our expansions, we have always believed that you needed to be in multiple sites around the U.S. and those sites need to be interconnected with one another, and that's the way you need to build a platform to provide your customers with the ability to put applications around the U.S., so that they can take advantage of the newer technologies and get lower latency and increase the user experience to their customers. Last year, we didn't -- we took a breather from that, because what we felt was that as we expanded into new markets, which are dilutive to your business that our investors just didn't fully appreciate the strategic benefit of that, and were more focused on the short term dilution associated with going into those new markets. And so last year we made that pivot to focus on just putting our capital to work in our existing markets. We think longer-term that strategically, you need to be in those other markets, so once we start developing our expansion capabilities, and what those plans are, will talk about them at that point, but for the next quarter, at least, we're going to be focusing on deploying capital where we are currently at today. Just dovetailing to what some of Simon's questions earlier on strategy, if there's opportunities that come up where you could do other accretive acquisitions that give you the new geographies or customers, we would absolutely continue to look at that as a way to build out that presence.

[Matthew Heinz:]

And then just a follow-up if I might, on the margins this quarter. I mean, is this a fair jump off point to how we should think about the combined business going forward? I guess, relative to my model, you were a little lower on the NOI margin but in line with EBITDA. And you're already tracking towards 55% EBITDA margins. I mean, and you haven't really wanted to point out a long-term target, but how much improvement do you think we can see there?

[Gary Wojtaszek:]

Yes. This is the fifth quarter, fifth sequential quarter, Matt, that we've increased our EBITDA margins, and I think, really, that is just highlighting the scaling capabilities of the platform that we've been creating. And those margins are going to be tempered by a couple different things, right? I mean, the biggest one, that's a big driver of this is associated with power, right? And there's been a lot of confusion on that over the last five or six quarters because, as you scale that, that really worsens your margins, because you're just inflating both your revenue and expense. But putting that aside, I think you should expect that if you never went into another new market, that your EBITDA margins will continue to increase nicely towards that double nickel that you mentioned there. But clearly, if you look at us versus some of the other players in the space, if we had doubled the size of our business, you'd get enhanced margin improvement, just associated with scale on your below-the-NOI line expenses that we are currently incurring.

[Operator:]

Ladies and gentlemen, we've reached the end of today's question-and-answer session. I'd like to turn the conference call over to Mr. Wojtaszek for any closing remarks.

[Gary Wojtaszek:]

Thanks a lot. Hey, I think as everyone knows, this is going to be Kim's last earnings call. And I wanted to take this time to acknowledge all over the tremendous contributions she has made to the success of CyrusOne. She has been a fantastic partner to me, as CFO, and her leadership in this Company through our REIT conversion and the IPO process has been outstanding. For those of you who have invested with us since the beginning, and particularly the real estate focused guys, recognize that we are the third best-performing REIT in the RMZ index, and that success is in no small part due to all of the contributions that Kim has made to this organization. And it's mixed emotions here. I think it's bittersweet. She is going to go on and do other interesting things in her career, after she takes some time off, I hope, and she's going to be missed by me and the entire team at CyrusOne. So I wish her the best of success in her future endeavors, and look forward to keeping in touch with her as we continue to build our business. Thanks, everyone. On our next earnings call, we'll update what our 2015 guidance is going to be, but we're pretty excited, given where we sit at the moment. We think the industry is very healthy. We've been seeing really robust broad demand across all of our markets. Not unlike, I think, what every one of our competitors recently has posted as well. Thanks a lot, and have a great Thanksgiving. Goodbye.

[Operator:]

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