Digital Realty Trust, Inc.
Q2 2011 Earnings Call Transcript

Published: 28 Jul 2011

[Operator:]

Good afternoon. My name is Christie, and I will be your conference operator today. At this time, I would like to welcome everyone to the Digital Realty Trust 2011 Second Quarter Earnings Conference Call. [Operator Instructions] I will now turn the conference over to Pamela Matthews Garibaldi.

[Pamela A. Matthews:]

Thank you. Good morning, and good afternoon to everyone. By now you should have all received a copy of the Digital Realty Trust earnings press release. If you have not, you can access one in the Investors section of Digital's website at www.digitalrealtytrust.com, or you may call [phone] to request a copy. Before we begin, I'd like to remind everyone that the management of Digital Realty Trust may make forward-looking statements on this call that are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual outcomes and results to differ materially from expectations. You can identify forward-looking statements by the use of forward-looking terminologies such as believes, expects, may, will, should, pro forma or similar words or phrases. You can also identify forward-looking statements by discussions of strategies, plans, intentions, future events or trends or discussions that do not relate solely to historical matters, including such statements that relate to leasing trends, lease commitments, commencements and terms, construction, development and redevelopment plans, supply and demand for data center space, targeted cash returns, acquisition activities, capital markets activities and the company's future financial and other results, including the company's 2011 guidance and related assumptions. For a further discussion of the risks and uncertainties related to our business, see the company's annual report on Form 10-K for the year ended December 31, 2010 and subsequent filings with the SEC, including the company's quarterly reports on Form 10-Q. The company disclaims any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Additionally, this call will contain non-GAAP financial information, including funds from operations, or FFO; adjusted funds from operations, or AFFO; core funds from operations; earnings before interest; taxes; depreciation and amortization, or EBITDA; adjusted EBITDA; same-store net operating income, or NOI; and same-store cash NOI. Digital Realty Trust is providing this information as a supplement to information prepared in accordance with Generally Accepted Accounting Principles. Explanations of such non-GAAP items and reconciliations to net income are contained in the company's supplemental operating and financial data package for the second quarter of 2011 furnished to the Securities and Exchange Commission. And this information is available on the company's website at www.digitalrealtytrust.com. Now I'd like to introduce Michael Foust, CEO; and Bill Stein, CFO and Chief Investment Officer. Following management's brief remarks, we will open the call to your questions. To stay within our one hour time limit, questions will be limited to one per caller. If you have additional questions, please feel free to return to the queue. I will now turn the call over to Mike.

[Michael F. Foust:]

Great. Thank you, Pamela. Welcome to the call everyone. My comments today will focus on providing some additional color around our leasing results, including renewals and pricing trends, as well as our recent acquisitions and construction activity. I'll also provide our view of the supply and demand fundamentals, including absorption rates for New Jersey and Santa Clara markets. Following my remarks, I'll turn the call over to Bill, who will discuss our recent financial performance, provide an update on our capital markets activity and 2011 guidance. As reported in our leasing results for the quarter, this was the second best leasing quarter in our history and best since the third quarter of 2008. We continue to see strong demand for our Turn-Key Datacenter solutions across 3 major regions

[A. William Stein:]

Thank you, Mike. Good afternoon, everyone. I will begin by reviewing our year-to-date capital market activities and then briefly discuss our financial performance and revised guidance for the year. Year-to-date, we've raised approximately $615 million of new capital from the following sources

[Operator:]

[Operator Instructions] Your first question comes from the line of Sloan Bohlen of Goldman Sachs.

[Sloan Bohlen:]

Mike, just a quick question for you. Obviously, it's a topic that's come up before about Internet gateway users potentially shifting to owning their own facilities. But a recent article showed that they're also in leasing space from wholesalers, leasing at shorter-term leases. I wonder if, one, that's a trend that you guys are seeing in your own portfolio? And two, if you could maybe kind of frame what percentage of demand outstanding is made up of these Internet gateway users?

[Michael F. Foust:]

Well, if I understand what you're asking about, telecom network providers, colocation, managed services providers, financial services companies, it's a pretty wide range of -- and financial services trading, securities trading, commodity trading, it's a pretty wide range of users that are attracted to the network density and the Internet gateways, so...

[Sloan Bohlen:]

I guess, Mike, I was maybe trying to get more at the Googles and Facebooks of the world.

[Michael F. Foust:]

Oh, those aren't Internet gateway customers for us. Those customers are more standalone and oftentimes in some multi-tenants, but more often in single-tenant facilities. And as has always been the case, those -- I tend to call them Internet enterprise customers, your Microsofts, Googles, Facebooks, they always have and always will rely mostly on their own owned facilities. And that's a trend that hasn't changed in the 7 years we've been public. So it's a good category for us. It's about 10% of our revenues, which has been a pretty stable percentage over the years. But we don't see any change there in our portfolio experience. And we think it will continue to -- that group will continue to be around 10% of our revenues.

[Operator:]

Your next question comes from the line of Michael Bilerman of Citi.

[Emmanuel Korchman:]

It's Manny here with Michael. Just had a question. In Dallas, there's been a significant amount of new development recently, and I was wondering what gives you enough confidence to buy the rest of the Datacenter Park asset?

[Michael F. Foust:]

Well, we haven't seen much development actually of built-out space in Dallas. So we see a lot more demand than we see supply of built-out space. So by acquiring the minority ownership from our partner, it gives us a lot more operating flexibility to accelerate our building of that site. I mean, we've got 68 acres and over 750,000 feet of structures on the site. In addition, we have pads for build-to-suit. We have a potential for 90 megawatts. So we think this is a great long term -- we've got our Dallas portfolio demand set and supplies set for the next several years there. So it worked out well for us, it worked out well for our partner, because we see a real lack of built-out space in that Dallas market.

[Emmanuel Korchman:]

So what's been your all-in cost with that asset? The yield if you can give it?

[Michael F. Foust:]

We're not giving that detail out of this point.

[Operator:]

Your next question comes from the line of Jordan Sadler of KeyBanc Capital Markets.

[Jordan Sadler:]

My first question is just really regarding the acquisition pipeline. It sounds like things may be a bit more competitive. But maybe 1 or 2 deals may have slipped from the pipeline. Can you maybe just provide a little bit more color around what you're seeing in the market and where you're seeing assets or flow?

[Michael F. Foust:]

Yes. I mean, there's a limited number of properties that are of the quality and tenant-quality -- if you're talking about income-producing properties that are more stabilized.

[Jordan Sadler:]

Yes, income-producing.

[Michael F. Foust:]

Yes, yes. So there's just -- it's a relatively small universe, though, as I mentioned, we're tracking and engaging on about $200 million and $300 million of income properties today. And in addition, we're seeing a lot more activity on the build-to-suits. And for us, that's a really interesting way that we can effectively make income-producing investments, utilizing our acquisition and development capability. And we think that's going to bear some really interesting fruit for us going forward. And we're engaged on about $300 million of build-to-suit opportunities right now that we've got under consideration.

[Jordan Sadler:]

And markets, is it domestic or European? The acquisitions and the build-to-suits?

[Michael F. Foust:]

It's mostly -- for the income properties and build-to-suits right now, it's mostly domestic. Though internationally, there's always a couple of portfolios that are out there that may or may not be opportunities that we continue to monitor. But that's not part of that $200 million, $300 million.

[Jordan Sadler:]

Okay, that's helpful. And Bill, just real quick, on the debt strategy here, I see you seeing prepaying and reducing some of this secured debt. But at the same time, the line of credit is being utilized increasingly. What are sort of your thoughts strategically here? Is the unsecured market looking attractive to you guys here or what?

[A. William Stein:]

Well, it's definitely in unsecured market. Tenure treasuries are under 3%, it's a pretty good benchmark. And so I think that you could see us coming into the bond market once things stabilize in Washington. We might also consider a potential preferred, which should be more of a retail product.

[Operator:]

Your next question comes from the line of Rob Stevenson of Macquarie.

[Robert Stevenson:]

Mike, can you just talk a little bit about the sort of trend on leasing? I mean, you talked earlier on the pricing. It seems very stable, and that was very helpful. Can you talk about what you're seeing today in terms of tenant's desire on the length of lease? And then also, sort of what percentage of your leases are now phasing in over an extended period of time?

[Michael F. Foust:]

Sure, yes. If you look kind of quarter-to-quarter, pricing has maintained very stable overall and at good levels, good strong returns, as I mentioned. So we're very satisfied with them, and I think because of the quality of our product and our ability to perform, were able to sometimes achieve somewhat of a premium in the marketplace. Lease lengths tend to be, for the data center space, we are averaging over 8 years lease terms, and I think that's been pretty steady, 7 years to 8 years, for our kind of average, weighted average lease terms. So that seems to be very consistent. We expect build-to-suits will be probably more in the 10 years to 15 years range. And so as those start to execute, we'll be lengthening those a little bit.

[Robert Stevenson:]

And then on percentage of leases that are sort of phasing in over extended period of time?

[Michael F. Foust:]

Well, I wouldn't say extended. Most leases -- customers usually have a couple of months of ramp-up. And it will vary from tenant-to-tenant, lease-to-lease. And sometimes, there might be a ramp-up based on our delivery of a space as well, where lease commencements will be upon completing different phases of Turn-Key space.

[Robert Stevenson:]

Okay, but you're not seeing the need to write down the phase stuff in over 9-, 12-, even 18-month periods?

[Michael F. Foust:]

No. Usually not that extended a period, no.

[Operator:]

Your next question comes from line of Jamie Feldman of Bank of America.

[James C. Feldman:]

I was hoping you guys could discuss the recent government announcement of shutting down a bunch of data centers and kind of what you think the impact will be on the competitive landscape and then what you think the impact will be on DLR specifically?

[Michael F. Foust:]

Sure. Our initial sense is it's not going to have very much of an effect at all, positive or negative. I think it's more likely to be a positive effect because if the government is going to consolidate, then there could be a need to consolidate -- as we see in the corporate world, you need new facilities into which to consolidate. From looking at the preliminarily list -- I mean, they made this announcement about a year ago as well. It's kind of the second time around for this announcement. And from some of the additional comments that have been made, it sounds like a lot of these data centers are very small. 2,000, 3,000 feet embedded in office buildings or other facilities that aren't acquisition opportunities, and they aren't additional demand or additional supply, I should say, putting in place in the market. So it remains to be seen as GSA and DOD and NSA and some of these other department start kind of bringing out these facilities. Some of them -- I would guess that the great majority will never see the light of day to the broader market, because they're embedded in already operating facilities.

[James C. Feldman:]

And then in terms of the opportunities set for you or your competitors?

[Michael F. Foust:]

It's unknown. It's unknown.

[Operator:]

Your next question comes from line of John Stewart of Green Street Advisors.

[John Stewart:]

Mike, I was wondering, how much of the 16 megawatts of net absorption in New Jersey have you guys captured?

[Michael F. Foust:]

Oh gosh. Oh let me think. I know it's probably close to 100,000 feet roughly. And let's see, it's probably between 10 megawatts, 11 megawatts.

[John Stewart:]

Okay. And with respect to the competitive pricing environment for income properties, what are you seeing on pricing, particularly on properties that you are -- can't make work, they're are going to somebody else?

[Michael F. Foust:]

Where we've lost business lately, it's really been for a lack of supply in our part, rather than pricing.

[John Stewart:]

I'm sorry, I was referring to the acquisition pipeline.

[Michael F. Foust:]

Oh, I'm sorry. So you're asking if deals have gone away from us on the pricing basis?

[John Stewart:]

Right. What are you seeing?

[Michael F. Foust:]

There have been a couple that have dropped either into low 7s cap rates or mid-7s cap rates. And then we've got -- our capital allocation model, it's more fruitful not to dip that low. But I think we'll see a number of opportunities that are kind of more in the 8s or 9s, depending on tenant mix and location and build-out. But yes, for us, on a couple of these deals, when they dip that low, it's better for us to maintain our discipline.

[John Stewart:]

Sure. Well, what markets would those be in, and who is buying in the 7s?

[Michael F. Foust:]

Private REITs primarily, looking for return, looking for cash flow or even at prices that we might consider 2x replacement costs. We've seen a couple deals in Texas markets like that.

[Operator:]

Your next question comes from line of Suzanne Kim of Crédit Suisse.

[Suzanne Kim:]

Just calling about the -- you had a 24% retention for the Turn-Key properties. Where do tenants go if -- you can only retain 24%. Do they go and build their own facilities? Or they go into competitive product?

[Michael F. Foust:]

No, no. We had 94%. 94%.

[Suzanne Kim:]

Oh, I apologize.

[Michael F. Foust:]

Yes, sorry.

[Suzanne Kim:]

Yes, it's okay. And then the other question I had was in construction management costs. You talked about that 59% was unallocated in the second quarter. So I'm just trying to think of a good run rate in, like, in terms of modeling, construction management revenue and expenses going forward?

[Michael F. Foust:]

Oh, It's going to vary widely from project-to-project. And I think in the particular case that Bill was referring to, a lot of our cost were upfront, so the revenues coming in will be largely cash flow to us, because our costs were incurred upfront. But it's going to vary so widely by project-by-project and geography-to-geography. I would hesitate to try to give you a rule of thumb on that.

[A. William Stein:]

Yes, that's really lumpy income.

[Operator:]

Your next question comes from the line of Bill Crow of Raymond James.

[William A. Crow:]

A couple of questions. Any update on the government consolidation efforts in Australia and where your bid stands and maybe the timing of an announcement?

[Michael F. Foust:]

Yes, there are -- the near term initiative is the state of New South Wales, and they've extended their decision-making timeframe by about another 6 months. We're hoping that they'll make a decision sooner than that. We are one of 2 finalists for that requirement. That would be in Sydney and then on a university campus north of Sydney. So we are hopeful, but we're not counting on it. So we're moving ahead with the first phase of the Erskine Park project regardless and planning on that to be multi-tenant, the first phase, if we're not successful on the government. Though if we are, then we'll start the second phase straightaway to meet the multi-tenant demand that we are seeing in the market.

[William A. Crow:]

Can you just remind me of the scope of that consolidation effort?

[Michael F. Foust:]

We would be -- it would take the entire phase-in over the entire 100,000-foot first phase. And then a smaller requirement on the university campus north of there.

[William A. Crow:]

Then the second question is we recognize the redevelopment platform is a large driver of your same-store growth. Help us understand what the delivers are going to look like in 2012 versus 2011, so we can think about where same-store growth could potentially be?

[Michael F. Foust:]

That's a really good question. We haven't published that information yet, and we probably will not kind of put that out there until later this year. No, probably with the third quarter call. But I would say -- my sense is that it's probably going to be at fairly similar, the same level of construction delivery as we're seeing this year.

[Operator:]

Your next question comes from line of Vincent Chao of Deutsche Bank.

[Vincent Chao:]

Just another follow-up on the acquisition pipeline of income-producing. Can you give us a sense of how many projects that entails, just so we can get a sense of the size of the deals you're looking at?

[Michael F. Foust:]

I'd rather not talk about that at this point, because we're in various stages of discussions. But I would say, a typical deal would be in the $50 million range.

[Vincent Chao:]

And then just trying to get a better understanding too of how you're thinking about deployment between development properties versus acquisition and income. It sounds like the income-producing maybe is dropping off a little bit as pricing gets more competitive. Do you look at the development projects completely separately? Or is it sort of bouncing the entire pie?

[Michael F. Foust:]

I tend to think of the build-to-suits and the income investments as kind of part of one category. Because we're -- it's not the spec development that our construction program, development program is focused on. And if you look at combination, we've got $500 million to $600 million of offered active opportunities, combining the build-to-suits and the income properties. And then we'll complete about $550 million of construction this year we're planning in that range. That's more our spec development, ground-up, as well as redeveloping from our redevelopment inventory. So as I tend to -- I put the build-to-suits, because they income-producing upon completion, in a similar category as the income producing properties. And the returns are similar as well.

[Vincent Chao:]

Okay. So I mean, if it's say, if the income-producing opportunity set includes the build-to-suits, it was looking even more robust than it is, it wouldn't have had any impact on your decision to go forward with the other development properties that you've been buying?

[Michael F. Foust:]

No, no. Not at all. Because on our more kind of spec development, that $500 million, $550 million of construction. That's really delivering product where we're seeing demand in these various markets that we're active in.

[Operator:]

Your next question comes from line of Todd Weller of Stifel, Nicolaus.

[Todd C. Weller:]

I have 2 questions. The first question is in Northern Virginia. Equinix appears to be marketing larger business suites, and they seem more akin to wholesale offering versus colo in their DC data center, which is leased from Digital. So I wanted to get your thoughts on this. Also, kind of latest thoughts on wholesale colo convergence and how you think about the potential dynamics where existing tenants could become more competitive with you guys?

[Michael F. Foust:]

Yes. That's a good question, and it's really not a new phenomenon. For folks like Equinix, they have a lot of customers that continue to grow and expand and grow in their facilities in the larger customers. And so you're going to get overlapped, and sometimes we'll have customers in some of our smaller footprint requirements that they're more, kind of, smaller footprint colo types as well, though the great majority of our focus is on the larger footprint customers, and the great majority of somebody like Equinix is on the smaller footprint customers that need more hands-on and network services. So the dividing line oftentimes is more kind of what level of additional services does the tenant require, and how much hands-on requirements or network requirements do they require. And are they an existing customers as well?

[Todd C. Weller:]

And then the second question is on the Silicon Valley market. If we rewind 2 quarters ago, a lot of concern around that market. I think you guys were pretty cautious and saying, "Look, we have some capacity, we'll lease it up and see how things shake out." It does feel like there's been a fare amount of healthy activity in that market, and it seems like you're a bit less cautious on that market. Is that the right read?

[Michael F. Foust:]

You could say that. I mean, we're confident on the market, we're confident on the demand. There's certainly a lot of products come online, over the last quarter even, that had been under construction obviously for the past year. And we have been more cautious about bringing on a lot of Turn-Key space. In retrospect, we probably should have been more aggressive. And we'll maintain a reasonable pace of deliveries, because we are seeing demand grow. What's interesting about Silicon Valley is that new demand comes out of nowhere. And you'll see very large requirements from a lot of the technology companies, social networking, software services providers, and their businesses are growing so quickly that, that demand builds pretty rapidly in that market. So we think, while there's a lot of supply, it will get absorbed in an orderly fashion.

[Operator:]

Your next question comes from line of Dave Rodgers of RBC Capital Markets.

[David Rodgers:]

Mike, can you update us on Savvis' activities in the market, I guess, since their merger? And have you been able to continue to do deals with them?

[Michael F. Foust:]

Yes. As you know, now that Savvis is part of CTL, as we've seen in the press, the Savvis organization and management team is taking the lead for the data center business in CTL broadly. A lot of that was historically from the Qwest side, and Qwest has always been a very large top 5 customer of ours as well. So we continue to be actively engaged with the Savvis management team. They're a great customer of ours. And we're exploring different ways that we can continue to help them to grow. Because they certainly have a very strong growth plan for their portfolio. So I'm confident we'll continue to be -- see us doing more business with the Savvis team.

[David Rodgers:]

Great. And then second question, I know you've never been a huge fan of the Chicago suburbs. It seems like some of the public and private competitors have had more success there recently with cloud applications and other services. Would you look more aggressively to Chicago, given your success in the CBD market, to expand there?

[Michael F. Foust:]

Yes, both for the more CBD, as well as some suburban sites. We're virtually -- I don't know, we might be 100% full or 350 Sirmac [ph] at this point. We do have some space at Printer's Square on Federal Street that's more network-oriented type space. So we're definitely looking at new opportunities to expand in Chicago.

[Operator:]

Your next question comes from line of Chris Lucas of Robert W. Baird.

[Christopher R. Lucas:]

Mike, just a kind of a bigger picture question. Some of the market dynamics you've described suggests that a number of the U.S. markets are just much more mature and in balance right now. And I guess I'm just wondering, as you look out, how you're think about capital allocation in the U.S. relative to Europe and Asia and how your incremental capital spend will look going forward?

[Michael F. Foust:]

Certainly. We're seeing good opportunities in Asia and in Western Europe as well in the markets in which we've been active. So I think, you'll -- I'm confident you'll see more capital allocation in Asia-Pac, certainly because it's a new region for us. And the Singapore project is going extremely well, and we're confident on Sydney and Melbourne, and we're working hard to try to acquire our first opportunity in Hong Kong. So you'll definitely see us allocate more capital internationally on a dollar amount. As a percentage, it's hard to tell right now, because we've got so much great opportunity, development opportunity here in the States with a lot of different markets, Silicon Valley, Phoenix, Northern Virginia, northern New Jersey, Boston, if we find new opportunities in Chicago. So there's just a lot of markets here in the U.S. that are going to continue to keep us busy, but you'll certainly see a greater dollar amount invested in both Asia and Europe.

[Operator:]

Your next question comes from the line of Jon Peterson of Jefferies.

[Jonathan Petersen:]

I guess kind of piggybacking on the last question talking about the Sydney and I guess the Melbourne market as well. I just wanted to get some color on how you see the supply demand characteristics in those markets? Maybe compare them to some of the U.S. markets with, I guess, where do we draw the closest comparisons? And then what do rents look like there compared to other markets in the world?

[Michael F. Foust:]

Sure. I mean, we like both Sydney and Melbourne because they are such major hubs of commerce, finance, technology. And that's where -- that's kind of our first priority when we're look at new markets or deploying capital in existing markets. Is there a lot of commercial activity and growth, and we're certainly seeing them in both of those markets. And what's interesting is that there's very little built-out space available. So for these new requirements that we're pursuing, space has to be built. There's literally no existing space for larger enterprise deployments. There's colocation space for smaller footprint deployments, but there's really existing today very little built-out space. So we see it as a really ripe opportunity for us. I think we'll see returns on our speculative builds, similar to what we're seeing in our North American markets, though lease rates and costs, development costs, are certainly higher in the Australian markets.

[Jonathan Petersen:]

Okay, and then, I guess, looking at -- you guys sent Adobe to the development that you guys have going in Singapore. Do you guys see that as a niche focus for you as you expand to some of the new Asian markets to be able to market to some U.S.-based companies that are expanding internationally? And I guess, on the other side of that, do you find you have a difficult time being an outsider appealing to local tenants?

[Michael F. Foust:]

Yes and no, to the first part and the second part. In terms of international customers, especially existing customers, U.S. multinationals, a lot of our demand in Singapore come from existing relationships and relationships that we have with customers in Silicon Valley and across the U.S. and a lot of existing customers. So that's almost half, probably, of our potential demand for Singapore, are existing customers of ours who are looking to expand, or companies with whom we have banking relationships. Singapore is a very interesting market because it is a hub of international commerce overall. Everything from shipping to finance. So it's a natural for us. And we don't feel any inhibitions or a bit that we're at a disadvantage at all by being an international firm in that market. And I think we have a great presentation and a great reception from international companies and in companies that are domicile in the region. Similarly -- well, actually, Sydney and Melbourne, or the Australian markets in general are different because those markets really are the -- a large amount of domestic, Australia domestic activity. And our reception there has been extremely positive. And we have a very good and, I think, well-deserved reputation internationally because of our platform, our ability to deliver high-end enterprise solutions. And frankly, our financial stability and strength is really what -- pretty widely recognized especially in Asia-Pac. I think at this point, we've come up against our hour time limit. So we're -- we appreciate everyone's focus and good questions today and focus on DLR. And I want to thank our team for continuing to perform in a very extraordinary way. And we're very, very positive about what we see ahead for our data center markets. Thank you very much.

[Operator:]

This concludes today's conference call. You may now disconnect.