QTS Realty Trust, Inc.
Q3 2016 Earnings Call Transcript

Published: 26 Oct 2016

[Operator:]

Welcome to the QTS' Realty Trust Third Quarter Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Stephen Douglas. Please go ahead.

[Stephen Douglas:]

Thank you, Operator. Hello, everyone and welcome to QTS's third quarter 2016 conference call. I'm Stephen Douglas, Head of Investor Relations at QTS and I'm joined here today by our presenters, Chad Williams, our Chairman and Chief Executive Officer; and Bill Schafer, our Chief Financial Officer. We're also joined by additional members of our executive team who will participate in Q&A. Our earnings release and supplemental financial information are posted in the investor relations section of our website at www.QTSdatacenters.com on the investors tab. We also have provided slides and made them available with the webcast and on our website which we hope will make it easier to follow our presentation today. Before we start, let me remind you that some information provided during this call may include forward-looking statements that are based on certain assumptions and are subject to a certain number of risks and uncertainties as described in our SEC filings. And actual future results may vary materially. Forward-looking statements in the press release that we issued yesterday, along with our remarks today, are made as of today and we undertake no duty to update them as actual events unfold. Today's remarks also include certain non-GAAP measures, including FFO, operating FFO, adjusted operating FFO, MRR, return on invested capital, EBITDA and adjusted EBITDA. We refer you to our press release that we issued yesterday and our periodic reports furnished or filed with the SEC for further information regarding our use of these non-GAAP financial measures and a reconciliation of them to our GAAP results. These documents are available on the investor relations page of our website. And now I will turn the call over to Chad.

[Chad Williams:]

Thanks, Stephen. Hello and welcome to QTS's third quarter 2016 earnings call. As you can see from the results we released yesterday, QTS had another solid quarter of strong financial results and leasing performance, enabled by our differentiated service platform and mega scale data centers. On slide 3, our integrated technology services platform is a result of us listening to our customers and developing products with the flexibility and scalability to deliver real solutions to their complex hybrid IT infrastructure requirements. As a result of rapid change and complexity in the enterprise IT stack and the ever-present and growing risk of cyber security breach, enterprise customers are finding it harder and harder to find the skilled IT staff and make the capital investments required to keep pace. QTS can offer these customers a customized and flexible approach to their IT requirements and a focus on high-end security and compliance, delivered through our premium service support staff. In addition, by offering these services on top of our world-class mega scale data center infrastructure that we own and manage, we're able to offer our customers a long term visible path for their IT infrastructure, to scale as their business grows. Together, our people, products and mega data infrastructure provide us the opportunity to drive strong customer satisfaction and industry-leading combination of growth and return on invested capital. Next, onto the results on slide 4. For the third quarter 2016, our business continued to produce strong year-over-year growth across key financial metrics. For the third quarter 2016, we achieved revenue of $103.5 million, up 16% over the third quarter a year ago. Adjusted EBITDA of $47.3 million, up 21% year over year. And operating FFO of $37.4 million, up 26% year over year. Operating FFO per share for the third quarter of $0.67 was 10% year over year. Our continued momentum is a supported by our strong booked but not billed backlog of approximately $51 million, as of the end of the third quarter which provides high visibility into our future growth. For the third quarter, we achieved an annualized unlevered return on invested capital of 14.2%, a decline from 15.1% reported in Q2 which we discussed the last quarter as was expected as a result of opening our new Chicago site and a full quarter of ownership for our acquired Piscataway asset. We anticipate our return on invested capital to ramp back up towards our target level of 15%-plus unlevered return on a fully stabilized basis as these facilities ramp In addition, we're excited as we're continue to see strong leasing momentum in our business. During the quarter we saw new and modified leases representing approximately $14.5 million of net incremental annualized rent which is 55% above our prior four quarter average. Moving on to slide 5. In our continued effort to enable investors to better understand the value of our integrated services platform, I'd like to take the next couple of minutes to provide some additional detail on how our services stack in driving our business. I'm going to start by providing an update on our connectivity solutions but also discuss our broader services stack beyond just network solutions. Our fully integrated services, powered by our people, is the core to what differentiates QTS in the marketplace. At QTS from day one, we recognized that robust carrier-neutral connectivity is a crucial component of any data center solution which is why from early on, we have enabled diverse fiber connectivity into our data centers and interconnected each of our facilities leveraging national carriers. From network connections within our facilities to connections within the metropolitan area, to low-latency connections between our data centers, QTS provides access to hundreds of network carriers, making interconnection simple and reliable to support customers' growing data requirements. In addition, because of -- our model supports a broad and diverse customer base and due to the mega data center scale of -- our data centers can support an extensive ecosystem that attracts and enables significant fiber and robust connectivity. In our Atlanta Metro site, as an example, we have approximately 230 customers installed in our 450,000 square foot raised floor facility. Those customers have access over 150 carriers and networks through both direct and indirect dark fiber connectivity. Within just this facility alone, we have more than 2,000 cross-connects, making this site one of the most interconnected ecosystem-rich in the entire Southeast and a critical internet exchange point. Across our entire footprint we have more than 20,000 network connections supporting our customers and infrastructure. This compares to more than 12,000 connections we had at the time of our IPO. Of that total, the number of customer cross connects that can support direct revenue and drive customer ecosystems has grown from 7,000 cross connects at the time of our IPO to over 10,000 cross connects today, representing nearly a 45% growth. The revenue we're generating from this connectivity represents approximately 6% of our total MRR and has been growing annually at more than 15%. Historically, we had only charged a one-time up-front fee to customers for a cross connect. Over the past several quarters we have transitioned to charging for cross connects as a recurring revenue item for new leases and upon customers' contract renewals. This is an ongoing process and while it's off a relatively small revenue base, we do see incremental upside from this approach over time. In addition to our footprint and scale, our breadth of services is also driving our interconnection. As an example, through our disaster recovery as a service product, we're able to support business's continuity plans for customers through a network connection from either their own internal data center to a QTS data center or between QTS sites. As an example of our service stack driving our connectivity story, several quarters ago we introduced our cloud connect product to enhance our hybrid cloud solutions. This product provides a point-to-point private connection between a customer's cloud or our co-location space within a QTS data center directly to a public cloud provider. As we announced last week, QTS is now one of only two data center providers in Chicago to offer AWS Direct Connect in their facility. This is a significant win for our team and even further strengthens and differentiates our offering in a new state-of-the-art data center facility in Chicago. Ultimately, we expect our mega data center in Chicago to develop into one of the most interconnected ecosystem-rich in our portfolio. Next onto slide 6. Key benefits of the interconnection include enhancing value for the customer, driving additional revenue on top of our space and power, in addition to helping lock in and retain customers and providing incremental support to our return on invested capital. We believe all of the same benefits apply to our broader C3 portfolio. And while we remain excited about the growth potential in our connectivity solutions, the value of our integrated technology services platform extends well beyond just connectivity. We talk internally about our ability to sell not just the square feet, but the cubic feet, through our services platform. Our ability to sell C3 services on top of our core colocation space allows us to drive higher efficiencies and utilizations from our data centers while at the same time intersecting our customers in a much deeper and effective way. In addition to connectivity, customers need various managed services to support their infrastructure needs. When a customer does not want to send a tech over to the data center in the middle of the night to reboot a server, we offer 24 by 7 onsite hardware break fix support. For customers concerned about cyber security threats, we offer anti-DDoS monitoring and mitigation services integrated into our network support service to deliver real-time internet threat intelligence. And for those customers that need an active business continuity plan, we offer our disaster recovery as a service product which provides a continuous active replication of the physical or virtual server environments. Through each of these services and many more, that are available through QTS C3 service platform, we provide hybrid solutions that support our customers while enhancing our revenue, increasing our customer retention and supporting above-average returns to our facilities. Currently approximately 60% of our recurring revenue is generated from customers using more than one of our C products which is up from about 40% as of our IPO. The vast majority of this, are C1 and C2 customers using C3 services on top of our space and power. In fact, of our C1 and C2 recurring revenue, more than 50% is generated from customers that are also using C3 which is up from approximately 30% as of our IPO. Our ability to layer services on top of our core C1 and C2 products allow us to generate higher revenue per customer and continue to up-sell into our customer base over time while maximizing capital efficiency. The C3 revenue we're layering on top of our core colocation services effectively increased our C1 and C2 customers' overall data center spend with us by approximately 35% as of this quarter. For our C1 and C2 customers that are using C3 services, this add-on revenue generated approximately $170,000 of incremental annualized C3 revenue per customer. This is more than double the average contribution from C3 as of our IPO. And we have found that once customers start to take some form of services with us, they tend to increase their consumption of our broader portfolio of services over time which provides incremental value for them and increasing growth and returns for us. We expect to continue to build and innovate our services portfolio to drive valuable solutions for our customers and increase efficiencies across our facilities. Moving on to slide 7. I would like to highlight some of the key customer wins during the quarter. Following our official Chicago data center opening during Q3, we're pleased to sign a 3 megawatt C1 deal with a leading global software provider as an anchor tenant in our new facility. This initial lease will ramp gradually through 2017 and into 2018 and includes expansion options to the customer that could triple the footprint over time. Similar to what we're seeing broadly across the software industry, this customer was looking for a partner that could provide capacity quickly and with this ability to expand over time to support rapid growth as their transition to more of a SaaS model has increased their data center needs. This customer chose QTS based on our strategic location of our (technical difficulty) adjacent to downtown Chicago, our ability to quickly deploy capacity and provide a path for future growth at our mega data center and the quality of our on-site operations team. New supply in downtown Chicago has been limited over the past five years, due to difficulty in developing meaningful scale and access to power. We believe our ability to offer customers mega scale capacity in a purpose-filled data center adjacent to downtown Chicago, combined with our services platform and customer service, gives us an opportunity to drive strong success in this market. In addition to this anchor-tenant C1 lease, we have signed numerous smaller C2 deals in Chicago and remain encouraged about our pipeline in this market. One of those C2 deals we signed during the quarter was a new logo for us as a large local institutional investment firm in Chicago. This customer chose QTS based again on our strategic location of our site, quality of our on-site operations team and also the access to connectivity we were able to provide in the facility. This customer contract has a three-year term with multiple renewal options and initially includes 24 cross connects which we expect to grow as they scale up over time. This deal is a great example of the value of our Chicago site being able to offer scale compute power paired with diverse network and latency sensitivity, interconnection access through our lit fiber connectivity. Robust connectivity remains a core part of QTS's integrated services platform and as we've said previously, we continue to expect our Chicago site to represent a great example of our growing tech the story. Shifting to Piscataway, during the quarter we were pleased to sign a 1.1 megawatt C1 lease expansion with one of the existing tenants. This customer will ramp into the new space over the coming quarters, effectively doubling their footprint with the QTS in New Jersey. To have signed up to incremental lease just one quarter into our ownership of the new asset is a strong testament to the efforts of our integration and sales team, as well as the value of this particular customer saw in QTS's broader service offerings that weren't previously available on the site. Having conducted interviews with all the existing tenants in the facility prior to and following our acquisition, we believe and continue to believe, we have strong opportunity to remarket to these customers, as well as to bring in new customers with a broader integrated service offering. In addition, as we've discussed, this property was previously marketed exclusively to large wholesale customers. We continue to believe our higher touch, integrated technology services model is well suited to the New York, New Jersey colo market and that we can drive incremental revenue in the facility. We're currently making the investments necessary in the Piscataway site to allow the facility to support our full suite of products and we expect to be complete and relaunch the Piscataway site early next year. Finally, during the quarter we signed a new C2, C3 public sector customer to a three-year lease in Dulles, Virginia and Phoenix, Arizona data centers. This customer, a federal department focused on the state employment initiatives, was looking to migrate an application to FedRAMP-compliant environment, combining colocation and our cloud solution that would allow it to scale over time. We were able to provision a solution that fit this customer's needs through what is now the QTS government cloud, in addition to a smaller C2 footprint. As we announced several weeks ago, we recently acquired the sole rights to the FedRAMP cloud solution that we jointly developed with VMware. The benefits of having sole rights includes our ability to seamlessly integrate our various offerings and market the product directly through our internal sales channel which we believe will drive higher revenue and increased returns. QTS's continued focus on security and compliance has differentiated us in the market, not only within the federal space but also among enterprises and remains a key source of new business or QTS. Now moving onto our leasing performance on slide 8 for the quarter. As I previously mentioned, we signed new and modified leases representing approximately $14.5 million of net incremental annualized rent, 55% above our prior four quarter average. This includes the 3 megawatt anchor-tenant lease that we signed in Chicago with the leading global software provider that I discussed earlier. Visibility on future our growth remains strong, based on our significant level of booked but not billed backlog of $51 million at the end of third quarter which is up slightly compared to our second quarter ending backlog of $49 million. As we've consistently said in the past, this number will continue to approach a more normalized level over the coming quarters as we deliver on a few larger customer contracts. Churn during the quarter came in at 1.1%, bringing our year-to-date churn to 4.8%. Third quarter pricing from new and modified leases was 10% above our prior four quarter average. C1 pricing per square foot was up more than 50% over our prior four quarter average due to an increased number of relatively smaller C1 deals signed in the quarter and continued positive pricing trends across our markets. Pricing for C2 and C3 new and modified leases was down as compared to our prior four quarter average due to a handful of larger C2 leases signed in the quarter which carry lower per-square-foot pricing based on the larger size. This also drove increased volume in our C2 and C3 leasing. Adjusting for changes in product mix, we believe the overall pricing environment across our footprint remains positive. Regarding renewals on a like-for-like basis where customers renewed contracts without a change in square feet, we experienced renewal rates for the third quarter 2016 reflecting an increase in pricing of approximately 1% above the pre-renewal pricing rates. We continue to expect renewal increases in the low to mid single-digits. Leasing commits to pricing during the quarter was up 22% across our blended product mix compared to our prior four quarter average and was up in both our C1 and C2 and C3 products. Overall, the pricing environment across our footprint remained strong and is consistent with the positive market trends we're seeing. With that, I'll turn it over to Bill Schafer, our Chief Financial Officer, to discuss our financial performance, balance sheet and outlook in more detail. Bill?

[Bill Schafer:]

Thanks, Chad and good morning, everyone. As you can see on slide 10, our adjusted EBITDA margin continues to demonstrate the operating leverage inherent in our model. For the third quarter, we generated an adjusted EBITDA margin of 45.7%. On a year-over-year basis our adjusted EBITDA margin increased 170 basis points. On a sequential basis, our adjusted EBITDA margin declined 50 basis points, driven by a lower seasonal NOI margin and also the full quarter impact of our recently-acquired lower-utilization Piscataway facility. As we experienced in 2015 and have noted in the past, NOI margin tends to drop in Q3, driven primarily by seasonally higher utility costs and then ramp back up in Q4. Turning to development on slide 11, for the third quarter we brought online 14,000 square feet of raised floor in our CHicago mega data center as part of our initial launch. As of the end of the quarter, our total portfolio built-out raised-floor was nearly 1.3 million square feet which represents just over half of the total powered shell raised-floor capacity of 2.3 million square feet in our existing facilities, not including land that we own adjacent to our mega data centers. This capacity continues to provide us with enhanced visibility into our future growth at a known lower-cost and lower-risk profile. We continue to anticipate bringing online additional capacity in Dallas and Atlanta over the course of 2016, consistent with the development plan we disclosed last quarter. Moving to slide 12, I will review our resulting balance sheet and liquidity position. Our total debt outstanding, including capital leases, as of September 30, 2016, was $874 million. Our third quarter ending net debt to annualized adjusted EBITDA, was approximately 4.6 times. We expect our leverage will increase in the coming quarters as we deliver on our development pipeline. We have significant liquidity capacity in our balance sheet. At the end of the quarter we had a total of approximately $380 million in liquidity in the business, made up of availability under our credit facility and cash on hand. We remain pleased with the strength of our balance sheet position, including attractive interest rates, no near term debt maturities, minimal secured debt and significant available liquidity. Finally, on slide 13, for full-year 2016, we continue to expect core organic revenue growth in the mid teens and have lowered our annual churn expectation to a range of 5% to 7% from 5% to 8%, factoring in our better-than-initially projected year-to-date performance. We also expect cash capital expenditures of approximately $300 million. We're raising the bottom end of our adjusted EBITDA guidance by $2 million to a range of $180 million to $187 million. We're also raising our OFFO guidance range to $139 million to $143 million. As a result of our updated OFFO guidance and updated estimate of our full-year share count, we're raising our OFFO per share guidance to a range of $2.57 per share to $2.65 per share. Our 2016 OFFO guidance includes an estimated non-cash tax benefit of approximately $7 million. In Q3 our reported OFFO included a $3.1 million non-cash tax benefit. We expect this tax benefit to decline significantly in Q4 and as a result, we anticipate a quarter-over quarter decrease in our OFFO and OFFO per share, driven purely off this reduction in non-cash tax benefit. I would now like to spend a few minutes to provide some initial color on our expectations for 2017. For 2017, as a result of a full-year ownership of lower-utilization sites like the Piscataway and Chicago, we anticipate our overall NOI margin to decline year over year. However, as a result of continued operating leverage in our business, we expect our G&A intensity, as a percentage of revenue, to also decline. We expect the net impact will drive our adjusted EBITDA margin in 2017 in line with our margin in 2016. In addition, we continue to expect our adjusted EBITDA margin to approach approximately 47% over the next few years. For 2017, we continue to expect revenue growth for our core business in the mid teens. However, we also now anticipate a one-time customer loss expected at the beginning of the year at one of our leased Northern Virginia facilities. The C2 customer and IT services company which represents approximately $10 million of annualized rent, has a lease that expires in early Q1 of 2017. This customer had previously contacted for C2 space in one of our facilities in anticipation of one of their government customers renewing a key government contract. This government program ultimately was not refunded and as a result we do not expect this IT services customer to renew its contract. This customer loss, combined with the previously disclosed and expected loss of a customer in our Piscataway facility, will reduce our 2017 revenue by approximately $12 million. Even with this one-time revenue impact, we continue to expect our annual churn for the year to be in line with our historical target range of 5% to 8%. However, due to the front-end-loaded timing of these particular events, 2017 revenue growth will be affected by nearly the full-year impact of this churn. I point out that for the remaining top 10 customers, they all have meaningful term left on their contracts and/or are deeply invested in our platform and growing across multiple sites. I'd also like to note that while we don't like to lose revenue, this customer is currently the sole tenant in a leased facility in Northern Virginia. We will look to release this facility as soon as possible but we'll also have the opportunity, as part of our customer migration initiative, to exit this facility and reduce our ongoing operating expenses in future years and continue to migrate to wholly-owned facilities. This will continue to support our business strategy of moving from non-core leased assets to driving value in our core strategic assets. Overall, we remain pleased with our financial results. We're excited about the incremental growth opportunities from the investments we're making and we believe we have positioned our balance sheet and liquidity to support continued future performance. With that, I will turn it back over to you, Chad.

[Chad Williams:]

Thanks, Bill. The third quarter performance demonstrates the strong momentum we're seeing in our business. We continue to execute with our differentiated business model and I'm pleased with the success we're having in the marketplace. Our ongoing conversations with current and potential customers reinforces our view that a focus on premium customer service, wrapped around our integrated technology services platform, is the right approach and something that customers value. As the enterprise customers of today and tomorrow increasingly move towards hybrid architectures integrated into their data center needs, we believe QTS is well-positioned to drive valuable solutions to their complex IT infrastructure requirements. In addition, the reception from the market to our newest expansions in Chicago and Piscataway have been encouraging and we're confident as ever that these assets will prove to be strong additional drivers of future growth for our business. Finally, I want to thank our customers and shareholders for their continued trust and confidence in QTS. In addition, I'd like to recognize and thank our dedicated QTS employees whose hard work and commitment make QTS's success possible. Now I'd like to open up the call to questions. Operator?

[Operator:]

[Operator Instructions]. The first question Jonathan Atkin of RBC. Please go ahead.

[Jonathan Atkin:]

So I was curious about the cross connect switches which was prominently mentioned in the scripts and wondered over time, what kind of percentage of revenues would you anticipate reaching from the current cross connects and then I was interested in the rent generation, the increases that we saw during the quarter in Piscataway, Richmond and Dallas and was that mainly C1 or C2, presumably a lot of that would've been the commencement of the backlog from earlier sites C1 business maybe just a little bit more color about each of those properties in the increases that you saw in the MRR.

[Chad Williams:]

Hey, John, this is Chad. Thanks for both questions. Dan Bennewitz is here and I'm going to have him take on a couple of these revenue questions. But I'd say just from a philosophy on cross connects, I think one thing that we're trying to do a better job on is communicating around the interconnections story and platform at QTS, you know, we really believed in have that infrastructure since the beginning, but as you heard in our call this morning, we're thinking about that from our cloud and managed service and connectivity bucket or our C3 bucket even more strongly especially with the announcement with one of the two AWS pops now in our Chicago facility. And you are going to hear us talk about that and start to be more clear about kind of the strategy around that because it's been a core of who we're delivering services when services company's deliver services, there is no platform without world class interconnection and the ability for us to drive that with our staff and people in process, but I will let Dan speak a little bit more about the direct revenue expectations and then take on the C1, C2, C3 Dallas [ph] question.

[Dan Bennewitz:]

You heard Chad talk about the importance of cross connects and we think that’s important and you heard the metrics there. We think it's part of the story, the overall story is the portfolio of services that we offer to customers, cross connects are a piece of that and we think that those services from managed services to multiple different types of connectivity including cloud connect, obviously we're very excited about the Amazon direct connect in our Chicago data center. All those combined to have a wide portfolio services that our customers take advantage of that in the more they do that the stickier they are, more value that they can provide to them and obviously, it ends up in the revenue. For the second question, could you repeat the second part of your question?

[Jonathan Atkin:]

Yes. There were some increases in you know, basically rent generation in Dallas and in Piscataway and in Richmond and I'm assuming a lot of that just given the magnitude would've been C1. But if you could give us a little bit of a sense as to what the incremental activity was in terms of the commencement revenues in those three sites.

[Dan Bennewitz:]

Yes, so let's take a site by site. So the Piscataway is obviously a C1 client an existing client that is expanding with us and Chad referenced the win, we're excited with them expanding with us. It shows, I think the confidence that they have an us as a provider as well as you know, they're very interested in taking advantage of more of the services we offer in there. And in Dallas and even Chicago I think we saw a balanced growth across both C1 and then C2 and C3. Both of those are --obviously Chicago is a new market. We talked about the anchor client there. In Dallas we continue to see our core customers for their continuing to expand as well as landing new logos in both the C2 and C3 markets. And, in Richmond we continued to see growth there. I think what's exciting to us is Richmond and now we have Dallas as a data center combined to offer a nice combination to customers both in the commercial space as well as the federal space to offer a broader set of portfolio if they need to be up in the Northern Virginia area we have an option for them. Let's say, can be in Richmond and there are some advantages to be in Richmond, that is attractive to them as well and we see that continuing to hold up particularly with the customer that we talked about taking advantage of our QTS government cloud which is the VMWare government cloud solution that we acquired during the quarter and that's an example where we our [indiscernible] both that QTS government cloud with a co-location environment and it plays in this hybrid IT environment. So, we're very pleased with the balanced growth. It's not just if you will one cylinder firing, we're seeing balanced growth across the portfolio.

[Jonathan Atkin:]

And, then maybe if I could just ask about Chicago in the central point situation and obviously that's got a couple of years left before that commences but just wondering how you think about that development you probably looked at it in the past and any kind of comments from where you said and then lastly, shifting to the West Coast, I did notice the NOI contribution dollars declined in both Sacramento and Santa Clara and wondering what the factors were there that are driving that?

[Chad Williams:]

Okay. Jonathan, this is Chad. I will take on Chicago. I love our site, is my answer. I do know there's been a lot of speculation around a building, coming out of the ground I think one thing that we appreciate is with our 30 acres of site and infrastructure and really open data center facility it will be a lot of demand in the areas so I think we feel really good about the opportunities for us to get off one thing that I find kind of humorous when I left there at the Chicago site, how so many people say we can park at your data center and of course on 30 acres we do have some parking left, although Jim likes build every square inch of it in data center if possible but we’re going to leave parking, it's a great site, great security, great infrastructure and that's why I think we like ours and if and when, they get a chance to build something, it won't be quick and it won't be easy, it is a challenging area to develop, but I'm sure that they will be fine.

[Bill Schafer:]

Yes and with regard to your questions on the NOI, at Santa Clara and Sacramento, Sacramento was down slightly. There's probably about 100,000 that’s related to utilities and actually in the second quarter of this year, there was a tax refund from prior years was a couple hundred thousand dollars that came through. So it was probably a little bit higher in Q2 historically. With regard to Santa Clara, we had a customer, when we opened our initial, second building out of Santa Clara, over five years ago, we had a C1 customer that took that space and our inventory levels in Santa Clara, have been historically constrained, that was -- one customer was a rather low rate that we were not willing to renew at. And because of our inventory limitations and so forth, on that contract it came up at the end of Q2 of this year, we elected not to move forward with the renewal and basically, so you're seeing some of the initial impacts of that just in Q3 and I think you know, we have already have had positive activity within the Santa Clara market with regard to that space.

[Dan Bennewitz:]

And just to add to that, we have seen very positive bookings in the quarter here. So expect to quickly fill that up at a much more attractive dollars per square foot than we have in the prior claim.

[Bill Schafer:]

Yes, evidence of that just briefly in general, for the business in Q3 it tends to be a heavy utilities quarter. So overall, you’re going to see NOI impacted by the cost of utilities and you’re going to see margins get hit at an NOI basis based on Q3 and that's going to happen at a seasonal basis every year. If you look at the property table what you'll see is the MRR coming out of our Chicago facilities is up. So the revenue is growing it's just a cyclical utility costs

[Operator:]

The next question is from Jordan Sadler of KeyBanc. Please go ahead.

[Jordan Sadler:]

If you could back up and maybe just give us a sense of where we sit today, in terms of the demand funnel, as you look at it, maybe for Dan Bennewitz, I'm looking at the leasing activity in the quarter, noticing you know, a nice bump up from the 2Q level which it was a nice bump up from the prior fourth quarter level and so, I'm just curious about the sustainability of the activity we've seen in the last couple of quarters.

[Chad Williams:]

This is Chad. I'm going to let Dan take this, but I want to just say something from Dan's earlier comments that I think is very relative is that we feel and since demand in the market but what we love about what we're doing is that there's a balance demand across our portfolio not just in multiple sites but in multiple products and, I still think that the longest and best way for us to create value for our shareholders and to be good stewards of capital is to find a way to continue to challenge ourselves to balance and fill our facility but also balance our products and ability to drive above-average returns and diversity of client and to Dan's point, we're seeing that you know, working through the system in a balanced approach and not just relying upon you know, one or two big deals to carry the quarter, that's kind of been one of the strengths I think the last couple of quarters and I will let Dan speak to it directly.

[Dan Bennewitz:]

Yes. I think couple of points, first off, C2 as we talked about the core engine of our business. We're pleased with our performance lately and want to continue that and I think in the C1 space we're pleased with our results here but the other thing I want to stress here is that we want to take a balanced approach to our C1 opportunities. The right clients leveraging the right data center, structures that we have in our mega data centers and where we get the right returns. So we will be I think continue to be disciplined on that, where you are not going to see mega signings every quarter, but we want to be very balanced on that. And the other thing is, if you look at the overall demand of funnel, I would characterize it, we're pleased with the amount of that and what our teams are working and are excited about the future.

[Jordan Sadler:]

Okay. And then, as it relates to the space that was leased in Chicago, during the quarter, what percent of the initial capacity is now leased, it's hard to tell obviously from the supplemental, it says in the footnote, that you’ve got north of $6 million, of revenue or at least rent assigned to this facility now which is great. But how does that correspond with the available initial capacity brought online and then, when you launch the next phase.

[Jeff Berson:]

Jordan, this is Jeff. So the answer is, that there is a long lead time in terms of booking and billing for some larger deals and so in particular, the 3 MW deal that we referenced is going to really ramp over the course of '17 and actually into early '18 as well. So, we have the ability to bring space online as that client ramps, as that customer ramps and use a good portion of the space that’s in service today for additional new customers.

[Chad Williams:]

Yes and one thing that I might mention on this particular client, Jordan is that this client being one that wanted to deploy at a higher density which was great because that you know, out of our -- it took less of our 14,000 square feet because they utilized our high density deployment capabilities. So that was another win for this particular deployment.

[Jordan Sadler:]

Sure. Last quick one if I could sneak it in. Just, the customer that is leaving in Northern Virginia, was this known -- I assume this was a Carpathian [ph] facility, was this known at the original underwriting and, what is the lease expense and ultimately expiration of this lease?

[Chad Williams:]

Yes, so, this is a lease facility. It's a C2 customer, the customer is a federal agency which is not direct through us. It's through an integrator. So our visibility is not with the federal agency direct. You know, from what we heard the program wasn't refunded and determination happens early next year. It will be the conversation among us that you know, do we want to try to retenant the C2 space in Northern Virginia which is obviously a pretty high demand market. We will talk about that with Jim and Dan and the facilities team. The good thing is, as the underlying lease expires in 2018 with the mobility to expand beyond that if we want to keep it but I think right now it's early and we're going to try to figure out do we want to retenant it and take on some more space in Northern Virginia to support our sales effort in Northern Virginia or make a decision that would be a good opportunity to continue to go to QTS own space and our own Dallas facility and maybe push customers to Richmond. So those conversations are early.

[Operator:]

[Operator Instructions]. The next question is from Paul Morgan of Canaccord. Please go ahead.

[Paul Morgan:]

Let's get the one question and, I guess. Now I have to think just in terms of the know, follow-up on the Northern Virginia situation. I guess the one thing I wanted to get was what was the rent expense for the lease space and if you had to decide now which way do you think you would go with letting it go or expanding?

[Chad Williams:]

Paul, we'll give you a couple of questions. We actually don't mind staying on the phone a little extra this morning since we do have a lot of people in the queue. So I can't think of anything better about this team has to do than answer some great questions. So let me take on this first one. This was about the tenant that’s leaving Northern Virginia. I think it's hard to argue, that Northern Virginia is not one of the warmest markets in the country for space and power. So you know we’re going to take a look at it and it's in a nice facility, it was a C2 cost, it's already deployed with PDUs and power and it's actually designed to a very high level of security and it also has some pretty unique government fiber. So Dan and our federal sales team are kind of doing some evaluations, I just think it's early to kind of determine but as we kind of make some decisions on that [indiscernible] stay connected with but we will let you know. We will be making that evaluation over the next several months and I think if you really go either way at this point, it really could.

[Paul Morgan:]

And then in Chicago it's great to see the momentum there and then in the AWS direct connect as well, what's your initial read based on the tours on where the sweet spots are in terms of both C1, C3, as well as segments of the market in terms that are most interested and most looking for space in that facility.

[Dan Bennewitz:]

Yes, Paul, this is Dan. So I think Chicago we think about it as obviously one of our mega data centers that can handle all of our three Cs, so we see obviously we talked about C1 client, this quarter, we also talked about a customers coming in and leveraging our C2 co-location as well as our managed services, very excited about the network density there, I think you know, I would also like to say we're extremely pleased that we were selected by Amazon to be one of the direct connect sites in Chicago. I think that they did that because of the partnership and the confidence that they have with our company as well as the Chicago site. And it plays in with our view of a hybrid IT. So we think we’re in a hybrid IT world that’s going to be hybrid across wholesale co-location, managed cloud, public cloud, private cloud, this is a hybrid IT environment. So we're very excited that demand profile for Chicago and solutions is going to cover the entire solutions portfolio. So we're very excited about it and mostly because it's going to leverage the breath of our offerings.

[Paul Morgan:]

And then last really quick, any update on New Jersey now that you've owned it for a quarter, what things are looking like there?

[Chad Williams:]

It's been a great asset. I mean it really was one of the finest data center infrastructures in that whole area. I really think and we spoke about it a little bit, I will let Dan add a little color. I think the opportunity for us, that market is a 500KW to kind of 2MW market. People are deploying infrastructure because they need it close to engines that drive financial insurance and all sorts of things obviously, to deploy 20MW, it would be hard not to think about being in a more cost-effective environment from a power standpoint. But I think it's just as a simple our model works, it's a world class asset, it's got tremendous scale and opportunity. It's something that we can easily convert to our product and Jim and the development team are actively working on that and I think we're going to continue to see momentum, I think Dan's team unlocked the great opportunity with a current customer just from the time we opened it and Dan you can add a little color.

[Dan Bennewitz:]

Yes, so we're excited that existing customer decided to double their deployment there, so obviously it's a little confidence and we’re going to relaunch from a C2 solution point of view, you will see that early next year and so we're excited about the emerging opportunity for that. I think that's more 2017 than the fourth quarter.

[Operator:]

The next question is from Simon Flannery of Morgan Stanley. Please go ahead.

[Simon Flannery:]

I wanted to come back to the big hyperscale contract. Can you talk about the returns on those sort of contracts, the length and escalators and is that consistent with returns on the other businesses, how you think about that and there's been a lot of debate in the industry about to what extent this demand is ongoing or is this you mentioned capacity constraints dealing with the growth that they have. Is this something that is more temporary given some of their issues or do you see them adopting more of an outsourcing model and using QTS and others to fulfill some of that demand? Thanks.

[Chad Williams:]

One thing I want to make sure and point out, is our win in Chicago with a C2 type of win really kind of high density but also a smaller C1 type opportunity. So it wasn't what we consider hyperscale. I think hyperscales kind of the new word you know, cloud used to be the new word it really depends on what deal, what market and what you're doing for it. And I think that's why we continue to be encouraged about the opportunities within the larger scale deals but also fairly particular because where we have huge infrastructure or mega data center, where we have the ability to take on large space and power early in an asset to maybe brings ability to that asset while we deploy our C2 and C3 which takes longer periods of time because you're selling in smaller increments, we're absolutely, we absolutely think it's core and a big part of our focus. But we're not out driving because I do think that returns in some places vary to some degree and I think we try to be fairly disciplined around, it's got to be two or three dozen objectives to be focused on that but we continue to be thoughtful and I think we have place within our platform and Dan you may add a few things here

[Dan Bennewitz:]

Yes, this is Dan. I think [indiscernible] the declines of software company, so we're very pleased that they selected us. So for our C1 offerings, as we continue to remain disciplined as Chad talked about, it has to make sense for the client so we go after the right clients with the right data centers and they have to meet the right return profile for us. And we have been pretty disciplined on this and I expect it will continue to be very disciplined going forward.

[Chad Williams:]

I do see that Simon just to your the other part of the question, there is going to be a continued fair amount of demand out there. I do think that it's still rather early and I think that people need access to infrastructure and that's not always easy to find in certain markets where they want to be and I do think that there is going to be good demand for the space and power. I just think that QTS will have more balanced approach but will certainly be relative in that business over time.

[Simon Flannery:]

And on the M&A market Chad, there is a lot of offsets out there, anything of interest to QTS?

[Chad Williams:]

You know, I like to look at our own portfolio and say we can more than double it with our existing foot print with known cost and known execution and I will tell you, we spend the most time looking at the things internal.

[Operator:]

The next question is from Frank Louthan of Raymond James. Please go ahead.

[Frank Louthan:]

Looking at some of the churn that you've got coming up next year, any other customers like the one you know, the Carpathia customers or others that you are aware of that are potential to churn and then can you give us an idea of how much potential CapEx you maybe saving next year with some of this churn that you wouldn’t have to deploy that you can refill?

[Chad Williams:]

You know, you never know when you drive an active business there is always things that happen. People get bought, but type of stuff. So you never know kind of how that works out long term, but I think looking through our list I think this was a unique situation and was limited in a number of factors and you know, I think we feel good about what we have -- I also feel good that we really have stayed within Dan and his team have performed exceptionally well on the churn and impact and are really even with some of this you know, within guidance on kind of our expectation on annual churn and really outperforming that.

[Dan Bennewitz:]

Yes. Frank, this is Dan, just to emphasize Bill Schafer's comments, next year's churn will be in the 5% to 8%. So we are still obviously giving that guidance. The other thing is we feel good about our top client profile, we continue to work with them and continue to grow the number of services in the number of data services. So we feel good about it. And I didn’t say never say never but we -- the guidance we have we feel good about the guidance next year 5% to 8%.

[Frank Louthan:]

And just quickly since maybe you're taking couple more questions. Where do you see cross connect revenue going over the next 12 months and at what point do you think you can disclose cross connect, little bit more color, thanks.

[Dan Bennewitz:]

Yes, I think we disclose you know, this quarter 6%, we think that will continue to grow with the overall platform. Again, I just want to emphasize is the way we think about cross connects they are important but it's a piece of the entire story. And the entire story is around our connectivity and other managed services which we think is much more meaningful. We obviously break that out and the more that we can get sell services to our clients we’re providing more value to them and they become stickier and they grow with us. So I think you know that’s how we think about cross connects and how we think we’re moving forward here.

[Chad Williams:]

And Frank, hopefully you'll see we've given you a lot of data in terms of just how that business both from interconnection, cross connects and broader service deck has improved over the course of the last three years since we went public. And you know, we're enthusiastic that we will continue to see the benefits out of it.

[Operator:]

The next question is from Matt Heinz with Stifel Nicolaus. Please go ahead.

[Matt Heinz:]

Just one on Chicago, it looks like there's another 34,000 square feet finished and maybe 5MWs in the first data hall [ph] in Chicago and it sounds like you’ve some good visibility with the anchor and a strong funnel there. So I'm just wondering why that additional space wasn't shown in the development table as being under construction you know, how quickly can it be brought online and at what sort of incremental cost?

[Chad Williams:]

Matt, it sounds like you’ve been out to the facility.

[Matt Heinz:]

Well, you guys have some great virtual shots in there. So I appreciate that.

[Chad Williams:]

Yes. So Matt, as you know, our approach is to make sure that we can deliver a very capital efficient way. So we feel Chicago is another great asset where we can do that. We're ready to bring on space very quickly with our supply chain. So you know, as orders materialize [indiscernible] we can bring those on inside of a couple months and down to a few weeks depending on the customers' requirements. So we look forward to bringing that on early in the first half of 2017. And feel that overall, the long haul our development cost in Chicago will be slightly north of our average of 7 million megawatts given the higher construction costs etcetera in Chicago. Overall I feel like that asset is well-positioned for us to earn our 15% return on capital.

[Matt Heinz:]

Okay. Just in terms of the first data outlook, do you feel like most of the capital for that space has been spent?

[Chad Williams:]

So, capital for what we put in service obviously has been spent but we have a lot of raised floor that's available for us to them at additional power and additional capital necessary to add that for that additional power and again can do it in very expandable small blocks as necessary.

[Matt Heinz:]

And not a second question but clearly just a follow-up. I appreciate the color that you gave on the 2016 tax benefits, but I'm wondering how much of that benefit we should expect to flow over into 2017 FFO?

[Bill Schafer:]

Yes again, we're in the process of going through our 2017 budget, where we will provide more guidance, you know, with the conjunction with our year-end call. But again it's something we continue to expect to go down as we basically normalized and grow the C3 platform.

[Chad Williams:]

And the other thing to point out, if you look at our non-cash tax estimates for the year and you look at what we had during Q3, it is worth pointing out, that number came in relatively high in Q3 and is going to drop materially in Q4 and those points it will continue to drop into next year. So it is something to be mindful of that from an OFFO per share, we pulled some of the benefit of that non-cash tax from Q4 into Q3, you may the OFFO per share from Q3 to Q4 dip down all because of purely just a pulling up of a non-cash tax. The core business continuing to grow and perform.

[Operator:]

The next question is from Eric Luebchow of Wells Fargo. Please go ahead.

[Eric Luebchow:]

I wanted to ask about the cloud and managed services. I saw that kind of on a sequential basis, there is a tick down for the third straight quarter and kind of those migrations from C3 to C2 or is it more of a timing issue and what can we expect in the coming quarters?

[Dan Bennewitz:]

This is Dan. I think a couple of points I want to put up there, if you look at the supplemental in the annualized C3 MRI you will see an uptick 2Q to 3Q. So we feel good about that on the reflexive bookings that we had during the quarter. And, the actual MRR realized in fact some of the things that you mentioned that happened earlier in the quarter. So, we feel good about C3 returning to growth and supported by the bookings and then as you saw you will see in the supplemental data where the annualized MRR went from $62.4 million versus $61.5 million in the second quarter.

[Chad Williams:]

And Eric I might add, this is Chad, I do think and we continue as a team to feel like it's a win even when somebody takes or moves from one product to the other product. So instead of having the conversation around they are leaving QTS, if we can keep that conversation where somebody grew up and needed to move into you know, say C3 to C2 for us we consider that still a win. But it is something that you know, it is something that happens within our platform because, quite frankly customers just have choices for the solutions that they need to drive their business and I think that's a good thing for the customer and for us. Thank you.

[Operator:]

The next question is from Richard Choe of JPMorgan. Please go ahead.

[Richard Choe:]

I will keep it to one question. With a $12 million in churn and the C1 deal in Chicago coming in through '17 and then in early '18, it seems like there's a decent headwinds for next year but you reiterated, your midteens guidance, can you give us a little bit more color on why you feel confident that you would still reach that mid-teens guidance for next year?

[Jeff Berson:]

Yes. Sure. This is Jeff. I would say, the core business at midteens which we feel very good about you know, we're not thrilled about the $12 million that comes out from the customer churn that will come out of that guidance. But the core business still growing in that midteens and that's happening off of a much larger basis frankly today than we had a year ago and a much larger base than we had two years ago. So we're happy that given the incremental facilities we're driving more revenue out of that, we’re maintaining the right core growth metrics across a broader footprint. And, we feel good about that. That mid-teen growth when you pull out the 12 million that gives you about 300 basis points of growth pressure. So pro forma for that one-time customer leaving that midteens growth next year is going to be hit by that 3%, but again, the core business still supporting the overall growth that we have and that we have show in the past.

[Operator:]

And next we have a follow-up from Jordan Sadler of KeyBanc. Please go ahead.

[Jordan Sadler:]

So, my question really is market oriented, you had kind of had some early success in Chicago and of course, you discussed some success in Piscataway already as well. I'm curious on your appetite you know, for incremental market additions as we look into 2017.

[Chad Williams:]

You know, I wake up every day thinking about the ability to double our platform with our existing footprint. Did I say that earlier? You know, Jordan, we will stay opportunistic and look at things you know, I think Piscataway that we're was a great asset addition for us in the platform. We did not really you know, we just felt like it connected on a lot of different levels. I think we're really excited about Chicago filling in that gap. You know, we do as a leadership team, need to think about how do we build QTS into a stronger, larger platform but, I think the best discipline is we just have a lot of abilities and a lot of levers within the platform today that allows us to grow and I think the best opportunity to stay disciplined is to not have to go do something and I really do feel like this team does not wake up every day feeling like we've got to go do something to ensure success. We've got a lot of levers, we got to stay disciplined about how we operate the business, how we build the sales and operations and customer centric focus in multiple products and that gives us a lot to focus on but when opportunities do present themselves, we have a proficient M&A group led by Jeff Berson and the team and they continue to build capacities to look at things and do things and are very good stewards of making sure that we understand what's going on in the market but also understand how that affects and drives what we do internally. So, we're just excited about the opportunity growth for that we have. We really are pick

[Jordan Sadler:]

And then, I'm just trying to get my arms around a little bit the ability to backfill the churn in customer and what the timing was like again. I didn't hear the move out date if you could provide any specifics that would be helpful. And then, how would you sort of characterize the ability to backfill that customer, I guess you'd have to balance it against the rent that you’re being paid and whether or not there's a sort of a profitability or profit opportunity there.

[Chad Williams:]

Yes, so here's a couple of things, essentially you might say the space would be given back by the end of the first quarter next year and it was deployed really as a C2 customer, it's about 15,000 square feet a space roughly and from that standpoint, you could kind of characterize it as its kind of a C1 lease that had a C2 customer in it. So you can kind of grapple from there that there is an opportunity to do something. I mean I think, like I said earlier, there's uniqueness about the space because of the security standards it was built to because there was a federal agency operating in there and there's some pretty unique fiber assets in there. So I think Dan and the federal sales team within QTS are kind of having some conversations, but this is a little bit of a gut check on -- this a leased facility. Do we have control of the space with some options for a longer period of time, yes. But it's not necessarily our exact business model to go lease somebody's building and then put a client and it, but we do have partners and where it makes sense to take some space and have the ability to put C2 and C3 in it and build a profitable revenue center then we will consider that and I will just, I think it's a little bit early right now but we will look forward to kind of keeping you posted on it and Dan I don't know if you have anything to add to that but that’s kind of the way we're looking at it.

[Jordan Sadler:]

What are the terms of the option that you have, is it a fair market value option on your lease?

[Chad Williams:]

I would characterize it as, we would know what the expenses would be going forward within terms of the options and I would characterize the option as kind of a multi-quarter multiyear option. And, I don't have that document in front of me. So I don't want to get too far out in front of my skis on that but we're considering, it is in one of the best markets in the country arguably. And, I think that's what's making it a little more -- if this was a second tier market, we would probably be telling you, that it's just a good way to get rid of the leased facility and move on, but this is a great market and we want to spend some time thinking about it. Thanks for the questions and look forward to following up.

[Operator:]

This concludes the question-and-answer session. I would like to turn the conference back over to Chad Williams for closing remarks.

[Chad Williams:]

Well, thanks for being patient with us. I know we had a lot of the people in the queue. Look forward to following up with anything that people didn't get a chance to ask. It was our honor and opportunity to continue to be able to talk with all of you about the business. We're excited about the quarter, excited about the future and also appreciate all the work that goes into it. I want to thank all the QTSers around the country that make it happen. So thank you customers, thank you shareholders and we look forward to talking to you next quarter. Thank you.

[Operator:]

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.