Digital Realty Trust, Inc. (NYSE:DLR.PK) Cowen 8th Annual Communications Infrastructure Summit Conference August 9, 2022 1:10 PM ET
Company Participants
Bill Stein – CEO
Conference Call Participants
Michael Elias – Cowen
Michael Elias
All right. Well, good morning, everyone, and welcome to Cowen’s Eighth Annual Communications Infrastructure Summit. My name is Michael Elias, and I’m the data center and content delivery network analyst here at Cowen.
For this meeting, we have Digital Realty and from Digital Realty, we have the CEO, Bill Stein. This session is structured as a fireside chat, which will run for about 35 minutes. I’ve prepared to list of questions, but I’ll do my best to pause at the end to take any questions from the audience.
So with that, Bill, thank you so much for being here.
Bill Stein
Michael, thanks for having us. It’s great to be here. You guys put on a wonderful conference.
Question-and-Answer Session
Q – Michael Elias
Thank you. So let’s keep things off and talk about the demand picture. Starting off with that, the management highlighted a record pipeline across multiple customer verticals in the second quarter earnings call. Specific to hyperscale demand, though, could you talk a little bit about how the demand profile of these customers has changed since this time last year.
Bill Stein
Well, you’re right. I mean the hyperscale demand has been tremendous. It’s 50% higher right now than it was this time last year. And it’s very broad-based. It’s broad-based in terms of geography and industry group. So we’re obviously very pleased with that. We’ve seen — historically, we’ve seen a lot of demand out of the flat markets in Europe. Now it’s spread into similar markets in Europe. So North America is the same. There was a report out recently that showed that vacancy in North America was, I think, about 4% or 4.4%.
So these markets are getting very tight.
Michael Elias
Tightening strong demand amid still difficult to supply. It’s challenging to bring supply online. At the end of last year, we saw Facebook or now Meta, come to market in a big way, which drove demand across multiple U.S. markets. Could you give us a sense for the subset of hyperscalers that are active in the market or that have been active in the market since the beginning of the year as we contextualize this rise in demand?
Bill Stein
Well, frankly, they all have been. In different markets for different hyperscalers and some newer players, who had been active a few years back, have come back again in size. So we’re seeing a tremendous amount of demand across the CSPs, the content providers. It’s just there’s, frankly, almost call it a, tsunami of demand. I’ve been talking to some of our competitors — at your cocktail party last night, and our experience is hardly unique. I think the — in some ways, the challenge is keeping up with the demand.
Michael Elias
Yes. So I don’t want to put words in your mouth, but I imagine Digital Realty wants to win more than its fair share of deals as you operate in the market. What, in your view, differentiates Digital Realty? And what can you provide the hyperscalers that’s unique to you that those competitors at cocktail party yesterday can’t provide?
Bill Stein
Well, look, obviously, we have a global platform, we have a full spectrum of products. And we just have resources that the smaller privately capitalized firms don’t have. But I want to emphasize that our goal is not to win every deal. We actually are fairly selective in terms of the deals we want to — we go after and want to win. It’s important that they fit our communities of interest, if you will. That they are would be a magnet for the enterprise customers that we want to attract to our business as well.
Our goal is really to generate the highest returns we can for our shareholders, the highest total return for shareholders, and not to get the highest market share of hyperscalers.
Michael Elias
All right. As the — just talk about supply chains really quickly. As supply chains have become tighter and self-build to become more difficult for the hyperscalers, we’ve seen an increase in the percentage of demand that’s going to third-party data center. I feel like that’s something that, based on my conversations is, I’m hearing pretty broadly. Can you give us a sense for the markets or regions where you’ve seen the most pronounced shift?
Bill Stein
Well, I would say that historically, until today, you would see the hyperscalers going into the smaller markets where they didn’t have a presence, where they didn’t have a piece of land where they could build a data center. And that’s still the case. But more and more today, we’re seeing them looking for capacity in their existing markets, too, where they have their own builds, but they’re looking to obtain as much third-party capacity as they can today. So it’s really across the board.
Michael Elias
One thing that, and I think this is something that came out in a recent short against the data centers is, talk about where the balance between self-builds and leasing settles out over time. There are definitely different schools of opinion on this. As you think of that balance, where do you see that trending over the long term? Or how do you see that evolving?
Bill Stein
I think it’s important to think about what your — what the view is of the industry long term and what the ultimate architecture is. And we think that the end-state architecture is hybrid IT, when your multi-cloud hybrid IT. So what that means is that the enterprises want to access multiple cloud service providers. And ideally, they sit in one location and access those CSPs.
That being the case, that vision really is not consistent with our CSP building its own data center, because that CSP is not going to build or its competitors. So you’re just not going to have multiple clouds. So I think at the end of the day, I think the short thesis just is incompatible with where the world is headed, which as I said again, is a multi-cloud hybrid orientation.
Michael Elias
So let’s transition and talk about the enterprises and what you’re seeing on that side. Over the last two years, Digital has gained momentum in its bookings with enterprises in that 0 to 1 megawatt category. Could you talk a little bit about the weight in which Digital is positioning itself to win that business and the go-to-market engine that’s been fueling the traction that you’ve seen with those enterprises?
Bill Stein
Well, a few years ago, we created something called PlatformDIGITAL, which is a full suite of products that was targeted at the enterprise. And then more recently, we announced our Service Fabric, which was a — it’s basically a software-defined networking product that allows our customers to, in a sense, point and click, and they can access fiber — various fiber providers, various customers that are in our data center and outside of our data center. It’s an open ecosystem, a layer.
So I think that we put products in place that make us highly attractive to this group of customers. And you’re right, we’ve been successful. We’ve been — for the sub-1 megawatt category, we’ve been averaging $50 million of bookings every quarter now for some time. And it wasn’t so long ago that, that number was 15%. So we’ve seen a big jump up. And we hope that we’ll continue to see steady progress in that area.
Michael Elias
So sticking with that point about the jump up, Bill, when you and I met at NAREIT in June, one of the things that you mentioned to me, which struck me was you anticipated another step function higher in terms of enterprise leasing in the future. What in your view is the catalyst that will drive that step up?
Bill Stein
I think it’s the recession. We saw this in 2008, 2009, 2010. The recessions are good for our business. There are strong secular demand drivers, that’s always there regardless of the economic cycle. But when companies are looking to reduce their costs, putting more of their applications, if you will, into a multi-cloud hybrid IT environment accomplishes that and it also drives revenue.
So I think it just tends to force these changes. We had the same thing happen during the pandemic. The companies that had the more advanced digital strategy were the ones that did better in the pandemic and those that didn’t paid attention and are now trying to accelerate that part of the business.
Michael Elias
All right in terms of new logos, Digital is also seeing traction on the new logo front and bringing those into the ecosystem. One of your public peers recently disclosed that nearly 60% of its new logos came through the channel. As you think about fueling that new logo engine, which is the flywheel that land and expand characteristic, how do you think about the — or could you give us a sense for how the role of the channel — or what the role of the channel currently plays and how you see that evolving over the future?
Bill Stein
I mean we’re definitely focused on using the channel to drive new logos. When we acquired Interxion about two years ago, since then, we’ve added 1,000 new logos to our mix. And we announced that we’re closing on the Teraco South African acquisition on August 1, and that’s going to bring over 600 additional new logos into the mix. Some of those we already have, but we haven’t figured exactly what the overlap is yet. But I would tell you that when you look at the channel, just in the last year, the percentage that the channel represents of our new bookings is up 28%.
I think it’s from 14% to 18%. So it’s off relatively low numbers. But I would hope that we can continue to drive that significantly. I mean just a footnote, our Chief Revenue Officer, Corey Dyer, before he joined us, was at Equinix, the competitor you were referencing. And Corey was quite instrumental in developing their channel program. So he knows how to do it. He brought in the staff and the resources to do it. And we’ve seen significant progress since he’s been here, and he’s determined to accelerate that over the next several years.
Michael Elias
Supply chain headwinds have been — continue to be a theme that’s weighing on the time line for new data center builds. As you think of your own supply chain, where are you seeing the greatest shortages? And as part of that, in what ways does your VMI program helped to insulate digital from the impact of the shortages on your build time lines?
Bill Stein
So I think the component that is in the shorter supply are chips, semiconductors. And that goes into lots of different components. We have something that we call a VMI program. And that allows us to lock in our supply cost and supply itself for an extended period of time. So — and right now, in North America, we’ve locked that down into 2023. We’ve also bought ahead. So we doubled our inventory that we keep in storage to enable our construction programs around the world. So I think that we’ve been able to use our balance sheet to protect ourselves fairly well both in terms of units of availability and prices.
Michael Elias
Just going back to your comments about chips and obviously, chips going into servers and other electrical components, those continue to be in short supply. Have you observed any delays in terms of installation time lines of your own customers due to issues procuring servers?
Bill Stein
Not too much. I mean our customers are pretty darn sophisticated. And they’re quite adept at planning ahead. And the last thing they want to do is take down data center space and not have servers to populate the data center. So they’ve done a good job of buying ahead as well.
Michael Elias
Okay. And then just going back to the VMI program. So management has talked about expanding that program to further assist customers. Can you just unpack the way of what that might look like in the future as we plan ahead?
Bill Stein
I think it’s the biggest benefit to our customers is the availability of equipment under that. We can basically assure them of having of our ability to deliver product on the schedule that they desire. And frankly, deliver at the cost that has been agreed upon that allows them to — allows us to earn a reasonable return based on the rent they’re paying and the costs that we’ve incurred.
Michael Elias
To transition and talk about supply, and this has definitely been a big theme at the conference thus far. As you discussed in your recent earnings call, issues with power transmission in [NoVA] have led Dominion to notify customers that they may not be able to supply power to some new data center builds until 2026. As we think about the 78 megawatts of data center capacity that you currently have under construction, for what portion of these builds have you secured an ESA and thus have visibility into getting that power?
Bill Stein
So Dominion, who’s the power company in question here, hasn’t been exactly clear on what the new ground rules are. Their issue is not power generation. They have plenty of power to generate, their ability is to get the power to the sites. And so there will be some sites that are affected. We have 24 megs that we are certain we have power for. It’s not clear that customers that have ESAs are actually going to get the power. So that’s — that’s not clear. But we are sure on the 24 megs. We also have 200 megs that we can build in Manassas, which is not part of this supply pinch, if you will.
But I think it’s important to keep in mind, too, that we will have roughly 50 megs every year becoming — that’s rolling over basically for the next four or five years. So that’s all inventory that has power and that. And we would expect that these — this power issue will have a positive effect on pricing. That’s certainly been the scuttlebutt in the quarters here.
And you and I were just talking about it. I think it’s anybody’s guess as to how high these prices are going to go. But the fact of the matter is prices are going to go up, because supply is constrained. And we have 500-megawatt portfolio in Northern Virginia. And we’re in a, I think, as good a position as anyone from — to benefit from increased pricing in this market.
Michael Elias
All right. As we think about the Western Lands, you guys acquired that property a few years ago. Now it seems like you’re in a position to really capitalize on that property. While I believe you’re not working directly with Dominion for that campus, my understanding is that the substation has been built on the campus requires transmission lines from Dominion.
Given the capital that’s been deployed into that substation as well as your scale in the market, how should we think about the risk that Digital isn’t able to get the requisite power for the Western lands for an extended period of time?
Bill Stein
So even if we had all the power we needed, we wouldn’t be delivering there until the end of 2014. Our first data center there is going to be 96 megs, and we believe we have the power for that.
Michael Elias
Okay.
Bill Stein
And so that will be delivered at the end of ’24, subsequent data centers to be delivered, obviously, in ’25-’26, which should be as this power starts to come online. But as I said, we have land build in Manassas as an alternative to Dulles lands in the event that we can’t get the power there. I mean the potential power in Dulles lands is — or in the Western Lands site as much as 1.5 gigawatts. So when it’s done, it’s going to be a huge campus.
Michael Elias
For that Manassas land that you talked about, do you have all the requisite permitting and everything should you need to be able to build on that?
Bill Stein
I believe we do, yes.
Michael Elias
Okay. All right. So that’s in a position to go. So we’ve been talking about power constraints in Northern Virginia. And it feels like it’s also emerging in more markets globally. As you consider your footprint, are there any markets globally where you think we could run into a similar issue with power transmission or generation, perhaps Frankfurt. Your thoughts on that for markets around the globe?
Bill Stein
We have seen it in other markets. So going from West to East in Europe, we’ve seen it in Dublin. We’ve seen it in Amsterdam. We’ve seen it in Frankfurt. We’ve also seen it in Singapore. Frankfurt is interesting, because with the war between Russia and Ukraine, there’s obviously pressure on not only the price of energy, but the availability of energy for Germany. But Germany has designated data centers to be critical IT infrastructure. And thus, we believe that there will be energy available to power the data centers in Germany.
Now the power situation is alleviating in Dublin. And I think it’s depending on where you build in Amsterdam, there’s power there as well. Singapore is focused on renewable power. And that aligns with our view of the world as well. We’re big buyers of green power and expect to be larger buyers in the future.
Michael Elias
So just to double click on that. One of the things that’s been a topic is with the shortage of energy for Europe, there have been some concerns among investors that the availability of grid energy may not be there for where the data centers, and thus they’ll have to rely on backup diesel. You’re not worried about the availability of power for your European portfolio?
Bill Stein
Well, I think it could be a combination of generators and grid power, and we’re prepared to do that, we need a combination.
Michael Elias
Okay. So I want to transition and talk about build costs a little bit. Earlier this year, you noted that your build costs are hedged through 2023 through your VMI program. But thereafter, you could expect to see bumps the tune of around 5% is what you highlighted at the time. Is that still a fair expectation? Or would you expect the change in build costs to be higher than that?
Bill Stein
I think it could be higher. Look, I think that — if you think about what’s locked in or what’s less susceptible to inflationary pressures, you have land, obviously, most of the land we have bought some time ago, and we got a very good prices. While labor costs are going up, it’s not at the same level as the equivalent costs or construction — hard construction costs. And then carry costs have gone up somewhat with interest rates, but again, not at the same rate as some of the major pieces of equipment. I’d say equipment is roughly maybe 50% of the overall build.
Michael Elias
Okay. So putting it together, where are we looking at maybe like 10%, 15% increase in the overall cost to build for Digital?
Bill Stein
Probably not in the overall. I think that’s just the impact on that the equipment.
Michael Elias
So that’s the impact on the 50%.
Bill Stein
Yes.
Michael Elias
Got it. Okay. So I presume that you have seen build cost pressures on build cost across all the puts that we did so de just talked about the 50%. Where are you seeing the most acute pressure? Where have we seen the greatest increases on those costs? And what are the things you can do to mitigate against that?
Bill Stein
Well, as I’ve said, it’s buying ahead. It’s putting equipment in store rooms. So buying at today’s prices. It is the vendor managed inventory program. It’s keeping — it’s having long-standing relationships with our vendors, and being in close contact with them all the time to make sure that the equipment arrives when it’s supposed to arrive.
Michael Elias
Have you — just transitioning talking a bit about the labor, because that’s another component of build costs. We have seen pressures on labor costs in other areas of communications infrastructure. Can you give us a sense for what you’ve observed in terms of, one, the availability of the labor and the construction teams in order to build the data centers and the cost — the change in cost in terms of what you need to pay these — for that labor?
Bill Stein
So the availability is good. And the reason it’s good is that we have projects running, multiple projects frequently in markets, and we’re able to keep the construction firms fully loaded, which is to say when they finish a project with us, they know where they’re going next. A smaller operator when you finish a project, you’ve probably done for a while. So they appreciate, I think, the certainty of knowing that they’re going to continue to work on the project down the road.
As far as costs go, costs again have gone up, but it’s in that range that we talked about.
Michael Elias
Okay. I want to transition and talk — we touched on it a little bit earlier, but I definitely would be remiss if I didn’t talk about it. So in late June, there was a short thesis that was published on the data centers, which highlighted, among other things, increasing competition from the cloud providers as well as technological obsolescence. What would you say in response to those parts of the thesis?
Bill Stein
Well, I kind of addressed part of that earlier on, which is the industry, I think, is moving towards a multi-cloud hybrid IT topology. And so that topology doesn’t work if there’s a self-build. So that I think that part of the thesis is wrong. In terms of older data centers versus older — newer data centers, we frankly have gotten some of the best rents out of our new — our older product rather.
And one of the reasons for that is the older product has more established communities of interest. So by that, I mean, we have a cluster of customers that want to be with each other for various reasons. So they could be partners, they could be suppliers that they want to connect to those customers and thus, they’re willing to pay a premium to be in that community of interest.
So — and you can just see it in our numbers. Some of the oldest product has really commanded the best rents even on new leasing, because the customers want to be in those buildings with those other customers.
Michael Elias
Right. I want to transition to that point and talk about pricing. You haven’t been shy in terms of noting that this is the environment to push hard on pricing for both new deals and renewals. And as we think about the new deals that you’re signing, on average, how much of your price has increased since the beginning of the year, perhaps in percentage terms?
Bill Stein
Well, first quarter it was — on a like-for-like basis, Northern Virginia was 6%. It was up again in the second quarter. It varies by market, right? It depends on supply demand in individual markets. Some markets like Singapore, the pressure on prices is extremely high. But I think it’s safe to say that pricing has been very good. And it’s — I’d say the upward trajectory — I’ve been in this business since pre-IPO with Digital in 2004, so almost 20 years at this point. And I don’t think I’ve ever seen the percentage increase in price that we’re seeing as favorable to providers, such as ourselves, as today.
Michael Elias
All right. You mentioned Singapore is one of those markets. I think given the dynamics that are happening in Northern Virginia, that’s another one. Any other of your bigger markets where you’re seeing a meaningful lift in terms of — in terms of that pricing?
Bill Stein
Santa Clara is really tight. Toronto has been tight. I mean Chicago is tightening up. Dallas is tightening. So I would say the major markets that we’re in, in the U.S. have gotten much tighter. Tokyo has always been a tough market in terms of supply. So it’s — I go around the world and it’s pretty good throughout.
Michael Elias
Good pricing environment for you guys.
Bill Stein
But I mean there are a few exceptions, but very few exceptions.
Michael Elias
Okay. All right.
Bill Stein
So it’s broad.
Michael Elias
Given the supply crunch that we’re seeing in Northern Virginia specifically, I mean, we were talking about this earlier. How have your asking prices changed? Once at the beginning of the year, but then have you also reset them higher just given what’s happening in the market with Dominion?
Bill Stein
Yes, that’s an interesting one. I mean Dominion is pretty new news, but we are definitely reevaluating our current pricing in Northern Virginia, which was, as I said, it’s quite a bit higher than it was six months ago. So we will be — I mean it’s — at this point, it’s very clearly a finite resource for the next few years, and we will be pricing it appropriately.
Michael Elias
All right. You’ve also noted recently that Digital’s pushing for CPI-based escalators on some new contracts globally. And I believe that excludes Japan with a 2% floor and a cap of 6% with CPI in between. Could you walk us through how you thought about evaluating going to those CPI-based escalators versus increasing the percent — the fixed escalators that you have on your current customer contracts?
Bill Stein
So I mean, look, it’s basically an inflation hedge. It’s — I think the two to six CPI index is basically fair for both us and our customers. If you put a fixed number out there, over time, it could be too high or too low. So you’re at the casino and you don’t know at which it’s going to be. So what we try to do with the two to six is, the six represents a guardrail, it’s a floor. So they’re saying, we can’t budget if you have an open ended CPI. We say fine, so we’ll give you 4%, we’ll give you a ceiling, which was cap, the 6%.
Some customers just aren’t comfortable with that wider range and they would rather, I think, have a higher fixed rate increase. And so in limited cases, we’ll work with them on that, but we do think that a CPI-based escalator is fair for both parts.
Michael Elias
Okay. And what’s the reception been from customers in this regard?
Bill Stein
I would say it’s mixed. The initial reaction is always no or — but we’ve been pretty good at convincing them that this is — this is kind of the way we’re going as the road we’re going down, right? And I think our competitors are at the same point of view. So that’s what’s out there now. That’s the new model.
Michael Elias
One of the — I want to transition and talk a bit about renewal spreads. One point of investor focus for Digital has been that these hyperscale leases that are older vintage, call it, 2014, 2015 need to get rolled down to reflect current market rates. But now we’re seeing market rates go in the other direction. You discussed that you’re pushing hard on renewals. But as we think of the path forward, have you been able to renew those older leases of that 2014, 2015 vintage, flat cash renewal spreads given the current pricing and supply environment?
Bill Stein
Inflation is clearly our friend in that regard. So I mean it’s still going to depend on when the leases were put into place, what the starting rents were, what the escalators were. So you don’t know it depends on what the ending rate is based on the escalators and depends on the market still. What’s the current market rate in the market where the lease is rolling. But I think in general, you’re going to see roll up. I don’t know it’s necessarily going to be Prologis mark-to-market. That’s the industrial REIT that’s advertising, 50% plus. But I think that our — I believe our re-leasing spreads will be quite healthy.
Michael Elias
And as I put it together, demand environment remains strong. The vacancy rates have dropped. We’re seeing pressures in multiple markets in terms of bringing on new supply. I just feel like since last year, the backdrop to which you were renewing these leases, I mean, it seems to have shifted meaningfully into your favor?
Bill Stein
It definitely has, and you see it in our reported numbers, where we’re showing positive re-leasing spreads at this point, ahead of what we had been guiding to.
Michael Elias
Right. I want to transition a bit and talk about M&A. Digital has historically been very acquisitive in terms of putting together the puzzle pieces for a true diversified global data center platform. Can you remind us what the key considerations are both financial and strategic that Digital prioritizes when evaluating an M&A deal?
Bill Stein
Sure. There’s three basic criteria. The first is that the acquisition needs to be strategic. It has to fill a gap for us, whether it’s a geographic gap or a product gap. Secondly, will it be accretive, either accretive to bottom line FFO or accretive to growth. And third, it’s not so much a criteria, but we don’t want to — we’re not going to play games with financial engineering. We’re not going to lever up to make the numbers work. So it’s — it will be a leverage-neutral transaction.
Michael Elias
All right. then going deeper into Digital’s M&A ambitions. I believe you previously noted that you intend to focus on M&A outside the United States. I think particularly in APAC was a region that you’ve highlighted. Do you believe there are any platforms out there that could be a good fit for Digital? And also, to the extent you wanted to do another large deal, is the balance sheet in a position to support it?
Bill Stein
So I don’t believe there’s anything in Asia that compares to the Interxion acquisition that we made in Europe or the Teraco acquisition we made South Africa or even Ascenty in Latin America. So the answer is no. I don’t see us making any large acquisitions in Asia. I think what we’re committed to doing is growing organically.
So we added Barcelona, for example, as a market as an alternative to Marseille for subsea cable networks in Europe. We announced a joint venture in Israel recently. We’re making some smaller acquisitions along the coast of Africa, Kenya, Mozambique, Nigeria and, of course, Teraco, which is not a smaller acquisition.
So — but in general, we’ll be doing some tuck-in acquisitions, but I don’t see us doing anything that’s major. As our CIO, Greg Wright has said he’s put the elephant gun in the closet.
Michael Elias
Okay. So just talking about that smaller scale M&A. I mean, you’ve talked about that in the past that you want to continue pursuing those tuck-in transactions. It seems like you see more deals like that on the horizon, but perhaps to kind of double-click on where you’d be most focused, where do you feel like you need to expand your footprint where you don’t already have existing capacity?
Bill Stein
Well, clearly, Asia. I mean, Asia is our weakest region in terms of market share. We’re one or two everywhere else in the world. So Asia is the market. I mean Asia’s in some — in many ways, harder to execute in than Europe, because it’s such a broad region. But we’ve hired a new head of acquisitions for the Asia region, who actually came from Prologis and we’re optimistic that we’ll find some opportunities there.
Michael Elias
Right. To that point, I mean, public market valuations for — in the data center space have come down since late 2021 due to a multitude of factors, rising rates, perhaps the most notable among them. As you look to do these, let’s say, tuck-in transactions, are you seeing private market valuations come down to a similar extent that public market valuations that have that creates a greater opportunity for you?
Bill Stein
Not so far, the private market has been sticky, which is one of the reasons that we have been a seller of assets, too. We want to take advantage of these private multiples. So we’ve been selling noncore assets outright, and we’ve been selling or contributing core assets into our Digital core REIT Singapore REIT, which is — those are stabilized assets.
Michael Elias
Well, Bill, I could sit here with you and ask you a bunch of other questions, but unfortunately, we are out of time. Thank you very much for being here with us today.
Bill Stein
Appreciate it.
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