Digital Realty Trust, Inc. (NYSE:DLR.PK) Citi Communications, Media & Entertainment Conference January 5, 2023 1:15 PM ET
Company Participants
Matthew Mercier – CFO
Jordan Sadler – SVP, Public & Private IR
Conference Call Participants
Michael Rollins – Citigroup
Michael Rollins
Good morning, and for those of you web-streaming welcome back to Citi’s 2023 Communications Media and Entertainment Conference. For those of you who haven’t met, I’m Mike Rollins, and I cover communication services and infrastructure categories within Citi Research. And before we get started, I’d like to mention that we do have disclosures available at the registration desk, and on the Citi Velocity page from which you’re streaming the audio.
We’re going to work to incorporate your questions into today’s discussion. You’re in the room, you can light up the microphone and we’ll get to your question. if you are online you can submit your question into the box, and we’re going to continue the tradition of using live surveys. They’re completely anonymous. They could be accessed on the live polling Q&A section of the streaming site as well as using your connected devices here in the room.
So with all that out of the way, I’d like to welcome Matt Mercier, newly appointed Chief Financial Officer of Digital Realty; and Jordan Sadler, SVP, Public and Private Investor Relations of Digital Realty. Thank you both for joining us today.
Matthew Mercier
Thank you, Mike. I appreciate being here.
Jordan Sadler
Thanks for having us.
Michael Rollins
Well, congratulations on the new role.
Matthew Mercier
Thank you. Thank you.
Michael Rollins
And so we’re curious to — for you to share your first acts now as — and priorities for CFO of Digital Realty and even just more broadly, how you’re thinking about those priorities for the company, maybe differently than what we would have been talking about a year ago.
Question-and-Answer Session
A – Matthew Mercier
Sure. Well, I’ve had the benefit of being around digital for a good part of the time we’ve been public, being behind 2 great CFOs, Bill Stein and Andy Power and have had the pleasure of being part of the journey we’ve been on over the last, not only my 15 years but in particular over the last, call it 3 to 5, as part of building out the strategy and repositioning the company to where it is today.
And so I don’t foresee any major shift in the strategy that we’re embarking on. If you go back just even a couple of years, I think, Michael, as you know, we’ve been embarking on strategy, which is encompassed by kind of the 3 key terms that we like to talk about, which is being global, being connected, being sustainable.
And in terms of global, as I think, hopefully, most of them know, we’ve been on that pursuit with and made, I think, great progress in terms of where our portfolio is today. I think it would be hard to us to find some of would tell you that our portfolio isn’t stronger than it was 2 years ago and 3 years ago and 4 years ago between our combination with Interxion back in 2020, most recently having — getting a majority stake in Teraco. So we’ve been — and other acquisitions in between there that have been, call it, more network-centric and enterprise-oriented in places like Greece and Croatia.
So I think you’re going to — we will continue to embark on being part of the cloud service providers, one of their preferred vendors and partners going forward as well as continuing to, call it, attack and gain share within the enterprise colocation segment as part of that — as part of our ongoing strategy going forward.
And so at the same time, I think what we’re — what we’ll emphasize even more is I think at this point, we’ve — in terms of global, I think we’ve not fully checked the box, but I think it’s a pretty good check the box in terms of where our portfolio sits today globally. We have 300 data centers across 50-plus markets, 26 countries. I think our view and belief is, we’re in the majority of the major markets you want to be in to be a global player and to be able to deliver the capabilities and the deployments that our customers are looking for across both our — both segments, both the hyperscale, the cloud service providers as well as the enterprise.
So I think now then we’re looking — we got the breadth of our portfolio. Now we want to call it, go into the depth in terms of creating and optimizing what we do have messaging and further creating a more powerful value differentiator for customers, in particular within the enterprise segment through our connectivity offerings. We launched ServiceFabric last year, continuing again to make — overall, make it easier for those customers to do business with us as well as connected with others across the globe. So — and all of that, I think, comes back to one of our — one of our key goals, I think, for going forward, which is all the work that we’ve done is really accumulating in positioning our portfolio for sustainable organic growth.
So that’s really what we’re targeting to deliver. And I think we’ve started to see that over the last year with improved pricing, re-leasing of vacant capacity. And we think with where the environment is today, you’re going to continue to see continued strength within our organic growth as that becomes a focus of ours or has been a focus of ours and I think we’re positive about where those trends are going. And then I’d say second, we’re also — priority is to, call it, restore the balance sheet and bring that to where it was over time.
Michael Rollins
That’s really helpful and gives us a lot of topics to drill down into. We’ll introduce our first survey question, see what our audience thinks. One question that we’ve asked before, we’re going to ask you again, does Digital Realty need to acquire additional assets to strengthen or expand the global strategy?
You were just talking about that a little bit. Curious what our audience thinks. The choices are going to be, yes, expect digital to add new markets through acquisitions of additional platforms. Yes, expect Digital Realty to further consolidate retail-centric data centers in campuses? Or no, Digital Realty has the geographic footprint it needs and can expand through organic development.
And just a reminder, these are completely anonymous, and so we’ll aggregate those results. And while we do — maybe you could just talk about a little bit more, since the first time we’ve been together, since there were some transitions both for Andy and for you, can you just unpack a little bit of just maybe what led to the unexpected timing and process for the management transition and were there any performance issues for the company in the fourth quarter of ’22 or unexpected developments for ’23 that investors should be mindful of?
Matthew Mercier
Yes. I mean just to hit the — maybe your last part straight, I mean there’s no performance issues or unexpected developments that led to this. I mean this was understandable in terms of like the — maybe the abruptness of the timing between announced and actual final date. But the — if you look back, the overall transition plan has been in place for well over a year. Andy was appointed President back in November of last year, with that came additional responsibilities that you would say signaled kind of where the path that we were on behind the scenes which wasn’t as visible myself.
I’ve had a lot of the financial operations of the company for not only that period of time, but in some cases, even further beyond that in terms of running the finance FP&A group capital markets, accounting. So I’ve been in the same boat in terms of transitioning for this point in time. So this was not a — this was a planned succession plan and understand that my view would be abruptness in terms of timing, but this was something that was put in motion some time ago.
Michael Rollins
That’s helpful. And just to share the results of the first survey, so 14% of our audience expects Digital Realty to continue to add new markets through acquisitions of additional platforms; 29%, consolidate retail data centers in campuses; and 57%, that you have the geographic footprint that you need and can expand through organic development. As you think about these choices, do you fall into one specific bucket over another?
Matthew Mercier
I mean I think the — as usually happens, the majority tends to be right. So I think — look, like I said before, I think we — looking across where we’ve been and where we come from a global perspective, we reiterate, we’re in 300 data centers across 50 markets. At this point in time, I think we believe that we’re in most of the major markets that we need to be in.
That side are markets over time that we’ll look to expand into. That’s obviously not off the table because we want to be where our customers want to be, and that evolves over time. But I think as of now, we’re in most of the major places we want to be at this time.
Michael Rollins
So we’re just talking about the asset positioning. Can you unpack a little bit of where the sales organization, the support organizations sit. Are those in a good place to execute the sales strategy going forward?
Matthew Mercier
Yes. I mean, I would say, looking at it in kind of our 2 buckets, right, the cloud service provider, the hyperscale component, that’s a finite limited group of customers that doesn’t take a large sales force to be able to attack, that also continues to be a good majority of the business that we’re signing anywhere between, call it, roughly 60%, whereas the other 40-ish percent depending on the quarter comes from our enterprise more retail colocation.
And we’ve been — while we’re looking to grow that enterprise footprint, we also have to make sure that we’ve got the inventory in place to be able to sell it before bringing on excess headcount that won’t have the right capacity to sell. So I think as of today, given where we’re at and where our inventory profile is, I think we feel pretty good about the sales organization and where it is.
We’re obviously continuing to look at bolstering our channel partners and having that sales force multiplier. But overall, I think we feel pretty good about the sales organization and where it is. And as we continue to grow and look to penetrate further in enterprise, then we’ll reevaluate that.
Jordan Sadler
I would just maybe add to that or point out that over the course of the last 4 quarters, 3 of them were record quarters in terms of lease production. So I think the sales force is sort of adequate and it’s been pretty mixed across product type too. So I think we feel pretty good about that. It’s — I think, as Matt said, it’s an opportunity as we sort of scale and look to go into different product areas and markets, but no sea change.
Michael Rollins
I’m glad you brought the bookings up because that takes us right into the second survey of our time together. And we’re going to ask our audience how will average quarterly bookings in 2023 compare to what I recall the last 8 quarter average being around $136 million.
So we’re just going to simply ask, is the quarterly bookings in ’23 going to be higher than that average, similar or lower than that average? And we’ll go to the polls in a moment. But while we’re doing that, and this might help inform some of our audience on what the right answer should be, according to what you were saying, maybe if you could share a little bit more of what you’re seeing in the sales funnel, sales cycle, I recall back on the third quarter, you noted that maybe some smaller customers were seeing some weakness within the channel. If you can give us an update on what you’re seeing on that front.
Matthew Mercier
Yes, I…
Jordan Sadler
Yes, go for it, Matt.
Matthew Mercier
Yes. So, overall, we are — we feel pretty about the demand profile. I mean, as Jordan mentioned, over the last year-to-date, we’re, I think, close to $450 million in total bookings. We’ve had 2 record quarters this year.
I think as we’ve all experienced, this has been a volatile year in terms of macro changes. And as a result of that, in the third quarter, we thought it was prudent to mention sliver where we are seeing some softness. But I think overall, that softness is — we’re not seeing it get any worse.
In fact, I think it will be same to improving potentially within, again, a small segment of our, call it, 0 to 1 megawatt that we’re attacking. Within hyperscale, we continue to see a lot of demand — in some cases, I think more demand in certain markets than their supply. So, overall, we feel pretty good about the demand profile, the pipeline and what we’re seeing in terms of what we have available.
Jordan Sadler
I might just add to that just to come back to the small medium enterprise comment that we made on the third quarter call. This was a decision to basically be transparent with the investor and the analyst community and say, “Are you guys seeing anything? The capital markets are falling apart. Interest rates are up dramatically. Are you seeing anything macro that you would identify or call out because we were already obviously well into October?” That you could say, “There’s something going on in your business, how are all of your customers behaving? We obviously have well over 4,000 customers.”
So we did see something, so we said something. And what we saw was, in this smaller medium enterprise segment of our business, which is, for us, a smaller piece of the business, right? It fits into the 0 to 1 megawatt business as opposed to the greater than 1, obviously. And within the 0 to 1, we sort of subsegment into 0 to 500K dub and 500k dub up to a mega. It was at 0 to 500, where we saw a hesitancy from CFOs and CTOs to make that capital commitment as the quarter came to an end. And it wasn’t — it was an anecdotal comment.
And so we wanted to make sure that we flagged that anecdote for folks. Much of that pushed into the fourth quarter pipeline. So there was a hesitation and then we think an execution behind that. But people have to assess based on current conditions. What are we going to do? And I think some people will not want to spend their own capital, they’ll look to lean on partners, maybe go to the cloud or bare metal, and others will commit and execute because they need the product.
Michael Rollins
So from the survey, I’ll read out the results about 40% was similar and about 60% was lower in terms of the quarterly booking opportunity for ’23 versus ’22. Given what you’re describing about the demand for hyperscale and what you’re describing on the portfolio broadly, how would you vote in the survey?
Matthew Mercier
Yes. Well, I’ll give some context, right? I mean, look, what we’re seeing is, we’re seeing solid demand. We’re seeing that in, like we mentioned, record quarters, 2 of which happened this year. So we’re coming off a solid year performance. On top of that, we’re also seeing that there are supply constraints in certain markets, one of which being the largest market in the world in Northern Virginia as a result of power constraints. So if you think about just those 2 kind of anecdotes in terms of hard to keep putting up record after record as well as supply constraints in certain markets, I think that will kind of give you an indication of where things might be heading.
Michael Rollins
In terms of kind of getting to the next topic, you mentioned some energy constraints, and there’s just higher energy costs, overall, in certain of your markets right now, are you seeing any customer resistance or pushback or change in demand because their total cost of operating in a data center may be higher than it was a year or 2 years ago?
Matthew Mercier
No. I mean, we haven’t. I mean we’ve been — I think this has been telegraphed for some time, right? People are aware of the increase in power cost. We for the customers that we’re targeting, these aren’t decisions where they can have a data center point or not. These are mission-critical to their business. And as a result, they’re maybe not happy about where power costs are, just like probably most of us aren’t. But these are necessary deployments that they can’t necessarily delay. So we have not seen any material change as a result of pricing — power pricing increases within any of the major markets that we’re operating.
Michael Rollins
And on the other side of this, with some supply constraints and inflationary backdrop, can you give us an update on how Digital is approaching pricing? And what kind of opportunity that is for the organic financial performance of Digital Realty?
Matthew Mercier
Yes, yes. I mean, we’ve — look, I think, hopefully, as I said in the beginning, I think we feel pretty positive about where the trajectory of pricing is going, and that’s across most of our major markets. I think that’s been reflected in the fact that this year, I think the first time in several years, we guided to positive renewal spreads — and we’re hopeful and optimistic that, that continues. Part of it is, again, an offset to some degree of limited supply is that pricing could and should go up along with that, and we are seeing that in a number of our markets. In addition, we’re looking to include further escalators in where we are pricing even to not only be a reflection of the pricing environment but also some version of the inflationary environment.
So I think as we announced on last quarter call, we’ve got — we were able to get roughly 40% of our contracts with CPI inflation, which is an adjustment to what we typically have, which is, call it, anywhere between 2% and 3% fixed on average. And so we’re — we feel pretty good about where pricing is trending. We think pricing power has shifted towards the owner/operators hands. And we think that also, back to kind of some of the opening remarks, should then be reflective of an improvement in overall organic growth.
Michael Rollins
So that brings to our next survey question for our audience. Will the potential improvements in pricing push stabilized KPIs for revenue and NOI back to meaningfully positive territory in 2023? And this is a simple no or yes answer. So we’ll go to the polls in a moment. But as you’re thinking about these price increases and the opportunities for these inflation-based escalators and this might help inform our clients on what the right answer should be here, do you kind of view this as 0-calorie revenue where it’s just offsetting inflationary pressures in the business? Or do you view this as an opportunity to get better value and returns out of your portfolio?
Matthew Mercier
Look, I think ultimately, we view and our objective is to increase the overall bottom line from pricing, especially from an organic portfolio called stabilized same-store perspective. We’re also not immune to inflationary pressures within the operating expenses. But outside of power, which we talked about, which for our business is largely a pass-through. The operating expenses that make up the majority of it underneath that or I think we’ve been able to control very well. And therefore, as we look to our revenue growth from an organic perspective, we think that we’ll see not only improvement at the top line but then, therefore, should flow down to the bottom line as well.
Michael Rollins
And if you take the power pricing out of this question for a moment and you look at the core margin performance, you look at what you’re doing with these connected services and these ecosystems that you’re building for customers and broadening the sales opportunities — as you look at the cost structure, should investors expect Digital to be a net investor? Take a little drop in margin to drive more top line, neutral to margin? Or do you have the scale and you have the people you need where now you can actually get that operating leverage and expand margins?
Matthew Mercier
Yes. So again, I think the main point is excluding power because depending on how you look at it, that’s — we are expecting an increase in overall power cost, and therefore, reimbursements, which depending on how you’re looking at margin, would have an impact. So excluding margin, our view is — again, going back to our objectives, we’re looking to increase our occupancy — so bring in which we’ve been embarking all over the last year with moving ready initiatives. And I think you’ve started to see that even in the last quarter where you saw our stabilized portfolio and our overall portfolio increase in occupancy.
And I think that’s probably one of the bigger drivers of getting better margin improvements just filling some of the baking capacity that we’ve had, which we’ve done a good job of doing. Then add on top of that, better mark-to-market opportunities, which we think we’ll see going forward. And I think overall, we’re looking at an organic growth profile where we should be able to, I’ll say, maintain, if not move in the direction of improving our margin excluding energy.
To answer your question directly, back to, do we think we have the investments that we need in most — I think for the next year, I think we do. I think after that, we’ll continue to evaluate year-by-year depending on the profile of the market, the profile of our inventory and our objectives and make decisions from there.
Michael Rollins
So coming back to the question about the KPIs for revenue and NOI to get back to meaningfully positive territory — and I’ll kind of — I should have included in the question, but I think it is on a constant currency basis, just to take that out of the mix.
It was a mixed response, 60%, no; 40%, yes. Curious how you’re looking at the opportunities to get these KPIs back to meaningfully positive territory constant currency? And are there any hot holes in the road as you’re looking out at the highway that we should just be mindful of, one-timers or special situations and things of that nature?
Matthew Mercier
So I think I’m hopeful people look at — I think we’ve already started to see some reversal, if you will, in reversal meeting. We are — we have started moving in a positive trajectory in terms of our stabilized organic growth, both from the top and bottom line. And I think based on all the factors that we just discussed, meaning looking to improve occupancy looking at a better pricing environment overall, I think we’re pretty positive that we’ll be able to show continued improvement in those metrics. And obviously, we’ll come out with guidance on that towards the — on our fourth quarter earnings call, which will be in, call it, mid-February. And I think that will — we’ll be able to discuss it even further then.
In terms of headwinds from that organic, I think we talked about it, most of that as well. So from a power perspective, we feel very insulated. We’ve had hedging programs. The majority of our contracts are passed through. The ones that aren’t passed through, we have the ability or the contract to adjust the pricing as a result of increases in power. So that gives us a lot of comfort from one of the big areas of expected increase, which is on the power side.
From other operating costs, I think we’ve done a great job of with our scale and with our vendors being able to control increases in operating expenses — and so we’re not — I’m not aware of as of today any major wildcards. Property taxes, it’s always something that comes up here and there, but again, at this point, nothing has come to life that gives us any concern on that front. So we feel pretty good about where we stand as of today, in being able to deliver positive message around our stabilized organic growth.
Michael Rollins
And maybe moving over to the balance sheet for a few minutes. You talked about that earlier in our conversation about the focus on balance sheet. Can you walk us through where you are effectively leverage today, where you would like to get that to in the journey of what investors should expect to get to that level?
Matthew Mercier
Sure. Yes. I mean our leverage is, I would say, higher than it’s been in the past. And we are — as I think mentioned in the opening remarks, one of our objectives is to get the balance sheet, restore that back to where we have been. Much like it didn’t — it wasn’t an overnight journey to be where we are today. I don’t necessarily see it’s going to be an overnight journey to get back to where we want to be. But I think we have an ability and a number of different options at our disposal that we are working through to be able to bring leverage back down to levels that we’ve seen historically.
I think that will — again, I think that will take time as we work through that over the next year and maybe beyond. And some of those things that we are working on include things that we’ve done in the past, which include noncore disposition, outright dispositions is one part. We’re also continuing to look at JV and potential stabilized assets where we’ve got a number of partners that we’ve done over the course of several years between Mapletree and other partners and also looking to potentially new partners. And the third leg of that is also to look at the potential to joint venture some of our development projects and bring in a form of equity capital for the development pipeline that we have in place today.
Michael Rollins
And as you think about how you got to the current leverage that you’re at, was there something that didn’t go right in terms of underwriting assumptions or the progression of the business? Or was it simply a function of the investment, the assets that you wanted to bring into the portfolio was worth moving up in the short term to benefit the company for the long term.
Matthew Mercier
Yes. I mean, I look at our — we’ve — I’ll take sort of — let’s take a rating-agency, if you will, type view on where we’re at. I mean, if you look at our company back to 5 years ago, we are more diversified, better customer concentration, fixed charge coverage over 5x. I think our view is it’s hard for us to say that our portfolio isn’t in better shape than it was some time ago, and therefore, has capacity for slightly more leverage than where we’ve been historically.
That said, I think we’re also at a place where we had a lot of volatility in the capital markets in the last year, as I think we all know, and that was part of limiting options that we had available to us historically. And so I think between those 2 things, I think we’re at a place that we don’t think is — it’s higher than we want to be. But I don’t think it’s — when you look at the fundamentals of our business, when we look at our ability and the options we have to bring it down, when you look at the development pipeline that over time will deliver EBITDA and give us an ability to naturally bring it down from that. I think we feel pretty comfortable that we’ll be able to manage this effectively over time.
Jordan Sadler
I might add, it leverages a static metric as at — we bought a nonstabilized portfolio in August that has pretty good growth potential and lease-up as occupancy commences or as leases commence. So that will be a nice driver as Matt alluded to and described. And so that will sort of help but also we had a disposition guidance for this year as well. We’re not all the way through it. We were not as of 3Q but we’re still working towards some of those dispositions and that piece of that. And unfortunately, there is substantial demand for the assets that we own, and we think there’ll be ways to continue to monetize portions of the portfolio.
Michael Rollins
Does the — I’m thinking I’ll add with this question, but does the balance sheet on a consolidated basis not barely represent the underlying leverage because you have consolidated assets that you might have less than 100% ownership in, you have joint ventures that you control and manage that are more mature or growing that are not in the balance sheet. So is there — in some way, does the consolidated, if I just pull up a balance sheet in the 10-Q for you — is that not the fairest representation of leverage because of a little bit more of a complicated investment structure?
Matthew Mercier
My answer to that would be generally no, because the way we — while you don’t see — the way we calculate leverage that we disclosed and reported is we include our share of joint ventures within the numerator and the denominator. So I think we’re — and we’ve done that for some time. So I think we’re giving investors and analyst community a good and a clear picture looking through not only our consolidated but also our unconsolidated ventures.
Michael Rollins
And I can’t remember if it was in some meetings or if it was on the third quarter earnings call, but I think there was an acknowledgment that the team was going to — as rates were rising at that point, maybe take a different look or different lens on development in 2023. Any updates in terms of how you’re thinking about the pace of internal development?
And given some of the comments you mentioned on pricing and supply constraints in certain markets, should there be a natural benefit to the development yields when we start looking at those schedules over the course of the next 12 months?
Matthew Mercier
I mean I think the simple answer is yes. I mean we have always taken a very prudent and strict approach to how we monitor and how we improve development projects with an eye on our yield and an eye towards what is going to cost us to bring that yield onto our balance sheet. But — and in light of, I think what everyone’s probably should be doing, I mean, we’re — as we said, we’re going to an even stricter review of our projects going forward.
Again, some of that’s going to be natural in terms of — there’s places in markets where inventory is scarce. And so all those things cost of capital increasing some level of inflation, although I think that’s fairly contained. And we will be looking at, I think, over time, our goal would be to improve the overall quality of the projects and call it the yield within their — associated with that within our development pipeline.
Michael Rollins
So in our final couple of minutes, Matt, is there a misunderstanding that you feel is out there that you sort of want to address and raise awareness in terms of what you think that is and how you look at that topic or issue?
Matthew Mercier
I don’t — I think — I might go back to the survey results, and I’ll sort of repeat, which is probably the one that I think there — I think that we’ll — I think there’s a view that it’s a show-me story, right, in terms of our — in terms of being able to show organic stabilized growth. And I think we feel pretty confident that we’ll be able to show as we — as I hopefully mentioned a few times, that that’s going to be moving, it has been and will continue to move in positive direction given some of the tailwinds that are now, I think, at our back in terms of pricing, in terms of filling vacant capacity, in terms of inventory constraints that are really circled back to a pricing dynamic that should be in the developer’s favor and where competition should be and pricing as well. So I think that’s a major item. And then the other objective is, again, I think we’re restoring where our balance sheet is. And I think, again, showing that we have the ability to do that.
Michael Rollins
And on that last point, just one follow-up. Does the — are you also seeing a dislocation between private market values and public market values? And is that helpful as you’re thinking about private capital whether it’s in joint ventures for stabilized assets or for monetization or for even development?
Matthew Mercier
Yes. I mean I think that’s why we view that, call it, avenue in terms of part of the deleveraging strategy. I think we see that there’s still a demand for this type of product — there’s a lot of people out there that are looking to either grow their exposure to the space or just get into this space. And so that’s why it’s one of the key elements of where we’re going to be — to steal from Andy, have many fishing poles in the water, that’s one of the key ones that we’re going to target.
Michael Rollins
Well, Matt, Jordan, thank you for spending time with us today.
Matthew Mercier
Yes, pleasure.
Jordan Sadler
Thanks for having us.
Michael Rollins
Yes, Thank you.
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