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TL:DLR - Expectations Management

|Includes:Digital Realty Trust, Inc. (DLR)

TL:DR is a common phrase on the internet which means "too long; didn't read" usually in reference to forum posts en.wikipedia.org/wiki/Wikipedia:Too_long;_didn%27t_read .

My play on words in the title is in reference to DLR's Q3 earnings release transcript seekingalpha.com/article/1790032-digital-realty-trust-management-discusses-q3-2013-results-earnings-call-transcript, as this post is meant to be my analysis of the call and to provide some context for those investors wondering why the stock sold off so violently today after the press release last night and remained down after today's investor presentation (-15.27%).

To set the stage, in the after hours press release on 10/29 seekingalpha.com/news-article/8002112-digital-realty-reports-third-quarter-results, Bill Stein, CFO, made the following disclosure:

Revised 2013 Outlook

"With improved visibility on the range of outcomes for full-year results, we are revising our 2013 FFO per share outlook to $4.60-$4.62 down from $4.73-$4.82 previously, and revising our 2013 core FFO per share outlook to $4.65-$4.67 down from the prior range of $4.74-$4.83," said A. William Stein, Digital Realty's CFO and Chief Investment Officer.

"The primary drivers behind our revised outlook include: (1) the non-cash straight-line rent expense adjustment; (2) the near-term reinvestment drag until proceeds from the joint venture with PREI can be accretively redeployed; (3) lower-than-expected acquisitions of income-producing properties; and (4) delayed lease commencements, reflecting the needs of strategic customers for phased delivery of custom-built space for large-scale requirements on long lease terms."

Now, if I look at the midpoint of the prior guidance for core-FFO of $4.78 and compare it to the midpoint of the revised guidance of $4.66, the 2013 results for "core" FFO will be $0.12 lower than expected. I've underlined the key drivers cited by the CFO for the lower guidance and assigned them numbers as they will each be considered separately in this post to try and reconcile this decline.

1) Straight-line rent: DLR caught an error in their computation of straight-line rent, which resulted in a $10M cumulative downward adjustment to FFO, or $0.07 per share all recognized in Q3. Only $830K of this adjustment related to the 3rd quarter and is treated as "core" FFO, so $830K/$10M*$0.07 per share = $0.00581 per share lower Q3 "core" FFO for this change. If we extrapolate this for the full year, we can explain $0.023 of the decline (special thanks to MathRulz for spotting the need to annualize this). This is a non-cash item, so I'm not overly bothered by it from an economic perspective (i.e. dividend stability). Mistakes do happen in finance/accounting, but it doesn't leave investors with great feelings about management's oversight ability and feeds into the perception problem after the accounting for repairs under $10K change in Q2. But what this really means to me is that only about 19% of the $0.12 "core" ffo decline can be explained by this error, which tells me it does not fully explain the price drop.

--> $0.023 explained

2) JV with PREI: As most of us know, on October 2nd, DLR announced a transaction with Prudential seekingalpha.com/news-article/7753462-digital-realty-and-prudential-real-estate-investors-announce-369-million-joint-venture where they placed 9 100% leased properties into a JV and retained a 20% interest (plus a promote) and management fees and took back cash for the 80% they gave up. What they didn't disclose at that time was the impact of the transaction on "core" FFO guidance. Fast forward to the end of the month, and we find in the earnings release Faust and Stein explain that the JV is dillutive to FFO to the tune of about $0.03 per quarter even after management fees and debt paydown with the cash proceeds. Side note: The company also indicated in the Analyst Q&A that they recognized a tax gain on the transaction and plan to use what appears to be a "spillover" dividend from their January 2014 regular distribution to disgorge 100% of taxable income. To me this means they will be raising the 2014 dividends to prevent a perceived dividend cut of regular 2014 quarterly distributions as some of those are applied to the 2013 tax year. Accordingly, they will have additional demands on their operating cash flow to cover these increased dividends next year.

--> $0.053 of the "core" FFO explained

3) Lower than expected acquisitions: The simple relationship to observe here is that if your guidance assumes you will be issuing capital/borrowing money to buy income producing property and such opportunities do not present themselves (or are not to your liking), your results will not reflect that additional FFO that was previously in the guidance. I wasn't able to completely figure out the impact of this on "core" FFO based on the transcript, so its somewhat of an unknown. However, one observation I will make is that in order for DLR to grow, they have been buying land (e.g. in Tokyo this past year) and are building from scratch. When they undertake this construction, and perform tenant build-outs, their "core" FFO and AFFO are benefited significantly through GAAP as they can properly capitalize interest and employee costs related to the development (I'm projecting around $64M for these capitalized costs in 2014 based on Q2 financial footnotes). More traditional non-developer REITs (like the triple-nets) which acquire stabilized properties instead of building these from scratch, have to deduct all of their interest through FFO and AFFO if they were buying a pre-constructed property (and they probably wouldn't have the development personnel on payroll). Regardless of the accounting treatment, capitalized interest and staff costs are similar to capitalized leasing commissions, recurring capex charges and maintenance obligations, since all of these costs really do cause cash to go out the door, but they aren't reflected in FFO (only recurring capex, capitalized maintenance and capitalized leasing commissions are in AFFO). This is one of my main concerns when an investor relies upon a misleading figure like "FFO payout ratio" to determine a REIT's "margin of safety". They really need to look at the cash flow statement and financial footnotes to make a proper assessment of a REIT's ability to grow their dividend.

--> $0.053 + $0.0x of the "core" FFO explained

4) Delayed lease commencements: This is what I believe to be the main driver of the decline in "core" FFO and forward guidance. The Analyst Q&A spent the vast majority of their comments on this point and I believe the company was very strategic in bringing their Senior VP of Sales on the call to roll out their new leasing strategy which I'll explain in a moment. Essentially, one of DLR's biggest competitive advantages has been their ability to build large megawatt deals for large customers. However, their large customers may sign a lease contract but are not required to "commence" the rental period (i.e. pay rent) until various "pods" are fully built-out by DLR and delivered. Accordingly, they have been including the entire contractual rent in forward FFO guidance for the street, but they aren't recognizing that rent until each "pod" is delivered to the tenant which may take up to 6 quarters to fully phase-in. One analyst asked if this was similar to a free rent period, and the Company agreed it was similar but a unique accounting issue for their business (as they can't pick up straight-line rent for the "free" period under the contract). Even though the contractual rent is expected to be fully earned, the timing of cash flows and revenue recognition (i.e. FFO) is very skewed to the actual delivery date of each pod. The bottom line here is that the analysts were pretty shocked that management wasn't able to bake this rent "stabilization" feature into their earnings guidance, and I believe this is the main reason the shares did not rebound after the call. Management credibility is very badly damaged by this Q3 revelation which only compounds the Q2 maintenance capex issue.

TL:DR - This is a classic example of poor "expectations management".

Thus, the $0.12 decline in "core" FFO for 2013 guidance = $0.023 for straight line rent error + $0.03 for the partnership + some amount related to lower income property acquisitions + some amount related to poor guidance on lease commencement timing (which I believe to be the bulk of the issue).

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As a follow on point to the rent commencement timing for their large tenants, on the investor call, the company announced a new leasing strategy to focus on the middle market tenants which typically only need one "pod" and much lower megawatts for their deal. Accordingly, the company believes this will alleviate their revenue recognition timing issue with their large tenants so they can better match rental income with working capital, debt service and dividend payout cash requirements. However, there are costs here as DLR expects to increase its leasing staff by around ~1/3 to cover the larger number of deals that would need to be completed to lease the same amount of space as a large tenant (although these costs will be capitalized as leasing commissions). My main concern with this strategy is that it erodes some of the company's competitive position because the newer data center REITs appear to be quite capable of handling lower megawatt deals. Thus, there will be more competition at the middle market and that could either imply pricing pressure for everyone, or it could mean DLR eats their competition's lunch. Time will tell.

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I truly enjoy financial analysis, and would like to turn this instablog into a resource for fellow investors that enjoy this type of deep dive analysis as much as I do. Please feel free to send me a private message with any suggestions for improvement. Thanks and best of luck with your investing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I have no affiliation with the company and I wrote this post myself. As of this update on 11/17/2013 I may initiate a long position in DLR preferred in the next 72 hours.

Stocks: DLR