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I prefer to research before buying and to monitor while holding. I have a background in tax/finance/accounting with a career focus in the real estate industry. My username has a personal meaning and has nothing to do with the metal.
  • TL:DLR - Expectations Management 14 comments
    Oct 31, 2013 3:37 AM | about stocks: 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).

    -------------------------

    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.

    --------------------------

    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
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Comments (14)
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  • financeminister
    , contributor
    Comments (1140) | Send Message
     
    This was a good write up on DLR's earnings.Thanks! This should really be an SA article for more exposure as I'm betting that there could be a lot of readers who would want to follow up on various points and will find this useful as a starting point for more investigation. I have a small part of my portfolio in DLR averaging at 58/share. It didn't cause much of a dent to my overall portfolio and the dividends sort of cushion this drop so I ignored the bleeding. I'm not adding at this point as I'm low on cash and really don't know the financial potential of this company due to the volatility from the last few months however I note that many investors have sizable chunks in DLR as the dividend is looked as an offset for risk.

     

    as an *aside*, I'm trying to get better at financial analysis. Did you hone this by self learning or are you one by profession? If the former, what resources do/did you use.
    31 Oct 2013, 08:25 AM Reply Like
  • Palladium31
    , contributor
    Comments (544) | Send Message
     
    Author’s reply » FM, thank you!

     

    My experience is a little bit of both I think. I do have many, many years of professional business tax and accounting experience, but the finance part is mostly self-taught (although having worked on numerous large transactions from "soup to nuts" has certainly helped).

     

    That said, Seeking Alpha has really been a great outlet for me, and I have found that I learn quite a bit by reading through earnings transcripts (especially the analyst Q&A) and SEC filings, particularly 10Q and 10K filings and connecting the dots between what management is telling the street and how the actual operating picture unfolds over time through the Qs and Ks. Whenever I come across a concept or term I don't understand, Google and Investopedia have admittedly been very useful research tools as well.

     

    Best Regards,
    P31
    31 Oct 2013, 11:51 AM Reply Like
  • Qniform
    , contributor
    Comments (3820) | Send Message
     
    Very interesting analyses, Palladium (this one and Realty Income, below). Thank you for sharing.
    31 Oct 2013, 11:19 AM Reply Like
  • Palladium31
    , contributor
    Comments (544) | Send Message
     
    Author’s reply » Thank you Q. I very much appreciate hearing that.

     

    Best Regards,
    Palladium
    31 Oct 2013, 11:52 AM Reply Like
  • MathRulz
    , contributor
    Comments (644) | Send Message
     
    Palladium,

     

    Thanks for digging in to this!

     

    On your item 1 above, I read the press release a little differently.

     

    "whereas only the current period portion of $830,000 has been included in core FFO for the third quarter of 2013."

     

    Clearly core FFO for third quarter only includes $830,000 attributable to that quarter, the $.006 per share. However, as I read the release it does not say that the $10 million is not fully included for the year in core FFO. In fact, I think it is in the core estimate for the year. It clearly belongs there because they included the third quarter's share in the third quarter core.

     

    If I am correct on this, it relieves some of the amount that you have put in the other categories.
    31 Oct 2013, 11:59 AM Reply Like
  • Qniform
    , contributor
    Comments (3820) | Send Message
     
    I made that interpretation also, MR. 'Included' is pretty loose. I wish they had said something like "while the entire $10MM has been recognized in the revised 2013 projection, only $830K is attributed to the Q3 FFO" - or something like that. I bet if we asked IR they would respond...
    31 Oct 2013, 12:06 PM Reply Like
  • Palladium31
    , contributor
    Comments (544) | Send Message
     
    Author’s reply » Math,

     

    Thank you very much!

     

    My interpretation of only a $0.006 impact to "core" FFO is correct. No need to call investor relations.

     

    Here is what Bill stated on the call (from the Seeking Alpha transcript): "We booked a $10 million noncash true-up in the third quarter because we discovered that we had not previously remeasured the straight-line rent expense related to one of the handful of leasehold interests in our portfolio when we executed a 10-year early extension and modification of this leasehold in September of 2010.

     

    The $10 million adjustment that we booked during the quarter represents a catch-up of the noncash straight-line rent that should have been recorded from the fourth quarter of 2010 through the third quarter of 2013 at a run rate of approximately $830,000 per quarter.

     

    The entire prior-period adjustment has been included in reported FFO, whereas only the current period of $830,000 has been included in core FFO for the third quarter of 2013. Let me emphasize that the straight-line rent is always and everywhere an add back to FFO in the calculation of AFFO. So there is no impact on AFFO, regardless, for any period involved."

     

    Remember that FFO is a non-GAAP measure, and "core" vs "non-core" is even further removed from GAAP, so there is no requirement that they put something in one grouping versus another. But because the "core" concept is useful, I've decided to analyze what they've given us.

     

    Best Regards,
    P31
    31 Oct 2013, 12:29 PM Reply Like
  • MathRulz
    , contributor
    Comments (644) | Send Message
     
    P31,

     

    If that's right, not putting the $10 million in core for the year, I don't see why they bother putting the $830,000 in core for 3Q.
    31 Oct 2013, 12:41 PM Reply Like
  • Palladium31
    , contributor
    Comments (544) | Send Message
     
    Author’s reply » Math,

     

    I think its because $9,170,000 of the "true-up" recognized in the quarter related to prior periods and had nothing to do with actual Q3 earnings, whereas $830K actually had to do with the Q3 earnings and would have been in there had they gotten things correct from the get go. Thus, I think "core" is the company's way of saying "actual without regard to one-time events that may distort the picture of normal operations". Does that help?

     

    P
    31 Oct 2013, 12:47 PM Reply Like
  • MathRulz
    , contributor
    Comments (644) | Send Message
     
    P,
    No, doesn't help me. If they think it actually had to do with Q3 earnings and put it in core for Q3, then it actually had to do with Q2 and Q1 earnings and will for Q4, etc and they should put it in core for the year.
    31 Oct 2013, 12:51 PM Reply Like
  • Palladium31
    , contributor
    Comments (544) | Send Message
     
    Author’s reply » Math,

     

    I see your point and I think what you're saying is that you'd expect $830K*4 = $3,320M to show up in "core" ffo for 2013. I think I can agree with you because Bill's comment that I was basing my original number on actually appears to be Q3 specific. Thus, after making this change we can explain $0.023 of the "core" FFO decline instead of $0.006 as I was initially thinking. I'll make the change above. Thank you.

     

    However, I think I would still draw a similar conclusion that 2.3/17 = 13% of the decline in "core" 2013 FFO relates to this error, so it's definitely not the key driver.

     

    Best,
    P
    31 Oct 2013, 01:07 PM Reply Like
  • MathRulz
    , contributor
    Comments (644) | Send Message
     
    P,

     

    "so it's definitely not the key driver. "

     

    Definitely agreed. More like something to just make the muddy water a bit murkier.
    31 Oct 2013, 01:24 PM Reply Like
  • YCantIRetire
    , contributor
    Comments (531) | Send Message
     
    TY:P31
    31 Oct 2013, 12:09 PM Reply Like
  • Palladium31
    , contributor
    Comments (544) | Send Message
     
    Author’s reply » YCIR,

     

    You are very welcome as always.

     

    Best,
    P31
    31 Oct 2013, 12:36 PM Reply Like
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