QTS Realty Trust, Inc. (NYSE:QTS)
Q1 2016 Earnings Conference Call
April 26, 2016 10:00 a.m. ET
Stephen Douglas - Head of IR
Chad Williams - Chairman and CEO
Bill Schafer - CFO
Dan Bennewitz - COO of Sales & Marketing
Jeff Berson - Chief Investment Officer
Jon Petersen - Jefferies
Jonathan Schildkraut - Evercore ISI
Jordan Sadler - KeyBanc Capital Markets
Matthew Heinz - Stifel
Simon Flannery - Morgan Stanley
Jonathan Atkin - RBC Capital Markets
Vincent Chao - Deutsche Bank
Richard Cho - JPMorgan
Fred Moran - Burke & Quick
Good morning, and welcome to the QTS Realty Trust First Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note that this event is being recorded.
I would now like to turn the conference over to Stephen Douglas. Please go ahead.
Thank you, operator. Hello everyone, and welcome to QTS' first quarter 2016 conference call. I'm Stephen Douglas, Head of Investor Relations at QTS, and I'm joined here today by our presenters, Chad Williams, our Chairman and Chief Executive Officer; and Bill Schafer, our Chief Financial Officer. We're also joined by Jeff Berson, our Chief Investment Officer, who will participate in Q&A.
Our earnings release and supplemental financial information are posted in the Investor Relations section of our Web site at www.qtsdata centers.com on the Investors tab. We also provided slides and made them available with the webcast and on our Web site, which we hope will make it easier to follow our presentation today.
Before we start, let me remind you that some information provided during this call may include forward-looking statements that are based on certain assumptions and are subject to a number of risks and uncertainties as described in our SEC filings, and actual future results may vary materially. Forward-looking statements in the press release that we issued yesterday, along with our remarks today are made as of today and we undertake no duty to update them, as actual events unfold.
Today's remarks also include certain non-GAAP measures, including FFO, operating FFO, adjusted operating FFO, MRR, EBITDA, and adjusted EBITDA. We refer you to our press release that we issued yesterday and our periodic reports furnished or filed with the SEC for further information regarding our use of these non-GAAP financial measures, and a reconciliation of them to our GAAP results. These documents are available on the Investor Relations page of our Web site.
And now, I will turn the call over to Chad.
Thanks, Stephen. Hello, and welcome to QTS' first quarter 2016 earnings call. I am pleased to be speaking with you this morning on another strong quarter and executing QTS' differentiated strategy.
On slide three, our approach to infrastructure and products continues to differentiate QTS in the marketplace, and this is the foundation of our consistent performance. We believe we are uniquely positioned through our diversified revenue base to capitalize on increasing positive demand trends within our sector, by offering services across C1 customized data center, C2 colocation, and C3 cloud and managed services. We are able to diversify our revenue mix, drive higher returns on invested capital, and position the business to drive higher value and broad solutions to build strong customer partnerships.
Ongoing growth in data, cloud expansion and increased sensitivity around security and compliance are adding more complexity to enterprise IT stacks than ever before. We believe the prevailing view among CIOs in major cloud players is that ultimately enterprises will move towards a hybrid architecture, including a mix of both in-source and outsource data centers and private and public cloud. As a result, the enterprise customers are increasingly looking to outsource their IT infrastructure solutions to third-party providers like QTS, who can provide the flexibility and broad solutions capabilities that are the cornerstone of QTS' differentiation.
At QTS, we offer customers a flexible solution with the product mix and engineering support to work with customers as the IT stack grows in complexity. We are also able to work with customers as they move from C2 colocation environment into C3 private and hybrid cloud environment without the need to shift providers, should their cloud migration strategy and timeline change. Our ability to offer this type of flexibility is what customers need from the marketplace, and is valuable differentiator for our ability to win new business.
Risk management and compliance also continue to play a critical role in the enterprise decision around data center outsourcing. Each well-publicized cyber security breach reinforces that many enterprise customers are not equipped to manage today’s security threats. QTS has invested early in our security and compliance function, both in terms of physical and logical security, including an in-house audit and compliance staff. And we continue to hear from our customers that our capabilities and focus here are differentiating us in the market.
Offering less level of customization and flexibility, wrapped around a culture devoted to the highest security and compliance standard is why QTS is proud to be known as an industry-leader in customer service. Together, our product mix and data center infrastructure provides us the opportunity to drive strong and steady growth, industry-leading return on invested capital and a higher customer satisfaction and retention.
Next on the results on slide four, for the first quarter of 2016, we have continued the strong momentum that we experienced exiting 2015, with healthy year-over-year growth rates across all key financial metrics. For the first quarter of 2016, we achieved revenue of 95 million, up 54% over the first quarter a year ago; adjusted EBITDA 43 million, up 53% year-over-year; operating FFO of 33 million, up 70% year-over-year; and operating FFO per share of $0.68, up 35% year-over-year. This successful momentum has also led to an increase in our booked-but-not-billed backlog to 52 million at the end of first quarter, up from 48 million last quarter. This signed and committed backlog supports solid revenue growth, de-risking 2016 and driving growth into 2017.
We also achieved an annualized unlevered return on invested capital of 15.6% for the first quarter of 2016. This ROIC remains above our target level of 15 plus percent unlevered returns on a fully stabilized basis. During the quarter we brought on an aggregate of 34,000 square feet of raised floor online in Dallas, and Atlanta, and made great progress building out our Chicago site for an early third quarter opening.
Lastly, we continue to move forward on customer migration discussions. As detailed in prior calls, are in dialog with a number of customers regarding their potential to migrate to core QTS facilities. We are confident that this migration would drive operating efficiency, reduce cost, and enhance shareholder value in 2016 and beyond.
Moving to slide five, Chicago remains a market that we are very excited about, and we remain confident we have the right asset in the right market at the right time. Located in downtown Chicago on 30 acres, two miles from the primary carrier hotel facility in Chicago, our site will be able to initially support up to 133,000 square feet of raised floor, with the opportunity to more than double that through development of adjacent landholdings. Our Chicago sales team is now in place and has been building a pipeline of demand, and we remain confident that Chicago will be a great success for our business for the years to come.
We look forward to updating you on the progress in Chicago as we open the facility in Q3 of 2016, and ramp up during Q4 and into 2017. As we discussed last quarter, typically with the initial phase of a new development, we would expect the opening of our Chicago facility to slightly reduce our overall return on invested capital to below our 15 plus percent target in the second half of this year, ramping back up as Chicago operations commence and grow.
Next on slide six, I would like to spend a few minutes discussing our approach to return on invested capital. Our company-wide unlevered return on invested capital target of 15 plus percent or greater is the standard against which we evaluate investment opportunities internally and externally. We continue to believe that there are two key differentiators to the QTS story that allow us to generate above-average returns. First, our patient and opportunistic approach to finding mega scale infrastructure has resulted in a below-market build cost for the company. Second, our commitment and investment in our integrated solution affords QTS the opportunity to maximize utilization and capital efficiency, while driving higher rents per square foot, and better customer retention.
Using Richmond as an example of our mega scale integrated model, we have seen the return on invested capital in Richmond grow to 12.2% as of Q1, driven by the operating leverage in rising C2 and C3 revenue penetration. Since opening the facility four years ago, we have brought on over 150,000 square feet of raised floor in service, supporting our acceleration in returns on capital. Additionally, we still have over 400,000 square feet of remaining capacity to sell add incrementally higher returns in the future. We have seen the success of this strategy in Atlanta, and are now seeing it in Dallas now as well, and look forward to executing on our strategy in Chicago, once it opens in Q3.
On slide seven, I’d like to highlight some of the key customer wins during the quarter. The first customer, one of the largest and fastest growing Hyperscale cloud service providers in the world signed an eight megawatt C1 lease in Dallas-Fort Worth data center, with four megawatts signed during Q1, and an additional four megawatts signed subsequent to the end of the quarter. This lease-signing demonstrates the continued momentum and success we are seeing in Dallas. Including our updated expansion plans, we now expect to end 2016 with approximately 110,000 square feet of raised floor build out in Dallas. And we’re excited to have accomplished this just in a little over two years.
Additionally, there is clearly a lot of momentum regarding cloud in our industry, and we at QTS believe we are well-positioned to capitalize on this trend, by one, providing C3 cloud service directly to customers. And two, supporting larger cloud providers, like this customer in Dallas, through our C1 mega data center footprint. This new QTS cloud customer, in addition to the recent announced signing of Virtustream, another leading enterprise cloud providers, as well as two of the largest global public cloud providers already in our portfolio. This demonstrates our continued success in differentiating our products to appeal to the private and public cloud verticals.
Next, we signed a new C3 customer in Dallas, Virginia, and Phoenix, Arizona data centers. This customer, one of the world’s largest defense contractors worked with QTS and VMware for over six months to develop a FedRAMP-compliant cloud solution. QTS was selected for the high levels of physical and logical security we were able to offer, as well as our expertise around protecting data and compliance with our FedRAMP certification that is supporting over 50 authorities to operate or ATOs.
Also in the first quarter, we had existing C2 customer, a multi-billion dollar global software company who is looking to leverage cloud architecture to move to more of a SaaS model. We were able to work with them as their IT stack shifted to more of the pure C2 footprint to reduce C2, and an incremental C3 combined footprint. In doing so, we were able to significantly increase our annual revenue with this customer in a three-year multi-product contract. Our ability to offer enterprise customers a product roadmap, as well as contractual flexibilities to support their changing and evolving needs continues to be a core value proposition for QTS in the marketplace.
In addition to this customer, we also had a new C2 retail manufacturing customer that signed with us, in large part driven by the optionality we were able to provide in their contract to shift C3 as their needs changed over time. Once again, these are great examples of how our C3 business supports our C1 and C2 customers by providing flexible IT solutions to meet ongoing changes around customers, IT stacks and cloud migration, and enables deeper and more connected relationships which grow and adds profitability over the relationship.
Now moving on to our leasing performance for the quarter on slide eight, for the quarter we signed new and modified leases representing approximately 8.6 million of net incremental annualized rent. Slightly below our four-quarter average, this does not include the incremental four megawatt lease expansion signed subsequent to the first quarter with a leading global Hyperscale cloud provider, which we previously discussed. Had that expansion contract occurred during the first quarter, our net leasing would have been nearly double in Q1.
Our overall results this year were strong, but we were impacted in part by two contracts in our C3 cloud and managed service business that I will discuss in more detail. First, we experienced elevated downgrade activity during the quarter largely driven by one customer that reduced its MRR by approximately 2.4 million on an annualized basis. A primary driver of this reduction is that the customer shifting a portion of their product mix has a transition their infrastructure from QTS c3 to their own infrastructure environment house within QTS data centers. As a result, the customer received a price reduction in line with the difference in pricing from C3 to a blended C2, C3 environment to reflect the operational savings and cost advantages that benefit both QTS and our customer.
In addition, due to this product shift, a portion of revenue from this customer shifted from C3 to C2 during the quarter. This demonstrates again our ability to work with customers as their IT stack changes and evolves; in this case, from a customer moving a portion of their IT stack from C3 to colo, while we retain this rapidly growing customer.
Second, we had a customer that exited our platform which drove churn from approximately 1.3% to 2.3% for the quarter. This quarter after signing up with us was part of a spin-off from its parent company and as part of this restructuring their IT infrastructure requirements changed. Although we were hoping to keep this customer, we did anticipate this past possible churn and it was factored into our full year guidance of 5% to 8%, which has not changed.
In addition to these two larger transactions, we have also seen general turn in downgrades from a handful of smaller C3 customers as we begin to work with the customers on migration from leased facilities to core QTS-owned facilities. As a result of these factors, we saw lower sequential cloud and managed service revenue for the quarter. We anticipate additional pressure from these events to be reflected in our Q2 results as we absorbed the revenue shift and pricing impact from Q1 events over the full second quarter. We anticipate our C3 customers and revenue trends to normalize during the second half of the year.
Although we never like to see revenue reduction, it is important to note that our ongoing customer service flexibility and migration initiative will result in some revenue tradeoffs in order to allow us to grow with our customers, drive more efficiency and profitability in our model and a meaningful driver of our expectation of margins expanding 300 basis points over the next few years. In addition, these items including the one-time churn event were fully factored into our 2016 guidance, which has not changed.
Our pipeline continues to grow. Our momentum in the new markets is strong, and are expected to increase with Chicago and our return on capital, margin improvement and profitability has never been stronger.
Moving on to pricing, first quarter pricing for the new and modified leases was up approximately 10% in C2 and C3, compared to the prior full quarter average. C1 overall pricing was down as a result of higher leasing volume and larger scale leases signed during the quarter.
Regarding renewals, on a like-for-like basis where customers renewed contracts without exchange and square feet, we experienced renewal rates for the first quarter of 2016 that were consistent with our pre-renewal rates. This excludes two customers who shifted their services, which impacts pricing per square foot, but does not reflect changes in market pricing. With the inclusion of these two customers, our overall renewal rates were down 3.7% from the pre-renewal pricing rates. As we've said in the past, this number will fluctuate by customers changing their product mix during different periods.
Lease commitments pricing during the quarter was 30% higher compared to our prior fourth quarter average driven primarily by C1 pricing strength and a higher mix of C2 and C3 business. Overall, the pricing environments across our footprint remain strong.
In summary, we're pleased with the momentum in the business and remain confident that our fully-integrated platform, mega data center infrastructure, and security and compliance capabilities will continue to differentiate us in the market, and drive consistent growth and return on capital.
Now, I will ask Bill Schafer to discuss our financial performance, balance sheet, and outlook. With that, over to you, Bill.
Thanks, Chad, and good morning everyone. As you can see on slide 10, once again, we were able to generate strong across our key financial metrics on a year-over-year basis.
We saw this growth consistently across our facility footprint. Year-over-year, Q1 NOI increased 17% in the Atlanta market and our California market NOI increased a little over 8% despite still limited available capacity. Our Richmond and Dallas mega facilities continue to drive outsized year-over-year NOI growth at 55% and 250% respectively. And we see continued run rate to invest and drive significant incremental growth in these facilities over the next several years.
NOI within our lease facilities declined year-over-year due primarily to the items within C3 that Chad previously referenced. Our margin in the first quarter showed significant improvement over the prior year quarter as well, increasing 110 basis points to 45.4% in Q1 from 44.3% in Q4 of 2015. This was driven by a combination of ongoing expansions f our mega facilities and from the efficiency measures we are implementing with customer migration. It was also impacted by lower utility costs during he first quarter which typically dropped during Q1 and increased again during the second and third quarter.
On slide 11, our backlog of annualized booked-not-billed revenues from signed but not yet commenced leases stood at 51.6 million of annualized revenue as of March 31, 2016; up from 47.7 million last quarter. In addition this increased backlog does not incorporate the additional 4 megawatt expansion signed after the close of the first quarter. This high level of backlog continues to give us great visibility in the cash flow growth embedded in the business.
Next on slide 12, capital expenditures incurred during the first quarter were approximately 61 million. Our continued focus and commitment to capital efficient growth drove an average annualized return on invested capital for the first quarter of 15.6% for a business that still has tremendous capacity available to drive incrementally higher returns. This continues to meet our target level of 15%, although it varies based on the timing of new development projects, acquisitions, and other expansion opportunities.
Turning to development on slide 13, for the first quarter, we brought online 34,000 square feet of raised floor at out Atlanta-Metro and Dallas Forth Worth mega data service. As of the end of the quarter, our total built out raised floor was over 1.2 million square feet, which represents just over half the total powered shell raised floor capacity of 2.2 million square feet in our existing facilities.
Factoring in land that we own adjacent to all of our mega data centers we could double our current power shelled capacity. This capacity provides us with comfort that we can control our future development at a known lower cost and lower risk path to support our future growth.
We continue to anticipate bringing online additional capacity in Chicago, Dallas, Atlanta, Richmond, Santa Clara and Jersey City over the course of 2016. As a result of the large 8 megawatt deal referenced in our first release we now expect to bring an additional 16,000 square feet of raised floor online in Dallas in 2016 relative to the redevelopment plan we disclosed last quarter.
We will continue to focus on capital efficiency in our development plans and of accelerated this development schedule without changing our 2016 CapEx guidance of 300 million-315 million.
Moving to slide 14, I will review our resulting balance sheet and liquidity position. On April 1, 2016, we issued 6.3 million shares of common stock. The net proceeds from the issuance were approximately 276 million which were primarily used to repay amounts outstanding under our unsecured revolving credit facility and for general corporate purposes.
Since we received the proceeds from the offering on April 1st, our quarter end does not reflect the receipt of the equity proceeds. Pro forma for the equity raised are total debt outstanding including capital leases as on March 31, 2016 was 681 million or approximately 276 million less than the reported balance as of March 31st.
Our pro forma debt to first quarter annualized adjusted EBITDA was approximately 4.0 times as compared to the reported 5.6 times. We do expect this will increase in coming quarters as we deliver on our development pipeline. Pro forma for the equity offering we have significant liquidity capacity in our balance sheet at the end of the quarter we have a total of approximately 576 million in liquidity in the business made up of availability under our credit facility in cash again pro forma for the equity raise.
We remain pleased with the strength of our balance sheet included attractive interest rates, no near-term debt maturities, minimal secured debt and significant available liquidity. We will continue to lock in fixed rate, extended maturity debt over time. However, following the recent equity raise and lowering resulting balance of variable rate debt at present there is no immediate need to lock in fixed rates.
Finally, on slide 15, we are reaffirming our core operating guidance for 2016 and updating our OFFO guidance to reflect the impact of lower interest income following the common stock offering which was completed subsequent to the end of the quarter.
We continue to expect core organic revenue growth in the mid-teens adjusted EBITDA to be between $177 million and $185 million and annual churn of 5% to 8%. In addition we continue to anticipate approximately 300 basis points of adjusted EBITDA margin expansion over the next few years. We have raised our full year operating FFO expectation to a range of a $135 million to a $140 million, up from our previous guidance of a $125 million to a $130 million due to lower interest expense following the equity raised and close subsequent to the end of the quarter. The proceeds of which were used to repay amounts outstanding under our unsecured credit facility. Although we have raised our OFFO guidance for the year our operating FFO per share guidance is unchanged from last quarter at $2.54 to $2.64 per share due to offsetting impacts from a higher share count following the equity issuance.
A new higher share count and the resulting interest expense savings are the only significant changes that are made affecting our guidance. And our core operating guidance remains consistent with last quarter. As a reminder our 2016 operating FFO guidance includes an estimated non-cash tax benefit of approximately $4 million to $5 million.
Lastly, as we already mentioned our 2016 guidance for capital expenditures is also unchanged at between $300 million and $350 million. Looking at Q2 we want to highlight two items just to provide some additional clarity from modeling stand point, first we want to anticipate OFFO per share to decrease sequentially in Q2 as a result of a higher share count following the equity raise which was completed at the end of Q1.
Second as a reminder, when thinking about adjusted EBITDA margins we typically see higher seasonal utility costs in the second and third quarters which we expect to reduce margin somewhat from Q1. Overall we remain pleased with the underlying trends in our business and are excited about the significant run rate received or incremental profitable growth in our markets.
Our 51.6 million booked-not-billed pipeline of business provides enhanced visibility and we believe we have positioned our balance sheet and liquidity to adequately support strong expectations for future performance.
With that, I will turn it back to you Jeff.
Thanks, Bill. We are off to a strong start in 2016 as demonstrated by our first quarter performance. We continue to be excited about the opportunities in our markets and with our customers. And we are focused on executing on our core strategy to consistently drive above average returns. QTS is gearing up for the upcoming launch of our Chicago mega data center at the beginning of Q3 and we look forward to updating you on the progress there on future calls.
I want to thank our customers and shareholders for their continued trust and confidence in QTS. In addition I'd like to recognize our employees for their continued hard work and commitment delivering premium customer service take dedicated people, and we at QTS are powered by our people. We expect our comprehensive solutions-based approach to customers will continue to differentiate QTS in the market, and drive long-term value for shareholders.
Now, I’d like to open up the call to questions. Operator?
Thank you. We will now being the question-and-answer session. [Operator Instructions] Our first question comes from Jon Petersen of Jefferies. Please go ahead.
Great, thank you. So I guess I had a few modeling-type questions first. In terms of the -- you guys had just talked about guidance, maybe we can touch on that. The 300 basis points of expanded EBITDA margin, was that -- I guess, what do you expect to drive that more, operating expense or G&A, because I think G&A probably increased a little more than I would have thought. I would have thought we’d be a little more flat this year.
Yes, hi, Jon. This is Jeff. So just to be clear, that guidance is off of the pro forma margin that you saw at the end of last year with the Carpathia acquisition. So we’re at about a 44% EBITDA margin at the end of last year, looking for that to grow by about 300 basis points over the next few years.
Part of the driver of that margin expansion is, as we talk about driving efficiency in the business and customer migration. So that’s where you’re seeing part of it. You’ll see some of that happen at the NOI line, and you’ll see some of that happen at the G&A line. Part of the reason that the G&A was pretty stable this quarter was the attempt to see incremental expenses in G&A from accruals and taxes early in the quarter. And then that ramps down towards the end of the year. So being relatively flat on G&A as a percentage of revenue from Q4 to Q1 is actually demonstrating some efficiency in the G&A number as well.
Okay, all right. That’s helpful. And then just kind of a higher level question, the federal government for many years has been talking about consolidating their data center, all the data centers they’re having around the country, but they came out like a month or so ago, and put a freeze on incremental spending. I was hoping you could talk high levels, among the data center guys you focus probably more on the government than anybody else does, and what you’re seeing in your business in terms of government expansion if you’ve seen any slowdown in the last few months?
Yes, Jon, this is Chad. Government and slowdown probably does go together from a word context, but we do have a unique opportunity with our infrastructure both in Richmond and in Dallas. The products that we offer with FedRAMPs, one of the few FedRAMP-certified cloud providers within the space, and I do think, and I’ll let Dan add to this, we feel opportunistic that the opportunity for the government once they do kind of get the rhythm of what they want to do and how they do want to consolidate I do think there’s some themes around they do want to consolidate and mostly because they have to, because they have to reduce cost and have to deliver their services in a more comprehensive way. And even though they traditionally are a slower mover or a machine to move that direction, we do feel like that we are well-positioned that if that opportunity does exist and comes through, that we’ll be one of the few that can deal with them across the spectrum of our products, whether it’s large wholesale in Richmond or cloud and integrated FedRAMP services better focused on security and compliance with our tools there. Dan, I don’t know if you have anything to add to that.
Yes, Jon, what I’d add is -- first back on Chad’s remarks, one of our key wins this last quarter was a federal contractor who re-signed a FedRAMP cloud with us and VMware across three of our data centers. So I think that’s an example of some of the solutions that are gaining traction in the federal marketplace. So, our ability to offer both cloud as well as data center capacity we think will play well. As you can imagine and know, the federal government is a large and complex organization, and some things move slower than in the commercial space, but we feel good about our solution portfolio and the relationships we have with the contractors and systems integrators in the federal states.
And one thing you should add to that, Jon, and the way we think about that is it’s more of an opportunistic lever that gets pulled when the opportunities present themselves. It’s not something that we’re foundationally building our growth profile on, but just like with strategic mega data center or Hyperscale customers, when the right opportunity, the right profitability and the right mix comes along, we can be very effective in the marketplace, and it’s an accelerant for growth.
Okay, all right. Thank you.
Our next question comes from Jonathan Schildkraut of Evercore ISI. Please go ahead.
Hi, great, thanks for taking the questions this morning guys. I guess, Bill, maybe I could start out with some simple ones, and then I had some sort of more strategic questions. But you guys have talked about the incremental transaction with a Hyperscale cloud provider. Is there any way that you can give us an updated backlog perspective in terms of where the number goes as we include that deal into the mix of stuff that we have visibility in terms of commencing over the next several quarters? And then I’ll swing back with another question if I may.
As far as with the backlog, our booked-not-billed did grow to almost $52 million. Again, this was a customer that -- when we sign the C1 deals, there’s typically a ramp. It’s going to be very back-ended as it relates to this year, but again, as we kind of build out our Dallas facility, and we’ll be looking to open Chicago in the not-too-distant future here. And I think we continue to see solid growth in the pipeline of the deals. And I can turn this over to Dan to have any comments there.
Yes, I’ll just add, as you recollect, our booked-not-billed increased about $4 million quarter-to-quarter. And Bill said it’s almost 52 million. I think you’ll the impact of the latest announcement we saw in 2017.
Okay, so I'm not going to get an answer. That's all right. Let me ask you this, the mega scale guys that you’re out there competing for today, and I guess, first, are you seeing the market tilt towards larger footprint deals right now? Or are you still seeing a fair good spread on the types of deals that are out there? And then secondly, when it comes to winning some of these mega scale providers, they are not looking for C2, C3, they’re coming in and they’re looking at the value proposition of the large footprint opportunities. Where does QTS come in from a value proposition perspective for somebody who really is only looking for C1? Thanks.
Yes, thanks Jonathan. I’ll try to answer this question. So our mega data center footprint allows us to have the size and scale at the infrastructure level to have all of those conversations. Now keep in mind that from our standpoint, the driver for our business or the standard in which we view our business is our return on invested capital. And so if it gets down to a C1 deployment where they need massive scale but they also are looking for extremely aggressive pricing, you could say that on our footprint, in our infrastructure and our low-cost basis of infrastructure, we can deliver that and still be very profitable. But we also have a robust business, to our point around C2 and C3 that drives our space and our demand.
So what we’re looking for is intersecting the right type of customers that we feel like are strategic, and that will be profitable clients for us, not just short-term, but long-term. And I think the value proposition they have, because keep in mind there’s about four or five of those types of customers alone in the cloud space in our space today. And what they do value about QTS is our differentiation around service. And we have people, and process, and personnel that deliver a much different service than maybe a traditional wholesale, where it’s literally, here’s the keys, because they are taking advantage in having the opportunity to intersect at a much higher level -- a service level. And when you take compliance and security, which is a focus of theirs also, the conversations are very rich and very rewarding in our ability to differentiate, and play at the mega data center infrastructure level. And we’re finding good opportunity. And Dan, I don’t know if you have anything to add to that?
First off, we’re looking through profile of -- they're about of the value -- they're looking for fits [ph] our model, and as Chad said, we house not only the recent win we just announced, but also a number of other larger software-as-a-service cloud Hyperscale providers. And when they’re looking for more than just a low price, they’re looking for how do we handle their logistics, how do we handle and support their operational efficiencies. That’s the -- a really good fit for their requirements with what we can provide. And we do that today with clients in Richmond, in Atlanta, in Suwanee [ph], and in Dallas.
I think the other point I’d add is our low basis and our ability to have low-cost advantages allows us to lean in strategically, particularly early in a site development, which we’ve done. And we can still do that and get the double-digit returns that we look for in each of our sites.
Awesome. Thank you for taking the questions.
Thank you, Jonathan.
Our next question comes from Jordan Sadler of KeyBanc Capital Markets. Please go ahead.
Thanks. Good morning. Something of a follow-up to the prepared remarks and then the prior questions, in terms of organic growth, where are you seeing better momentum from a product perspective, C1 or C3? And I guess, Chad, you alluded to the momentum in the cloud, both for C3 potential customers and C1, but where at the margin, in 2016, will you see better momentum between the two products?
Yes, thanks Jordan. I’ll take a little bit at the front, and then I’ll hand it off to Dan, as he’s on the ground with our people every day. The one thing that we also talk about, maybe not as focused in this earning’s as past, is that we really do consider the engine in our business, our retail, our C2. And it continues with our people across the country, and having teams in each location that kind of go out. So we think about that being the driver of our business, intersecting customers, and cages and cabinets, and attached services. And you’ll hear Dan talk a little bit about our service-attach initiatives around connectivity, and storage, and services, and those types of things.
So we consider that to be kind of the engine, and the basis of our ability to just execute. And then we really do look for the C1 opportunities, and the C3 to be more of an accelerant to that core business. And so if I was to tell you today, what does Chad Williams think will be a accelerant for growth in ’16 to complement the engine in retail, obviously there is a lot of momentum around Hyperscale cloud deployments, and what’s happening around the markets. And we have the infrastructure and scale to be able to have very relevant conversations when they’re strategic fits for QTS and for that customer. So I would say this year, unlike some past years, C1 has certainly got momentum. And we’re certainly going to try to continue this conversation.
Dan, I don’t know if you have…
Yes, I think -- Jordan, this is Dan. Just to tag along with what Chad said. If you look at previous bookings, we had the 19 megawatt win previously, the eight megawatt win we just announced. They’re going to be ramping later this year, and into 2017. So I think those will drive C1 revenue for those periods. But we also see -- C2 is the engine of our business, that steady-state run rate business, and C3 ramping particularly in the second-half of this year. So I think we’ll catch up to the C1 ramp. But maybe as a follow-on to that, we’re seeing interesting –- with a demand for C3 is our, the legacy Carpathia customers, there’s a number of situations where our scale is very attractive to those customers. And I think we’re excited about that.
We also see the additional expertise in cloud and managed hosting that we got from this acquisition attractive to QTS customers. So we think this combined team allows us to have an expanded solution portfolio that’s attractive to a larger or a different segment of the market that typically we didn’t play-in in the past. So that’s why we feel good about the second half of the year, the C3 momentum. Obviously, in the prepared remarks we had some one-time events this quarter that are impacting C3, but we feel very good about that moving forward.
As a follow-up, can you maybe talk about the discussion with the Hyperscale cloud customer as it related to your internal cloud that you host? Was that viewed as an opportunity, competitive threat and sort of -- what was the discussion over the interplay there?
Thanks, Jordan. I’ll take the first, and then let Dan talk a little bit about from his perspective. But what’s interesting about it, and I know most of -- there is a lot of conversation around this, how does this intersect. I will tell you that the conversation around that with this particular client was very non-event. I mean, people kind of understand that the world and complexity is growing. And the needs for customers and solutions are abundant. And I think at the end of the day, do not feel competitively threatened by a core product, whether it’s our compliance and security, our private or managed cloud that we’re offering to a very specific group of clients.
The scale and the opportunity in which they’re building their businesses, at least from my perspective and what I hear, it is not a competitive landscape. And I know that that’s been something that a lot of peers have talked about. I actually don’t see that playing out in the world that we live. And it’s not affecting our clients. And they are valuing the services we can bring. Because, keep in mind, with that ability to do a higher level of touch and service comes benefits for them that they recognize and value. Meaning that our compliance and security teams, even though they may not be on our FedRAMP-compliant cloud product, and they’re taking mega scale data center infrastructure. That product starts at the physical layer of security and infrastructure. And the value of our compliance and security abilities blends through to all of our products.
So, our C1 customers are getting the benefit of those additional services. And once they are a customer, they even see and feel that more with our ability to deliver a higher level of service, even for the C1 product. And, Dan, I don’t know if you have anything to add to that.
Yes, Jordan, I’d answer it is, it’s really a non-issue. They don’t run into QTS in the marketplace, and we don’t run into them. They’re really different market segments, so it’s really a non-issue.
And I would add that the one thing that we are having conversations about is our ability to let our clients burst into public clouds of scale as an additional connectivity product that QTS offers our customers. So we’re taking it as, if you’re going to use our infrastructure and be in this place, there’s a lot more ability to cooperate than compete, and that’s what we’re seeing play out in our data centers.
Okay, thank you. One last one for Jeff if possible, Bill managed to raise some capital post-quarter-end. I'm curious, there's no change in the CapEx guidance, but I know you guys are real sensitive to return on invested capital, and this raise obviously has some impact there on the denominator. Any thoughts on putting that capital to work and may be how you were able to maintain CapEx guidance but sort of increase the amount that you're going to be able to deliver?
Sure, Jordan. And I think at some level you kind of helped me in answering that question. Because the reality is we are constantly focused on capital efficiency and return on capital. And so, what we like is the ability to increase our development this year, a little bit off of that four megawatt or eight megawatt deal that we just signed. Bringing our balance sheet down to have some capacity to the extent that we need to continue to accelerate our capital and grow our business at the right returns. But just because we have the debt capacity and the incremental development capabilities, it doesn’t mean we’re just going to go out and spend additional money. We’re going to be disciplined on what we do there.
And as we talk about CapEx, and not CapEx spending. And if we’re in a situation where we accelerate our CapEx spending, it’s all going to be based on being able to hit those 15 plus percent return on capital thresholds, and managing that capital efficiently. So we are on a regular basis, looking at how we spend that money, and making tradeoffs and decisions about where to shift capital to drive those returns.
Our next question comes from Matthew Heinz of Stifel. Please go ahead.
I was hoping to gain a little more clarity on the C3 downgrade. Was this a legacy Carpathia customer that you believe would have otherwise churned out completely? And then, also, was the revenue from its C2 transition fully recognized in the first quarter?
Well, first of all, I’d say is all the customers are QTS customers right now. And I think what we typically see in churn is that customers churn when there is an event like a merger or an acquisition, or in this case, it's spin-off. And so, we continue to see that and expect that, and we saw that early on, and included that in our guidance. And I think you will see in addition, we saw some shift that we talked about in Chad's remarks, one customer who had a downgrade, but also shifted -- spent with us from C3 to C2. And we think that's a great example of how our integrated platform and service portfolio allows us to be relevant to more customers as they grow in as their needs change in the future.
Okay. So, I guess, what I'm driving at is, was this event an example of perhaps one of the benefits of the acquisition in being able to transition that customer and keep the customer in the QTS footprint in a case where you may have otherwise, or Carpathia as a standalone may have lost the customer?
Yes. You hit that nail on the head. Our ability to offer C2 solutions across the portfolio of data centers is very attractive to discuss.
And Matt, I mean, you heard two examples on this call working in both directions, right? You've heard about a software company that was a traditional C2 colocation client moving to a SaaS model wanting to escalate to a cloud combination of C2-C3, and we were able to host that and do that quite effectively. And I think there are a lot of examples to that, but interestingly, you also saw an example of a more traditional C3 cloud clients that wanted to increase colocation capabilities and was able to take that blend with us as well. And both of those were good examples of the partnership that we are able to now deliver with the combination on Carpathia.
Okay, great. And then as a follow-up regarding the Hyperscale customer in Dallas, I'm just wondering why the lease was split into two separate four megawatt chunks. Was this just due to the fact that the capacity wasn't yet fully built out in the first quarter?
I think we saw a partial impact in first quarter, and we will see residual impact in the second quarter of that.
Okay, great. And then as a follow-up regarding the Hyperscale customer in Dallas, I'm just wondering why the lease was split into two separate four megawatt chunks, was this just due to the fact that the capacity wasn’t yet fully build out in first quarter?
From our perspective, the initial transaction ended up at a four megawatt. This particular client thinks about their infrastructure growing and those kinds of chunks. And they negotiated an option for an additional expansion of their similar style. So everyone in this space is a little different. This particular customer kind of thinks about things in four megawatt chunks, and I think that's why it is naturally unfolded. Dan, I don’t know if there is anything else, but…
No. I think you are right. They are speaking four megawatt chunks, and we were able to successfully win that in the first quarter, and they like -- I think they like what they saw, with working with QTS and their capacity needs accelerated. So it was a win-win for both partners.
Okay. And is that space then -- or I guess, both four megawatt slugs are currently under construction, or are they currently sitting available?
No, one is delivering and the other one is in construction, and deliver us starting late this year.
Yes. You won't see the real impact on that on the P&L until late this year and really into 2017.
Okay, great. Thanks a lot, guys.
Thank you, Matt.
Our next question comes from Simon Flannery of Morgan Stanley. Please go ahead.
Great, thanks very much. I wonder if we could come back to the migration of the leased data centers. There was a drop sequentially, just talk about how that was how much of that went to other data centers, were you able to migrate that and how much was just lost and then how should we think about that evolving over the course of 2016? And then, coming back to your equity raise, the industry has seen a lot of deal-making. You've done some deals; there is some Telco assets out there. How are you thinking about the M&A opportunities out there? Thanks.
Dan, why don’t you take the migration, and I will talk a little about acquisition.
Yes. Hi, Simon.
First off, just to remind is the way we're approaching these migrations is a very deliberate approach, and we look at this that you have already included in guidance. The point of these migrations to move them out of leased facilities into QTS-owned data centers. So that's the objective here. We've done a small handful of these, and we're encouraging with what we're seeing. As Chad said, we've seen some elevated churn in downgrades, but we also see some migrations or slight increases in MRR and the ability to sell additional services. So I think that's what we see. We're encouraged. We are going to continue to approach this deliberately. We do see some impact that we've included in our guidance. And as a reminder, this initiative is contributing to our margin expansion over the next couple of years. And that's the way we are look at, but we never like to see MRR decline. The way we're approaching this is how do we make this a win-win, and for us to win is if we expand margin. And we can do that by migrating them to QTS facilities, QTS-owned facilities.
And Simon on the M&A front, there is a lot of activity out there. We, as most people, we're going to always be diligent to look at things and opportunistically review things that are in the marketplace as I'm sure everyone does. I do think that our ability to continue to invest in QTS' ability to go from a million square feet to over 2 million of just what we owned today continues to be a high threshold for capital. So, when we think about return on invested capital, we think about the opportunities being rich within our own controlled today, but obviously we've made -- we've built the company on infrastructure rich-low basis assets that are in strategic new locations that QTS feel they can wrap their integrative product and delivery, and when those opportunities exist at scale, we will look at those, but we will just review and be thoughtful that we have a lot of internal capability to grow and deploy capital, which obviously we see as a primary focus.
You don’t feel like there is a geographic area, or whatever, where you really want to kind of add some capabilities?
There is not -- we don’t feel there is a significant gap or weakness in the markets that we are in today, especially with Chicago opening later this year.
All right, thank you.
Our next question comes from Jonathan Atkin of RBC Capital Markets. Please go ahead.
Yes, I have two questions. One is I wondered if you felt like commenting about cross connects and prospects for modified [technical difficulty] on a monthly recurring basis? And then secondly with respect to Chicago, just interested you've got salespeople in place now and are your discussions primarily with existing customers? Or are there other new opportunities potentially in the pipeline? Thank you.
So, Jonathan on cross connects, as we've talked about, we probably, as most didn’t productize that as soon as we should, we always viewed it as wrapped up within our portfolio and as part of our delivery service. We have in excess of 12,000 cross connects within our portfolio today. Dan and the team have a big initiative of around service attach that they rolled out this year, which is talking about monetizing the cross connects and connectivity products whether it's bursting into the public cloud or whether it's connecting through to get to different type of networks and interconnection type plate that they've rolled out, that is -- that's early. And we are continuing to be excited, but as well as that, it's just not interconnecting connectivity, it's service attached on storage, and service attached on network and monitoring, and those type of things. And so that's a huge initiative that we feel like it's -- in the world that we live in owning and controlling our real estate, it's something like selling like the cubic feet of the data center versus the square feet, and we love that ability. It makes the customers more sticky, and drives tremendous value and growth, and profitability. And we're a hundred percent focused on driving that service attached initiative that Dan has.
From that standpoint, Chicago, it's one of the most large markets in the U.S. We couldn’t be more excited. One of the lessons we learned in Dallas was we didn’t have our team on the ground as early as we did for Chicago. So, Dan put his senior sales leadership and teams around that earlier, and I'm happy to say that our Chicago team, both from a site level and a sales level is almost a 100% built out, and is building pipeline for Chicago's opening in Q3, which I think was a lesson learned. Even though we did tremendously well in Dallas, we felt like we're playing a little bit of catch-up on getting sales folks in the seats and all of that still had success and felt like we can learn some lessons in Dallas, and take that to Chicago. So they are building both new customer pipeline and existing customer. Of course, with over 1000 customers on our portfolio today, you can imagine there are customers that have intersections in Chicago that we are already talking to them about and opportunities for growth. So, Dan, I don’t know if there is…
I think you said it perfectly, Chad.
Great. Thanks very much.
Our next question is going to be from Vincent Chao of Deutsche Bank. Please go ahead.
Hey. Good morning, everyone. Just to stick with Chicago there for a second, you just noted that you're kind of taking some less blends in Dallas into Chicago, you know, obviously Dallas leased up pretty nicely and maybe fasted than you originally anticipated. I'm just curious if there is any color you can provide in terms of the market dynamics between the two that maybe has resulted in not as quickly lease up here in Chicago as in Dallas, and maybe on the pipeline, it sounds like there is healthy demand pipeline building. On the 133,000 square feet that are coming online, I mean, can you give us a sense of how much activity you're talking about, I mean, is it enough to cover the entire building, or something less than that?
Yes, so Vin, we do feel very strong about Chicago, but again, it's really building across the broad products. So what I'm most encouraged about is our ability to see opportunities across our full spectrum of products on the integrated platform, so C1, C2 and C3 opportunities. Traditionally, we're focused on getting the commercial engine revving and that's what we're going to be focused on in Chicago, and try to keep a well-balanced approach on how do we see that starting, and again, we did learn some lessons in Dallas. We did have a lot of success in Dallas. I think Chicago as a market as everybody know, it has probably even tighter occupancy or higher occupancy levels than just about any market in the country, just with its constraint on space. And obviously that's why we're excited about getting open.
This is Dan. Just to add, you know, as Chad said, there is a tight supply and demand profile in the city of Chicago. We're excited about the asset we have there. We have stepped up. The sales team we have, we are pleased with the level of activity in the pipeline. As in Dallas, we don’t anticipate significant pre-leasing, but we're excited with the activity level, and as I said the opportunity pipeline as it stands now in April for Chicago assets that's opening in the third quarter.
Okay. Just maybe one follow-up question on the Hyperscale tenant that we've talked about quite a bit here; in the press release you talked about the fact that it met your underwriting standards return thresholds. I'm just curious, I mean I know 15 is the overall average but on individual leases I guess maybe plus or minus from that. I was just curious if that lease were done, had a 15% stabilized return? And then also what kind of lease term was negotiated?
Yes, Vin, on most of the Hyperscale things, those are all in excess of -- traditionally, all in excess of five-year deals, right? They can be anywhere from five to 10-year deals. We really think about the ROIC at the asset level, right. So we're not in a position to -- we want to make sure that the hype scale deals that we do are competitive. We can't lean forward, because of our cost basis allows us to return double-digit returns on those type of deals, but obviously we look at the blended ability of the site. So, the allocation of how much of that Hyperscale space do we want to let go off in a particular facility, that would still unable us to meet kind of our 15 plus percent return at the asset level, and that's really the way we are driving our thought.
Okay, thank you.
Our next question comes from Richard Cho of JPMorgan. Please go ahead.
Great, thank you. I just wanted to clarify a little bit on some of these deals; just in the release you noted that there was a strategic signed in the first quarter, is that revenue been hit in the second quarter? And then, it looks like the eight megawatt deal that revenue is not really hitting much at all this year, but more for next year. Is that the right way to think about those two deals?
Well, I think the announcement that we released yesterday, the Hyperscale as you mentioned, we signed four megawatts in the first quarter. A tranche of that we’ll start building later in second quarter. Most of the impact is in later this year and the second four megawatts that we just signed will be hitting in 2017.
Yes, so most the impact to that first four megawatts is really the back half of '16 impact on the business and the other four megawatts is really into '17 from the -- on the Hyperscale customer. And was there another customer you asked about?
The C1 contract with the strategic customer was signed in the first quarter or is that the same one?
Yes, Richard, I think the strategic customer that was signed, that was the first four megawatts and then we signed the additional four megawatts subsequently in the same quarter with the same customer. And the expectation when we put out guidance already incorporated the scale into that first four megawatts late in the year.
Okay. And then at scale into next year, I assume there would be a top 10 or even a top five customer?
I think they're already a top customer. I think obviously this will keep them in the top echelon.
Okay. And then in terms of churn for this coming quarter I think shall we expect churn to kind of fully hit in this second quarter and then get better from there, or is it going to be kind of steady throughout the year in to that 5% to 8% range?
Yes, Richard, we're still comfortable at the 5% to 8% target level. Obviously the churn in the first quarter was elevated largely because of one customer that increased out from about 1.3% to 2.3%, and you will see some heightened churn a little bit more in Q2 and then we do expect that to drop, but feel comfortable with the overall levels of that five to eight.
Great, thank you.
Thank you, Richard.
And our next question will come from Fred Moran of Burke & Quick. Please go ahead.
Thank you. I just wanted to ask a little more about pricing. You said these large customer leases excluding them renewals would be consistent in the first quarter rather than up but you still are looking for low to mid single-digit pricing growth for the year. If you move into more of these C1 wholesale Hyperscale-type pricing deals, could you actually still see low to mid single-digit pricing and why was it lower in the first quarter?
This is Dan. So first I’ll point out, the renewals we saw in the first quarter were for C2 and C3. You look in the supplemental you'll have the details there. And so the C1 leases, as Chad mentioned, are typically very long leases. So you see those are long maturities. The majority of the renewals coming up in 2016 are C2 and C3, and we still feel comfortable with the guidance of low single-digit growth at renewal. Particularly we've been there this quarter if you exclude the two customers that we referenced in the remarks.
Okay. Thank you.
In the interest of time, we are going to have to end the question-and-answer session. If you have any further questions please feel free to follow up with management. At this time I’ll turn the call back over to Chad Williams for any closing remarks.
Well, thank you again for participating. We appreciate the continued confidence and trust. QTS is excited about the business and the execution, the progress we’re making in 2016, and we look forward to keeping everybody appraised next quarter. Thank you.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines. Have a great day.
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