QTS Realty Trust, Inc. (NYSE:QTS) Q2 2016 Earnings Conference Call July 27, 2016 10:00 AM ET
Stephen Douglas – Head-Investor Relations
Chad Williams – Chairman and Chief Executive Officer
Bill Schafer – Chief Financial Officer
Dan Bennewitz – Chief Operating Officer–Sales and Marketing
Jeff Berson – Chief Investment Officer
Jim Reinhart – Chief Operating Officer-Operations
Jordan Sadler – KeyBanc
Eric Luebchow – Wells Fargo
Richard Cho – JPMorgan
Jon Peterson – Jefferies
Matt Heinz – Stifel
Thank you, operator. Hello everyone, and welcome to QTS’ second 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 additional members of our executive team who participate in Q&A.
Our earnings release and supplemental financial information are posted in the Investor Relations section of our website at www.qtsdatacenters.com on the Investors tab. We also provided slides and made them available with the webcast and on our website, 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 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, return on invested capital, 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 website.
And I will turn the call over to Chad.
Thanks, Stephen. Hello, and welcome to QTS’ second quarter 2016 earnings call. We’re pleased to be speaking with you this morning on another strong quarter of execution enabled by our differentiated services platform.
On Slide 3, our consistent performance continues to be driven by our differentiated products and mega data center infrastructure. Our commitment and investment in the integrated services platform is driven by the ongoing conversations we are having with customers on the demand they have around flexibility and scalability within their hybrid IT stack.
Growth in data and cloud technology is driving unprecedented change in complexity to the enterprise IT stacks. As the enterprise customers move more towards a hybrid architecture, including a mix of both insourced and outsourced data center and private and public cloud, they are looking for solutions QTS offers. QTS is able to intersect customers at a much deeper level and drive real, customized solutions to their complex infrastructure needs.
Another major focus among enterprise CTOs is data security and compliance. The risk of cyber security breach is ever present across all industry verticals and is rising. Our decision early on to take an active role in partnering with our customers on security and compliance both in terms of physical and logical security differentiates us in the market.
Through QTS’s integrated services platform and focus on security and compliance, we believe we are one of the only providers in the market that offers customers a unique, highly valuable product solution including flexibility, customization and security to meet their needs. And we are able to deliver these solutions based on a mega scale own data centers with significant capacity and room to grow with customers.
On the infrastructure side early on we recognized the value of scale in the data center business. We built our platform overtime by focusing on mega scale infrastructure and remaining patient and opportunistic. This approach has allowed us to consistently find the right opportunities to acquire infrastructure rich assets at a low basis, giving us permanent cost to build advantage.
The most recent example of this approach was our acquisition of a data center campus in Piscataway, New Jersey for a $125 million, which I’ll discuss in more detail later on in my comments. This was classic QTS opportunity, where we were able to immediately lock in north of $125 million cost advantage and a facility that had more than $250 million perviously invested in it. Securing a permanent cost advantage like this upfront is a key driver of our ability to achieve our above average, unlevered return on invested capital target of 15 plus percent. Together, our product mix and our data center infrastructure, provide us this opportunity to drive strong and steady growth, industry-leading return on invested capital and high customer satisfaction and retention.
Next on to results on Slide 4. For the second quarter 2016 we continue to demonstrate strong momentum in the business stemming from a healthy pipeline of demand, with strong year-over-year growth rates across all key financial metrics. For the second quarter 2016 we achieved revenue of $99 million, up 45% over the second quarter a year ago. Adjusted EBITDA of $46 million up 43% year-over-year and operating FFO of $35 million up 49% year-over-year.
Operating FFO per share for the second quarter of $0.63 was up 18% year-over-year. Our continued momentum is supported by our strong booked-not-billed backlog of approximately $49 million as of the end of second quarter. This level of fine business drives high visibility into our future growth and provides confidence in our continued momentum in the business.
For the second quarter we achieved an annualized unlevered return on invested capital of 15.1%, which remains above our target level of 15 plus percent unlevered returns on a fully stabilized basis. During the quarter we brought on and aggregate of 43,000 square feet of raised floor online in Richmond, Atlanta, Dallas, and Santa Clara. Additionally in early Q3 we were excited to announce the official opening of the initial phase of our development in downtown Chicago comprising of 14,000 square feet of raised floor. Lastly, on June 6 we announced the acquisition of a 360,000 square foot mega data center campus in Piscataway, New Jersey.
I will now discuss both of our Chicago site development and the Piscataway acquisition in more detail. Starting with Chicago on Slide 5, we are please to announce the official opening of our mega data center in downtown Chicago at the beginning of Q3 and hosted a dedication ceremony for the site on July 15. Our asset in Chicago is located approximately three miles from the primary carrier hotel and we were expected it to develop into one of the most interconnected sites in our portfolio.
Upon opening we have 14,000 square feet of raised floor available but have the ability to scale up to 48,000 square feet very quickly. The facility was able to support up to 133,000 square feet of total raised floor. And we’re reviewing development plans that could potentially bring capacity to even a greater scale. In addition we have the opportunity more than double our existing shell capacity through the development of the adjacent landholdings. Our Chicago sales team has built up prior to the opening and is continuing to build a pipeline and we remain encouraged by the demand we’re seeing and what we believe is one of the tightest Tier 1 markets in the U.S.
Difficulty in developing meaningful scale and access to power in downtown Chicago, has limited new capacity over the past five plus years. As such we believe we have a differentiated asset and together with our product mix the opportunity to drive strong success in the market.
Next on Slide 6, I’d like to spend a few minutes discussing our recent acquisition in New Jersey. On June 6, we announced the simultaneous purchase and closing of 38 acre of campus purpose built data center in Piscataway, New Jersey for $125 million. the site currently has 89,000 square feet of raised floor and 18 megawatts of critical power built out. With capacity to expand to a total of 176,000 raised floor and 26 megawatts.
The eight ongoing customers in the facilities currently occupy approximately 56,000 square feet and 8.4 megawatt, leaving room for both new customers and expansion of services. This is the state-of-the-art data center facility with 18 carriers already in place and a total of more than $250 million that have previously been invested in the site.
Our ability to acquire this property at a cost of less than $7 million per megawatt in a market where build cost are typically in that $12 million plus range is yet another example of our core competency of identifying and opportunistically acquiring large infrastructure at a low basis.
At full capacity we estimate a total built out cost including acquisition price of approximately $9 million per megawatt. This immediate cost advantage and large scale capacity further supports our ability to achieve our return on invested capital target of 15 plus percent at full stabilization and enhances the internal growth opportunities within our portfolio.
In addition, this property was previously marketed exclusively to wholesale customers, we expect to be able to leverage QTS’ broader, integrated product offering to bring in new customers and remarket to existing customers and drive incrementally higher utilization, efficiencies and returns overtime.
We expect the facility to initially generate annualized recurring revenue of approximately $7.5 million and adjusted EBITDA of $3 million. Note, that this excludes approximately $1.8 million of annualized recurring revenue related to a customer that had previously provided notice prior to our acquisition that he will not be renewing his contract in the first quarter of 2017. We expect the transaction to be slightly accretive to our OFFO per share for 2016. Bill will discuss the impact of the acquisition on our full-year guidance later in his comments.
Moving on to Slide 7, we’re excited to be able to deepen our presence in the New Jersey in addition to our existing facilities in Jersey City and Princeton. New York, New Jersey remains one of the largest data center markets in the world. Demand in this market tends to lean more towards smaller wholesale and colocation customers typically in a 0.5 megawatt to 1.5 megawatt type range, which is right in QTS’ sweet spot.
We see a strong opportunity for growth, specifically within our C2 and C3 products with the financial services and healthcare verticals. Combined with our existing assets in Princeton and Jersey City we have a sales force and infrastructure in place to hit the ground running in Piscataway. And we look forward to updating you on our success in the coming quarters with this asset.
On Slide 8, I’d like to highlight some of the key customer wins during the quarter. During the quarter we were please to expand our partnership with one of our largest customers, a leading international IT services company. QTS serves as this customer’s go-to-market data center provider. We were able to sign them to an incremental 0.5 megawatt of C1 leases split between Dallas and Richmond with additional C3 services on top. This represents the third time this customer has signed up for additional capacity outside of our initial arrangement in 2014. QTS’ broad footprint, scale, capacity and services focus positions us well to continue this partnership going forward.
Next, in the second quarter we had a new financial technology services customer who is looking to leverage our security and compliance platform. This customer started out as C2 opportunity. However, once they were able to sit down with our in-house security and compliance team and work with them to design a solution, they ended up signing up for a full C3 dedicated hosting contract in our Suwanee facility. This lease was signed at an MRR six times, what was originally being discussed, as a C2 deal, making this customer now one of our largest peer C3 customers. This was a great win for QTS and proof of the success of our integrated model and our focus on high-end security and compliance capabilities, in practice. This is a situation that our sales team, solutions engineers and support staff, pride themselves on.
In addition to the superior customer service, we partner with our customers and provide the flexibility to deliver a solution that meets their ever-changing needs. Risk management and compliance continues to play a critical role in the enterprise decisions around date center outsourcing. QTS invested early in our security and compliance function and we continue to hear from customers that our capabilities and focus here are differentiating us in the market.
Next, we signed a new C3 logo in our Atlanta-Metro data center, this customer, a leading Silicon Valley cloud storage company needed a customized, managed cloud solution and QTS will be managing every thing up to the application layer for them. Without the enhanced product and services we acquired through the Carpathia transaction, this customer likely would not have been able to win. Carpathia has enhanced our C3 product offering and continues to drive positive results for our integrated services solution. This new QTS cloud customer also demonstrates our continued success in differentiating our products through flexible and customized solution, instead of appeal to the cloud vertical.
Now moving on to our leasing performance for the quarter on Slide 9, for the quarter we signed new and modified leases representing approximately $13.3 million of net incremental annualized rent, 54% above our prior fourth quarter average. This includes incremental four megawatt lease expansion signed at the beginning of the quarter with a leading global Hyperscale cloud provider that we were discussing during last quarter’s earnings call.
This quarter’s leasing performance was driven by broad streams across our product lines. In fact, we experienced the strongest C2/C3 gross quarterly bookings in the company’s history. As we have mentioned in the past, C2 colocation remains the engine of our business. Combined with our ability to leverage our C3 product to managed services to up sell and drive increased capital efficiency from our customer base, the consistency and predictability of our core C2 colocation product drives steady underlying growth in our business. We are then able to benefit from our C1 business, driving quarters of accelerated growth, like we saw this quarter, when we find the right strategic opportunities that meet our internal return metrics.
In addition to our continued leasing activity, visibility on our future growth remains strong, based on our significant level of book, not build backlog of over $49 million at the end of the second quarter. This represents a slight decrease, compared to our first quarter ending backlog of $52 million, as we delivered on several large previously signed contracts. This signed contract and committed backlog support solid revenue growth, de-risking 2016 and driving growth into 2017. As I’ve said in the past, this number will continue to approach a more normalized level as we continue to deliver on a few large customer contracts over the course of the year.
Churn during the quarter came in at 1.3%, bringing our year-to-date churn to 3.6%. This is consistent with our full-year churn expectation of 5% to 8%. Second quarter pricing from new and modified leases was slightly lower than our prior fourth quarter average, due to a higher mix of C1 deals, during the quarter. C1 pricing first quarter was slightly below our prior fourth quarter average, due to large C1 deal signed in the quarter, including previously mentioned four megawatt lease expansion with a leading Hyperscale cloud provider.
Quarter-over-quarter C1 pricing was up 10%. Pricing for C2 and C3 new and modified leases was up 5%, as compared to our prior fourth quarter average. And on a significantly higher volume of activity due to higher mix of C3 leases signed in the quarter, which carry a higher first quarter pricing relative to C2. Adjusting for changes in product mix, we remain encouraged by the overall pricing environment in the market.
Regarding renewals on a like-for-like basis, where customers renewed contracts without change in square feet, we experienced renewal rates for the second quarter of 2016, reflecting an increase in pricing of approximately 2%, above the pre-renewal pricing rates. This is in line with our general expectation of renewal increases in low-to-mid single digits.
Lease commencements pricing during the quarter was up across both C1 and C2 and C3, compared to the prior fourth quarter average. Overall the pricing environment across our footprint remains strong, and is consistent with the positive market trends we are seeing.
In summary, we continue to execute with our differentiated business model and I am pleased with the momentum in our business. Our combined product offering and mega scale footprint continues to give QTS the ability to consistently win in the market and drive industry-leading combination of growth and return on invested 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 11, once again we were able to generate strong growth across our key financial metrics on a year-over-year basis. We saw this growth broadly across our facility footprint.
Year-over-year Q2 NOI increased 19% in the Atlanta market and our California market, NOI increased nearly 6%, despite still limited available capacity. Our Richmond and Dallas mega facilities continue to drive outsized the year-over-year NOI growth at 62% and 168% respectively. And we see continued run rate to invest and drive significant incremental growth in these facilities over the next several years.
Our adjusted EBITDA margin of 46.2% in the second quarter continues to demonstrate the operating leverage inherent in our model. On a sequential basis, our adjusted EBITDA margin increased 80 basis points, driven by a combination of continued operating leverage from our mega facilities and the efficiency measures we are implementing with customer migration. We continue to expect to see our normalized adjusted EBITDA margin approach 47% over the next few years.
Next on Slide 12, capital expenditures incurred during the second quarter were approximately $39 million. Our continued focus and commitment to capital efficient growth drove an average annualized return on invested capital for the second quarter of 15.1%, above our stabilized target level of 15%. As we have discussed previously, typical with the initial phase of a new development, we would expect the opening of our Chicago facility, at the beginning of Q3 in combination with our acquisition of Piscataway, New Jersey 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 commencing growth and occupancy in Piscataway rises.
Turning to development on Slide 13, for the second quarter we brought online 43,000 square feet of raised floor at our Richmond, Atlanta, Dallas and Santa Clara mega data centers. All of this was in line with the development plans we disclosed last quarter. In addition as discussed we acquired 89,000 square feet of raised floor capacity in Piscataway.
As of the end of the quarter our total built out raised floor was nearly 1.3 million square feet, which represents just over half of the total powered shell raised floor capacity of 2.4 million square feet in our existing facilities, not including land that we own adjacent to our mega data centers. This capacity provides us with greater visibility into our future growth path at a known, lower cost and lower risk profile. We continue to anticipate bringing online additional capacity in Chicago, Dallas, and Atlanta over the course of 2016.
Moving to Slide 14, I will review our result in balance sheet and liquidity position. You may recall the beginning of the quarter 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. Our total debt outstanding, including capital leases as of June 30, 2016, was $839 million.
Our second quarter ending debt to annualized adjusted EBITDA was approximately 4.6x, down from 5.6x reported at the end of Q1. Largely driven by the equity issuance completed at the beginning of Q2 that was previously mentioned, net of proceeds used to acquire the facility in Piscataway. We do expect our leverage will increase in the coming quarters as we deliver on our development pipeline.
We have significant liquidity capacity in our balance sheet. At the end of the quarter we have a total of approximately $417 million in liquidity in the business, made up of availability under our credit facility and cash.
We remain pleased with the strength of our balance sheet, including attractive interest rates, no near-term debt maturities, minimal secured debt and significant available liquidity. We will continue to monitor market opportunities to lock in fixed-rate extended maturity debt overtime. However, following the recent equity raise, we have no immediate need to lock in fixed rates.
Finally on Slide 15, we are raising our 2016 guidance to reflect the recent acquisition in Piscataway, New Jersey. We have raised our adjusted EBITDA guidance to a range of $179 million to $187 million, up from our previous range of $177 million to $185 million.
Our 2016 OFFO guidance is now expected to be between $135.5 million to $140.5 million up from the pervious range of $135 million to $140 million. Finally, we anticipate our 2016 OFFO per share to be in the range of $2.55 to $2.65 per share up from $2.54 to $2.64 per share perviously.
We continue to expect core organic revenue growth in the mid-teens, annual churn of 5% to 8% and we anticipate our adjusted EBITDA margin to approach approximately 47% over the next few years. In addition our CapEx guidance of between $300 million to $350 million is unchanged. As a reminder, our 2016 operating FFO guidance includes an estimated non-cash tax benefit of approximately $4 million to $5 million.
Overall we remain pleased with the financial success we are achieving and the growth in our core business. We are excited about the incremental growth opportunities from the investments we are making and we believe we have positioned our balance sheet and liquidity to support expectations for consistent future performance.
With that, I will turn it back to you Chad.
Thanks, Bill. The second quarter performance built up strong momentum we are seeingin our business. We’re excited about the opportunities in front of us in the markets, particularly in our newest expansions in Chicago, and Piscataway, New Jersey. Our ongoing dialogue with customers and our substantially booked-but-not-billed revenue backlog supports our confidence in being able to continue to generate strong returns.
Our market leadership in driving an integrated technology services platform continues to be a strong customer differentiator in the market. Combined with our scale and flexibility, we believe this strategy positions our business well. As enterprise customers of today and tomorrow increasingly move towards hybrid solutions integrated in their data center needs.
Finally, I want to thank our customers and shareholders for their continued trust and confidence in QTS. In addition I’d like to recognize and thank our dedicated QTS employees, who work hard every day to their commitment to make QTS success possible.
Now I’d like open up the call to questions. Operator?
Thank you, ladies and gentlemen. Before we proceed to Q&A, I’d like to apologize for technical difficulty prior to, and at the beginning of our call. The technical issues were on our end here in Pittsburgh. So we do apologize and we thank you for your patience. We will now move to queue – our question-and-answer session. [Operator Instructions]
Our first question will come from Jonathan Schildkraut of Evercore ISI. Please go ahead.
Hi, this is Rob for Jonathan, thanks for taking the question. C2, C3 leasing was very strong in the quarter, it looks like pricing was up a bit but also the number of leases. And I was wondering if within that was there anything in particular that stands out in terms of vertical or customer type geography or product or was it just broad-based? And I have a second follow-up question.
Yes, Rob this is Chad, thanks. And I’m going to have Dan add in. But I think what was most encouraging about the quarter was just the general diversity of the revenue base, the location and the opportunity just to drive our commercial business, colocation and cloud and services. So it’s been engine of our business for – since the beginning and it continues to be something that is reliable and repeatable.
And Dan, I may have you add a little bit more color to that.
Yes, hi, Rob this is Dan. Obviously we’re pleased with the C2, C3 leasing performance. And I think what we’re seeing is we’re pleased with the uptick and adoption I’ll term it more complete solutions to customers. We’ve been on this journey of integrating our broad portfolio services with our colocation sales, which get tailored to the individual customer specific needs and requirements. This is – we call it solution selling, but when we’re successful at this the average transaction size gets bigger, the value that the customer receives from our relationship is broader in number and will become more of a partner as opposed to just a vendor.
So I think we’re pleased with the results, we think that starting to take hold and obviously we’d like to keep continuing.
And Rob you had a second question.
Yes, the other question really just relates to CapEx and I was just wondering based on the CapEx incurred to date and excluding the acquisition in Piscataway, but actually development CapEx and the remainder on the books for the year, if you could reconcile that with the $300 million to $350 million guidance, because it looks like you have more spending in the second half of the year. I just wanted to get that straightened out.
Sure Rob, hey this is Jeff. So we reaffirmed our guidance at $300 million to $350 million, we feel good about that. Some of that CapEx towards the latter half of the year will go into Piscataway. And if you look at our development, we pulled back a little CapEx on Jersey City because we’ve now got more capacity in that market through Piscataway. So we’re trying to manage our capital efficiently as we always do.
Part of the aspect that you see, it is a big back end loaded in terms of what we’ve spent to date versus our guidance. If Chicago coming online in the second half of the year and the continued ramp in Dallas, that’s where you’ll see some of that additional capital going in the second half of the year.
Okay, great thanks very much.
Our next question will come from Jordan Sadler of KeyBanc. Please go ahead.
Thanks, good morning. So Chicago, how fast can you scale from 14,000 to 48,000 specifically and maybe talk about the mechanics of that? And then talk a little bit about the early demand and what you’re seeing there?
Hey, Jordan this is Chad. I’ll take a little bit of that. So in Chicago of course the facility is about 300,000 square feet as you know it was a kind of typical QTS infrastructure rich asset. So you should think about the physical asset and infrastructure being capable to scale at fairly short order. We brought on 14,000 square feet of space in Phase I with a couple megawatts. But the procurement group and the development group continue to kind of refine and work towards delivery of those spaces in a pretty timely fashion. And the opportunity for us to kind of scale past that will be in the period of months not a year.
And we look excited about the opportunity to really focus that start strongly and focus it in mostly commercial and retail spaces just because of proximity and the demand and the size of deals that we see. Jim, I don’t know, do you want to add anything on the development side on ramping?
Yes, Jordan our design continues to evolve. So it can be more and more capital efficient. We’re now able to open a mega data center with as little as two megawatts and then rapidly expand. So basically we can match our capacity to customer demand. So pretty much if anybody wants to come on and [indiscernible] 48,000 square feet will very comfortably could meet any aggressive ramp schedule that they would have.
And as far demand goes Jordan we just did the dedication there, July 15 which happened to be my 21st wedding anniversary, which was fun.
And we had 400 people through the facility. And the energy and excitement, one of the things lessons learned that we learned from Dallas is we got – Dallas has been smashingly successful, but we really opened the facility and then staffed the people. And in Chicago we made a firm commitment to go recruit kind of a world-class group of people and failed operations first, which gives us even more confidence and more capability for Dan and his organization to focus on the sweet spot of our growth in Chicago, which we really do see the opportunistic C2 commercial and service attach initiative that Dan talked about earlier, just because of the proximity and location in fiber-rich environment.
We will have the scale and opportunity on that 30 acre campus to do things across all of our products. But it is something that we’re excited because we have sales folks, operations folks and people that have been on the ground in Chicago for a period of time. And Dan may add a little bit to that, so.
Yes Jordan, this is Dan. Just to add here I think on the tourists that Chad talked about on the 15, you see the build out and see the initial customer build out of the customers who have already signed up. We are very pleased with the opportunity pipeline that we see, obviously, to reinforce Chad to focus on the retail side. So we feel very good about the future here in Chicago.
Okay and then just to the – follow-up, on Carpathia, today you guys are doing some really strong C3 leasing, as have the Carpathia is involved, instrumental there. But when I look at the leased facilities, I notice that sequential decline in Hawaii and revenue in those facilities, pretty meaningful from 1Q to 2Q. Can you talk about that, is that disruption oriented, and purposeful or and is moving into some of the other data centers or what is it?
Yes, we think of our self as just QTS now, and we have integrated the businesses, but it is apparent that our strength in our clouded and services and service attach ability has grown significantly with the integration of the people. Now John Greaves is our new Chief Technology Officer, which was an announcement that was made not long ago, reporting to directly to me on the team and was one of the Carpathia architects of building that business over the last five, six, seven years.
And as John now is on my team is having that integration, the ability for us to have even more solutions based conversations are starting to pave the way and starting to see in the deals that we can do and the announcements that we make and the growth that we will have.
Again though I think the strength of what we want to build here is this ability to cross this product sector from three seas, right, for the wholesale all the way through retail and cloud and services, because that is where we’re seeing the interest from the clients, flexibility, scalability, the opportunity to have a real solutions conversation. And I think from the facilities standpoint with the small movements, you’re going to continue to kind of see we will have great opportunities from time to time to take customers and do some migrations and continue to kind of work down that path. But it’s nothing that’s going to happen all at once, it’s a multi-quarter, multi-year process.
And I know Dan can may be speak a little bit more directly to this with some of the customer conversations.
Yes Jordan, this is Dan. I think specifically on the lease facilities the way we are thinking about them, is they are an important part of our portfolio. And we’re having balanced discussions with these customers. And what makes sense for them and what makes sense for us. And in some cases it makes sense for them to migrate to a QTS owned facility and in some cases it makes sense not to.
I think one example that I think demonstrates this is one of our large customers, several of us will have and the west coast earlier this week to talk to them about sort of the outcome of a successful migration from a lease facility into our Dallas facility. And the way they are thinking about that is the U.S. both in Dallas is there a U.S. deployment in the QTS data center. We’ll work with them globally as they deploy and rapidly expand globally and those are going to be with our – at least facilities partners.
So we think about as part of our portfolio and not an arbitrary this as asset what make sense for the customer, what make sense for QTS. I think that’s actually the power of our portfolio of being able to provide those types of solutions to customers both in the U.S. and globally.
Can you tell us what happened from 1Q to 2Q though in NOI? In the leased facilities, why they go down by a $1.5 million?
Well, part of that I think is the example we talked about is the customer, I just referenced, moved from a leased facility into our…
That was – so that already happened.
Okay, I thought you were saying perspectively, okay. Thank you.
Actually we are out there sort of as a closed move to frankly celebrate the successful transition that we had with them.
Okay, thank you for the color.
[Operator Instructions] Our next question will come from Eric Luebchow of Wells Fargo. Please go ahead with your question.
Hi, thanks for taking the question. Just a quick question on your EBITDA margins obviously they came in pretty strong this quarter just over 40% and you mentioned some customer efficiency initiatives. I mean are you still planning to hit the kind of 47% mark by the end of 2017 or is there chance you could to hit that sooner? And if you could just go through some of the puts and takes into achieving that?
Obviously that’s a goal that we’ve kind of laid out before and I think our expectations there will see some pressure kind of going forward with bringing on our Chicago facility because of the ramp in revenues associated with that. And also the Piscataway acquisition that we did again has lot of our lease up capacity to do and we put a little bit of pressure on with that rate as going forward. But again we’re encouraged by those facilities. And again the ongoing integration activities that have occurred and we do expect that to go up.
And again you get into some seasonality too with certain operating expenses like in Q3, for example, utilities have essentially been the highest expense during that quarter just given the summer months, and so forth.
Okay, great. And just one more if I may. You had a few thousand square feet at Santa Clara facility and your development pipeline last quarter that I didn’t see this quarter. Was that pushed out or has there been any kind of change in the demand environment? And then kind of more broadly with Santa Clara and Sacramento do you have any thoughts around an expansion on the West Coast given that relative to the rest your portfolio, it’s a relatively small amount?
Yes, Santa – this is Chad. Santa Clara has been a great site for us and a consistent performer. It is not a mega data center site. So it is one of the sites that we continue to have to optimize and make choices around both in capital and development and also customer. We have seen a good pickup in interest. We’re mostly focused on our commercial C2 and C3 business there. We have had some opportunities to take some space back and repurpose in a commercial and retail environment, which we’ve taken advantage of. So that’s some of the movements that you’re seeing there. Because we really do want to optimize that site to be a full, kind of commercial location just proximity and location, it’s one of the best.
And in that market we just don’t have – it’s not a “mega data center”. We will have one small development piece left there that Jim and the team will work through. But I think with the recapture of some space and some new inventory that we can bring online for retail, we felt that the capital allocation discussion, which we constantly have is something that draws some of the movement.
Jim I don’t know if you have anything to add.
Yes, as Chad said, we like the improving market dynamics in San Francisco, Silicon Valley. And as we see those improving market dynamics was a great opportunity as we had below market rent customer lease and free up some occupancy for us to put that available space back into the market. And as Chad said to be capital efficient we’re able to delay the expansion that we’re going in at Santa Clara by a quarter or two. So you obviously see that space come on early next year as we fill up that space up and vacate [ph] above that below market clients.
Okay, great. Thanks for taking the questions.
Our next question will come from Richard Cho of JPMorgan. Please go ahead.
Hi, thank you. Cloud and managed services revenue fell again this quarter, is this was kind of bottom and should we see a growth from here rental revenues remain strong. But the cloud and managed services kind of fell from 89% to 17% and is this kind of a bottom or is there some – going to be declines there?
Yes, Richard, this is Dan. Let me take that. You recall last quarter when we discussed some churn we saw with the C3 customers earlier this year. And also there’s a large customer who migrated from our C3 product over to our C2 product. So they’re growing but it’s in a different product area. Both of those we saw the full impact in our C3 business in the second quarter. Obviously you see the second quarter bookings were very strong, particularly in the C2, C3 space along with a strong pricing.
So we expect to see the growth in that C3 segment as we move to the second half approach more normal levels.
Great. And with the Piscataway facility is there work that needs to be done to before we could see revenue come through? Or can you start signing business right away or is it going to take some work and then ramp up through the year and the next year.
Richard this is Chad. The facilities are world-class facilities so it is – it has space and power available. But it was not set up for our product offering and in our commercial and retail footprint. So the team is working diligently now to capitalize on existing network and to bring our service attach products in and to really bring the facility into a position of being able to lease up existing space and power at the same time we’re working through the deployment of our C2 product there and our C3 product and also the ability for us to really think about the next chapter of growth of that facility.
So it is something that Dan is getting to know the customers we are rolling out QTS, 3C products to those customers, engaging the conversations to who we are and what we bring, we are staffing the facility to the appropriate QTS level with our data center operations folks. And that’s all the engines chugging down the track on all of that. And we’re encouraged and excited to have that opportunity. Dan or Jim do you have anything?
Yes, as Chad said, we think it’s a world-class facility obviously it was designed for large wholesale customers. We will be converting that by putting some additional capital into it, so it can support our entire C3 platform. And again are encouraged by the response we’re getting from the existing tenants, as well as some perspective tenants on the ability for QTS to serve on that facility. So we’re excited to own that and to expand that facility pretty quickly.
And Richard this is Dan. Again we’ve owned the facility for about a month. So we’re – you heard the excitement that we have with the asset, we’re excited with the asset in the New York, New Jersey market that we not had a whole lot of space and power in that market. We have a sales force there, obviously they we’re excited to have a C2, C3 product, as well as our C1 product to be at scale that we can sell into that market.
Chad talked about the current customers there, who are pleased with that and introduced them to the QTS family. And we’re also very pleased with the initial interest and the demand that we’re seeing in the market, particularly as we build out in the C2, C3 space.
Great, thank you.
Our next question will come from Jon Peterson of Jefferies. Please go ahead.
Great, thank you, guys. Curious for, maybe a little commentary on what you’re seeing from the Hyperscale cloud guys, I know you did the four megawatt lease in the quarter. There has obviously been some large deals out there that you guys have passed on. I think you’ve mentioned economically you didn’t think it made sense for your business. But I guess what I’m curious about is I know you guys probably see all the RFPs they get tempt out into the market from these guys. And I’m curious as the year’s progress, if you’re seeing an increased level of RFPs from the Hyperscale cloud guys? And kind of what your current, gauge kind of your current interest in pursuing those opportunities.
Hey, Jon, this is Chad. We have the privilege to work with a number “the Hyperscale cloud” companies and customers today. And, yes we are having kind of conversations across the Board. What we benefit from is we do have sites in locations that can handle that type of scale and in business, in some cases fairly, uniquely because of the sheer infrastructure. Our portfolio, we operate a little over a million square feet, we can take that two – over two million square feet with just what’s built and powered today.
So when you think about the ability for it to intersect us, we certainly can have those conversations from time to time. But I do think we feel like the best business for QTS is to balance all of the opportunity for growth with also the opportunity to keep our customer base diversified, our focus and commitment to returns in capital allocation. We are big believers in growth, and we will continue to benefit from that and continue to drive that as a key part of our focus.
But at the same time it’s kind of a balanced growth, balancing concentration risk profile, and the product offering and the ability to drive higher returns and those types of issues. So that’s a combination of things. But when the right strategic opportunity presents itself and our cost basis advantages in most of our mega sites, you can feel good that when the bell rings we can be an effective partner and/or an effective partner for a number of those types of clients.
Dan, do you want to add some Hyperscale insight?
I just support what Chad said is we feel very good that when we – we like to engage, we engage and we provided a high value solution and are able to compete very well. We’ve talked a little bit about a couple of Hyperscale customers, we’ve signed up this quarter as well as previous quarters. It’s a win-win when we get the right client in that – in there that they deploy with us and then they keep growing with us in the right way and they take advantage of our scale. So we continue to focus on as it’s a win-win for both parties, that’s the very attractive opportunity for us to go after.
Jon, the one thing that I might say and we are – I don’t want any of our comments to be that we’re not excited about the Hyperscale growth and the overall ability. But I’ve been around long enough to know that the Hyperscale clients have periods of immense growth. And from the leader of this organization, I’m very focused on how do we build a reliable, and repeatable and scalable business that has the ability to build a diversified and high quality enterprise portfolio of customers that are valuing us across many different intersections of solutions.
And it’s not that we’re not excited about Hyperscale because we got some exciting things that we can offer because of our scale, but we also understand that in this business things tend to come in and out of favor from time to time, whether it’s wholesale, or retail, or vice versa. And we just want to make sure we don’t get too caught in the lack of balance in our portfolio. And I think we’ve got to leverage our technology integrated platform to make sure that it helps us balance all of those considerations, as we build this company for a long-term value creation.
Okay. Yes and those comments are very helpful. But I think just in your last comments about how it kind of comes and goes in periods is kind of really between the lines of my questions is where I am getting out. Are you – you talk about have you ever had conversations with these guys. I guess what I’m getting out is, are you having more, since the last time we talked a quarter ago are having more today, are they approaching you more today with seeking out opportunities than they were three months ago, or six months ago, or are we at the kind of the tail end of this week, we are in right now?
No, I think there is a lot of a conversations going across the sector and there is a number of Hyperscale cloud companies that have ambitious plans for growth. So don’t take the comment as we think that this is some tail end of the Hyperscale cloud need. I think there’s a number of them that are going to be driving significant scale and businesses, they build and scale their platforms and to deliver services that some are created and some aren’t even created yet.
So Hyperscale is something that is going to be a big driver in growth in the sector. But I also just want to calibrate our team. I want to use the full breadth of assets that this company has in its products, in its scale to make sure that we’re always balanced and all those type of things. And we’ll participate like we’ve said in the right times at the right opportunities and those conversations are happening across the sector and have a very encouraging pace and feel to them.
Okay, all right that is helpful. Thank you.
Ladies and gentlemen, I am still in our last question. [Operator Instructions] Our next question will come from Matt Heinz of Stifel. Please go ahead.
Hi, thanks guys good morning. Regarding the booked-not-billed backlog and the $8 million or so of incremental revenue, you expect to commence this year, should we see that come on fairly equally over the next two quarters or is there any lumpiness we should be aware of?
No, I think that will come on in a kind of a steady fashion over the balance of the year. I think we’ve indicated even on the earlier calls that we’ve had – there’s some of this stuff is a little bit back end loaded. So obviously, we are in the second half of the year, but I mean there are some that’s coming on in Q3 and I think you’ll see more of that will impact Q4 based on the timing.
Okay, and follow-up just on Richmond, it looks like the sequential NOI there had a very nice ramp and I’m just wondering if that’s coming from the large C1 you signed last year just sort of ramping into the deployment or maybe something incremental? And just kind of what the overall leasing trends look like there in the Richmond market is sort of a lower cost alternative at Ashburn.
Yes, hey, Matt this is Chad. What’s great to report, we do have a C1 business that, with the scale of that asset you’ll continue to see the ability for us to intersect C1 business there and are enjoying some of that ramping. What’s also impressive is the commercial and retail business continues to be appealing and opportunistic for clients. So we’ve had some good C2 wins and C3 wins in that market too.
So again it’s about we’ve got this – one of the largest data center in the world is in Richmond with a cost advantage on power and infrastructure and a number of things to your point. At the same time, we want to balance a commercial portfolio there that grows across the broad products that. And we have a several kind of initiatives there because of proximity to DC. So that kind of ties in with the Dallas story with the data center at the vault.
So we’re continuing to kind of think about that as a DC type solution redundancy and opportunity for scale clients across C1 an alternate kind of path for customers that are in Northern Virginia, an opportunity to talk about Northeast customers and then more recently Dan had some wins where we had some Dallas and Richmond replication work happening, which was separating power grids, and infrastructure and cost advantage from that. So Dan anything to add?
Yes, I think, hi Matt, Chad talked about a customer example that deployed in Richmond and Dallas, we have other examples where customers are deploying with us in Richmond and in Atlanta. And so we continue to see uptick in Richmond, both in the retail side, as well as you mentioned in the C1 space.
Okay. That’s very helpful. And just one last one if I may on the guidance. It seems like just if I de-annualize the contribution from Piscataway that that seems to be the primary driver of your EBITDA guidance increase. I guess I’m just wondering – it looks like you left a low end unchanged but the high end moved up. Just wondering kind of what the moving parts are in the EBITDA guidance?
Yes, sure. Hey Matt. So I’ll confirm those numbers but I think our intention was to raise both the low and the high end of guidance by $2 million. And you’re right that is largely based on Piscataway. But we shifted the guidance on EBITDA at both ends by that same number.
Okay. Thanks, guys.
And our next question is a follow-up from Jordan Sadler of KeyBanc. Please go ahead.
I just wanted to sort of finish where Matt left off there on Piscataway. If I take the 670,000 of NOI and sort pro rate that for the 25 days or so that you guys held it. I get to a NOI number for the year that looks like something close to the $10 million on an annualized basis. And that sounds or seems we’ve been high, at least relative to the revenue that’s in place.
Was there anything going on in that quarter, sorry, in that 25 days? How could we normalize that to just really understand what’s going to happen in the second half in Piscataway?
Yes, Jordan we’ll – I can look at how – and work with you on how you’re annualizing the short period that we owned it over Q2. That number is high, but what we talk about from an annualized standpoint is recurring revenue of $7.5 million now that number was going to be higher for the second half of this year because we also have a customer that had previously announced, they are going to be leaving at the beginning of 2017. But that customer will be in there for the first couple of quarters that we have that business. And that customer is at an annual run rate of 1.8. But that will slow down to the NOI and ultimately down to EBITDA.
Part of the other aspect that you’ve got in terms of the impact in those margins, is that we are going to be layering our service, we are going to be layering in our support. And just like any other facility that when we bring it online and it’s fairly underutilized on top of the model that we have with high level of customer service and customer support, you wind up with lower margins early on and ultimately if you drive utilization in that facility, the margins start to improve pretty drastically.
That makes sense. And in terms of the mechanics there in New Jersey, when will try to ramp up the leasing immediately or is there that needs to be done in advance. I mean how should we think that the timing there?
Jordan, you should think about that is something that, Dan as he said earlier has a sales force in market already. And so you should think about existing customers being introduced to the full breath of QTS, you should think about the C2 cloud and managed services and colocation deployments kind of happening, preparing for that to happen to where we have that space converted from an infrastructure standpoint. And sales where you should be able to walk in and see kind of where your cages and cabinets and that type stuff might go over the next month.
And then you should think about the opportunity for us to repurpose and continue to build where Jim, as he said earlier can take that infrastructure and build out additional capacity on a pretty short opportunity.
So to Dan’s point, we’ve owned it a month. But you should think about active conversations happening and we're not waiting for somebody to invite us. So we’re out in the market. And we’re talking to the existing clients and introducing QTS’ full breadth of product and capability and how we take that world-class asset and make this transformation, which will be something that is very capable for the asset and for us to kind of walk people through.
So we’re in the midst to that right now.
Okay. And then you mentioned in your prepared remarks, the volume of C2, C3 on a gross basis, of a record quarter. You gave us a couple of the highlights which I appreciate. Can you give us a little bit more granularity in terms of the types of customers that were signing leases with you all in the quarter, either on the C2, C3 side and maybe parse that into the new versus existing customer, if you can give us a percentage break out, maybe across all the revenue committed in the quarter? And then just maybe a little bit of granularity on those customers that'll be helpful.
Jordon, will it be better, if we just gave you names of customers, so that Dan can…
Yes, you can just send me an e-mail. That will be great. I’m catching leases as well.
Well, I knew that, this is Dan. So, I think, if I answer your question, we have a alternate [ph], we’re very happy with the mix of new logos, new customers that we’re acquiring to our platform, as well as current customers that are upgraded. And so I think the two examples that Chad talked about in his prepared remarks are emblematic. The types of discussions we're having with customers today which is very different than the ones we are having a year ago and that we were able to have a much deeper conversations around broader set of their requirements. And that we have a broader solution that we can supply to them.
So in that sense, it’s a heck of a lot more than just commodity space and power. We’re having discussion on their IT needs and then what are the additional services that we can add value to them. So, I think you’re going to see that. As I mentioned before that’s purposeful for us to be able to have those discussions of more of a tailored solution to them. It helps us with the transaction size being larger than just commodity, colocation space and power discussions.
And Jordan, I might add to that, if one other aspect of this that I think it's pretty cool that maybe part of your question which is – so if we at QTS have the scale and infrastructure to be able to talk to the hyperscale and intercept those clients as we’ve had and be effective when they're strategic. Do we also have the same ability to attract cloud companies that may infer or see the opportunity where they might be a customer or a competitor? And I think what’s encouraging to me is, is that we continue to get see the results and success of the service attach initiative, actually driving infrastructure cloud companies that look at us in a more appealing way, because of what the end solutions are providing to them.
So, for example large cloud integrating company that wanted to rely upon our FedRAMP compliant and security, infrastructure in backbone to power their cloud. Conversations around companies that are running, and marketing and delivering their SaaS product or their cloud product, running on QTS infrastructure. So it is being something that we continue to feel very good about that we can balance the service attach initiatives to tremendous value to company’s platforms, at the same time, intersect a broad set of products that have people able to kind of pick from a roster of what fits them and what they need and what they value from QTS. It is a powerful intersection of solutions and tools that we’re driving.
So we continue to be encouraged about this integrated services platform and the ability to deliver that in a market that is growing with complexity and hybrid [ph] nature of infrastructure.
Okay, that's very helpful. One last follow-up if I may, and this is just totally the [indiscernible] here, just on there was a recent piece in post by Microsoft about, as your stack, and potentially selling it separately. Eventually and I was just curious on thoughts surrounding your VMware stack and hosted cloud. If that is sort of a permanent in place to put solution, I know that's not likely. But how you would think about adding alternatives?
Yes and I’m going to let Dan highlight the product a little bit. But I’ll just say in general, we look at all of the public cloud providers as partners. And in complimentary what we're doing.
Jordan this is Dan. I think on that point is obviously public clouds are growing very rapidly in this Hyperscale term. We look at them as customers. We think that the market out there CIO’s are dealing with the hybrid IT environment, which spans public cloud, private cloud, colo and on-premise. And we want to position ourselves to be a value in that hybrid mix. And so, we don’t want to compete with the Hyperscales, as a public cloud providers, we want to be as Jeff said a partner and part of the solution to help enable CIOs manage this diverse hybrid IT environment that they have.
Yes. So another way, also Jordan is we’re not going to tussle or get ourselves in the middle of stopping people from optimizing their hybrid infrastructure. We’re zero and the different public cloud add value, we want to embrace, and help excel, and connect and drive solutions around.
So we have – obviously with VMware relationship, we're bringing out open stack capability and we think that will continue to evolve. And again we want to be in the middle of that mix.
Okay, thank you.
I think no further questions, this will conclude our question and answer session. I would like to turn the conference back over to Mr. Chad Williams, CEO for any closing remarks.
Well on behalf of the QTS executive team, Board of Directors, customers and great QTS is around the country, we want to thank you for participating in our call. It’s been a wonderful quarter, we’re excited to talk to you. We were really excited to talk to you at 9 A.M. Central sharp [ph]. And we apologize, because we value you and your time and understand that this disrupts a long day of service for you.
So for the people that we got behind this morning, we do apologize and we look forward to talking to you. And if anyone missed any comments or questions, because of the timing, we are here, and available and look forward to working with you. Thank you, very much and look forward to talking to you next quarter. Thank you.
The conference is now concluded, thank you again for your patience and thank you for attending today’s presentation. You may now disconnect your lines.
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