Digital Realty Trust's (DLR) CEO William Stein on Q2 2016 Results - Earnings Call Transcript

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Digital Realty Trust, Inc. (NYSE:DLR) Q2 2016 Earnings Call July 28, 2016 5:30 PM ET


John Stewart - Senior Vice President-Investor Relations

William Stein - Chief Executive Officer

Andrew Power - Chief Financial Officer

Matthew Miszewski - Senior Vice President, Sales and Marketing

Jarrett Appleby - Chief Operating Officer

Scott Peterson - Chief Investment Officer


Jordan Sadler - KeyBanc Capital Markets, Inc.

Jonathan Atkin - RBC Capital Markets LLC

Lukas Hartwich - Green Street Advisors

Colby Synesael - Cowen and Company

Jonathan Petersen - Jefferies LLC

Vincent Chao - Deutsche Bank Securities, Inc.

Emmanuel Korchman - Citigroup Global Markets, Inc.

Matthew Heinz - Stifel, Nicolaus & Co., Inc.

Jonathan Schildkraut - Evercore ISI

Richard Choe - JPMorgan Securities LLC

Sumit Sharma - Morgan Stanley


Good afternoon and welcome to the Digital Realty Trust Second Quarter 2016 Earnings Conference Call. All participants will be in a 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 Mr. John Stewart, Senior Vice President of Investor Relations. Please go ahead, sir.

John Stewart

Thank you, Dan. The speakers on today’s call will be CEO, Bill Stein; and CFO, Andy Power; Chief Investment Officer, Scott Peterson; Chief Operating Officer, Jarrett Appleby; and SVP of Sales and Marketing, Matt Miszewski are also on the call and will be available for Q&A.

Management may make forward-looking statements related to future results, including 2016 guidance and the underlying assumptions. Forward-looking statements are based on current expectations that involve risks and uncertainties that could cause actual results to differ materially.

For a further discussion of the risks and uncertainties related to our business, see our 2015 10-K and subsequent filings with the SEC. This call will contain non-GAAP financial information. Explanations and reconciliations to net income are included in the supplemental package furnished to the SEC and available on our website.

And now, I’d like to turn the call over to Bill Stein.

William Stein

Thanks, John. Good afternoon and thank you all for joining us. I’d like to begin today with the discussion on governance. We recently announced that Laurence Chapman has been named Vice Chairman of the Board of Directors in keeping with our commitment to sound corporate governance practices and longer-term succession planning. The Board expects to appoint Laurence as Chairman of the Board at its next Annual Meeting in May 2017.

Many of you have had the opportunity to interact with Dennis Singleton, who has served as our Chairman since April 2012 when the Company’s founder resigned from the Board. Dennis led the Board during a period of significant transition, including a change in CEO as well as several other executives, a change in Board composition, and two strategic acquisitions that have meaningfully enhanced the Company’s growth profile and product mix. It is expected that Dennis will continue to serve on the Company’s Board of Directors after he steps down as Chairman.

In addition, I’m pleased to announce that Mark Patterson has joined our Board effective yesterday. Many of you may also be familiar with Mark. He was formerly the Global Head of Real Estate Investment Banking at Merrill Lynch and prior to that he was the Global Head of Real Estate Investment Banking at Citi Group. He serves on the board of UDR as well as General Growth. We are absolutely delighted to welcome Mark to our Board. The governance principle behind these changes is balancing fresh thinking and new perspectives with experience and continuity.

I would also like to remind you that we maintain a destaggered Board. The majority of our Directors fees are paid in stock. Each of our Directors maintains a sizable investment in the Company. The Board and Senior Management are required to meet minimum stock ownership requirements. And finally, since 2014 100% of the senior management teams long-term incentive compensation plan has been tied to relative total shareholder performance.

We believe in eating our own cooking and we manage the business to maximize sustainable long-term value creation for all stakeholders. Along those lines we announced several industry-leading sustainability initiatives earlier this month including a long-term agreement to procure wind power offsetting 100% of our U.S. colocation and interconnection energy footprint.

Let’s turn to Page 2 of our presentation to recap the guide posts of our strategic plan. Delivering superior risk adjusted returns is our guiding principle. This entails emphasizing profitability over velocity and preserving the flexibility of our balance sheet. We are focused on the accretive deployment of capital and we are willing to turndown deals that do not provide a sufficiently positive spread above our cost of capital. We also execute when we can achieve the best long-term outcome for shareholders irrespective of short-term reporting requirements.

In terms of capital allocation, the highlight of the second quarter was the agreement that we reached to acquire a portfolio of eight highly strategic data centers in London, Amsterdam, and Frankfurt, three of the most important interconnection hubs in Europe as shown here on Page 3. This transaction met all of our acquisition criteria. It was strategic and complimentary to our existing business financially accretive and prudently financed.

These eight data centers are highly complementary to our European platform. The portfolio serves more than 650 customers predominantly concentrated in the network cloud and IT services, content and digital media and financial services verticals. The concentration lines up very well with our target customer verticals and more than 80% of these customers are new relationships to Digital Realty.

In addition, more than 80% of our traditional large footprint leasing activity has been repeat business with existing customers, underscoring the value of these new customer relationships. As you know, this sales process was dictated by the European Commission with the clear objective of standing up a business that would be immediately competitive in the marketplace.

What you may not know is that this business came staffed with 130 employees including 16 sales and marketing professionals. In contrast to the Telx acquisition, we have not underwritten any expense synergies in this acquisition. We are very pleased with the caliber of the personnel as well as the properties that we’ve acquired with this transaction and we welcome these new employees to the Digital Realty family.

In terms of integration, it’s still early days, but we are actively working to ensure a smooth transition for the acquired business into the Digital Realty platform. And we are leveraging the lessons learned from the Telx integration to create a seamlessly repeatable process.

Our teams are focused on communicating with our customers and employees and we are executing on short-term objectives for the business, moving people, integrating processes and standardizing reporting. Over the next quarter, we’ll finalize the plan to extend our colocation and interconnection platform and we will communicate it as appropriate. I should pause here for a moment to address the impact of Brexit.

We did anticipate a potential Brexit scenario in our underwriting and we did hedge the purchase price, but we have not altered our global strategy. Fundamentally, we do not believe the EU referendum will materially impact global data center demand or our global portfolio as the secular demand drivers remain intact and the transatlantic cable landings have not moved.

We believe our global platform is one of our key competitive advantages and we do not plan to exit either the UK or Continental Europe regardless of the outcome of the EU referendum. Early in the third quarter, we entered into an agreement to sell our fully leased [san andonin] data center in Paris to Equinix for approximately $210 million or $575 per square foot.

Also early in the third quarter, we closed on the sale of a four property data center portfolio as shown here on Page 4. The sales price was a $115 million or roughly $250 per square foot. Excluding 251 exchange, where the sole tenant is moving out this month. The portfolio cap rate is in the low 6s on forward contractual cash NOI and in the mid 7s assuming the near-term expiration were to renew. Since embarking on our capital recycling program in the second quarter of 2014, we have sold 10 properties and one investment generating net proceeds of $420 million not including the Paris property now under contract.

As I’ve said previously, we’ve been quite pleased with the execution that Scott and his team have achieved on the sale of our non-core assets and this portfolio sale substantially concludes our capital recycling program. We do however continue to believe that calling the asset base represents prudent real estate portfolio management. And you can reasonably expect to see us periodically sell another asset here or there, particularly non-data center properties or one-off assets that no longer fit our global connected campus strategy.

In terms of expanding our product offerings, we’ve been working closely with our customers and leveraging the combined heritage of Digital Realty as a large footprint leader in addition to the Telx colocation and interconnection legacy. We are close to launching our service exchange which will further allow us to enable customers with dynamically interconnected large footprint and colocation data center solutions on a seamless connected campus uniquely meeting customer requirements.

The service exchange is core to empowering hybrid cloud and IoT architectures in an extremely efficient and agile manner. We look forward to providing more details over the coming months and unveiling the benefits of the service exchange with our robust cloud ecosystem partners. In addition, we are continuing to make solid progress on the Telx integration. We are executing our systems roadmap. That work is on track and is expected to continue for the next several quarters.

We planned to sunset the Telx brand during the third quarter and we are in the process of unifying our multi-product global sales force which we also expect to complete during the third quarter. Along similar lines, our partners and alliances program continues to expand. I am pleased to announce that CenturyLink, our second largest customer has joined our program enhancing options for connectivity, managed services and cloud services for our customers.

During the second quarter, the partners and alliances program continue to drive revenues, including for hybrid cloud deployments that highlight the benefits of our connected campus strategy. I am pleased with the progress that we are making. In addition to adding CenturyLink to our partners and alliances program during the second quarter, we have begun executing on transactions for hybrid cloud deployments with one of our best customers and partners in advance of our formal go-to-market campaign which is set to begin shortly. As a result, we have already begun to realize revenue from this partnership and we expect to see even greater uptake once we formally launched the campaign.

During the first half of the year, the partners and alliances group increased the total contract value of deals executed by more than 20% albeit off a modest base. The pipeline remains robust at approximately $40 million even after several deals were executed during the second quarter.

Now let’s turn to market fundamentals on Page 5. New supplies picked up in Dallas and Northern Virginia over the past 90 days. Given the sector’s recent history, any uptick in supply bears watching carefully. However, demand is robust in both of these markets and pre-leasing levels on development pipelines are healthy.

In addition, current market vacancy rates are low at our own portfolios in these markets are likewise north of 90% leased. Northern Virginia and Dallas are both national data center markets characterized by robust leasing velocity and solidly positive net absorption.

And now let’s turn to the macro environment on Page 6. The global economic outlook has deteriorated slightly over the past 90 days, primarily due to uncertainty in the wake of the Brexit referendum. That data center industry has the good fortune of being levered to a subset of secular demand drivers that are both someone independent from and growing much faster than the broader economy.

We believe it’s still early days for cloud adoption and the related build-out of cloud service providers compute node footprints. Although cloud requirements are lumpy and price sensitive. From where we sit and looks like the wave of cloud service provider demand has not crested yet. And we see a set way building on the horizon from the Internet of Things and connected devices.

Gartner predicts that by 2018, 30% of enterprises will use cloud service providers direct when cloud connectivity services up from less than 1% at the end of last year. Given is expected growth strategic planners at the cloud providers are actively mapping out their approach. We believe that we are well-positioned to support this continued growth as we are one of the very few providers with the ability to meet the full spectrum of our customers data center demand requirements on a global basis.

And now, I’d like to turn the call over to Andy Power to take you through our financial results. Andy?

Andrew Power

Thank you, Bill. Let’s begin with our leasing activity on Page 8. We signed new leases totally $15 million of annualized GAAP rent during the second quarter, including a $6 million colocation space and power contribution. Interconnection contributed an additional $8 million and our total bookings for the second quarter were a little over $22 million of annualized GAAP revenue.

While this is towards the lower end of our recent activity levels. We are taking a much more selective approach to landing the right mix of customers to maximize the long-term value of our global connected campus footprint. We are winning diverse demand across attractive verticals including cloud service providers both big and small along with other growing segments of digital economy, IT service providers and other large sophisticated users.

You’ll note the appearance of a Fortune 50 hyper-scale cloud service provider on our top twenty customer list this quarter. At the same time we also added more than forty new logos for the second consecutive quarter. Long story short we are focused on landing demand from a diverse and growing customer set. Along those lines, I am pleased to report that during the month of July we have already signed an additional $20 million of total bookings, including space, power and interconnection.

This activity has included significant singings across all three geographic regions including a healthy mix of large enterprise software cloud providers, hyper-scale cloud providers, IT service providers and financial service customers. The total bookings figure includes $6 million of annualized colocation and interconnection bookings.

In fact, the month of July has already been the best month for Telx since our acquisition. While we are not satisfied with the level of large footprint leasing during the second quarter. The pipeline for the second half is sizable and we are cautiously optimistic that we are back on track to return to normalize activity levels in the second half of the year.

Turning to our backlog on Page 9. The current backlog of leases signed, but not yet commenced standard $70 million. The bulk of which is expected commenced within the next 12 months. The weighted average lag between second quarter signings and commencements was a record low at 1.5 months.

Turning to renewal leasing activity on Page 10, we retained 85% of second quarter lease expirations and we signed just under $60 million of renewals in addition to new leases signed. The average cash releasing spread was up a little less than 3% overall with a positive cash mark-to-market across all property types, including another quarter of plus 5% for colocation.

This was a bit better than expected largely because we did not execute renewals on the above market leases in Phoenix and on the East Coast that we have called out last quarter. We do still expect to renew those leases later this year, so we may see negative cash mark-to-market on our second half renewals. For the full year we now expect releasing spread to be slightly positive on a cash basis up from our previous guidance of flat on a cash basis.

In general we expect to see continued improvement in the mark-to-market across our portfolio driven by modest market rent growth and the steady progress we’re making on cycling through peak vintage lease expirations.

Let’s turn to Telx here on Page 11. The colocation and interconnection line of business generated $94 million of revenue during the second quarter representing 9% growth year-over-year. Although revenues remain split roughly 50-50 interconnection outpaced colocation with the year-over-year revenue growth in excess of 11%.

From the legacy 20 locations and prior to expend synergies, Telx generated $39 million of cash EBITDA during the second quarter. Telx continues to perform at or slightly better than our plan on all fronts and we remain on track to meet or exceed our underwriting targets. We have added a number of new sales reps who have already begun contributing to the success of this business.

As part of integrating our global sales force we planned to add - continue to add sales resources through the end of the year including key position to drive our vertical ecosystem development and solutions efforts. The colocation and interconnection strategy has been to focus on key facilities and drive growth associated with our ecosystem including multi-site customer wins. We are seeing progress across five emerging ecosystems, networks, subsea cable systems, mobile, digital content and over the top distribution and the cloud community.

During the second quarter, we announced that we landed another undersea cable system in our Hillsboro, Oregon facility. Subsea cable systems are an area of particular focus for us and we have had success today in the Pacific Northwest where there has been a heightened interest in landing cables.

In mid May we announced that we will be launching colocation and interconnection services on our Ashburn campus during the third quarter. We are scheduled to launch in September but the sale team has begun pre-selling the site. And we already signed a handful of new deals.

In addition, Atlanta has shown significant growth over the past few years and we are completely sold out. So we have begun working to bring on additional capacity to accommodate our overflow from 56 Marietta and should launch early next year. As mentioned last quarter Marketplace Live will take place in New York on September 22.

We look forward to providing updates on products and services and formally introduced in our revised branding and we hope many of you will be able to join us there. In summary, at the one year mark since the Telx acquisition announcement we’re on track to meet or exceed our underwriting targets and complete the integration process.

Turning to our financial results on Page 12, we reported 2Q 2016 core FFO per share of $1.42, $0.04 ahead of consensus. The outperformance was fairly broad based with the topline OpEx, G&A and interest expense is a penny ahead of expectations. AFFO per share was likewise well ahead of plan, partially driven by the beat at the FFO line as well as accretion from Telx and a further reduction in straight line rental revenue as shown on Page 13.

Recurring CapEx was also down significantly again this quarter. Although this largely reflects seasonally lighter CapEx spending and we do expect recurring CapEx to pick up in the second half of the year. Since a portion of the lower CapEx spend is essentially timing related the second quarter AFFO per share growth is somewhat inflated. But nonetheless we’re well on our way to delivering the double-digit AFFO per share growth we committed to at our Investor Day last October.

The AFFO payout ratio is now sub 70% and while we continue to view retained earnings as our cheapest source of equity capital. The current payout ratio provides flexibility and room for further dividend growth. The bottom line is that quality of earnings is improving and the growth in cash flow is accelerating reflecting the improved underwriting discipline we’ve instilled over the past two years along with consistently improving data center market fundamentals.

As you may have seen from the press release we raised our core FFO per share guidance by $0.10 at both ends of the range. We’ve raised the full year projected EBITDA margin by 50 basis points again this quarter to 57% at the midpoint. You may recall from our Investor Day presentation last October, the lease set out a target of a 200 basis point EBITDA margin expansion by 2018 from 55% to 57%.

We are nowhere close to hanging out the mission accomplished banner today and we do expect the EBITDA margin will continue to fluctuate over time as we reinvest in the business, but we are pleased with the progress we are making towards the final objective on our three-year guideposts achieving operating efficiencies to accelerate growth in cash flow and value per share.

We also raised our 2016 same capital cash NOI growth guidance again this quarter by 150 basis points at the low end up to 2.5% to 4% or roughly 3.5% to 5% on a constant currency basis. FX represented roughly 50 to 100 basis point drag on the year-over-year growth in our reported results from the top to the bottom line as shown on Page 14. I would like to remind you that we manage currency risk by issuing locally denominated debt to act as a natural hedge, so only our net assets within a given region are exposed to currency risk from an economic perspective.

As shown on Page 15, the UK represents approximately 13% of total revenues and approximately 5% is denominated in euros. Pro forma for the eight property portfolio acquisitions that closed in July. However, as you can see from the table in the middle of the page, we have over $1 billion of strong debt outstanding and we also completed our inaugural $600 million Eurobond offering earlier this year.

We have effectively matched the currency of our assets with our liabilities in these markets. So our total European net asset exposure including currency hedges is less than 5%. We may tap the sterling bond market again either later this year or earlier next year to further naturally hedge our sterling-denominated assets.

Finally, I’d like to point out that while our global footprint exposes our reported earnings to currency translation exposure; it also enables us to satisfy data center requirements, our strategic customers around the world which we believe is a key competitive advantage. In terms of our second quarter operating performance, same capital occupancy was flat sequentially at 93%. Overall portfolio occupancy dipped 50 basis points sequentially to 90.4% due primarily to development deliveries placed in service in our highest demand markets.

We expect overall portfolio occupancy to pick back up by the end of the year. Same capital cash NOI was up 3.3% year-over-year. On a constant currency basis, same capital cash NOI would have been up approximately 3.6%.

Let’s turn to the balance sheet beginning on Page 16. As you know, we executed a forward equity offering in mid-May to permanently finance the European portfolio acquisition. The underwriters also exercised their overallotment option in full, so we expect to receive total net proceeds of approximately $1.3 billion upon physical settlement of the forward sale agreements.

In the interest of time, I won’t dwell on the mechanics today, but I would like to point out that we have included a Slide here of Page 16 that does provide some detail on the mechanics of the forward sale agreements for those who may be interested. When we close the portfolio acquisition in early July, we initially funded the purchase with a drawdown on our line of credit in an effort to match sources and uses, which we have attempted to layout for you on Page 17.

In addition to the proceeds from the equity offering, we expected to close on the portfolio sale as well the Paris option property. In terms of timing for the uses, the preferred equity is not reviewable and the mortgage debt is not pre-payable until later this summer. Consequently, we expect to settle all or substantially all of the forward sale agreements by the end of the third quarter as we fund the additional use of the capital laid out here on Page 17. Remember that we can flex line of credit up or down at any time, but the forward sale agreement is a one-way drawdown.

Finally, on Page 18, we provided a recap of our 2016 capital markets activity on the right as well as the pro forma impact from the equity offering and the European portfolio acquisition on the left hand side. As you can see we are keeping our balance sheet well positioned for new investment opportunities consistent with our financing strategy.

This concludes our prepared remarks. And now we will be pleased to take your questions. Dan, would you please begin the Q&A session?

Question-and-Answer Session


Yes, sir. We will now begin the question-and-answer session. [Operator Instructions] Our first question will come from Jordan Sadler of KeyBanc. Please go ahead.

Jordan Sadler

Hi, good afternoon. I wanted to follow-up on the rent question. You talked about positive releasing spreads and the mark-to-market across the portfolio rising. Can you talk a little bit about the trends in rents you’re seeing in your markets and given essentially rising occupancies across most portfolios and very high pre-leasing rates amongst the development this out there?

Matthew Miszewski

Yes, Jordan, it’s Matt Miszewski. Thanks for the question. In keeping in alignment with what Andy have stated in his opening remarks and especially in our core markets but more broadly as well we see stable to slightly improving rates, which also happen to be coupled with some of the great work that Jarrett’s team is involved we’ve been focused on cost containment in design and construction.

So that we expect as the programs that we’re developing right now move forward to have even better performance from a pricing perspective. As our ecosystem development work that’s underway right now starts to take hold. The pre-leasing rates that in these markets similarly look good. Internationally in particular rates look fairly strong. So strength in Chicago, in Ashburn, in Dallas and in Singapore which is great given the new facility that we just launched.

Jordan Sadler

So it sounds like you are trying to, I mean, rates are stable now, but you are trying to dry them a little bit with some of the new programs. I guess as a follow-up, A, if you guys could characterize the funnel, it sounds like while this quarter was not the most robust in terms of total leasing volume, it sounds like there is a significant pipeline behind it. July was big. How would you characterize the funnel? Since you’re being selective, how would you characterize the funnel in terms of high margin versus lower margin opportunities?

William Stein

Great question Jordan and really since before the acquisition of Telx but really with the acquisition of Telx and working closely with that team we’ve been focused on making sure that the funnel is not just full, but it’s full of the right opportunities in the right target accounts.

Given our targeted focus on SMACC continuing, social mobile, analytics cloud and content, but especially inside that cloud and social verticals our funnel has been slightly - it has slightly improving margins in it currently and I do say currently because its pipeline and we have to close, but we’re pretty happy that we’ve been able to slightly expand the margin inside the funnel as we start to work together with multiple products.

In addition but we’ve been working together very, very closely with multiple clouds - large cloud service providers to make sure that we can match value for value going forward given their demand and given our capacity and given the pipeline, the pipeline margins this would give the pipeline margins for the rest of this fiscal year and moving into Q1 of 2017 potentially better outcome.

Jordan Sadler

Thank you.


And our next question comes from Jonathan Atkin of RBC Capital Markets. Please go ahead. Mr. Atkin, is your line on mute?

Jonathan Atkin

Sorry about that. So I was interested the remaining milestones that you have perhaps on the operations side. You talked about integrating the sales force and retiring the brand, but what remains to be done with the Telx integration as well as what would be some of the initial milestones as you look at the European assets that you just acquired?

Andrew Power

Thanks, Jonathan, this is Andy. In terms of remaining milestones I would say unifying the brand under one brand across the Company is a big one, one global sales force is another big one that is going on, both of those going on really right now. Remaining milestones other than, obviously, meeting or exceeding our underwriting targets probably be more back of the house oriented in terms of accounting systems that will eventually be fully united and kind of HRIS systems.

I think in terms of facing the customer and driving more revenue, the two that we mentioned on this call are the biggest that are kind of nearing the end zone. On the European portfolio acquisition, quite frankly its early days, we are delighted to receive approval from the commission and ultimately closing the acquisition what is I guess a handful of days or weeks ago.

We think we got a really talented team along with some very attractive assets coming on board. We have onboarded some consulting help to kind of help us simulate the 130 team members and assets with our existing franchise in Europe. So we probably have more to post you on that integration coming next earnings call, but just a handful of weeks of post closings, so far so good.

Jonathan Atkin

And then my second question or follow-up would be just on Telx and progress on some of the West Coast assets. If I look at your supplemental and kind of at the property level, it seems like it’s been fairly slow initial process in seeing increasing utilization there. So I just wondered if you had any commentary on how that’s progressing.

William Stein

It may have not flow through to our supplemental because until a commencement happens on a lease, it won’t show up in a utilization stat and some of those buildings are kind of portions of our building, so you can’t always see it transparently. We have seen some traction increase not on the East Coast, but also the West Coast.

I’m not sure that’s kind of coastal specific, I think it’s more a testament to onboarding more QBRs and we have several on-ramp that newly joined the Company. And they’ve, quite frankly, the new QBRs have driven a lot of new logos and customers which is what I would say attributed to Telx’s successor in the quarter which was certainly backend loaded more towards June and the beginning of the quarter and then that success is certainly spilled over in the month of July.


And our next question comes from Lukas Hartwich of Green Street Advisors. Please go ahead.

Lukas Hartwich

Thank you. Hey, guys. You kind of touch on this already, but I’m just curious how long do you to think it’s going to take to integrate fully the recent Equinix deal and then also along with that, does that kind of limit your ability to do other acquisitions or do you feel like you still have capacity to do other deals?

Andrew Power

Maybe just to rehash Lukas on the first part then I’ll hand it back to Bill and Scott on other deals. I mean quite frankly, we’re fortunate very similarly to our Telx acquisition in buying a very strategic and complimentary collection of assets and team members. In Europe, previously our position was much more anchored around our scale leasing and more campus oriented products.

What we’ve closed on with the eight assets and that team is prized assets in the Dockland of London or the size parker Amsterdam or actually in Frankfurt it works very well with the land we purchased and a sales force oriented towards selling that small footprint, higher price point, colocation and interconnection oriented offering. So that’s what makes this one a little bit easier, is that there is no expense synergies being sought here.

We actually want to put additional resources to support the sales force. It’s very complementary with the existing team over there. They’ll be moving into our office on Gracechurch Street within the month where we had a little space to fit the corporate team. And so I don’t have a date to fill, but I think this one could actually integrate more efficiently or more timely than Telx. And I’ll turn it back over to Bill and Scott to handle the back half of your question.

William Stein

Hey, Lukas. So as Andy said, actually I feel like we’re further along on the equity assets than Telx at the same time just because of the nature of the acquisition, so I think it should take less time. So looking at the M&A environment, there are certainly quite a few opportunities out there. I think that been written about. And Scott and his team are constantly scanning landscape and looking at those opportunities and we will see what happens. Scott, do you want to add anything to that.

Scott Peterson

Yes. I would agree we’re focused on integration. We want to be good stewards of our shareholder capital. I think one of the great aspects of these two acquisitions is these platforms give us a lot of flexibility. We can grow the platforms organically. We could grow through M&A, but we have a lot of flexibility and that allows us remain disciplined in our future M&A activity.

Lukas Hartwich

Great. That’s very helpful. Thank you.


And our next question comes from Colby Synesael of Cowen and Company. Please go ahead.

Colby Synesael

Great. Thank you. I wanted to start with the leasing numbers, the $15 million in the quarter. Would you characterize that more a function, and it being lower than what you’ve been doing, which you characterize that more a function of you’re not chasing the deals that are out there because you think that the returns don’t meet your criteria? Did you not necessarily have capacity in the markets where some of the bigger deals were being won this particular quarter? Or is it that you actually are bidding and you’re losing out perhaps to others?

And then I guess just a follow-up to that, in your prepared remarks, Bill, you mentioned that you don’t think that the cloud demand has crested yet and I guess that ties into some of the color that Matt gave in the first as it relates to the funnel and how you think you could see some strong demand I guess in the back half of this year and then into the first quarter and that could give higher margin. I was wondering if you can just give a little bit more specificity around what areas or what gives you the confidence that you guys will actually be involved with some of the cloud demand in the back half of the year? Thanks.

William Stein

Thanks for the question and thanks for fitting five questions into one question.

Colby Synesael

That’s a south-side skill.

William Stein

Yes. You had south-side got that skill. That’s right. So I would certainly characterize it as you did. I was not pleased with what I call below average scale product signings in the quarter. We do think that the pace was due to a couple of things that you mentioned, but also the normal lumpiness that’s become part of our business especially given the new hyper-scale demand that’s out there. But also as you said a more selective approach to making sure that we land the right mix of customers at the maximum - to maximize the long-term value that we think we have inside of our ecosystem.

So this means, as you said one of the potential reasons for that number is our continued commitment to a disciplined approach to our underwriting criteria and focusing really on top tier markets and not focusing on tertiary markets where some customers may have a desire to go and then maintaining a disciplined underwriting and pricing regimen to protect long-term value.

And on your second question, really the overall demand remains strong. It’s evident by the July that we’ve had so far in both sections of our global business as well as the healthy pipeline that I talked about which has the potential for margin expansion as we move on. We do think that we’re on track now to resume normal levels in the second half across all parts of the business in 2016.

Specifically though with regard to your question about demand and cloud demand remaining strong especially where we are in our global markets where we operate. It’s important to remember that that cloud business is still one of the fastest growing segments landing in our industry and from analysts from right scale all the way through to Gartner they all tend to agree that we are actually in the early innings of this new cloud ecosystem breaking out.

We are also starting to see the green shoots. We’re seeing mass adoption of a diversity of cloud players not just the major cloud players and early adopters that are out there which we think and to get your last question. We think we’re uniquely situated to be able to land.

We do believe that we’re the only Company in this space that is very focused on providing great scale solutions for folks who need scale solutions including those cloud service providers, but also providing colocation right next to it at a latency that can’t be beat as well as the security that comes with the power of private networking or interconnection products. So we really think that the secular demand drivers in the cloud industry are continuing to push them and we are uniquely situated to be able to address it.

Colby Synesael

Thank you.


And our next question comes from Jon Petersen of Jefferies. Please go ahead.

Jonathan Petersen

Great. Thank you. I guess just to follow-up on the leasing volumes, I mean, I know you can certainly have bad quarters. But this is essentially three quarters in a row where your volumes have been below some of your wholesale peers. I’ll just name them, like DuPont and CyrusOne. And so I guess given your comments on focusing on profitability over velocity, I guess that it kind of begs the question if the achievable profitability or the yields on these facilities have declined permanently and you guys just need to move your rents down to compete better.

Andrew Power

Sure. Let me timing this is Andy. Since matching dress and some of these already. So a couple topics one timing why I’d always love to have a better fiscal second quarter rather have a better deal on July 1, then a less attractive deal on the June 30. So I think you saw a little bit of that with the volume of sign that just got signed the first few days or weeks of the month of July.

And just to put a little more meat on the bone that’s going from a diversity of different types of customers. It’s included hyper-scale top three cloud providers, a sizable chunk from other cloud providers that aren’t in the top three and then another chunk from the rest of what we call smack of the digital economy or IT services or other transaction verticals. So we’re seeing that our demand signings in the second quarter and July from diverse growing customer sets.

The other thing I think that to draws the distinction, it is not just about pricing the profitability to we’re really focused on driving the long-term growth in the cash flow and attractiveness in value of our assets our campuses and our gateways with a diversity of different customers versus some of our peers who may be more focused on being in non-core market to us or doing a full build to suit with one customer in one shot. So we always want more exposure and more signings at the right rates from the top cloud providers but we’re focused on collective portfolio and drove that cash flow and value our assets.

Matthew Miszewski

And Jon just to give you a little bit of color. While we had a good quarter with regard to those top cloud service providers still 37% of the revenue we closed year-to-date has come from other cloud service providers. So we have a diversity of cloud exposure including 50 new logos that were landed year-to-date inside the smack verticals. So we’re fairly happy with that diversity.

Jonathan Petersen

Okay, and then just thank you for that. And then just kind of an unrelated question. On the guidance, I’m just trying to reconcile the $0.10 increase in the quarter. Obviously closing the EquiCiti assets, I would think, is what is driving the underlying increase. You also have cash rent growth. Now you’re expecting it to be positive rather than flat so all these kind of positive moves and yet I don’t see any change to top-line revenue. Help me kind of understand why we are not seeing anything increment there?

William Stein

Sure. So the breakdown on the $0.10 is really kind of a third, a third, a third story. The first third is kind of outperformance which we’ve already mentioned topline G&A, OpEx. That we kind of got in the bag from the performance in the quarter. The second, third is kind of flow through from that operational performance into the back half of the year and the last third is due to the big question.

Overall net accretion from the act the - buy the European portfolio acquisition and the funding with the asset sales and the equity and also the repayment of the debt and preferred. So the third, a third, a third, a third, the first two-third operational related the last third more or more accretion from our most recent investment.

On the topline the two things what’s kind of held us back from kind of nudging that up at this time, one was the - we are going to lose some revenue when we sell our fully leased property at St. Denis here fairly shortly. And two we do have some FX headwinds in the top revenue line item which or heads when it comes down to core FFO per share gains but on that top line of our guidance going to use the growth.


And our next question comes from Vincent Chao of Deutsche Bank. Please go ahead

Vincent Chao

Hi, everyone. Just want to go back to the Equinix asset acquisitions. You made a point of pointing out the number of employees that you picked up there, including 15 sales professionals. I’m just wondering at this point, have all the key players been sort of locked down in terms of them staying or is there still risk of some of those guys leaving the platform?

William Stein

Hey, Vince. The key guys are intending to stay through the balance of the year. And we’re working on contracts for them that will tie them up beyond that.

Andrew Power

I would add is that this particular team really of their own volition went into this process along with these data assets to kind of essentially at the EU request set up a standalone business that could stand on its own if it had to. So talented individuals across multiple departments coming together with the strong leaders and quite fortunately landed in our hands.

We’re the complimentary buyer no synergies expected, so very little overlap of any and we are able to kind of - we think the combination of our European portfolio plus data assets and teams, one plus one we feel is greater than two there.

Vincent Chao

Okay, yes. Thanks for that, and then just going back to some of the pricing commentary that we’ve been talking about today, and just looking at some of the data that you provide across the supplemental that might point to improving pricing, I’m looking at sort of the development yields that you’re expecting are up a little bit, I think, from last quarter. I don’t know if that is mix or not, but then the cash spread commentary also would point to maybe a little bit better market pricing. I’m just curious what kind of market price improvement are you expecting for this year and maybe next year if you have that?

Andrew Power

You know, I quite frankly we’re fairly cautious when it comes to kind of a going out too far in terms of future rank growth here. I could say at the larger end of the scale, the biggest buyers they are buying bulk and taking on numerous megawatts have the greatest pricing power and their rates are certainly flat.

They’re not seeing any type of rent spike. If you walk down to the other side of the spectrum and look at our smallest footprint colocation, I think you can look at the cash release and spreads which is up now 5% for the second quarter and it was a pretty sizable this quarter actually amount of leases - just in terms of colocation that rolled up, so we were able to roll these customers up 5%. And they are able to generate some pricing power. Between those two goalposts its very market and customer episodic.


And the next question comes from Manny Korchman of Citi. Please go ahead.

Emmanuel Korchman

Hi, guys. If we look at page 16 of the supplemental, the NAV, the components of NAV, and we look at the first section which is the cash NOI by property type, it looks like there is some significant movements between the business segments. And I’m just wondering if that was just a change in reporting or if there’s something going on with either the revenues or the margins impacting each business, specifically with colo non-tech and then leased Internet gateway coming down pretty significantly about 16%, 18% quarter-over-quarter?

Andrew Power

Manny, I am trying to flip to get that Page and are following this financial supplemental. I think the only - I think we may be more accurately mapping towards the NOI buckets this quarter than previously. I’m not aware of a dramatic change quarter-over-quarter.

Emmanuel Korchman

That’s fine. We call follow-up offline on that one.

Scott Peterson

Sorry about that.

Emmanuel Korchman

No, that’s all right. The other question I had for you, if you look at sort of the very, very short lease to commencement timing in this quarter, which certainly different than we have seen in the past, does that give you any concern that you’re not filling the backlog? And if we look at the July 30, excuse me, the post June 30 leasing that you spoke about, is that more similar to the four to six to seven month commencement or is that also kind of here now, take now sort of lease up?

Andrew Power

I think the short number is just a smaller sample size that actually closed during the quarter. So I think you can get back to the previous bars on what the signs in July in the rest of the quarter. So I mean, we like the short side to commencement because the cash flow comes quicker, right versus kind of the leaving something that you have to build and come online in a year to two years, but I don’t think one and a half months is definitely an anomaly.

William Stein

Manny, it was a disproportionate focus on market ready inventory that we were still clearing out, so I’ll agree with Andy that while I would love the 1.5 to stick a little bit. You should expect to see revert to the norm coming up especially given July.


And the next question comes from Matthew Heinz of Stifel. Please go ahead.

Matthew Heinz

Hi. Thanks. Good evening. In terms of the large, megawatt, multi-megawatt cloud signings we’ve seen this year, I’m curious to hear your thoughts on how competitive those bids are, what factors are going into those who are landing these deals, and I can appreciate kind of the diversity of your leasing mix here and the lumpiness of those signings, but it does appear that the rates you’re signing are substantially above where we’re hearing those other deals getting done. I am curious to just kind of hear your thoughts on the competitive environment behind those larger deals?

William Stein

Yes. Thanks, Matthew. So the competitive environment is I would characterize it as strong for especially what we turn the hyper-scale opportunities that are out there about 3.5 megawatts and above. And as you know we’re certainly not new to the cloud service provider environment. We continue to get our fair share each and every quarter, but most importantly our focus on is on getting them at the right returns for Digital Realty, so we stay very focused on that.

With the competitive bids, it does put a certain amount of power in these cloud service providers hands and we find that the closeness that we have with a number of them and extending to all of them as we move forward gives us the ability to have that value for value conversation that I referenced earlier.

So we know that they have a high degree of value on things like inventory availability and large scale inventory availability as well as connectivity to colocation facility. And as we unearth those opportunities with cloud service providers they see the value, they match the value and it allows us to not just go to the lowest price, but to go to the best value for Digital Realty. And so that’s really been our focus and it’s going to continue to be.

Matthew Heinz

Okay. Thanks. And just one more as a follow-up on the guidance, I’m wondering what you are assuming for revenue contribution and EBITDA this year from the EquitCiti transaction, and I guess with the revenue, again, with that number not moving, are you assuming that there’s just offset there from some portfolio sales and FX? Just a little deeper on the revenue guide if you would please?

Andrew Power

Hey, Matt. Could you hear that answer to that last question?

Matthew Heinz

I couldn’t hear it at all. We can follow-up offline.

Andrew Power

So in terms of the underwriting the second part of your question we’re still believe in our underwriting of the 13 times EBITDA that we announced when we made the acquisition announcement last May. So nothing’s changed in terms of outlook there and that’s what’s included in our revised guidance for 2016.

In terms of revenue it’s really about the gain from a partially a period on the pre-portfolio has been offset by FX headwinds and revenue loss associated with the safety knee asset. And also the portfolio assets that we’ve now closed on. So both of those disposed, we lose some revenue in the back half of the year and we have some ethics headwinds offsetting other revenue gains from the European portfolio. How that one do.

Matthew Heinz

That works just fine. Thank you.


And our next question comes from Jonathan Schildkraut of Evercore ISI. Please go ahead.

Jonathan Schildkraut

Great. Thanks for squeezing me in here. I guess two questions. Most have been asked and answered. First, Andy, maybe you could be a little bit more precise in terms of timing of the equity distribution from a share count perspective. Is it fair to assume, then, you’ll issue for modeling purposes, the shares at September 30? Is that the way we should think about it in sort of going through and coming out with our FFO numbers? And then I guess my second question, I will come back actually for that if you could help me first?

Andrew Power

Sure. So the whole reason with the timing is really just the moving parts on the sources and uses and we didn’t have 100% clarity when we were very able to close out for us to dispose and we think the safety need dispose will close shortly but it could be at the beginning of August could be at the end of August and we can repay that preferred debt till late summer anyways.

So what we did is we closed on the revolver short-term we used revolver closing the acquisition short-term. And then when all the dust settles on all these other uses of capital. We plan to pull down all if not all or substantial all of the equity which is 14.3 million shares including the over a lot option that was exercised. Probably I want say maybe probably before September 30 maybe the beginning of September is my guess when all the dust settles here?

Jonathan Schildkraut

Okay. That’s helpful. And then you know you said during your prepared comments, and Matt actually said in answering Colby’s question that you guys were very selective in your choosing of customers and so I just wanted to know exactly what that meant. Does that mean that you’re not taking the same customers as some of the other guys who are taking these hyper scale deals or that - I’m not sure what that meant?

Andrew Power

I think just to clarify and I will let Matt clarify as well had some a counter. I don’t think that we have lots of great customers over 2000 customers now could in our most recent acquisition. I don’t think we’re choosing customers that we don’t want to do business with and I regard I think all of our customers are great and we want to continued more business and grow our customer base. I think it’s making sure we pick our spots on the right opportunities.

So buildings on our campus or within are gateways that we can fill with the diversity of different take and small cloud service providers other parts of our smack vertical, IT service providers, corporate enterprise that all want to thrive and continue the growth space and there. We find that is a better opportunity to land versus it on the core market or outside the core market especially not going after a kind of one big swath of leasing slash capital and almost like single tenant build to suit opportunities. We think the former versus a lot us more attractive to what we put our capital.

Matthew Miszewski

And in Jonathan just real quick. I mean there’s that there are a couple of places where we are being more selective moving forward. As you know from the most recent Investor Day our focus on serving enterprise customers through the channel is certainly one of those cases, which actually makes the terms that that those organizations except a little bit easier on us and make the economics a little bit better for us as well as for the end customers down the road.

The second piece is that the ecosystem development that we’re undergoing right now will really drive who we pursue in terms of end target customers. We’ve moved to a new account targeting solution that allows us to hit not just the top cloud service providers, not just the massive cloud service providers but really about 500 targeted accounts that we can focus on and then also focus on the channel. So that’s the targeting that I was really referring to.

And the final piece is we do continue to have a great strategy of building up incredible campuses. And so we want to make sure that we have multi data center campus facility and so we need to attract those types of customers and I’ll let Jarrett.

Jarrett Appleby

Yes. I think partnering up with the partner in Alliance Group there’s a couple unique things. One having colocation now on the campus in Ashburn and Richardson next to the leading cloud service providers is high value we’re seeing severely wins in that. We do need that service exchange that provides those new connectivity options.

And the second is we’re getting multi-site deals in the ecosystems because we’ve expanded our cage capability in many of the buildings that we own that Telx is in and that’s now bringing more magnets in who bring their customer base in with them. So those are a big push that will have from our product and delivery.

And then finally with the new land we have acquired we’re now using our new design and can design and delivery capability. Now in Greenfield campuses at even larger scale and so you’re seeing that next generation of product in places like Ashburn and Dallas.


And our next question comes from Richard Choe of JPMorgan. Please go ahead.

Richard Choe

Great, thank you. I just wanted to follow-up on a clarification. Given the EquitCiti asset probably is a little bit lower margin that the core business and it’s staying in guidance, what gave you the confidence to raise up the guidance range for adjusted EBITDA to 56 to the 58?

Andrew Power

Hey, Richard this is Andy. Even with the absorption of - you’re correct lower margin than existing digital. Based on the outperformance we’ve seen on the EBITDA side or expense side year-to-date and what we’re trending for the remainder of the year. We think we’re going to be able to absorb that portfolio and continue to maintain - I should say deliver slightly higher than previously disclosed EBITDA margin. There is a little bit of an order of magnitude going on here with the portfolio being $900 million and relative to digital size.

Richard Choe

Makes sense. And then for the development CapEx guidance, it’s been very light for the past few quarters. It seems like it really would have to accelerate to even get to the low end, let alone midpoint or high end. Is that the right way to think about that?

Andrew Power

On the development CapEx spend. I think you’re right. We’re probably if you look to those two goal posts we’re probably close to the low end than the high end. But I won’t put it out of reach yet. But I would say we’re probably guide into a little bit on that spend towards the low end.


And our next question comes from Sumit Sharma of Morgan Stanley. Please go ahead.

Sumit Sharma

Thank you for taking my question. I was wondering if you could provide more color on the four assets you sold. Just trying to get a sense of whether these were non-core or more on the opportunistic side of things given the low 6 cap rate. Any color you could provide would be really helpful?

Scott Peterson

Yes. Scott here. Yes, it’s fair to determine or to call them non-core, St. Louis is a non-core secondary market, that asset was better placed in the hands of somebody pursuing that strategy. And then the two Northern Virginia assets, well that is a core market; those assets would not be considered core assets to our ongoing strategy.

Sumit Sharma

Okay. Fair enough. And in terms of the SS NOI guidance phase, the 2.5 or 3.5 on constant currency basis to 5, assuming there’s 3% escalators on all of your rents, I guess there has to be somewhere in there that just seems pretty significant asking rent hike around the 10% range. Just trying to get a sense of what kind of asking rents are you seeing and who is driving that kind of thing?

Andrew Power

Sure. I would say - so our bumps are 2% to 3%, but not all 3% just to be clear. So I think the reason we really changed increased our same capital cash NOI growth. We’re doing a little bit better on the retention. Doing a little bit better on a cash mark-to-market then from a quarter ago and that kind of translates into that kind of a 3 to 3.5 constant currency growth rate.

You are not - that space and there’s a pretty demonstrative footnote at the top does not have the Telx colocation, mark-to-market really running through it, as we want to really reflect the true chain capital stabilized portfolio, so you’re not getting the 5% plus mark-to-markets like we’re seeing on the colo side yet. Next year we’ll be in that pool, but right now this is just really retention and modest mark-to-market from the - are more of our scale leases expiring and for those and those 2% to 3% rate bumps and then managing the OpEx prudently.


And ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Bill Stein for any closing remarks.

William Stein

Thank you, Dan. I’d like to wrap up our call today by recapping our second quarter highlights as outlined here on Page 19. We had another very productive quarter characterized by solid execution against our strategic plan. In particular, we further advanced our global footprint with the European portfolio acquisition. We also delivered solid current period financial results. We beat the Street by $0.04 with better than expected results above and below the NOI line.

We also delivered outsized AFFO per share growth during the quarter. The quality of our earnings is improving and the growth in cash flow is accelerating. We raised guidance by $0.10 with an improving outlook for most of our key metrics and solid progress towards our three-year target of 200 basis points of EBITDA margin expansion. Finally, we further strengthened our balance sheet with proceeds from asset sales and a successful forward equity offering that coincided with our inclusion in the S&P 500 index.

In conclusion, I’d like to say thank you to the entire Digital Realty team whose hard work and dedication is directly responsible for this consistent execution against our strategic plan. Thank you all for joining us and have a great summer.


Ladies and gentlemen, the conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.

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