QTS Realty Trust Inc. (NYSE:QTS) Q4 2016 Earnings Conference Call February 22, 2017 8:30 AM ET
Stephen Douglas – Head of Investor Relations
Chad Williams – Chairman and Chief Executive Officer
Bill Schafer – Chief Financial Officer
Dan Bennewitz – Chief Operating Officer, Sales and Marketing
Jim Reinhart – Chief Operating Officer, Operations
Jeff Berson – Chief Investment Officer
Jonathan Atkin – RBC Capital Markets
Richard Choe – JPMorgan
Jordan Sadler – KeyBanc Capital Markets
Jonathan Schildkraut – Guggenheim Securities
Matt Heinz – Stifel
Simon Flannery – Morgan Stanley
Paul Morgan – Canaccord
Alex Sklar – Raymond James
Eric Luebchow – Wells Fargo
Good morning and welcome to the QTS' Realty Trust Q4 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Stephen Douglas, Head of Investor Relations. Please go ahead.
Thank you, operator. Hello, everyone and welcome to QTS's fourth quarter and year-end 2016 conference call. I'm Stephen Douglas, Head of Investor Relations at QTS and I'm joined here today by Chad Williams, our Chairman and Chief Executive Officer; and Bill Schafer, our Chief Financial Officer. We're also joined by Jeff Berson and 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 have 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 certain number of risks and uncertainties as described in our SEC filings and actual future results may vary materially. Forward-looking statements in the press release that we issued yesterday, along with our remarks today, are made as of today and we undertake no duty to update them as actual events unfold.
Today's remarks also include certain non-GAAP measures, including FFO, operating FFO, adjusted operating FFO, MRR – 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 measures and a reconciliation of them to our GAAP results. These documents are available on the investor relations page of our website.
And now I will turn the call over to Chad.
Thanks, Stephen. Hello and welcome to QTS's fourth quarter and year-end 2016 earnings call. As you can see from the results we released yesterday we delivered a strong fourth quarter to close out another successful year of execution for QTS. Combination of our technology services platform delivered across our mega scale data center infrastructure continues to drive differentiation for QTS in the market.
On Slide 3, it is our strong belief that customers are increasingly consuming IT infrastructure, resources in a hybrid environment. We see it from the public cloud providers, we hear it from our various contacts throughout the industry and most importantly we have consistently heard it and experienced it from customers. As an example as of our – end of 2016 the percentage of recurring revenue from customers using more than one of our C products is now 60%, which is up from approximately 40% as of the IPO. Due to a variety of factors whether it security, high-performance requirements, or infrastructure flexibility, to access cloud resources proportions of hybrid IT, enterprise customers need a partner that can deliver a full suite of products that allow them to customize their infrastructure based on specific and unique IT requirements.
A customer may want a Colo or private cloud for large-scale, always on workloads like databases or messaging platforms, but they may also need an on-ramp to a public cloud to take advantage of the elastic nature of certain workloads. We can do that. And seamlessly from a single pane of glass across multiple public and private cloud platforms, while integrating all of the fundamentals of the data center into this few. Another customer may be thinking about moving to a cloud environment, but isn't sure how or when the transition will occur. Our integrated services platform gives us the ability to have a conversation with those customers about solutions that can deliver the flexibility and customization to solve complex IT requirements. And always, with QTSs premium customer service and industry-leading security and compliance support.
Not every enterprise application or requirement can be delivered in the same IT infrastructure environment. This is what we refer to as hybrid IT and is the foundation of QTS's integrated services platform. Our ability to capitalize on growing hybrid IT demands gives us the opportunity to continue to deliver consistent long-term value to our customers and shareholders.
Next, on Slide 4, I'd like to reflect on what the QTS team has achieved during the past year. For the full year 2016, we remain – we maintained our strong momentum with healthy year-over-year growth across key financial metrics. We achieved record revenue of $402 million up 29% over 2015. Including 33% growth year-over-year in connectivity revenue, which now represents approximately 6% of our recurring revenue, adjusted EBITDA of $184 million was up 32% year-over-year, operating FFO of $141 million grew 35% year-over-year and operating FFO per share of $2.61 grew 14%.
We achieved an annualized unlevered return on invested capital of 14.8% for 2016, which is in line with our fully stabilized target level of 15%. The return on invested capital reported in fourth quarter and the second half of 2016 was well below our fully stabilized 15% target due primarily due to new lower utilized assets like Chicago and Piscataway. As we have discussed in recent quarters we expect our return on invested capital remain below our 15% stabilized target over the course of 17% and ramp over time at these newer data centers lease up.
Leasing trends remain positive across our product lines. During the year we added 114 the customer logos up 28% from the 89 customers added in 2015, and into the year with over 1,100 customers in total. We signed new and modified leases during the year representing $48 million of incremental annualized rent, net of downgrades representing 21% increase year-over-year. We reported annualized MRR churn of 5.6% for 2016 at the low end of our revised guidance of 5% to 7% and our historical target range of 5% to 8%.
In addition visibility into the future cash flow growth remains strong. As a result of our backlog have signed but not yet commenced annual revenue of $43 million as of year-end. As we've said in the past, this number will continue to approach a more normalized level as we deliver on a few larger customer contracts over 2017. Over the course of the year, we make numerous key investments in the business to position QTS for consistent long-term growth. We've deepened our presence in existing markets like Atlanta, Dallas, and Richmond where we are seeing strong growth and we expanded our footprint into new markets like Chicago where we formerly opened the state-of-the-art mega data center at the beginning of the third order.
When we acquired our Chicago facility it had a shell that supported 133,000 square feet of raised floor. As we look at the design of the site through the course of our development we've been able to increase the capacity and the existing shell from 133,000 square feet of raised floor to 208,000 by adding a second story to the existing building. In addition we still own the adjacent land on the 38 acre campus which allows us to build an additional 350,000 square feet shell that can support more than 200,000 square feet of additional incremental raised floor. At full development our Chicago campus will be able to support over 400,000 square feet of raised floor and 80 plus megawatts of power.
This capacity will continue to drive the momentum and success we're seeing in this market. We also added to our footprint through two separate opportunistic acquisitions that extended our growth path with a clear cost to build advantage. The first a 360,000 square foot facility in Piscataway, New Jersey was acquired for $125 million in June of 2016. And we remain encouraged by the initial response from existing and potential customers in the markets that QTS's differentiated approach to services and support. In fact, during the fourth quarter we're pleased to sign another expansion lease with one of the existing customers in our Piscataway site increasing their MRR with us by approximately 35%. This new lease follows a 1.1 megawatt expansion by separate existing customer announced last quarter. Our success and just two quarters since acquiring the property in Piscataway demonstrates the value that customer see in QTS's high end customer service and customized solutions.
We're also excited to have recently announced the incremental footprint expansion in Dallas market to the acquisition of a 260,000 square foot facility in Fort Worth, previously owned by one of the largest insurance providers in the world for $50 million. This facility provides QTS immediate sellable inventory in one of the strongest Tier 1 markets in the U.S. and strengthens the Company's position as a leading data center provider with significant incremental expansion potential.
On the services side, we enhanced our portfolio with the introduction of several new products including QTS Managed Cloud and OpenStack Cloud, the newly rebranded QTS Government Cloud and availability of AWS Direct Connect out of our Chicago make a data center. Our technology services platforms afford us the opportunity to offer incremental value and solutions to our customers on top of the space and power and it enhances the overall growth opportunity with new and existing customers.
More than 50% of our revenue from C1 and C2 customers is generated from those customers that are also taking C3 services, which is up from approximately 30% just three years ago. And, for these customers the C3 contribution reflects a 35% increase in the overall data centers spend with us. That is revenue we would not have the opportunity to capture if we did not have the opportunity or capabilities for service that we do. We will continue to look to enhance our C3 portfolio services to drive valuable solutions to customers in complex IT environment and maximize the utilization of our real estate by as we say selling the cubic feet.
Turning to Slide 5, I'd like to spend a few minutes discussing our recent acquisition in the Dallas market. On January 30, we announced the purchase of a 53 acre purpose-built mega data center of campus in Fort Worth, Texas for $50 million. The site was formerly owned and operated by Health Care Service Corporation, one of the largest health insurance providers in the United States. In conjunction with the acquisition may have signed a 1 megawatt lease to remain the anchor of tenant in the facility. Much like our acquisition of McGraw Hill data center in New Jersey in 2014, this latest acquisition represents yet another classic example of the value of two QTS's opportunistic approach to acquiring infrastructure. Our $50 million purchase price of the Fort Worth campus represents an upfront cost per megawatt of approximately $6 million, which will continue to support our ability to generate an above average return on invested capital in that market.
In addition, this transaction establishes a new strategic relationship with the leader in the healthcare insurance sector and provides potential opportunity to further support this customer's future hybrid IT requirements. QTS's differentiated focus on customer service, technology solutions and security in compliance allows us to earn trust with enterprise customers and continue to unlock value enhancing opportunities like these. The Fort Worth facility currently has 40,000 square feet of raised floor and 8 megawatts of gross power built out with the powered shelf that doubled this.
Ultimately including the adjacent land we believe the site can support a total of more than 300,000 square feet of raised floor and 60 megawatts of gross power. Since opening up the facility in Irving, Texas in 2014, we have experienced tremendous success, well ahead of our initial expectations, in fact including leases signed in our book but not billed backlog currently not reflecting in the occupancy and assuming all of the rights of first refusal we have provided to customers or taken, we have committed approximately two-thirds of the total 275,000 square feet of raised floor capacity at the current Irving site.
Based on that demand we have experienced since opening the facility just three years ago, we have begun the preliminary planning phase is to expand the site in Irving on the adjacent owned land. This capacity, however likely will not be available until 2018. The facility will be acquired in Fort Worth has located 20 miles from our existing site provides immediate sellable inventory for us to continue and satisfy future customer requires in the greater Dallas market. It also strengthens our service capabilities by enabling and enhanced high-availability solution through a dual footprint in market. Dallas continues to be one of the most attractive Tier 1 data center markets in the country and it will remain a focused area of investment and future growth for QTS.
Moving on to Slide 6, our model enables us to provide solutions to the largest of enterprise customers while also meeting shifting IT needs for smaller entities and government agencies. For larger requirements we continue to support growth and hyper scale of one of our largest customers are leading SaaS provider taking another 1.2 megawatts increasing their business with us by an additional 10% across two different QTS facilities. There expansion is a testament to the continued appeal by even the largest hyper scale customers to QTS's mega scale infrastructure and service delivery.
Our integrated solutions also enable us to work with smaller fast-growing companies huge rapid growth requires a flexible IT solution incorporating hybrid and shifting infrastructure. In Q4, we signed a Fortune 1000 digital media customer taking C2 and C3 services representing total annualized MRR of over $700,000 in our Dallas, Virginia and Irving, Texas site. We designed a hybrid solution for them where we are providing a combination of space and power, dedicated private cloud, and a cross connect into AWS. This is a great example of how our integrated services platform allows us to drive broader solutions for our customers and target a wider set of potential opportunities than our competitors.
Now, moving on to quarterly leasing performance on Slide 7. For the quarter we signed new and modified leases totaling approximately $11.6 million of net incremental annualized rent in line with our prior four quarter average, demand during the quarter was broadly distributed across to our product mix.
Moving on to pricing, during the fourth quarter pricing from new and modified leases was 16% above our prior four quarter average driven primarily by higher mix of C2 and C3 leasing volume. C1 pricing per square feet was up 9% relative to the prior four quarter average reflecting healthy industry pricing dynamics and a higher mix of relatively smaller footprint deals sign this quarter, which generally carry a higher pricing per square foot. Pricing for C2 and C3 new and modified leases was up nearly 40% as compared to our prior four quarter average due primarily to few sizable C3 deals in the quarter.
Regarding renewals on a like for like basis where customers renewed contracts without a change in square feet, we experienced renewal rates for the fourth quarter 2016, reflecting an increase in pricing of 4.7%, above the pre-renewal rates. We continue to expect renewal increases in the low-to-mid single digit. Leasing commencement, pricing during the quarter declined for C1 due to the higher mix of larger C1 commencements, which also drove increased commencement volume this quarter. Lease commencements, pricing for C2 and C3 also was down due primarily to a higher mix of C2 leases, which carry lower pricing per square foot.
Overall, the pricing environment across to our footprint remains strong and is consistent with the positive market trends that we're seeing. Regarding the 2 megawatts of lease space in Northern Virginia that we discussed last order involving a government customer that will churn in Q1, we continue to review our options. There are two primary options that we are evaluating. The first involves finding a government customer with the specific requirements for this unique space and signing them at a value that would warrant us extending our lease term in the facility.
The second option involves finding a short-term tenant for the duration of the remaining two years we have left on the lease. Adding value that would reflect a shorter-term contract, but not materially change our financial performance. We will continue to analyze our options and push towards and enhanced results.
With that, as I'm sure you saw in our press release yesterday we are excited to have announced that Jeff Berson, our current Chief Investment Officer will assume the role of Chief Financial Officer effective April 3. Jeff has been a critical member of our executive team since our IPO and his leadership across the business has enhanced, our capabilities around capital allocation, strategic analysis and long-term planning. I look forward to his continued leadership as the new head of our financial organization. Jeff will be succeeding Bill Schafer who is transitioning to a new role of Executive VP of Finance and Accounting. This change as part of QTS's proactive approach the C-level succession planning and provides for a strategic seamless transition in this key leadership position at QTS.
Bill will continue to lead our key accounting and finance functions within QTS indefinitely. I'd like to personally thank Bill for his contributions to our organization as our Chief Financial Officer for the past seven years. His friendship, guidance and steady hand have been and will continue to be a great asset to me and the rest of my executive team. Knowing bill as long as I have – I have full confidence in his ability to provide a smooth transition for Jeff into the CFO role. And I am excited about what QTS can achieve with their combined partnership and leading our financial organization. Those extensive accounting and audit experience in and the REIT industry will continue to be an asset QTS.
With that, I will turn it over to Bill Schafer to discuss our development pipeline, balance sheet and outlook in more detail. Bill?
Thanks, Chad. I appreciate your comments and look forward to continuing to work with our outstanding team like QTS. I have great confidence in Jeff's ability to step in and lead our finance organization. Since Jeff arrived in 2013 we have formed a solid partnership and I am looking forward to expanding that partnership with him to further QTS's growth and strategic goals.
Moving onto development, on Slide 9, for the fourth quarter we brought online 48,000 square feet of raised floor in our Irving, Texas and Suwanee facilities. As of the end of the quarter, our total build out raised floor was over 1.3 million square feet, which represents approximately half of the total powered shell raised floor capacity of 2.5 million feet in our existing facilities, not including land that we own adjacent to our mega data centers. This capacity continues to provide us with enhanced visibility into our future growth at a known lower-cost and lower risk profile.
Currently we anticipate bringing online 151,000 square feet of raised floor in 2017, which includes 28,000 square feet of raised floor in Chicago as part of our continued ramp in that market and over 67,000 square feet in Dallas between our Irving and Fort Worth facilities to support continued strong momentum we're seeing. We also anticipate bringing online additional capacity in Atlanta, Piscataway, Santa Clara and mount campus in Northern Virginia. The total cost to bring this space online is estimated to be approximately $250 million of which $141 million has been spent and $109 million will be spent in 2017.
Moving to Slide 10, we believe we have significant liquidity capacity in our balance sheet with no significant near-term debt maturities. Recall that in December we amended our unsecured credit agreement, increasing the total capacity from $900 million to $1.2 billion. As of December 31, 2016, we had a total of approximately $571 million in liquidity in the business made up of availability under our credit facility and cash on hand. Our fourth quarter ending net debt to annualized adjusted EBITDA was approximately 5 times, which compares to 4.6 times as of the end of last quarter.
I would note that our year-end debt balance includes the $50 million purchase price from our acquisition in Fort Worth, which officially closed towards the end of the quarter. Although, we remain pleased with the strength of our balance sheet, we continue to monitor market opportunities to lock-in fixed rate, extended maturity debt and other forms of long-term capital over time as we manage our balance sheet and capital structure.
Next, on Slide 11 with respect to financial guidance, we expect 2017, year-over-year revenue growth to be in the range of 11% to 13%. And we expect 2017 adjusted EBITDA to be between $203 million and $211 million. Our guidance assumes an approximate 100 basis point year-over-year decline in NOI margin primarily due to a full year of ownership of lower utilization sites like Chicago and Piscataway and Fort Worth. However, as a result of the continued operating leverage in our business, we expect our G&A cost as a percent of revenue to also decline. We expect the net impact will drive our adjusted EBITDA margin in 2017 in line with our margin in 2016, consistent with our commentary last quarter.
As our newer sites begin to ramp, we continue to expect incremental adjusted EBITDA margin expansion over the next few years. We also are guiding 2017 operating FFO to be between $151 million and $157 million or between $2.64 and $2.76 per share fully diluted. We anticipate year-over-year sequential growth for revenue, adjusted EBITDA and OFFO to be slower in the first half of the year as a result of the previously announced front-end loaded churn event during the year.
In addition, for Q1, we currently expect the sequential decline in reported OFFO and OFFO per share, again reflecting the impact of churn that we discussed. We expect growth across our key financial metrics to reaccelerate meaningfully as we move into the back half of the year. During 2016, we recognize the total non-cash tax benefit from operating results of approximately $6.4 million associated with OFFO, which we discussed throughout the year.
For 2017 based on our preliminary analysis and forecast, we currently anticipate recognizing reduced non-cash tax benefit amounting to approximately $3 million for the year, which is reflected in our current OFFO and OFFO per share guidance. As we did throughout 2016, we will continue to provide disclosure around tax benefits recognize to assist in comparing our results to prior periods.
Moving on to churn, our expectation for 2017 remains at a historical target of 5% to 8%, however given the previously disclosed churn, we expect to end up at the higher end of that range this year. To support our future growth, we expect to spend between $325 million and $375 million in cash, capital expenditures in 2017.
Finally, last week, we announced that we have declared a dividend of $0.39 per share for the first quarter of 2017. On an annualized basis this represents an increase of 8.3% compared to our previous rate. We plan to maintain this rate through 2017 unless circumstances change materially. Overall, we remain pleased with financial success that we are achieving and the growth in our core business. We are excited about the incremental profitable growth opportunities we see in the market and believe we have positioned our balance sheet to support strong expectations for future performance.
With that, I will turn it back over to you, Chad.
Thanks, Bill. Looking back over 2016, we are pleased with the momentum of the business. We are motivated to constantly find ways to improve upon our business results and efficiency. The data center market opportunity for hybrid IT requirements is expanding. We continue to believe that the right way to intersect our customers is through our integrated platform of highly compliance, highly secure technology services that can deliver comprehensive solutions to complex IT requirements.
We also remain committed to being good stewards of our people and our surrounding communities. The strength of our company is QTS is powered by people platform. And, I would like to thank our employees for their continued hard work and dedication in delivering premium customer service which continues to differentiate QTS in the market. In addition, I'd like to thank our customers and shareholders for their continued trust and confidence in QTS. Our goal is to be a world class business that focuses on creating long-term value through our emphasis on people, products and performance. And we will continue to invest and grow the company with that goal in mind.
Now, I’d like to open up the call to questions. Operator?
We will now begin the question-and-answer session [Operator Instructions] The first question is from Jonathan Atkin of RBC Capital Markets. Please go ahead.
Good morning. So I was interested if you could talk a little bit about the major developments you’ve got in Atlanta, Chicago, Irving and pre-releasing trends that you are seeing there. And then, as well as kind of the product mix that ultimately you expect to see in Chicago, a couple of quarters down the – give your pipeline and I have follow-up. Thanks.
Thanks, Jonathan. This is Chad, and thanks for calling in today. I'm going to let Dan take a little bit about the product mix in the opportunity for Chicago, but our development has been balanced and we continue to see great opportunities really across the market, but Dallas and Chicago have been – Dallas as we’ve talked about has been just such a super strong performer. We continue to be able to deploy capital there and continue to lease and Chicago got off to a fast start, but Dan you want to add a little color on the product mix in there.
Yes, Jonathan, this is Dan. So Chicago first, take a step back and we opened in the third quarter and saw a lot of success early and we discussed that in our last earnings call. In the fourth quarter with the addition of the AWS Direct Connect we've seen a lot of great activity across to our product portfolio. So obviously we've got C1 business there and we see continued interest in that product, as well as the our C2 and C3 offerings continue to grow. And quite frankly we are leveraging a relationship with AWS and the ability to act as a hybrid IT solutions provider for customers need Colo and Managed Cloud and help – move into the public cloud.
I think – yes, the same thing is true for Dallas. Dallas has been a great market for us both the metro area there as well as the national market. We deploy our entire portfolio there. So we are very excited about the opportunity to grow in there as well as the ability to take advantage of two sites there to be able to offer multistate solutions to our customers.
Yes. And Jonathan the other thing we've seen in Dallas is location does matter because traffic matters in Dallas. So when we are tracking the C2 and connectivity type focus clients, the Las Colinas location and from Downtown or to Fort Worth is just a very good location, centralized in that. So from a retail standpoint, we continue to see good demand on all fronts to Dan's point.
Okay. And then on CapEx, if I add at the estimated cost to complete your ongoing developments, it looks like its $109 million and then the guidance for the year is $350 million, so can you talk a little bit about the delta and the cost per – the CapEx composition there? Thanks.
Thank you. I’m going to have Jim Reinhart who leads development force talk about that.
Yes. As you mentioned obviously is our product continues to expand, we're able to add relatively quickly at a low cost. So the additional capital is really going towards those sites that we've laid out and continue to see good development cost across the Board.
The next question is from Richard Choe of JPMorgan. Please go ahead.
Great, thank you. And looking at the development schedule and all of the completion dates, it seems like it's pretty backend loaded, can you talk a little bit about what is going to be driving the growth in second and third quarter given that developments kind of later on. And then also can you give us a sense of how much fourth quarter is contributing to guidance in terms of revenue or EBITDA? Thank you.
Yes. Dan, you want to take the inventory question and then Jim you can follow-up on the development back half of the year.
Yes. So I think as you look at our business plan for the year, we’ve got sufficient inventory to be able to meet our objectives here across our product line. The development that we're putting in is going to drive the growth later in the year as well as into 2018. So, we feel good about that. We have a process where – at least monthly we're getting together and sometimes more frequently to look at where is the demand going, where are we putting our capital and how do we make sure we optimize that capital to see where the demand is as well as what products are being demanded in those markets.
Some of the timing also is dealing with the booked-not-billed backlog that we have. We know those commencements are going to start. And so, we kind of plan the capital spend to meet those needs.
As we have discussed overall our portfolio is well-positioned to add inventory when we needed and where we needed. Clearly, what you're seeing here is the first half that’s really kind of geared to what we’re seeing in the current demand and the second half where we actually have seen strong historic growth. Obviously if growth shifts to different markets, we’ll be able to move those dollars in that capacities where we’re actually seeing the deals land, but that’s what we really believe is the great outlook given historic trends.
Great. And I guess is there much in the guidance from Fort Worth or is that relatively small?
Hey, Richard. This is Jeff. So on Fort Worth when we announced that deal as you know we’re bringing on 1 megawatt from that that core anchor healthcare customers, so we’re excited about that that’s looking to hit starting on April 1, which is when that – that 1 megawatt is going to come in. Beyond that we are enthusiastic in giving that market in that location in that asset that we’ll be able to drive increased revenue in there. It’s going to take us a little bit of time to convert that that infrastructure into a multitenant environment, but towards the second half of the year we’ll be ready to go out there and start selling.
Great, thank you.
The next question is from Jordan Sadler of KeyBanc Capital Markets. Please go ahead.
Thanks, good morning. I was hoping for a little bit of clarification on the government customer churn event, Chad in your prepared remarks you outlined two scenarios, but maybe you could clarify is this – has this tenant – has the original tenant moved out of the space and ultimately…
Okay, they have. And so we should expect that space should be vacant or maybe how should we – what are you underwriting in your guidance in terms of that space?
Right now – Jordan, this is Chad. Thanks. The client has moved out and we’re in a bit of reposition of the space. Of course it’s fully built out. It’s built to a certification standard that’s fairly unique and with the location of it in Northern Virginia a proximity that the federal marketplace. And quite frankly the – some focus from our internal government services group, the team has made a pretty compelling case to say give us some time. So that team is kind of working through a series of conversations with that space. And if the right value connection can be made with somebody that needs secured comps, the separation and the certification of the skiff environment and a couple megawatts that come along with it, it’s very unique. I mean it is probably one of the most complete available skiffs in Northern Virginia today.
So, I guess, we're willing to kind of take a little bit of time and led our federal teams see if there's any opportunity. At the same time, the parallel path as really Dan has the commercial team looking at what has been a market that’s pretty much been constantly high occupation levels there in Northern Virginia and say hey if somebody in the neighbourhood needs a couple of megawatts and once it takes down the space with the remaining term that we have a couple of years and incentivise somebody to do that that’s another opportunity. It won’t have a significant impact on our financials, but we’re going to figure out one way or the other being a good steward of capital. We want to make a good decision with it, move on. Dan, I don’t know if you have anything to add to that.
Yes, Jordan, this is Dan. Just to reemphasize, so we’re pursuing multiple paths in parallel. As Chad said looking at government clients through value of the high security and the skiff aspects of that and it’s right price point we’ll extend in long-term lease. In parallel, we’re looking if there is a short-term leasing opportunities for requirements that are two years or less, is another option that we’re pursuing in parallel.
And Jordan to answer your question on the guidance, what we’re assuming currently in the guidance is that we retain the cost in that space, but that we don’t re-let it. So there is upside there. Although I’ll caution if we can bring in a government contract or government customer at the kind of pricing that that skiff space can support that could be some nice upsides. The extent that we just bring in a commercial customer and a short-term lease for 2 megawatts, we’re still happy to have it, but it’s not a material change in the numbers.
Okay, thanks. And then as a follow up, I wanted to just revisit the role that you’re anticipating for 2017. It’s about 32% of rent with the biggest concentration really in C2. And I think in renewals, you had a pretty good quarter and it sounded like low to mid single digits was sort of they anticipated renewal releasing spread that you’d expect to see. Is that the right read on things?
Yes, Jordan, this is Dan. I think first off we’ve got the event that we just talked about that’s in the numbers. So we think the guidance is out there at 5% to 8% that’s going to happen earlier in the year as we’ve discussed. We feel good about where we are in terms of leasing as well as releasing spreads in terms of low single digits for lease or rental increases and return part is 5% to 8% as we talk about. We feel good about both of those...
And Jordan just in terms of those contracts coming up for renewal, because your average contract length for C2 and C3 is typically three years, it’s pretty consistent. I think you’ll frequently see that because the C2 and C3 represent a good portion of our revenue. You'll often see those contract renewals coming up every year, but again to Dan’s point the renewal rates are up and the churn is low. So we feel good that those are opportunities to increase pricing.
Okay, thank you.
The next question comes from Jonathan Schildkraut of Guggenheim Securities. Please go ahead.
Great, thank you for taking the questions this morning. So I’d like to start with sort of what’s going on from a demand perspective. Chad as you look into 2017 maybe relative to 2016, are there any changes in the demand profile? The customer conversation that you’re having which would either put QTS in a better or worse situation relative to 2016? And then I'd like to circle back with a question on the sale lease back if I could. Thanks.
Sounds good, thanks, Jonathan. It’s good to talk to you. I have to say that we have been seeing a consistent engagement level, but what's most encouraging and even if you look at the fourth quarter as it’s been an engagement level with customers moving forward on all of the product set. So we didn’t – as you all know didn’t sign any hyperscale. We had one hyperscale customer that did expand almost 10% of their portfolio with us in fourth quarter, but what I loved about the quarter was the consistency across all of our products.
And that’s really a good thing for us because we think the healthiest environment is to be able to sell a healthy balance of all of our products across the portfolio. So I think we’re net positive on 2017 and opportunity for the hybrid IT environment that kind of drive lots of different things, connectivity, clouds, access to public cloud and all of such. So we see good momentum across all sectors. And obviously, hyperscale, where we feel like we can be strategic and then strategic within our platform and it meets our return hurdles. I think there’s going to be a lot of that opportunity across the board in 2017. Dan is there anything to add to that?
Jonathan, this is Dan. Just to add-on we see the demand continuing to move towards this hybrid IT environment, which is the mix of on-prem off-prem cloud-based solutions. I think the customer example that Chad talked about is a great example of the type of conversations we’re getting into with customers and prospects where the solution is a hybrid mix of colo, so managed cloud as well as managed public side, in this case of Amazon. And that end to end solution, customers we hope to position QTS as a go-to partner for customers that need to help migrate to this complex hybrid environment. So again we’re positioning QTS as a player to bring innovation to that space.
Great. And if I can ask one question on the sale leaseback side, obviously announced one early this year some very attractive numbers relative to sort of original construction cost. As we think about the move forward and enterprises maybe moving out of their own asset, and so maybe some more of these opportunities around sale leaseback. How should we think about QTS viewing the opportunity to invest in these types of projects versus sort of further development inside the assets you have. Is it a simple cost equation, or is there more that goes into it than that? And from our seat as investors and analysts I think that one of the challenges that we have with sale-leaseback transactions is that we don’t know the quality of the asset that is at QTS, or one of your peers build an asset.
We have a much greater visibility into the quality of that asset versus the sale-leaseback transaction. And I guess the second half of the question is that how do we get comfortable that the assets that are out there, the assets that you buy, or other peers buy, what are the questions we should be asking, to get comfortable around that asset quality? Thanks.
Thanks Jonathan, all great stuff, let me think where I’d start here. I think the best discipline that you are going to see that QTS has is that we don’t have to go do stuff because our ability to double our platform to your point exists within our portfolio today. So the work, that we’ve done over the last decade has put us in a position and I think I’d say that because the best discipline around that is not having to go try to create transactions for the sake of growth.
We have tremendous growth within our portfolio today and so that gives us good discipline on the return on invested capital and the focus because I think there is a very, very differing view of what infrastructure looks like on sale-leasebacks. And I think it is very astute of the market to kind of recognize that. I would say that the two transactions we’ve done in this space in 2014 and the one here, I don't put this up as you are going to be able to kind of count on this like clockwork because it is not that. It is opportunistic and it is also a part of our unique ability to have conversations with these kinds of clients at a whole different level.
The largest health insurance, or one of the largest health insurance providers in the world that decided that they needed a more flexible hybrid IT approach was more of a connection between our CTO and that group of technologists to have a conversation about how and what they do versus what they could return to put on their balance sheet. And I don't want to speak for them but the capital was one component but really the technology, the platform, the partnership, the security, the compliance, that is what’s unlocked our two biggest transactions in this space. And that is the investment in our people, our technology and our platform that enables us to have these conversations.
I would like to say uniquely, that there is not a bunch of people in those rooms and that is a kind of a unique way to build partnerships and drive that. So, we are excited about it. As far as the quality of the asset goes, love to get people there because it is institutional grade, one of the highest qualities that you could ever build to, and the economics that were behind that in the value of that infrastructure rich low basis asset is going to be a spectacular investment for us and most people don't know this. But Facebook made a lot of conversation in the Fort Worth market with building a large campus, which is adjacent to us.
So, when you think about connectivity and the community around us, it is a data center rich community around us and we don't think that has a negative impact in our ability to build our product set that's there with the richness and fiber and power and infrastructure that sits there in that Fort Worth market. So, we are excited about all those things, our neighbors, the building, the asset quality and couldn't be more excited to get going on it.
Great. Thanks for taking the questions.
The next question is from Matt Heinz of Stifel. Please go ahead.
Thanks guys, if I just look at the revenue guidance on a dollar basis and sort of annualize fourth quarter, annualize the fourth quarter run rate, step that down by that $10 million of churn, I get to the $ 40 million sort of an implied dollar increase in revenue next year. And I guess $20 million of that coming from the backlog, I'm just wondering, historically, transitioning into the next year, how is your outlook compared, it seems to be about 50-50 broken down between backlog commencements and new leasing.
Just curious if I am looking at that the right way and how that’s compared to your historical guidance.
Yes, hi Matt this is Jeff. You are looking at that the right way. We love the fact that typically when we start the year and this helps us with visibility, a good portion of what we are going to achieve during the year has already been booked, and it is sitting in booked-not-billed backlog. But we also drive incremental revenue during the year through what we call go get, which is deals at book and billed during the year and drive revenue there.
Typically what happens on that booked and then billed go get during the year is there is a lag, because once you book deals, again if it is C2 or C3 it can take a couple of months for that to start driving revenue. If it is C1 that could take six months, or even much longer than that for larger deals. So that balance is about right. You see a little more pressure, when you look at the 2017 numbers because we do have that churn event, early in the year, which hits revenue right in January. And then the deals that we will continue to anticipate that we’re going to book and bill during the year ramp over the course of the year.
So you do see a little bit more pressure coming from the front-end loaded churn, but overall the momentum, that we are anticipating and the guidance, the bookings and the accelerations of those bookings and profitability is very consistent with what we’ve achieved in the past.
Thanks, it looks like there was a nice – well a slight uptick in the C3 business this quarter, kind of getting that business back on track. What do you see moving forward there, obviously a good quarter for C3 bookings, what’s sort of implied in the guidance or outlook if you will around that business and what gives you the encouragement that business is set to get back on track?
Matt this is Dan. I think you’ve seen, you talked about it. We've seen an uptick and we’re pleased with the progress on our bookings performance. I think as we roll into 2017 the discussion we had earlier in the call around hybrid IT. This is our C3 solutions and were coming out with new capabilities around public clouds and build to manage, for example OpenStack clouds. We think the demand is moving that way, we’re very pleased with our portfolio in the C3 space as well as the opportunity pipeline as we roll through 2017. So the way I’d answer that, is we feel very good about that and we see the trends that you talked about continuing.
Matt I think you’re also seeing the encouragement and completion of kind of really having the engine running on the C3 side of the business after the full integration of the [indiscernible] team, the QTS family and the benefit of really having momentum headed into a year and having things where people are aligned, understand the goals, the objectives, the hybrid product. Dan has done a great job with the teams on really kind of making sure that the engine is ready to get going and really adding value to the overall stack this year. And I think that is what you're going to see as we execute through the year.
Okay. Thanks a lot guys. I appreciate that.
Yes. Thank you.
Our next comes from Simon Flannery of Morgan Stanley. Please go ahead.
Great thank you very much good morning and just a quick clarification on the churn. So if we take out the churn in Q1, it is the underlying churn still, it is sort of within the normal range or is there some other churn events that might be expecting to keep it at the high-end.
And then just a broader question, we’ve seen Verizon and CenturyLink and others make some sort of asset sales in this space. How would you characterize the competitive environment out there. You’re obviously getting larger as are some of our competitors but is the crud spending add here or are you seeing fewer stronger competitors as you look for a bid for some of this contracts. Thanks.
Yes. Simon this is Dan. So the first part of your question around the churn, the guidance is still between 5% and 8%. We think it’s going to be in the high-end given the churn event that you talked about, which is in the first quarter. So that we feel good about that guidance and with the churn even in the first quarter, obviously there is a bigger impact in the first quarter there. For the second part of your question around sales-leaseback and other competitors I will turn that to Chad.
So if you are talking about the type of assets like we just bought in Fort Worth, I think those are kind of unique in the standpoint of the point earlier which is we're kind of at the table because we bring a integrated services approach and can kind of work with their IT teams, it kind of really figure out how to unlock the in source to outsource. And that is really where we’ve kind of had a uniqueness that, that room is a fairly small group of people that can take on the real estate, the integration, show a history of doing that and have the technical folks to kind of walk people through that.
If the question is about broader M&A, I don't really know, it's been a pretty competitive environment but we just really haven’t focused a lot on that type of stuff. We’ve been more focused on our disability to grow with our own platform, invest in our own platform and look for opportunities opportunistically through like the deal in Fort Worth.
I think the question was also, but just about the lease, competitive environments on the leasing side of things.
Okay so, I’ll let Dan take the leasing competitiveness.
Yeah, I think so, Simon I think first-up, obviously it is a very competitive environment out there, but we see sort of rational behavior out there. We see supply not getting too far ahead of demand, in our markets. We think that is relatively balanced, and it doesn’t take away that every deal is very competitive and while we're trying to position QTS as being the unique partner to CIO’s to be able to help them in a complex environment, that spans multiple different IT deployment models. So our ability to do that to us help position us better to be a better integrated solution to clients and be able to win. I hope that answers the question.
Right, thank you.
Your next question is from Paul Morgan of Canaccord. Please go ahead.
Hi, good morning. If I look at kind of the composition of your booked-not-billed pipeline by year, what’s the potential for the $9 million in incremental revenue getting pulled forward from kind of what’s now 2019 and beyond into 2017 or 2018. Did you see that in terms of the change sequentially versus last quarter? Did any of that activity take place to boost kind of what you see kind of the revenue ramp from the pipeline into 2017.
Hey Paul this is Jeff. We absolutely do see circumstances particularly with some of the larger and hyperscale cloud customers that they are building in longer term ramps and then, we may get the benefits that as the business accelerates faster than their expectations. They’d pull some of that, so we have had some benefit from deals getting pulled-up over the course of 2016.
And we’d be thrilled to see some of that happen with the booked-not-billed. We don't build that into our assumptions, and we certainly, we basically are building in the expectation that customers are ramping along the initial schedule, but we do build in the flexibility and availability typically in space. So that if customers do want to pull up, we can be responsive and support their needs and pull up that revenue as well.
Okay, great. Then in terms of the CapEx, just to be clear, the $350 million versus what you mentioned as your cost to complete your existing projects, can you add any more color about kind of where that incremental capital is going to be deployed, I mean what markets, what assets and then kind of what’s embedded in your full guidance in terms of funding the 350?
The difference will be 250, which is really our cost to construct the data center for space and power, and 350 is the additional capital we put in sometimes for customers capital to help them build out their footprint from a compute and server and other aspects. And that drives the bulk of it. That is spread across the portfolio fairly evenly and consistent with our revenues and not really determined really where the customer load goes versus any specific projects.
So that doesn't include anything like a kind of a another phase that would be announced later this year, that would be incremental from here?
Okay and then just in terms of kind of the balance sheet and funding and that stand and what that looks like I think you mentioned kind of the debt angle but I mean I actually think about it in terms of what you thought of in your guidance?
Yes, This is Bill, we’ll continue to manage the balance sheet consistent with how we’ve done it in the past. At year-end, our debt to adjusted EBITDA was five times, we remain comfortable more above that given the backlog, that we do have. And we will continue to look at accessing capital in different fashions. We watched the long-term debt markets, we watched the equity markets. We expanded the credit facility in the fourth quarter, so he had nearly $600 million of liquidity. More than enough to fund the capacity that we’re anticipating. But this like I said, we’ll continue to manage the balance sheet as we have in the past, be prudent about it, and some of those things like we said between debt, between equity, between fixing some rate, through swaps, we will consider ATM, et cetera. So there is just a number of things.
And that is complicated in your FFO guidance, it's not just assuming that all goes on the line and then everything also gets done gets adjusted in guidance?
Okay, thank you.
Your next question is from Frank Louthan of Raymond James. Please go ahead.
This is Alex Sklar here for Frank. Just following up on the C3 question from earlier and given where you are trying to position yourself as a hybrid IT solution has that changed through your competing ends in the market. May be over the past six months or so, that gives you confidence on growing that business, and I have a follow up.
Alex, this is Dan, I think, The market out there who we are competing with has stayed relatively the same over the last six months, I think here the number of players that we compete within the C3 space is relatively limited. We're not trying to be a public cloud provider I just want to stress that we look at those public providers as A) Hyperscale customers to us and B) Partners of us as we want to be part of the customers on ramp to public cloud. So the people we compete against has been relatively stable again a very competitive environment and one of that is changing in terms of solutions but the competitive set is relatively consistent.
Okay, great. And then and the model the recurring CapEx is higher in the quarter, I think you would now the 3rd data center provider to report higher maintains CapEx and I am just curious, if anything has changed across the industry in terms of what being included that number.
Now this is been very consistent since the time we've been capturing this data, we continue to report in the same way and so you will typically see that number run pretty low. It does have lumping points where you’ll kind of go in and do a major upgrade, as things get towards end of life, but otherwise it’s pretty much stays on the same range in throughout the that time.
Because we have our own data centre operation team that is on-site on a regular basis there is also a lot of maintenance CapEx that frankly just gets incurred from our current staff and putting the P&L and it does not show in the maintenance CapEx side so there's a lot more ongoing CapEx to support the facility that is also in the P&L.
It shows up as maintenance expense versus CapEx.
Okay great, thank you.
Your next question is from Eric Luebchow of Wells Fargo. Please go ahead.
Hi good morning everyone, just quick one in Chicago you had a nice pickup in occupancy are there any particular customer where there you seen particular success in that on the 28,000 square feet you have in your development pipeline is that to satisfy the tenant lease you have in Q3 or will you also have new marketable capacity that is coming online in 2017 as well? Thanks.
So in Chicago, I would characterize the demand is across multiple industry verticals. We've got interest from SASC cloud providers which are more of a national market that want to be in Chicago and within the Chicago metro area we see the demand quite strong across financial services, manufacturing retail et cetera. We have been very pleased With that and where we are both in the Chicago market from a location of being in the city as well as our broad portfolio that we can be attractive to multiple industry verticals there.
Yes, that’s the initial expansion the first quarter in Chicago is mostly tied to the growth of a larger hyperscale customer in that facility and then the additional expansion throughout the year is tied both to that growth as well as additional growth.
Okay. Thanks guys.
The next question is a follow up from Jonathan Atkin of RBC capital markets. Please go ahead. It looks like there are no additional questions at this time. This concludes our question-and-answer session. I would like to turn the conference back over to Chad Williams for closing remarks.
Thanks everybody I know we ran a little bit over today. But we had a lot of really good questions. Remember we are available today and any time this week and would love to follow up with any of the questions or answers. Thankful for a successful year with our QTSers this year and looking forward to an exciting 2017. Thank you if you are trust and confidence and look forward to seeing you all as the year unfolds. Thank you very much.
The conference is now concluded. Thank you or attending today's presentation. You may now disconnect.
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