Earnings Call Transcript - DLR Q4 2022

Operator, Operator

Good afternoon and welcome to the Digital Realty Fourth Quarter 2022 Earnings Call. Please note this event is being recorded. I would now like to turn the call over to Jordan Sadler, Digital Realty’s Senior Vice President of Public and Private Investor Relations. Jordan, please go ahead.

Jordan Sadler, Senior Vice President of Public and Private Investor Relations

Thank you, Andrea and welcome everybody to Digital Realty’s fourth quarter 2022 earnings conference call. Joining me on today’s call are President and CEO, Andy Power; and CFO, Matt Mercier. Chief Investment Officer, Greg Wright; Chief Technology Officer, Chris Sharp; and Chief Revenue Officer, Corey Dyer are also on the call and will be available for Q&A. Management may make forward-looking statements, including guidance and underlying assumptions on today’s call. Forward-looking statements are based on expectations that involve risks and uncertainties that could cause actual results to differ materially. For a further discussion of risks related to our business, see our 10-K and subsequent filings with the SEC. This call will contain non-GAAP financial information. Reconciliations to net income are included in the supplemental package furnished to the SEC and available on our website. Before I turn the call over to Andy, let me offer a few key takeaways from our fourth quarter. First, the combination of strong demand and tightening levels of supply are translating into broad-based price improvements, which is reflected in the increased re-leasing spread expectations and the positive inflection in stabilized NOI growth that we are forecasting for 2023. Second, we remain focused on achieving the highest potential returns on investment and some progress on this front is evident in the sequential improvement in our development pipeline yields. And third, as most of you already know, we have made some changes to our management team since we last reported. Andy and Matt both have a long history with Digital and as expected, the transition has been seamless. But just as important, they also bring fresh perspective and energy to their new roles and the team remains excited about the opportunity that lies ahead. With that, I’d like to turn the call over to our President and CEO, Andy Power.

Andy Power, CEO

Thanks, Jordan and thanks to everyone for joining our call. While my voice is probably pretty familiar to most of you, this is my first earnings call as CEO of Digital Realty. I am honored to lead Digital Realty’s incredible global team and I am optimistic and excited as ever about the opportunity that lies ahead. I want to thank both the Board for their confidence in me and the support that they provide in executing our strategy and thank Bill Stein, who I first met in 2004 as we worked together on Digital’s IPO for his leadership over these many years. Finally, I want to thank the numerous customers, partners, team members and shareholders for the kind words of support and encouragement that I have received over the past 2 months. When I joined Digital in 2015, we were primarily a North American scale data center provider. Since then, we have evolved the company to be a global provider of the full spectrum of scale, co-location and interconnection solutions to better serve the growing needs of our 4,000 plus customers. Today, Digital is the global data center leader with an unmatched footprint of over 300 data centers in over 50 metro areas in 28 countries on 6 continents. Globally, our portfolio comprises over 2.3 gigawatts of IT load and we have another 400 plus megawatts under construction. I am extremely proud of the success that we’ve had and the position that we are in. But now is not the time to rest on our laurels as the path that has brought us to where we are today will not get us to where we want to be. In that being, we have swiftly taken action on a few fronts. First, we quickly backfilled the role of CFO with my long-time finance partner, Matt Mercier. Matt has played a leadership role across Digital’s global finance organization for well over a decade, including the successful integration of multiple platform acquisitions and the implementation of systems that will provide the foundation for our operations and evolving strategy. Second, we aligned and combined our strategy of business segments and investments team to assure that we have the right capabilities and are making the right investments in order to deliver the global meeting place for service providers and enterprises. Third, we moved to align all technology under our Chief Technology Officer, including our CISO and our recently appointed Chief Information Officer which will support the acceleration of our journey and identity as both a technology and a real estate company. Recent product launches, including service fabric, demonstrate the potential of bringing together innovation and technology to help drive our customers’ growth. Lastly, we further streamlined our global operations capabilities to maximize the potential of Digital Realty’s 300 plus data centers and our people under the trusted hand of a long-time digital leader with a track record of bringing global teams together. And here is what’s next on the agenda in terms of the top strategic priorities. First, as depicted on Slide 3, we will demonstrably strengthen our customer value proposition. Through the continued execution of our meeting place strategy by delivering sustainable connectivity-rich solutions to our enterprise and service provider customers, which will translate into better organic growth over the medium and long-term. Along these lines, yesterday, we announced a new AWS Direct Connect on-ramp at Digital Realty’s Ashburn campus, landing one of the highest consumption markets and adding coast-to-coast U.S. coverage to our robust existing portfolio of AWS Direct Connect locations across EMEA. And earlier this month, we advanced our commitment to sustainability with a new 10-year power purchase agreement for 116 megawatts of renewable energy, supporting the construction of a new solar park in Germany. Second, we are integrating and innovating our capabilities across our entire unmatched global asset portfolio and have topped the largest open network platform in the world. Many of these integration and innovation efforts will benefit both our customers as they seek to deploy new and complex workloads on the leading data center platform and our own internal team, unifying our ability to deliver value to the market. Lastly, many of you are familiar with my many fishing poles in the water mantra. And in this vein, we plan to further diversify and bolster our sources of capital in order to support our customer’s rapidly growing digital infrastructure needs, while improving capital efficiency and returns for Digital Realty investors. The opportunity before us is tremendous. We have all the key ingredients at our fingertips and a long runway for growth. When I assessed the digital infrastructure landscape today, including its fundamental prospects and then how Digital Realty is positioned within this sector, I’d say the following. First, demand for our product remains quite strong and well supported by ongoing digital transformation, migration to the cloud, and the overall evolution towards centralized compute...

Matt Mercier, CFO

Thank you, Andy. I am privileged to succeed Andy as CFO and humbled by the opportunity to lead an incredibly capable team. Over the years, I have had a chance to meet and spend time with many of you and I look forward to catching up with all of you over the course of the next several months at industry conferences and events that we are slated to attend. Let me jump right into our fourth quarter results. We signed a total of $117 million of new leases in the fourth quarter, highlighted by strong rebound in our 0 to 1 megawatt segment and record interconnection signings, which accounted for 40% of total bookings. Demand was geographically diverse, particularly within the greater than a megawatt segment, which saw nearly even contributions across the Americas, EMEA and APAC regions. Nine of our ten largest deals in the quarter landed outside of North America, with strong contributions from Japan, South Africa, Latin America and Europe, demonstrating the increasingly global nature of our footprint and customer base. At the other end of the scale, somewhat in contrast to the hesitation we noted on our last call, we saw a nice bounce back within our smallest customer segment under 500 kilowatts, which delivered the second best quarterly leasing volume of 2022 at the highest average rate seen all year. Geographically, our 0 to 1 megawatt deals play to our strengths in EMEA and the Americas with EMEA setting a quarterly record for 0 to 1 megawatt plus interconnection bookings. Importantly, pricing on new leases signed increased for the fourth consecutive quarter in each of our 0 to 1 and greater than a megawatt segments, reflecting improving fundamentals and tightening conditions across our regions. In the fourth quarter, we experienced nearly 90% customer retention and a further reduction in churn to just 0.8%, marking the lowest level in nearly 3 years, as our customers’ digital infrastructure requirements continue to increase, but the prospect of future availability is decreasing. Turning to our backlog. The current backlog of signed, but not yet commenced leases increased to a record $477 million at year-end, principally due to the inclusion of Teraco as other signings were largely offset by commencements. The lag between signings and commencements moderated slightly in the quarter, but remained elevated relative to historical levels at nearly 15 months due to a few larger longer-term leases that require build-outs. Approximately 60% of our record backlog is slated to commence throughout this year, split fairly evenly throughout the first and second halves. Moving on to Page 10, we signed $195 million of renewal leases during the fourth quarter with pricing increases of 0.8% on a cash basis. For the full year, we renewed nearly $700 million of existing business at a 1.8% increase on a cash basis, a touch better than our upwardly revised guidance of slightly positive for 2022. Renewal rates in the fourth quarter for 0 to 1 megawatt renewals remained strong across each of our three regions and were up 4.1% overall, the strongest quarterly increase since adding interaction. As Andy referenced, we did see a 3.6% decline on renewals in the greater than a megawatt category in the quarter, entirely due to a single lease at a single asset. However, we saw a better-than-anticipated improvement in market rents and an inflection in re-leasing spreads in 2022. More importantly, market conditions improved throughout the last year and our guidance for 2023 reflects this positive trend. Turning to our results, Digital Realty delivered operating and financial performance in the fourth quarter that was largely consistent with our expectations, highlighted by improving core operating performance, progress toward enhancing our returns on investment and increased liquidity. In terms of earnings growth, we reported fourth quarter core FFO per share of $1.65, consistent with the low end of our implied guidance range for the fourth quarter and down 1% on both a sequential and year-over-year basis, given a seasonal acceleration in operating expenses, a significant uptick in interest rates, and a full quarter’s dilution associated with the acquisition of Teraco on August 1...

Greg Wright, Chief Investment Officer

Yes. Thanks, Ari. Look, I think when you look at the – let’s look at first at the stabilized JVs and the development JVs, I mean, clearly, we are seeing strong demand for those assets. The private markets have a strong bid for those assets given the quality of the assets, stability of the income stream, the creditworthiness of the customer base. And the fact, quite frankly, that’s a hard asset class with strong secular demands we’ve seen really a significant rotation in the data center space from private capital over the last couple of years. Not to mention strong improvement in pricing and lower vacancies in all of our major markets have really gotten investors’ attention in terms of growth potential. So on that front we still think pricing has held in there. We’ve seen some transactions in the market recently. There have been some smaller transactions. We’re also aware of three sizable hyperscale platforms where that pricing is staying strong from what I understand. But what it tells us is that the sellers and their equity backers, who we think are sophisticated, are seeing strong value. So simply put, money on the sideline is outweighing the investment opportunities. And then in terms of cap rates with respect to the non-core asset sales, I mean, clearly, they are going to be all over the place like we’ve seen in the past. As you recall, over the last few years, we’ve sold roughly $2 billion of these non-core assets. And at some point, we talked about having roughly $1.5 billion left. But look, I think when you look at this, it’s important to understand that many of these assets are at different stages. So cap rates will end up in a range, and you look at our range right now at 0% to 10%, and it clearly depends on specific conditions. For example, if we sell land, right, that’s a zero cap rate. So there is a wide range and it depends on the asset.

Ari Klein, Analyst

Thanks and congrats, Andy and Matt on the new role. Maybe just starting on the balance sheet, the $2 billion in asset sales and JV is targeted for the year. Can you give us some additional color on the split between the two, the types of assets, the timing and pricing is a pretty wide range? Anything you can add on that front?

Eric Luebchow, Analyst

Great. Thanks for taking the question. I just wanted to touch base just on the general demand environment. It’s nice to see a pickup in kind of some of the enterprise colo bookings. Maybe you could talk about what you see in the hyperscale funnel. We obviously heard some a couple of hyperscalers talking about a bit of a slowing in revenue growth, but it seems like demand remains pretty robust, and maybe you could kind of touch on that for us?

Corey Dyer, Chief Revenue Officer

Yes. I’ll hit the demand overall. Thanks, first of all, for the question, Eric. Look, demand remains as strong as ever, and we’re more than happy with kind of what our pipeline looks like and whether or not we’ve got enough to support our demand on the hyperscale end. On the enterprise, we’re still seeing some really strong demand across and across the globe, really the traditional large build, but also some other interconnection needs. These hyperscalers are starting to come up for their connectivity options. It’s really the advantages that our portfolio plays out for them. We’re seeing that continue to grow that demand from them, utilizing our platform as a meeting place as they need to enhance their connectivity requirement. And so you’re seeing that across both places. And I would tell you that you also see the merits of our relationship around the opportunity to build up from the activity perspective for them. When you think through the cost and the difficulty getting power that we have right now, these hyperscalers and our relationship with them continue to evolve. I think improved and the value that we continue to bring to them will continue to drive demand for us and see the pipeline build across all of our regions, so really happy with where we are on that as well as the comeback on the enterprise as well. Thanks a lot, Eric.

Jon Atkin, Analyst

Thanks. So I was interested in just kind of big picture, your first conference call as CEO, any kind of principles to underscore things to contemplate and things to be putting into action around changes in overall operating practices, changes in product focus strategy. I think you already hit on capital allocation, but just any kind of big picture kind of items to call out?

Michael Rollins, Analyst

Thanks and good afternoon. I just want to also extend my congratulations to Andy and Matt in the new roles. If I can ask two financial questions. And I am just looking at Slide 14 from the deck. So, the first question is if you look at the midpoint of revenue growth guidance for revenue and EBITDA, can you break out the organic portion of the growth relative on revenue, you will have energy and you will have acquisitions and divestitures kind of a mix of stuff as you have been recycling assets and investing in new ones?

Andy Power, CEO

So, in my earlier remarks, I did mention something we didn’t talk about on in the Q&A, but I do think this is an incremental tailwind of demand for our industry and Digital Realty as it relates to AI-related applications that we believe is on the precipice of driving an incremental wave of demand. As a result, I just recently asked ChatGPT how AI would impact demand for data centers. Here is a summary of the response, and I quote, 'The impact of artificial intelligence and the demand for data centers is likely to be significant in the coming years. As AI continues to gain traction and more and more businesses adopt AI-powered solutions, the demand for data storage and processing is expected to increase significantly. AI also has the potential to create new data-intensive applications such as autonomous vehicles, virtual reality and personalized medicine, further driving the demand for data centers. In short, the impact of AI on the demand for data centers is expected to be substantial and companies operating in this space are well positioned to benefit from this trend.' Obviously, self-serving – but when you see some of the innovation that’s playing out here and just the general media in the news, this AI trend has certainly come to fruition. And while this AI is certainly still in its development phase, we at Digital Realty, agree and are excited by the forecast that ChatGPT just provided.

Operator, Operator

The conference has now concluded. Thank you for attending today’s presentation and you may now disconnect.